@valuabl

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Investor sharing value-oriented analysis of financial markets. Writer of Valuabl (valuabl.substack.com) and author of The Little Book of Big Bubbles (mybook.to/lbbb).
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Edmund Simms's avatar
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Fed watch • Credit creation, cause & effect • May 18, 2022
(1) The Federal Reserve buys and sells securities and (2) sets interest rates to influence: (3) borrowing costs, (4) lending activity, (5) inflation and employment; (6) with varying effects.

•••

TLDR: Last week, the Fed added $1.4bn net to its Treasury security holdings and $19.4bn net to its MBS holdings. The total amount of Reserve Bank credit increased by $14.8bn net. Note that additions at this stage are likely caused by previous purchases settling. Settlement can take up to 180 days.
  • The 10-year Treasury yield dropped by 3bp to 2.88%.
  • The 30-year fixed-rate mortgage fell by 5bp to 5.25%.
  • The market expects the federal funds rate to hit 275-300bp by year-end.
  • I have added an inflation-adjusted US house price index. I will update this monthly as the Bureau of Labor Statistics (BLS) updates its consumer price index (CPI) data and the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index comes out. This is current as of February. The expansion data is in section 5 and the chart is in section 6.

•••
1/ The Federal Reserve buys and sells securities

sources: Federal Reserve Bank of St. Louis, Board of Governors of the Federal Reserve System

2/ And sets interest rates

source: Federal Reserve Bank of St. Louis

3/ To influence: borrowing costs

source: Federal Reserve Bank of St. Louis

4/ Lending activity

source: Federal Reserve Bank of St. Louis

5/ Inflation and employment

sources: Federal Reserve Bank of St. Louis, US Bureau of Labor Statistics, S&P Dow Jones Indices

6/ With varying effects

'*'money multiplier is calculated as M2÷monetary base. The pre-GFC average (1958-2007) was 8.9. sources: Federal Reserve Bank of St. Louis, Valuabl

'*'calculated as the change in S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index adjusted for the change in CPI for all urban consumers. sources: US Bureau of Labor Statistics, S&P Dow Jones Indices, Robert Shiller.

•••

ELI5: Why is this gobbledygook relevant?
The Federal Reserve creates money and uses it to buy bonds. They do this to push interest rates down and to put more money into the economy. Low rates mean people can borrow more, spend more, and afford higher prices. More spending and higher prices mean people feel rich, and businesses hire new employees.

But, if prices rise too quickly or people borrow too much, the Fed does the opposite. It sells the bonds it has and then destroys the money it receives. These sales push interest rates up and take money out of the economy. Higher rates mean people can't borrow or spend as much and need to pay lower prices. It makes people feel poorer than before, stops them from being able to spend as much, and makes businesses trim employment.

In addition to this, the Fed borrows and lends to banks. If a bank doesn't have enough money for a day or two, it can borrow from the Fed. If it has too much, it can lend to the Fed. A group of people who work for the Fed, the Federal Open Market Committee (FOMC), decide the interest rate that the Fed will pay for, or demand of, these short-term loans.

The Fed does these because they believe in two objectives: first, that a low and stable inflation rate is good for the economy, and second, that minimising unemployment is desirable.
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AMA "Ask Me Anything" • Thursday, May 19, 2022
Want my value-oriented take on something? Let's have a chinwag.

I can't promise an excellent or insightful answer, but I'll do my best. I'm also not afraid to say "I don't know" or "I was wrong."

•••

My background: I studied mathematics and business. Spent a decade in hedge funds, mutual funds, and VC. Wrote a book about the history of financial bubbles. Now I manage a private fund and publish a value-oriented fortnightly journal of financial markets.
If buying your losing stocks is like watering dead grass...how do you judge when to buy and hold in markets like this one?
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Lunatics should pay the price
Following the collapse of Luna, small-time punters will want compensation. Lawmakers and courts should ensure the right people pay. Getting this wrong would trivialise our monetary system and undermine the credibility of legitimate blockchain technologies.

