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You and the Disembodied Stock Market

Evan Cooper Sep 08, 2015

Sometime in the 1980s or 1990s, as finance rather than commerce became America’s chief business, the stock market became a kind of distorted mirror of the American economy. To be sure, the market still serves as a pricing mechanism for the nation’s public corporations. And there’s no dearth of information or analyses of company earnings and prospects reflected in stock prices. So in terms of the quality of the pricing mechanism — in the sense that all participants have access to all information — the market has probably never been better.

The New Role of Equities

But equities have morphed into the building blocks of other financial products, and just as finance is the tail that now wags the American business dog in terms of influencing strategic decisions and company operations, stocks now march to the drummer of a financial beat that has little to do with a company’s performance.

The growth of passive investing, for example, has transformed a company’s stock into a component of a broader index. Mere inclusion in an index can boost a stock’s price, while a portfolio allocation change at a large passive investor can send an index — and its constituent stocks — lower, even though nothing about a particular component of the index has changed.

Risk-Parity Plays

Pointing out another troubling aspect of today’s markets is a recent column by alternatives guru Bob Rice in InvestmentNews, a publication for financial advisors. Rice believes that much of the recent stock market volatility stems from risk-parity investment strategies conducted by asset managers in charge of trillions of dollars of assets.

As Rice explains: “Risk parity seeks to equalize the risks that each asset class in a portfolio contributes to an overall risk budget. For example, in a simple 60/40 portfolio, equities are, historically speaking, the much riskier asset class. So if you lever up the fixed income side, its risks are magnified so that stocks contribute 50% of the risk and the leveraged bond portfolio does too. In a five-asset class portfolio, after leveraging appropriately, each of the five would contribute 20% of the overall risk.”

That all seems nice and neat and eminently sensible. But when the real world acts in ways never envisioned by the financial gurus who concocted these plays, all hell breaks loose as we saw over the last few weeks and at times of financial crises in the past.

The China Monkey Wrench

This time, Rice notes, China messed up the neat formulas. As China sold U.S. Treasuries to pay the bills for propping up its stock market and supporting its currency (until it threw in the towel and devalued), it offset the bond-buying that normally occurs when stocks fall. Since bonds barely budged when stocks fell, correlations among asset classes rose and risk-parity portfolios found themselves with too much risk. What to do? Sell stocks.

This selling, says Rice, caused even more selling as lower asset prices meant portfolios kept getting riskier. Because these strategies have gotten so popular, he says the risk parity dog is now chasing its tail. It’s likely, he predicts, that another stock downdraft will spark even more selling.

Nowhere in all this sophisticated portfolio engineering do you see anything about a company’s value as a business or its ability to generate steady dividends. For institutional investors, the “eat your broccoli” investment basics apply as a kind of vestige, accounting for perhaps a sliver of portfolios in the form of an allocation to value investing.

Challenges and Opportunities

For dividend-oriented investors, the irrationality presents challenges and opportunities. The forces behind swirling, and often irrational, market movements can’t be ignored, but can inform the way stock prices and values are thought about and how to proceed.

First, don’t get too upset or too elated when prices ride the roller coaster. Despite what you hear from the pundits, there may be nothing more to the giant losses and gains than high-speed traders executing algorithms or institutional investors rejiggering portfolios based on a formula. In short, the moves may or may not make any sense at all in terms of the businesses underlying the securities.

Second, dividend-paying stocks by definition have to be more tied to reality than stocks promising a big payoff in the future. Dividend payers must be earning enough to have something left over to pay a dividend and also have enough cash on hand to fund the payment. I know that reasoning is kind of basic and peasant-like, but the reality of it is comforting. So if you buy stocks that pay you something, regardless of how much the stock price itself goes up or down you’re still getting the income.

Finally, just because dividend investing isn’t new or cool, that doesn’t mean it doesn’t work. Think of all the sure-thing investments in the past that eventually fizzled and cost investors big money — the Nifty Fifty of the ’60s, limited partnerships in the ’80s, dotcoms in the ’90s, etc. — and then go cash your dividend checks.

Image courtesy of jscreationzs at FreeDigitalPhotos.net

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