patrick oshaughnessy jesse livermore upside down markets

Jesse Livermore on Upside Down Markets and Understanding Fiscal and Monetary Policy | Invest Like the Best

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Key Takeaways

  • Normally, an organically strong economy correlates with a strong stock market. In an upside-down market, this relationship is inverted
  • Unlike monetary response, the fiscal response provides unencumbered spending power
    • Lack of spending sucks income out of the system, fiscal policy undoes that effect by delivering income to the private sector
    • COVID will likely normalize future fiscal interventions
  • “If you don’t intervene in boom-bust cycles, things can get ugly. That’s especially true when you have the wrong initial conditions when you have a high level of interconnectedness which we have today” – Jesse Livermore
  • The Fed holding interest rates down in the face of inflation fears is bullish for equities
  • Under 0% interest rates and negative real return on cash and bonds, money will flow into equities
  • A negative scenario for fiscal stimulus, though unlikely, is president Biden combined with GOP holding the senate
  • It makes sense to get international exposure in case of potential corporate tax increases

Intro

Upside Down Markets

  • Normally, an organically strong economy correlates with a strong stock market. In an upside-down market, this relationship is inverted
    • For instance, bad news is suddenly interpreted as positive information, because it may cause the Fed to lower interest rates and make equities more attractive
  • An economy that needs fiscal stimulus can end up with a stronger stock market than an economy that doesn’t need fiscal stimulus
    • “It’s almost like you get the same growth either way, whether you are organically strong or whether you are organically weak. The difference is just whether you get the added benefit of stimulus to get you there” – Jesse Livermore

Monetary Easing, the Fed, and the Markets

  • In a downturn, the Fed can reduce interest rates to encourage investment and drive incomes and employment growth
    • However, Jesse is skeptical about the impact of lowering interest rates, especially in the current crisis, here is why
      • Spending drives nominal growth, borrowed money is still debt and may not stimulate spending
      • Additionally, the ability to get loans and spend is subject to other factors (E.g. creditworthiness, lender trust, etc.)
  • The Fed also provides loans as a lender of last resort, this is a more powerful tool with visible effects
    • Legislation now enables the Fed to directly lend to corporations, bypassing the banking system
    • COVID is a singular risk that banks can’t diversify away, the Fed secures this risk with funding backed by the full faith and credit of the US government

Impact of Fiscal Policy on the Economy

  • Handouts provide unencumbered spending power
    • If delivered to the right places, it can drive a greater spending response
  • Obstacles arise when wealth needs to be injected in places people view as unworthy (e.g. bailing banks and homeowners)
    • That said, COVID will likely normalize future fiscal interventions
  • Post 2008 warnings about hyperinflation and default risks didn’t materialize, similar warnings now fall on deaf ears
    • Inflation is still low despite near-zero interest rates. This demonstrates the empirical disconnect between the warnings and the actual outcomes

The Impact of Stimulus on Public Companies’ Fundamentals

  • One person’s spending is another person’s income
    • Lack of spending sucks income out of the system, fiscal policy undoes that effect by delivering income to the private sector
  • Fiscal policy lets the government reduce its net worth to inject income into the private sector
    • The government could also tax corporations to fund spending, or corporations could decrease wages to increase profitability
      • In both cases, the result is customers will have less income to spend

Assets and Stimulus

  • Fiscal policy lets the government reduce its net worth to inject income into the private sector
    • Government could also tax corporations to fund spending, or corporations could decrease wages to increase profitability
      • In both cases, the result is customers will have less income to spend