•••

Following the collapse of Luna, a cryptocurrency, Vitalik Buterin, a co-founder of Ethereum, tweeted that he supported rescuing minor owners of the stablecoin first. “Strongly support this,” Mr Buterin wrote from his account, “coordinated sympathy and relief for the average UST smallholder.” Buterin also suggested that the Federal Deposit Insurance Corporation (FDIC), a United States government-backed agency that insures the deposits of American banks and credit unions could do this. “The obvious precedent is FDIC insurance (up to $250k per person),” he added.

It’s unclear if Buterin believes the FDIC should, or even could, do this or whether he envisions the cryptosphere should create a similar backing. Either way, lawmakers should not reimburse Luna speculators with public money. If Buterin wants to champion a government-backed crypto-equivalent of the FDIC, they should discuss this independently of, and after, TerraUSD (UST) and Luna’s collapse. But if he proposes that the FDIC step in to make dinky Luna investors whole, this would be a mistake delegitimising the monetary system and worsening the crypto industry.

Franklin Roosevelt, the 32nd president of the US, set up the FDIC during the Great Depression to restore trust in the American banking system. Before this, one-third of all American banks had failed, and bank runs, where many depositors withdraw money believing the bank will collapse, were typical. Legislators passed the Glass-Steagall Act in 1933, which created the FDIC to insure up to $2,500 of individual deposits in member banks with the backing of the US government. Since the FDIC’s inception, the size of individually insured deposits has increased to $250k, and the system works. No depositor has lost any FDIC-insured funds. The agency and its foreign equivalents are fundamental underpinnings of the global monetary system because they provide three benefits:

First, depositors have confidence in the liquidity and security of their funds, safe in the knowledge that if the bank fails, they will be made whole. They can save and spend readily, providing liquidity and confidence to businesses and money markets.

Second, banks can lend freely and communicate directly. Banks can maintain fewer reserves and lend plentifully without the omnipresent spectre of a bank run looming over their heads. If withdrawal led insolvency were always lurking, banks would only ever lend for the short-term against guaranteed protection. Bolstering consumer confidence to prevent bank runs enables banks to make longer-term loans on new projects. This confidence helps entrepreneurs get the capital they need and lubricates the innovation engine.

Third, the government can adequately regulate and support the banking market to protect consumers and prevent banking crises. Without the FDIC government guarantee and the regulatory price tag attached, non-specialists wouldn’t know how to distinguish between safe and risky deposit-takers. Regardless of financial backing, whichever bank offered the highest interest rate would be the one to rake in the funds. A low-interest rate is unappealing even if safe, while a high-interest rate is fun.

These results are suitable for maintaining a functional monetary architecture. If regulators use the FDIC either directly or as a precedent to bail out Luna punters, this delegitimises membership. What good is a government guarantee if extended to the unguaranteed? It isn’t. A haphazard rescue package like this would drag down the utility of banking. As long as the masses have invested, seemingly anything would qualify as a depository institution. When everything is protected, nothing is safe. Savers would seek the highest-yielding accounts without regard for their security. Speculators and depositors would lose money, and the taxpayer would be on the hook for ever-larger sums. This tailspin is neither sustainable nor desirable.

Compensating Luna bag holders from the public purse will create more shysters in the future than otherwise. If folks believe that the taxpayer will ride to the rescue should their naivety lead to loss, they will be less discerning. And like a dank cupboard breeds mildew, this environment would breed a furry layer of Madoff-wannabes, offering colossal ‘guaranteed’ returns. Shooting for the biggest payoff is always the logical path without a downside. Moreover, authorities will infantilise their civilians by saving bad speculative investments in unregulated products. We collectively take another step into the moral hazard swamp by conditioning grownups to act like teenagers, desiring the freedom of adulthood but shirking the essential responsibilities, privatising the gains while socialising the losses.

Indeed, the rally-point of crypto has been that it operates outside the traditional financial system—a metaphoric middle finger to administrations and banks. It’s unclear precisely what Mr Buterin is proposing. He might want the crypto community to have their cake and eat it too. If that’s the case, lawmakers shouldn’t fall for the crocodile tears. As with all new industries, the cryptosphere is learning to walk, run and feed itself. It is evolving. Participants will make mistakes, and they will learn from them. Stepping in now with the cotton wool to prevent any pain would slow that maturation process and, like an overly zealous helicopter parent, prevent the industry from doing some much needed growing up. No matter how naive these smallholders were, lawmakers should not use public money to compensate them.

