“Believers In Markets Out-of-Step With Markets”

Jim Grant has always offered a good balance between a theoretical understanding of economics and a practical experience in working the markets. Last month, he gave a keynote speech at the Cato Institute about the post-bailout monetary era.

In the speech, he notices an apparent contradiction in markets and public opinion: people who are advocates of markets tend to believe that asset prices are currently over-valued, whereas people who oppose the market system tend to think that company fundamentals are not terribly relevant to asset prices. As Grant says in his speech, “…they distrust the resiliency of the price system.”

For the ordinary person, what the time since the financial crisis has meant is that people who have been able to attach their personal wealth to asset markets have done quite well, whereas people who have been less connected to the monetary spigot have done poorly (as in most laborers who are not bringing in money from a pension of some kind).

This is actually a common historical progress seen in other paper money regimes: enterprise suffers, while paper speculators thrive. This is because of the real process of inflation, which differs from the bureaucratic definition as a ‘general increase in prices’ as defined by a committee at the Federal Reserve.

The disconnect happens for a simple reason: there are choices about how you allocate your funds.

You can buy a stock, or you can buy products and services with that same money. That money is staying in the asset markets. You give your cash to the broker, who handles the exchange, delivering that money to the seller, and taking it as a cut. The money might eventually go into the real economy circuitously, but as more money piles into the asset markets, it tends to stay there, or get recycled into the asset markets after a brief detour into the ‘real’ economy.

In the corporate sense, the companies can do stock buybacks or they can invest into expanding operations by hiring new people, building new facilities, or giving raises to existing employees. In the case of governments, increasingly state governments have to allocate funds into the asset markets to pay past employees, while having to cut payrolls for existing employees. Apple spent $17B last quarter on share buybacks instead of spending that $17B on hiring, as an example.

One market is subsidized in infinite amounts by the Fed, and the other gets the deferred trickle-down, and even then only in certain markets.

We see this sort of time-displaced asset jump in markets like the SF-Bay, where pension money goes into the hands of venture capitalists, and is then deployed into money-losing companies and then into the hands of real estate developers & hipster hackers spending $5,500 a month on rat-infested apartments with water damage. The money gets deployed to the SF-Bay first because the people who manage the assets allocated to them don’t want to fly to the cooler markets, and the entrepreneurs aren’t either, because the point isn’t to allocate capital intelligently into profit-making structures, but to allocate capital from the asset markets into their pockets.

When you reward people for pumping up asset prices as high as possible without regard to the fundamentals, entrepreneurs will do things like fill a company with useless employees because the companies are valued based on technical headcount rather than fundamentals. If you value the company based on a compelling investor story, you get fraudulent stories that are more common to mafia-run pink sheet scams than they are to brand name venture capital firms.

Or, at a larger scale, you’ll get executives who borrow tons of money on the bond market, and then use it to build out sham product lines that never sell, or otherwise just use it to push up the stock, which they then sell, and recycle into some other investment. To people who primarily work in the asset markets, it seems like a boom, because it is, whereas the people who don’t will tend to see it as depression conditions.

If earnings are not a primary determinant of stock prices, then employees who grow earnings will be under-valued compared to how they have been in the past, because what matters most is boosting the stock price instead of the fundamentals that are conventionally supposed to be driving that price.

Because markets seek equilibrium, eventually, the disconnect corrects, with a convergence between the pumped-up asset market and the liquidity-starved market for the underlying assets.


Charles Hughes Smith covers the corporate bond issuance & stock buyback trend.