1929 vs. Today

  • In the current environment, cash and bonds serve the same function because they have the same yield
  • Governments can inject wealth into the private sector but it usually ends up in investors’ portfolios, rather than circulating in the economy
    • Future stimulus injection can increase cash and reduce equity allocation from 46% down to 42%
      • Under 0% interest rates and negative real return on cash and bonds, money will flow into equities
  • All economies are subject to boom and bust cycles. Busts can create devastating positive feedback loops
    • On the fiscal side, unemployment leads to reduced income, spending, and revenue, this lowers corporation confidence and leads to more unemployment
    • On the monetary side, reduced creditworthiness causes tighter lending standards which lead to tighter risk management and even more lending reductions
    • These loops will eventually stop if left to their own mechanisms. However, the great depression has shown us how far it can go
      • Keep in mind, the risk is now magnified because of a globally interconnected economy
  • For centuries before 1929, we had a Laissez-faire economics with no centralized monetary authority or lender of last resort
    • A bank run on a failing bank could cause credit contraction for the whole economy
  • To summarize, “If you don’t intervene in boom-bust cycles, things can get ugly. That’s especially true when you have the wrong initial conditions when you have a high level of interconnectedness which we have today”
    • Get the virus out of the way and the economic wound would automatically heal

Inflation Fears are overrated

  • The Fed purchases assets and converts them into bank deposits, this increases broad money supply
    • Inflation is too much spending which is a function of spending power, this isn’t impacted by changing the format of wealth
      • What matters is the absolute level of wealth, which hasn’t changed
  • A possible inflationary risk comes from fiscal expansion, particularly The CARES act and other future interventions
    • If you increase the wealth of the private sector, you increase its spending power which will, at some point, overtake the economy productive capacity
      • The key is to figure out the balance point, which only becomes apparent after the economic recovers
  • The Fed can always increase interest rates and intervene to stop inflation, this allows us to go even harder on fiscal policy

Will the Pendulum Swing Back to Labor and Higher Wages?

  • The bull run in asset prices has favored asset and capital owners and corporation profit margins, at the expense of labor and wages
    • This income diversion between labor and capital is not about fiscal or monetary policy. Rather, it’s about market forces, such as,
      • Technology has reduced the value of labor skills and more training is now required to provide value to the economy
      • Concentration in industries means less competition for hiring employees
      • Globalization is pushing wages down
    • Historically, the highest profit margins have correlated with tight labor markets (e.g. before the crises of 1948 and 2008)
  • While inflation is not bad for equities, it can force interest rates hikes and cause bankruptcies
    • Thus, the Fed holding interest rates down in the face of inflation fears is bullish for equities

Impact of Stimulus on Different Sectors

  • We are seeing a divergence between growth and value
  • Fiscal policy helps strengthen the banking system and increase borrower creditworthiness.
    • All else equal, a strong fiscal policy response will probably favor value over growth
  • Market cap-weighted investing makes you agnostic to where the economic stimulus is applied
    • If you own the same percentage of every company in the economy then you don’t care where the revenues go
      • That said, if you know how the stimulus will affect certain parts of the market, you can change allocation to get more out of the stimulus

What to Watch For

  • A negative, though unlikely, scenario for fiscal stimulus: president Biden combined with GOP holding the senate
    • It could thwart a strong fiscal response, with even worse effects if COVID vaccines are delayed
  • It makes sense to get international exposure in case of potential corporate tax increases
    • A booming stock market with big capital gains puts pressure to transfer value to main street, possibly by raising capital gains and corporate taxes
      • Nonetheless, this is not hard to do in a bullish economic scenario

Potential Risks

  • Risks don’t get destroyed, they just get shifted around
  • Political risk depending on how government composition looks in the coming years
  • There is a lag between action and effect: is the money going to the right places and is it enough or too much?
  • Targeting risks, just because you are targeting revenue or growth or employment, doesn’t mean the fiscal action that follows will necessarily hit profits, which could still go down
    • Increasing revenue doesn’t necessarily mean increasing profits
  • Taxes going up
  • The phrase ‘you don’t lose money until you sell’ is a result of confidence in the ability to find a buyer
    • The price that you would pay if you couldn’t sell is the intrinsic value of a security, the premium is the liquidity value
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Notes By Mostafa Khaled

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