What are the financial markets (equity/stock, bond/debt/credit, commodity) good for?

During the workweek of August 24, 2015 through August 28, 2015, the well-followed and well-covered (by the press, at a minimum) Dow Jones Industrial Average index and the Standard & Poor’s 500 index experienced daily increases and/or decreases in excess of 2%.  Even though most market observers probably would not think that a 2% change in the price of a certain stock from $100 to $98, or from $100 to $102, was a big change to worry about, such percentage changes so many days in a row in the equity indices seem to generate massive euphoria or worry amongst market observers.  I am not sure if such euphoria or worry is rationale or irrational.  But I do believe that the financial markets are extremely important and useful aspects of our society.

Starting with the bond markets, which sometimes also are referred to as the credit or debt markets, is probably the easiest place to begin explaining why the financial markets are so important.  The bond markets, and specifically the integrity of the bond markets and the prices and yields of bonds, are of paramount importance in a capitalist society because the interest rate that investors demand for lending money to a borrower provides real-time information to potential investors about the risk of default (not meeting financial obligations in a timely/scheduled manner) of a given borrower.  When functioning properly (with brokerage firms making a profit on making markets in bonds and investors buying and selling bonds that meet the investors return requirements), the bond markets act as a risk-siren and opportunity-siren (frequently in the exact same bond security, but to different investors), providing information that enables risk-averse and risk-inclined investors and lenders to select organizations to provide capital to; moreover, when the markets are functioning with integrity, the lent capital (also referred to as ‘temporary’ capital) is usually more stable for the borrowers than if the lender is ill-informed of the risk characteristics of the borrower and therefore seeks to end the lending relationship.  Therefore, it is critical that the information that borrowers provide to the debt markets is accurate.  If not, and such inaccurate information is used by lenders, which provide critical capital to borrowers that have smart ideas for that capital to generate higher returns than the interest rate that the lender charges the borrower, lenders may lose faith in the integrity of the information that borrowers provide.  For example, if securities industry analysts assert that a borrower has a strong ability to make interest payments and repay principal when such ability is actually quite weak, then lenders will re-price risk rapidly, and in the case of the U.S. housing financial crisis of 2008-2009 lenders when information systematically lacked integrity, and lending sources may cease lending to massive components of an economy.  As such, the efficient and generally accurate pricing of repayment risk of borrowers is critical to economic stability and economic growth in a capitalist economic system.

In contrast, the stock market is driven (or should be driven) by quite different dynamics.  In almost all cases, but with a few variations, owning a share of stock represents a residual interest in the earnings of the stock issuer.  Shareholder rights to proportional earnings of a company are subject to more fluctuations than bondholders contractual legal rights to cash flows of a company.  As such, stocks probably should be more volatile in price ranges than bonds because more factors may affect the perception of the potential residual earnings power of an organization, and such factors will probably change more often than the factors that affect perceptions of organizations’ ability to repay borrowings, which rank much higher in an organization’s capital struck than the ‘permanent’ equity capital that stockholders provide to corporations.  For example, a corporation, AFTER meeting its obligations to bondholders and other creditors, may decide to invest in building inventory or adding to research and development expenses, rather than paying out more profits to shareholders; few, if any, organizations would intentionally put research and development expense or inventory build-up ahead of paying obligations to bondholders or other lenders – if an organization did that, it would probably only get the chance to do that ONCE because the bond market participants would penalize the borrower severely through demanding higher interest rates or by suing in the legal system.

After working primarily in the financial markets for almost 20 years, I live in a town where many of the residents work in the financial services industry, and I teach many of their kids at the high school level.  I also am fortunate to continue to interact-with and consult-to some outstanding professionals in the financial services industry.  These people and their organizations are very important to our capitalist society because they play a role of helping price loans and risk, which drives investments or in some cases prevents investments.  Their work fuels economic growth and regulates what entrepreneurial and business growth opportunities should be pursued and which should not.  I think it is very important that we continue to encourage some of our best and brightest young people to keep improving upon the integrity and efficiency of these vital tools of our capitalist society because the financial services industry and our markets ARE very good for society when these markets function with integrity and efficiency.

