An engineer’s unfiltered take on the stock market
Note I’m not a financial advisor or qualified in any way to give a professional finance opinion, but I am an engineer, and here’s how I break the market down.
Understanding the financial market is like trying to capture an ocean full of water. You can cup some water in your hands but inadvertently as you try to analyze it, it’ll start to slip from your fingers. The market is as fluid as the water. Filled with currents and eddies that drive prices up and down.
Aptly, fluid dynamics might be one way to model the market behavior but don’t worry, I’m not going to break out any Navier-Stokes equations to do a fluid simulation. I’ll break it down with my simple understanding after having a beer.
Asset Classes
- Equities — basically stocks
- Bonds — IOU issued by governments and companies when they want to borrow money from investors. Fixed interest and percentage return is based on risk, and they usually have a fixed timeframe of return
- Property — commercial or residential. Real Estate baby
- Commodities — Oil, Gas, Metals, traded primarily on the Chicago Mercantile Exchange. Futures set the price of these commodities.
- Cash — Rock hard, stone-cold cash. Liquid AF. Slosh baby slosh
And that’s pretty much the gist. You can trade one asset class for another and some asset classes are more liquid than others. For instance, I can buy a yacht with cash, kinda hard to buy a yacht with a house, until I sell it. Then it’s pretty much cash, right?
Inflation
Why don’t people just save cash, why stocks or property? Well, your money has a decay rate. Every year in our society prices of goods and services inflate at a certain rate. This rate is targeted by the Fed to be 2% (Fed or the federal reserve is the central bank of the United States that controls the monetary policy). That means your 100 dollars this year can buy ~98 dollars worth of stuff last year.
That’s why the price of coke has increased over the last half-century:
The reason the Fed does this is that supposedly it encourages spending. If your money is worthless over time then you wanna spend it buying things. If it’s worth more over time, you might think about saving your money for a better time in the future.
The way the Fed calculated the inflation rate is to use the CPI (or Consumer Price Index). They take items that are representative of what a US household buys and compute the price difference in those items year after year. Here’s what the US Bureau of Labor Statistics has to say about it:
The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought.
The reason this number is really tricky is that it doesn’t include equities, home prices, and if you pick and choose assets your uncertainty in the computation of inflation can vary greatly. Essentially different things lose or gain value differently. The average American household didn’t have to worry about the internet or smartphones 30 years ago, now they do. Globalization has pushed prices down because of the efficiency of production. Technology and automation have made things cheaper, i.e Amazon. So accounting for all that change in one metric like the CPI is really tricky.
As you can imagine we haven’t been hitting those 2 percent numbers, in fact, we’re far below that. And I gave you many reasons above why that could be.
To increase inflation the Fed has a couple of tools at its disposal.
Bank of Banks
The Fed can be thought of as a bank of banks. It can loan money to the banks us normal people use like Wells Fargo, Bank of America, Chase. Just like our banks lend us money when we need to buy a house or a car. The Fed lends money to these banks in the form of credit. And when you take a loan you have to pay interest on the loan. The same is true for the banks, and this interest rate is set by the Fed.
Interest Rates
For us mortals, our interest rate is set by a number of variables heavily weighted by our credit score. If our credit score is high, we make a lot of money and we pay our loans back on time, the bank will want to lend us more money at a lower interest rate. If our credit is poor we can get abysmal interest rates because I’m a riskier investment.
The target inflation rate is the driving factor for the Fed when setting interest rates. (It’s almost like the banks are too big to fail and a credit score for them doesn’t really matter, kinda. There are rating agencies like Moodys and Standard and Poors but not sure their incentives are aligned).
Anyway, if the Fed sees that inflation is too low aka your money isn’t losing its value fast enough they can decrease interest rates to encourage borrowing. I can borrow more and have the same interest payment if my interest rate is low. Borrowing 100 dollars at a 2% interest rate and borrowing 200 dollars at a 1% interest rate is effectively the same interest payment per year. The theory being more borrowing means more spending, meaning a higher inflation rate. Except there are problems with that thought process.
First just because the banks borrow from the Fed, doesn’t mean they have credit-worthy customers to lend to. Aka I have a pile of cash and all the people asking for loans are deemed too risky (so they say). I’m not just going to lend to everyone and anyone. But I don’t want this cash sitting in my bank account. So I invest in asset classes to ensure my money makes more money.