Instead of public bailouts, governments should join together to pursue Do Kwon and the other co-founders and executives of Terraform Labs, the company behind Luna. They should investigate whether the company misled speculators and whether Terraform Labs operated Luna as a Ponzi scheme by paying out early investors with money from new ones. If the judicial process finds Kwon and his associates guilty, courts should force them to make restitution to the people they duped. The taxpayer should not float punters more chips when they lose money in a backroom poker game. Unless this happens, the cryptosphere will remain a monetary and financial wild west where robber barons deceive and steal, undermining the credibility of legitimate technology.

•••

This article will be in next week's issue of Valuabl. I have made it free for now because I believe it's an important topic.
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"You may talk of the tyranny of Nero and Tiberius..."
Remember to think independently and heed Mr Bagehot's warning when analysing your investments:

“You may talk of the tyranny of Nero and Tiberius; but the real tyranny is the tyranny of your next-door neighbor... Public opinion is a permeating influence, and it exacts obedience to itself; it requires us to think other men's thoughts, to speak other men's words, to follow other men's habits.”
―Walter Bagehot, The Character of Sir Robert Peele, 1856
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The cost of capital, May 15, 2022
Interest rates and capital costs are the most consequential yet misunderstood prices in capitalism, connecting the future to the present.

•••

Equity markets crumbled again last fortnight. Investors wiped $6.9trn from global stock prices (see: 'A global stocktake' in Vol. 2, No. 10). In a sign of the times, Saudi Aramco, a gargantuan Saudi Arabian oil pumper, overtook Apple as the world's most valuable company. The S&P500, an index of large American companies, was down another 5.9% to 3,935. The index has fallen 17.5% from the start of the year and is now at its lowest level since March 2021.

source: S&P Capital IQ

As equities fell, so too did government bonds. Yields, the inverse of prices, marched higher as investors digested stubbornly high inflation data and central banks stayed hawkish. The yield on ten-year US Treasury bills, a key rate for valuing financial assets, rose by 17bp. Real rates, the difference between yields and expected inflation, turned positive for the first time since the pandemic began. Bond buyers can now expect to increase their purchasing power by 34bp per year—an insipid proposal, but less chilling than losing it—happy Friday the 13th.

source: Federal Reserve Bank of St. Louis

The equity risk premium (ERP), an estimate of the extra return investors demand to buy stocks instead of government bonds, rose by 28bp. The current premium, 5.49%, is the highest since the peak of the panic in early-2020 and higher than the average of the last five years. Equity investors' fear is rising.

Returning from their pilgrimage to Omaha, prospective value investors are likely to have the Oracle's words fresh in their minds, "be fearful when others are greedy and greedy when others are fearful." After watching stock prices tumble, they might reckon that stocks have finally become cheap—they are not. Stocks are not cheap; instead, the cost of equity is normalising, and stocks are just not as expensive as they have been for the last two years (see: 'No, stocks are still not cheap' in Vol 2. No. 10)

sources: Federal Reserve Bank of St. Louis, S&P Capital IQ, Valuabl

Equity investors aren't the only ones feeling more anxious. Creditors do too. The average corporate credit spread, the difference between corporate and government bonds yields, rose by 45bp. Spreads for riskier companies increased by more than safer ones as investors continue to expect rising interest rates to debilitate struggling firms' ability to make interest payments and refinance.

source: Federal Reserve Bank of St. Louis

Using the average ERP of the last five years, the current ten-year Treasury bond yield, analysts' consensus earnings estimates, and a stable payout ratio based on the S&P500's average return on equity over the last decade, I value the index at 4,249 compared to its level of 3,935.

source: S&P Capital IQ, Valuabl

This valuation suggests the S&P500 index is now 7% undervalued compared to 9% overvalued at the start of the year and 22% overvalued 12-months ago.

sources: S&P Capital IQ, Valuabl
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@valuabl great piece! Very thorough.

Question for you regarding equity valuations. I agree we were overblown for some time and this is a “normalization” of values. Ive been thinking my ideal scenario would be to see the markets trade sideways for a while.

