By Manav Midha ’19, Contributor
Reading the business news each morning, I have recently found myself confused. Not because of the fancy Wall Street jargon, but because of the irrationality in the markets. My belief is that there are only two real emotions in our world: fear and greed. All else is merely a derivative of these two sentiments. Currently, CNN’s Fear & Greed Index, comprised of seven technical market indicators, is flashing “extreme fear” in the markets. But the confusion arises from the fact that the real emotion that has driven the market over the past seven years is not fear, but greed. I will explain why.
Many market experts are attributing the current turmoil to slowing growth in China, massive supply gluts of oil, lack of inflation (for bold terms, see definition in glossary), and the strong dollar, among other things. Although these are important issues, I have a different theory. This past December the Federal Reserve raised the Federal Funds Rate for the first time in almost a decade (after Fed chair Ben Bernanke slashed rates to nearly zero after the subprime market crisis of 2008) by a minuscule factor of 0.25%. Market doves claim this raise in rates, as well as hawkish comments from current chair Jennet Yellen, are inhibiting one of the longest equity bull markets in history. However, what the doves do not see is the bubble that has been created by this frankly irresponsible policy for the past seven years. Of course, the lowering of rates was a factor in the economic recovery of the middle class man, allowing him to get loans easier and increase spending. The monthly jobs report for January did report an unemployment rate of only 4.9%, considered full employment! But really, the low rates were more beneficial for greedy financial businesses of all kinds by driving up equity positions to all-time highs, with no regard for fundamentals. Not only do prolonged low rates inflate stock prices, they also hinder the Fed’s ability to cut rates and introduce money supply in event of a crisis (quantitative easing). Low interest rates have also created “easy money” and allowed companies to cheaply borrow money to finance stock buybacks, artificially increasing prices even further. Currently the mean P/E of the S&P 500 is hovering at 21.13, still a good amount above its historic average of 15.57 (including the May 2009 outlier of 123.73). If mean-reversion theory is true as it has demonstrated time after time again, and earnings stay constant or grow slowly, the market still may drop 26.31% to 1411! Or in the case of the Dow, 12,097, its closing level five years ago on 1/31/2011. This looks eerily similar to a bubble.
Remember when I said that the Federal Funds rate serves the benchmark for a multitude of important rates worldwide? Well it also happens to be important in determining Treasury bond yields, which are a large chunk of the proverbial pie of US national debt. Since economic theory states that bond prices are inversely correlated with national interest rates, the yields usually have a predictable spread. When yields are low, government interest payments on debt are low, and that looks very, very good, politically speaking, on the administration. The government has immense greed that will end up hurting the American people.
Of course slowing growth in China is a global concern… they are our largest trading partner… but we have a whole planet of other countries we trade trillions of dollars’ worth of goods and services with too! If concerns about the value of the renminbi (yuan) is a cause of fear for investors, it is possible to short the currency with an ETF as a hedge against Chinese holdings.
About the oil crisis, the only reason prices are so low is the fear of slowing Chinese demand for oil in the futures market combined with Saudi Arabian reluctance to cut supply, stemmed from greed, in order to regain market share from higher cost producers. The hundred billion dollar budget deficit currently run by the Saudis is unsustainable, and they will be out of cash within five years. BlackRock Group, the largest asset management company in the world, has reported an outflow of Saudi dollars. This greed hurts Saudi Arabia’s own citizens. A solid play in the current market for safety and cash flow is ExxonMobil (XOM), with a beta of only .60 verses West Texas Intermediate (WTI) and a safe yet lucrative dividend yield of 3.91%. For hedging the systematic risk, an investor may also choose to short an oil ETF focusing on upstream oil and gas companies, such as XOP; removing the short term risk of Exxon’s exploration endeavors, as well as being a play on the inevitable amount of bankruptcies and defaults by high cost, highly leveraged producers.
Regional real estate bubbles in oil-producing states may also be possible, with the shale oil boom driving demand, and mortgage brokers giving risky loans.
The strong US dollar has been unavoidable, because when the world economy is struggling, investors rush to the supposedly-safe America. Although the strength of the dollar hurts international profits, it is a negative feedback loop of fear and greed speculation about the future that will eventually reverse itself. For investors with serious concerns, they may go long on a U.S. Dollar ETF such as UUP.
Judging from the November, December, and January jobs reports, wage growth has recently begun accelerating, and economic principle states that with rising incomes comes rising inflation. And with inflation comes rising interest rates, which is beneficial to the long-term stability of our economy. Although inflation will pick-up, TIPS may not be the best play right now.
Fear and greed are the emotions of the market. Although the indicator may be showing fear, greed is definitely the more powerful force. Fear may be evident in us common people, but greed is definitely the driver at the top. And that is dangerous.
Glossary
Inflation: the gradual rise in prices over time, necessary in low quantity to a healthy economy, measured by the Consumer Price Index (CPI)
Federal Reserve: the central bank of the U.S., the “bank of banks”, most powerful monetary policy body in the world
Federal Funds Rate: the short-term interbank overnight lending rate that acts the world’s leading benchmark for the vast majority of interest rates
Subprime: below investment-grade (BBB) bonds
Dove: a monetary policy official who is an advocate of prolonged low interest rates in order to stimulate the economy, arguing the benefits outweigh the costs of super-inflation, bubbles, subprime loans, etc.)
Hawk: a monetary policy official who is an advocate of higher interest rates for the economic stability they provide, arguing the benefits outweigh the costs of relatively slower growth
Bull Market: any securities market that is in a sustained uptrend
Bear Market: any securities market that is in a sustained downtrend of 20% or more
Quantitative Easing: the process of the Federal Open Market Committee (FOMC), the policy making branch of the Fed, buying government bonds in the open market, injecting money supply into the economy
P/E: the price/earnings per share ratio, a measure of relative valuation
S&P 500: the U.S. benchmark for stocks
Mean-Reversion Theory: the theory that states no security’s price can deviate any distance from its long-term mean trend line for long, eventually it will regress (reverse)
Dow Jones Industrial Average (Dow): the benchmark of 30 blue-chip U.S. companies
Bubble: inflated security prices based little on fundamentals (dangerous)
ETF: exchange traded fund; a basket of securities usually based on a certain index; trades intra-daily like any stock or bond
XOM: ExxonMobil Corporation
WTI: West Texas Intermediate (the U.S. benchmark for low sulfur Crude Oil)
Systematic Risk: the risk of the market as a whole declining
XOP: SPDR S&P Oil & Gas Exploration & Production ETF
UUP: PowerShares DB US Dollar Index Bullish
TIPS: Treasury Inflation Protected Securities; seen as safeguards against inflation because their value fluctuates according to the Consumer Price Index
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