This is step one. Cash from Fed to Assets. As long as my investments make more than the interest rate I’ve borrowed at, I make a profit.
RISK/RETURN
Normally there’s a risk associated with this. See if I invest in equities and commodities, I usually get a higher return but I also get greater volatility or swing in the prices. Over the long-run, I’ll probably make money and beat inflation but in the short term, I might gain and lose tremendous amounts of money. Again as long as I make the interest payments, I’m good. But again this is rated to be a risky investment because there are no guarantees.
Property is similar but usually has fewer fluctuations. It’s also less liquid though so I can securitize it or package it up to be more sellable. This was the mistake of 2008, the securitization of the residential mortgages. Everyone pays their mortgage right? So why not pool all the mortgages together and take the interest payments from those loans. Boom. A stable save recurring revenue stream. Risky homeowners have a high rate of return, less risky homeowners have a lower but more stable rate of return. Then they started to mix and match mortgages. If 75% of the mortgages in this security were rated as less risky owners then the whole package was rated as less risky and so on. You can see how this can cause issues. Nobody really knows the risk level and when they start to fail, it all comes crashing down. People default on mortgages and ya, ya go watch the Big Short…
So we’re left with bonds. Company and Government bonds. The US is pretty much too big to fail, so government bonds are rated the highest most secure type of bond. Some companies fall into this category and are periodically demoted or promoted based on the company’s risk profile determined by rating agencies. But why bonds over stocks?
Bonds are great, bonds are amazing. You have a fixed rate of return. For example for a bond with a yield of 0.5% over five years, you put a thousand bucks into a bond after 5 years you’ll get a guaranteed fifty dollars back. Risky bonds may fail but the US Government has always paid its debtors. Bonds have 1 year, 2 years, 5 years, 10 years, 20 years maturation rates (some are even perpetual, other timeframes exist though much rarer). What’s great about bonds is that you don’t have to hold the bond for its entire life cycle. You can sell the bond to others. Now, why would you want to do that?
Well, bond yields are based on interest rates which are set by the Fed. Bonds that have a higher yield are more desirable when the interest rates go down. Therefore the price of that bond goes up, and the total yield goes down. In our previous example a $1000 dollar would be worth let’s say a $1025 when interest rates go down as it’s a more desirable bond, but I still only get $1050 at the end so the effective yield would be $25 for whoever buys that bond from you and you as the seller make a $25 profit.
Quantitative Easing
As you can imagine after a depression, people stop spending and start saving more. They need money in their accounts for a rainy day. This leads to a vicious cycle of deflation (opposite of inflation). Remember the Fed wants people to spend their money. What if they decrease interest rates all the way to zero like after the 2008 financial crisis? What other tool do they have at their disposal to restart spending? How about just printing money?
This can be quite dangerous as it can lead to uncontrolled inflation if done wrong so the Fed got smart. They knew that all they needed was for people to start spending money and banks were one of the ways to do that. These banks had these assets, bonds, etc on their books, and to start lending the banks needed cash.
The fed thought: What if we bought those bonds and assets and gave the banks cash. Surely then they’ll start to lend this cash to people and the economic engine will start up again! And technically it’s not money printing. It’s asset swapping, right? Nevermind HOW those assets were priced and if they held any value on the Feds books. Bank here’s some cash now lend!
But wait, we went over this. Banks don't’ just lend to anyone and if they don’t have anyone to lend to then they can just put that money back in bonds (with higher yields) or stocks. So that’s what they did. Effectively the Fed gave em’ a blank check. If they made bad decisions, the Fed could effectively erase those decisions by buying those junk bonds and putting them on their books. (Again more nuanced than that but that’s the gist).
And so we had Quantitative Easing. It just increased the liquidity in the market. More cash, more pumping. And we entered one of the greatest bull periods in American History. Let’s go to the moon!
In a short amount of time, the Fed's balance sheet increased around 3 trillion dollars. But again that’s okay right, replace the less liquid assets with more liquid assets and the economy kick starts right?
Inflation?
