Why stocks are headed lower in a year that will challenge our ability to generate wealth in the future
Concerned by that sudden reversal in your superannuation balance from the statement that just landed in your inbox?
Be prepared for more of the same.
It's now clear that 2022 will go down in history as one of the great inflection points in the global economy, one that will have a lasting impact on all our wealth and our ability to derive an income.
In many ways, there's a certain inevitability about it all. The era of free money, which created huge distortions on financial markets and a yawing inequality gap as asset prices soared, has come to an end.
After 40 years of declining interest rates, central banks no longer fear the consequences of upsetting financial markets and protecting the wealthy, an about-face that finally is dawning on a bewildered investment community.
Instead, they now are pushing interest rates higher at the quickest pace in half a century in a desperate quest to kill inflation.
That it all has come about at a time when geopolitical tensions have resurfaced between Russia and China on one side and the West on the other only adds to the confusion and uncertainty.
Wall Street plunged back into bear territory last week, capping off the worst month since March 2020, in what has been a brutal quarter in a terrible year.
It now is down more than 20 per cent from its January peak. The losses are even more pronounced among the technology sector's high flyers who, collectively, have shed more than a third of their value.
For many finance professionals, bruised and battered by recent events, the only hope is that some calamity — such as the UK's disastrous mini-budget a fortnight ago — will force a reversal in the torrent of recent rate cuts.
Should we all be afraid? Our world certainly is going to be far more uncertain and volatile for quite some time.
But, if the past few decades have been an anomaly, we may simply be in the painful process of returning to more normal times. If not politically, then a resumption of norms from an economic perspective.
There's a great scene in the Hollywood extravaganza The Wolf of Wall Street that explains a lot about how our investment markets and those who work in them operate.
Having ascended to the pinnacle — landing a job on Wall Street — Leonardo DiCaprio's character is taken to a drug and alcohol-infused lunch at a high-end restaurant atop a New York skyscraper by his new boss, played by Matthew McConaughey.
As he extends his gratitude with a pledge to always act in his client's best interest, he suddenly is pulled into line by the experienced older hand. His main goal — he is told in no uncertain terms — is to earn as much money for himself at the expense of his clients.
"Number one rule of Wall Street. Nobody, I don't care if you're Warren Buffett or Jimmy Buffett, nobody on Wall Street knows if the stock is going to go up, down or in f***ing circles, least of all stockbrokers.
"It's all a fugazi … it's a wazie, it's a woozy, it's fairy dust. It doesn't exist."
While more caricature than character reference, it does manage to capture the Zeitgeist of that wild era of Wall Street from the 80s.
It also reinforces the point that — despite all the money accumulated by those who lord over our retirement savings — they have little or no idea of what the future holds, let alone how best to cope with it. Most just make an educated guess and hope for the best.
While many have been extremely clever, and ridden a boom unlike any in history, they've been aided by a huge dollop of luck, courtesy of a safety net extended by the financial system. Every time financial markets have taken a dive since 1987, central banks have stepped in to support them.
First, it was with rate cuts. Then, as rates approached zero, they began pumping newly minted money into the system.
During the pandemic, the US central bank alone tipped in more than $US4 trillion ($6.25 trillion). Japan, Europe, the UK and even smaller players like Australia took to the printing press, with a $US12 trillion splurge in the past three years that sent real estate and financial markets soaring.
For fund managers, the strategy during any downturn has been simple. It was called BTD — Buy The Dip — because they knew the system would bail them out.
The great technology billionaires, like Jeff Bezos, Mark Zuckerberg and Elon Musk, all have been swept along by this unprecedented tide of free money.
That's now ended.
Those that have built profitable businesses will survive. Those that haven't — those who have existed on debt and promises of growth — are likely to find the going extremely tough.
Here's how it works: There is a direct relationship between interest rates and stock values.
Interest rates are a measure of risk. The riskier the enterprise, the more a bank will charge to lend cash and the bigger a return an investor will require to hand over the dosh.
When money is cheap, the risk premium drops. When money is free, risk becomes pretty much non-existent and almost any valuation can be justified.
That's where we've just been, with crazy valuations put on companies that make no profit, all based upon a hope that at some time in the future they will deliver the goods.
From ride-sharing services like Uber and Lyft that barely scrape a surplus to our homegrown buy-now-pay-later operators and the host of privately financed start-ups once valued in the billions of dollars — many of which lose money — a massive shake-out is underway.
This graph shows the incredible correlation between the amount of money central banks have pumped into the financial system and the performance of what's known as the FANG index (Facebook, Amazon, Netflix, Google index).
As interest rates move higher, investors no longer need to seek out high-risk ventures to turn a buck. They can simply park their cash in a secure facility at a guaranteed return.
With less cash going into high-risk stocks, their value naturally drops. That's exactly what is happening on stock markets right now.
And it isn't just high-risk technology stocks that are on the hook. Even conservatively run profitable enterprises are being devalued as investors shift out of stocks and into interest-bearing investments.
From an operational perspective, the situation is even more alarming. Higher interest rates result in higher debt repayments. If you don't earn a profit and if your investors aren't keen to tip in extra cash, the corporate graveyard beckons.
Risk is now front and centre of most big investors' minds: risk of default for unprofitable enterprises and risk of lower earnings even for well-run outfits.
Once they were gurus. People like Cathie Wood at Ark Invest, who dominated Wall Street and much of the globe, or Hamish Douglass at our homegrown funds manager Magellan.
Both operators engineered massive outperformance within their funds management businesses, the kind of returns that seemed too good to be true.
In both cases, they rode the technology boom investing in high-profile but high-risk technology businesses.
This graph is a history of asset bubbles over the past 40 years. While Bitcoin wins hands down, Ark Disruptive Innovation (ARKK) is a clear silver medallist.
A quick scan of the fund's holdings reveals a host of unprofitable high-tech, biotech and cryptocurrency assets, dominated by Tesla and Zoom. While the Tesla holding is profitable, the bulk of the fund's 134 investments is in the red.
In 2020, Ark delivered a 150 per cent return to investors as the US Federal Reserve pumped up stock and property values and Cathie Wood was hailed a genius. Now her balloon is deflating almost as quickly.
Last week, she claimed a new wave of deflation was about to hit the global economy in a desperate plea for a renewed dose of central bank special sauce.
Her thinking? A global recession will cause prices to drop and central banks, led by the US Fed, will have to cut rates and print cash, thereby eliminating risk once again. Who knows, she may be right.
It's a similar story for Magellan. Its punt on high-technology stocks was a winner until this year. But its share price has plunged more than 70 per cent, with investors desperately retrieving their cash. More than $1.3 billion flowed out in the most recent quarter.
When does it all end? When central banks indicate their work is done in taming inflation. Or when the now-increasing chance of recession becomes an inevitability and forces an end, or even a reversal, of the rate hikes.
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