I’m in the middle of a long piece on wars of detainder, but since there is no special time pressure associated with those ideas (although longer term they will merely save Western Civilization), I’m going to interrupt the series to address the 2016 collapse in the equity markets.
Way back in the 1970s I was chairing the board of a company engaged, among other things, in silver mining. The officers of the company had developed a new process for leaching silver out of the ore – you use cyanide, just to make it interesting – that was more efficient than the old method. Unfortunately, the capital costs associated with the new process were very high, and with silver prices languishing around $6/troy oz., the board wasn’t enthusiastic about spending the money.
But then the price of silver began to rise, slowly at first, but then faster and faster as investors plunged into the silver market. The mining executives were pounding the table about their new process and, eventually, we succumbed and the board approved a major capital project to build out the new leaching system. Silver rose from $6 to almost $50 but then, two months before our new process was to come on-line, the price collapsed back to $11. We now owned a very expensive and very unprofitable silver mine, and thousands of silver investors around the world were wiped out.
It turned out that the price of silver had risen only because Bunker Hunt and his brother had been cornering the silver market, borrowing massively to finance their activities in silver futures. The Hunt brothers had made a paper profit of nearly $4 billion, back when that was a lot of money. But then, suddenly, COMEX changed the margin rules and a $100 million margin call went out to the Hunts, who couldn’t meet it. The Hunt’s primary broker, Bache (a predecessor of Prudential), looked like it was about to go under, as were several counterparties.(1) In the end, the Hunts were convicted of fraud and went bankrupt, but that was small solace to those of us who were victimized by this exercise in crass market manipulation.
The wrath of God came down on the heads of the Hunt brothers not just because people were annoyed that they seemed to be getting rich by cheating. It was because manipulation of capital markets has at least three other very serious effects: First, it causes capital to be misallocated (as in the case of the hapless silver mine). Second, it causes innocent investors to lose a lot of money. Third, it causes people in general to lose confidence in the integrity and usefulness of capital markets, turning them into Bernie Sanders voters. Market manipulation is, as the Hunts found out, punishable civilly by huge fines and/or criminally by long prison sentences.
Now we’ll fast-forward thirty years when a modern-day Bunker Hunt named Ben Bernanke (but with fancy degrees from Harvard and MIT) again tried manipulating the markets. But this time it wasn’t an obscure corner of the markets named silver futures, this time it was the largest equity market in the world. As with the Hunts, Bernanke borrowed massively to execute his manipulation. And just as the Hunts didn’t buy silver bullion directly, but drove up the price indirectly by buying futures, Bernanke didn’t buy equities directly, but drove up the price indirectly by buying bonds. Bernanke’s massive bond buys drove up the price of bonds, drove down their yields, and made them unacceptable to most investors as investments. These investors were forced out of bonds and into stocks, driving up the price of those assets. We found ourselves living in such a bizarre world that, as JP Morgan recently pointed out, stock prices were three times as correlated to Fed actions as to corporate earnings.(2)
But wait (I hear you pointing out), the Fed wasn’t doing this for nefarious reasons, they were doing it to kick-start the US economy! But market manipulation is market manipulation. For all I know, the Hunt brothers were trying to raise massive amounts of capital so they could find a cure for cancer. Tell it to the judge, Ben.
As I’ve pointed out ad nauseam in these pages, the Fed’s manipulation of the markets simply had to end badly for investors. For years equity prices rose and rose, pumped up by the Fed’s bond buying program (QE), while the US economy crawled along on its belly and the global economy tanked.(3) Then, one day, as it had to do, the Fed stopped pumping up equity prices and began withdrawing liquidity from the markets. This happened in December, 2015 and almost immediately the markets went to hell. Well, of course they did! Equity owners were, quite suddenly, forced to stop measuring the value of their stocks according to the certainty of a Fed put(3) and all of a sudden had to start wondering what the fundamental value of those stocks might be.
What equity investors found is that the markets had been manipulated upward far beyond what flat corporate profits and a slowing economy could support. Those prices had to melt down, to be right-sized, and the closer to the sun a stock’s price had risen, the more melting down it had to do. Cloud computing companies’ stocks have plummeted 40% just since 1/1/16, for example,(4) while economically-sensitive securities like bank stocks are selling, in at least one case, at a 30-year low.(5)
Most investors are in for a very bad time, especially retail investors and those who jumped on the Facebook/Amazon/Netflix/Google bandwagon. But readers of our humble blog are sitting in the catbird seat. We have continued to own well-diversified portfolios with a value bent and a cautious exposure to risk assets. Despite that conservative positioning, we have earned annual returns three-to-four times inflation. When the carnage is finally over and they’re practically giving away stocks down on Wall Street, we’ll be backing up the truck.
(1) This richly-deserved fate was avoided when a consortium of banks loaned the Hunts more than $1 billion.
(2) Eye On the Market, 2/8/16.
(3) A traditional “put” gives investors the right to deliver their shares to another party at a set price, thus offering protection if share prices head south. In a central banker put the bankers have explicitly (Draghi, Kuroda) or implicitly (Bernanke, Yellen) assured investors that stock prices won’t be allowed to head south.
(4) Market manipulation causes capital to be misallocated, which is deadly for an economy. And if there is anything at all to the “wealth effect,” then there is also something to the “poverty effect.” One especially sad consequence of the Fed’s market manipulation is that the stock market meltdown makes it far more likely that the US will fall into a recession that didn’t need to happen.
(5) Deutsche Bank. Meanwhile, BofA is down 29% and Citi is down 27% just since yearend.
Next up: Wars of Detainder, Part 5
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.