But wait how about inflation, doesn’t this raise inflation. Well, son, stocks and certain asset classes (the ones banks invest in) aren’t counted in the CPI. People still relatively bought the same amount of soda and food. It was more than elastic and inelastic goods. Different asset and sub-asset classes had different inflation rates. This is well known. So duh inflation wouldn’t show up in CPI. The assets that were inflating weren’t being measured in the inflation index, how shocking.
And everything was fine, the tech sector was roaring, things were looking good. Trump and his monetary policies were popping. And then in early 2019 the newly appointed chair of the Fed Jerome Powell raised interest rates just a teeny weeny bit. He knew that interest rates couldn’t stay close to zero, that was absurd and the effect was almost immediate. The stock market started to reverse its gains and it started looking bleak. Caving from harsh criticism he reversed his decision. And boom back to Bull town.
But the market flashed, it was hypersensitive to inflation in all the wrong ways. Jerome knew that but he punted that problem to a later date. Then it all came crashing down in March 2020 when the exponential effect of COVID took a major toll on the economy. The S&P 500 at its all-time high came crashing down. Investors lost confidence as they say. Sh*t went nuclear.
Money Printer goes Brrrrr…..
The Fed acted swiftly, lowered its interest rates to zero, and started a bond repurchase program. But that wasn’t enough. For the first time, the Fed floated the idea of corporate bond buybacks. This was unprecedented, companies would now directly be financed by the fed (but again this wasn’t really an increase in value because swapping one asset for another right? *sarcasm*). Then the government started giving cash directly to the people of the United States as well as to companies and banks. How was the government going to finance this? By selling bonds to the Fed. It was unprecedented and truly insane. Trillions of dollars just added to the money supply effectively in a couple of months. But it reversed the down-turn. There were some immediate second-order effects.
All bond yields effectively plummeted. This was because the demand for bonds skyrocketed as the Fed the monetary supply of the United States started buying. With an effectively non-existent yield and a zero-percent interest rate buying bonds with all this excess liquidity seemed stupid. Where do we put all this cash?
Companys, banks, and people now have all this excess cash. The government is selling bonds directly to the Fed effectively printing money to use. Cash floods the system and all parties start putting it to good use.
Just holding cash is off the table because cash doesn’t appreciate. All bonds are off the table, Fed’s buying em’ up and dropping yield rates. Commodities like oil seem to be off the table, no demand, no use pumping, maybe gold, but probably Bitcoin as it’s the new fad and it could be a replacement for gold to park my cash. It’s like cash that appreciates, magic for companies and even banks. And then stocks, oh baby, let’s load up on those stocks.
So there’s effectively an asset migration from bonds to stocks, plus retail traders bored out of their minds are just putting cash into the market. Prices just bubble. The asset buyback hasn’t stopped. The stimulus is still coming and money, money, money. Now companies and institutions are looking to diversify. They bought all the stocks they can, they’re looking into putting money in Bitcoin. P/E or share price to earnings look abysmal because the valuations are all inflated. We have to think of all of the creative ways to spend this cash. Now a 1.9 trillion stimulus is on the way and the market is at all-time highs as millions die from COVID around the world, eviction moratoriums extend until March (legally can’t kick people out for not paying rent), and the jobless claims hover around 800,000. It’s not value anymore it’s just liquidity and we’re juicing the market up.
When there’s too much liquid in a tank any small movement over time adds up to water sloshing out of the tank. When there’s too much liquidity in the market there are bubbles everywhere forming and popping, just like the water in the tank. Overall the energy in the system is higher effectively driving prices even higher.
Is it inflation? Maybe. Technically not hyperinflation but some inflation. Is it a mirage and just a higher energy state? Also possible. Will the market correct? Almost certainly when the Fed changes its a policy or some drastic trigger we haven’t yet anticipated (In the commodities market or otherwise). Timing this is most certainly suicide. I don’t have a crystal ball. This could be the new norm and the correction might only be 10–20% rather than the predicted 80–90%. Inflation will rear its ugly head somewhere, but at least now you know.
Jerome, only you can stop this madness. You’re running around trying to keep the tent afloat by pumping in the air, there are no supports. How long do you think you can keep this up? And if you do decide to change your mind give us a warning. I need to know when to pull-out. I don’t wanna get stuck bag holding.
Until then for the rest of us, YOLO and Diamond Hands cause that’s how we roll. Peace.