Currency Policy Trends and the Widening Wealth Gap

The global currency markets are simple in a completely free markets.  By "simple" I mean self-correcting when there is not government or financial services industry intervention that is not associated with private sector transactions related to a productive economic objective, such as Wal-Mart buying lightbulbs manufactured in Nigeria;  when Wal-Mart buys from a non-domestic U.S.A. manufacturer, two transactions occur:  (1) Wal-Mart authorizes payment for the good produced in Africa and payment is sent to the manufacturer's bank account, and (2) either Wal-Mart's bank or the manufacturer's bank converts Wal-Mart's U.S. dollar payment into local currency such that U.S. dollars are sold, and local currency units are purchased.  Such a pair of transactions results in a marginal weakening of the U.S. dollar currency because that currency has been sold and converted into the relatedly-purchased non-U.S. dollar currency.  When this occurs, all other things equal ("ceteris paribus" in economic speak) all goods and services produced in the United States become slightly less expensive to buyers using foreign currencies and goods and services produced in the home country of the producer of Wal-Mart's good or service become incrementally more expensive.

When the above-explained mechanism occurs with private sector actors (Wal-Mart, the foreign manufacturer, and the banks) all behaving in a self-interested manner aimed toward their goal of generating a profit, the currency markets generally provide a valuable role in societies as a regulator of trade and a measure of the attractiveness of various possible non-domestic sources of goods and services.  As a positive externality, foreign competitive goods force domestic producers to maintain competitiveness in quality, and may in fact force superior product innovation, as I believe has occurred in the case of German automobiles.  For multi-year periods and possibly multi-decade periods, Germany's post-WWI-reparations-driven fear of currency weakness has probably played some role in its high-quality automobiles and high-quality manufactured products track record more broadly.

In contrast to the benefits of free market currency externalities, when nations intervene in currency markets (such as the recent trends globally), protectionism rears its ugly head with regard to quality of goods and services produced in the absence of other nations responding.  Moreover, if other nations do respond with protectionist currency actions, those domestic workers without assets whose nominal values are correlated positively with currency weakening actions may experience a negative impact on their standard of living as their nominal expenses rise more rapidly than their nominal wages.  Thus, currency wars likely benefit politicians and currency bureaucrats who are seen as 'protecting' their employers and citizens jobs, but in reality drive further widening of the wealth gap.

So that is enough on currency at this time.  I believe that we have been in a currency war globally for more than a year since the European Central Bank began quantitative easing.  More recently, the Chinese Central Bank has joined the party.  At the same time, sociologists around the world seemingly write endlessly about the growing wealth gap.  And yet few, if any, relate the growing wealth gap to currency policies.   I think that lake of intellectual connection will dissipate in coming quarters and years.

Week of 8.10.15: The Most Interesting, but Under-covered Event of this Week - U.S. Treasury Bond Auction Demand

The most interesting, but under-covered, newsworthy item of the week was the weak auction of U.S. Treasury bonds during this past week.  While one weak auction does not make a trend, this is an area worth some vigilance, given the U.S. federal budget levels that require periodic debt re-financings or pure new issuances to fund deficits.  The weak demand is by no means a trend, but merely a data point.

A Philosophy

Absolute Value is a philosophy.  It is a practical philosophy because it relates investing decisions to economics, which some believe is an academic arena.  However, over the course of most of history, as I have read it, all investment opportunities are ultimately valued relative to the perceived risk-free investment opportunity.  Currently, as of August 14 in 2015, the 'perceived' risk-free interest rate is reflected in U.S. Treasury bonds, and specifically the 10-year U.S. Treasury Bond that yields roughly 2 - 2.5% in recent months.  In my view, successful investors will have proprietary processes for evaluating investment opportunities relative to the currently-perceived 'risk-free' rate of return.