I know everyone wants to go to the moon and all but do you think it would be healthy to see the market hold and consolidate for a few months to a year and get some of this macro stuff behind us?
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The latest issue of Valuabl is out (Vol. 2, No. 10)
The monetary ocean is draining. And when the tide goes out, will you be marooned? Valuabl is a fortnightly journal of the capital markets, helping investors navigate the financial seas, avoid shipwreck, and plunder precious booty.

Amongst the usual titillations, subscribers are getting my analysis on:
  • What is the S&P500 worth?
  • Are stocks finally cheap, or was 2021 a mirage?
  • What is the Fed doing, and how will the monetary policy evolve?
  • Is there any value in buying chocolate, or cardboard, production companies?

We are taking stock of some of the most dramatic market shifts ever. I welcome your readership. Subscribe here and devour the latest issue.
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"There is no housing bubble..."
According to Neil Barsky, managing partner of Alson Capital Partners and contributor to the Wall Street Journal, there is no housing bubble because of:
  • Low interest rates
  • Local job growth
  • Emotional attachment
  • Housing shortage
  • Low mortgage risk

He says that prices won't collapse, "they are likely to cool off slowly, if at all."

This was 2005.

Edmund Simms's avatar
$7.5m follower assets
Fed watch • Credit creation, cause & effect • May 11, 2022
The Federal Reserve buys and sells securities and sets interest rates to influence: borrowing costs, lending activity, inflation and employment; to varying effects.

•••

Last week, the Fed added $1.5bn net to its Treasury security holdings and $5m net to its MBS holdings. The total amount of Reserve Bank credit increased by $869m net.
  • The 10-year Treasury yield dropped by 2bp to 2.91%.
  • The 30-year fixed-rate mortgage rose by 3bp to 5.30%.
  • The market expects the federal funds rate to hit 275-300bp by year-end. This rate was 300-325 last week.
  • The labour force participation rate and employment rate are dropping. This drop is happening while wages and rents are rising. Households are being squeezed but are meeting the difference with credit—consumer lending is exploding.

1/ The Federal Reserve buys and sells securities

sources: Federal Reserve Bank of St. Louis, Board of Governors of the Federal Reserve System

2/ And sets interest rates

source: CME Group Inc.

3/ To influence: borrowing costs

source: Federal Reserve Bank of St. Louis

4/ Lending activity

source: Federal Reserve Bank of St. Louis

5/ Inflation & employment

source: Federal Reserve Bank of St. Louis

6/ To varying effects

*the money multiplier is calculated as M2÷monetary base. The pre-GFC average (1958-2007) was 8.9. sources: Federal Reserve Bank of St. Louis, Valuabl

•••

ELI5: Why is this gobbledygook relevant?
The Federal Reserve creates money and uses it to buy bonds. They do this to push interest rates down and to put more money into the economy. Low rates mean people can borrow more, spend more, and afford higher prices. More spending and higher prices mean people feel rich, and businesses hire new employees.

But, if prices rise too quickly or people borrow too much, the Fed does the opposite. It sells the bonds it has and then destroys the money it receives. These sales push interest rates up and take money out of the economy. Higher rates mean people can't borrow or spend as much and need to pay lower prices. It makes people feel poorer than before, stops them from being able to spend as much, and makes businesses trim employment.

In addition to this, the Fed borrows and lends to banks. If a bank doesn't have enough money for a day or two, it can borrow from the Fed. If it has too much, it can lend to the Fed. A group of people who work for the Fed, the Federal Open Market Committee (FOMC), decide the interest rate that the Fed will pay for, or demand of, these short-term loans.

The Fed does these because they believe in two objectives: first, that a low and stable inflation rate is good for the economy, and second, that minimising unemployment is desirable.
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Money vacuum go VRRRRR
Here is a sneak preview of tomorrow's cartoon in Valuabl, your favourite value-oriented journal of the financial markets.
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Plus ça change, plus c'est la même chose
A tidbit for students of history:

James Buchanan, the 15th US President, devoted the opening paragraph of his first annual message to Congress in 1857 to an attack on the "extravagant and vicious system of paper currency and bank credits, exciting the people to wild speculations and gambling in stocks."

The more things change, the more they stay the same.
@valuabl Dude I love your quotes keep them coming! Big fan of history myself! He wasn't wrong either Panic of 1873, Depression of 1882, these cycles are as old as the markets themselves.
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