If one goes back to the beginning, it can be surmised that the main reason for the creation of what became Wall Street was to raise capital for business and government. From the early brokers who gathered under the Buttonwood Tree in Lower Manhattan in 1792, the chief rationale of the stock market was to finance the future of the country.
For most of the first 125 years, stocks were considered a riskier but potentially more rewarding version of a bond. Common stocks were sold with a capital value of as much as $100 per share, which was their capital contribution. Common stocks were sold with a stated or implied dividend. If business was good, stockholders received an increase in their dividend, something other securities did not do. While corporations were under no legal obligation to pay the dividend (unlike some preferred stocks and all bonds), missing a payment would usually set off a crash of the stock and a denial of access to the capital markets to the company. Stock manipulators like Jay Gould and Elliot Fisk tried to take over companies with stock that had been issued but not paid for. This was known as “watering down” the stock, as the corporation’s capital account did not receive a monetary benefit from the shares issued. This was illegal, but prior to the invention of the Securities and Exchange Commission (SEC), it was caveat emptor.
After World War I, stocks were bought less for their dividend income and more for their earnings prospects. The 1920s ushered in the automobile, electrification, the telephone and radio, motion pictures, all of which enticed people to invest in the limitless future of these emerging and disruptive technologies. Often, if stocks paid a dividend, that was an afterthought. The investment idea was to capitalize on the trends.
All of which led up to 1929. So many people had used borrowed funds to invest that when the market turned down, they were forced to sell out of their holdings. This created a cascading effect, which resulted in the market’s fall in 1929 and 1930. Once again, stock yields exceeded those of bonds in the 1930s and would remain so until after World War II.
Today, we are witnessing another transition. Through the internet, hundreds of thousands of unversed speculators are being harnessed to focus on a few stocks. As this is being written, the stock of GameStop (a game retailer that was previously destined to go the way of Blockbuster in the video rental industry) has suddenly become a hot stock, having doubled in value just yesterday. This is the result of two things: a cabal of short-sellers who thought the company was going bankrupt and a legion of internet investors who wanted to make life miserable for the short-sellers. Think of it as populism meets capitalism.
Short sellers focus on stocks that they think are going down in value, ideally to zero. They borrow shares from a brokerage firm and sell them, promising to buy them back later. As the stock declines in value, the account of the short-sellers increases. Sometimes, short-sellers publish “research” on the internet to support the idea that the stock being shorted is toast.
In the case of GameStop, the effort backfired. Online brokerage firms like Robinhood aspires, on their clients’ cell phones, to promote endless trading of which they receive a fee (forget the deception of “no commissions”). Investor platforms like Reddit discovered through public information that GameStop stock was 105 percent short. This means that the brokers who sold the stock short did not collectively have enough stock to cover their positions. In the ensuing melee, GameStop’s stock oscillated between $10-500 per share before the SEC and brokerage firms stepped in to “maintain order” by making the stock more difficult to trade. By so doing, they were trying to drive down the price supposedly to protect the speculators but really aiding the short-sellers, who were at this point out billions of dollars. The brokers who sold them the shares short were facing ruin at the run-up prices if the hedge funds could not cover by buying back.
While some may see this as a victory for the little guy against the hedge funds who orchestrated the shorts (at least until the brokerage firms and SEC jumped in), it is also a commentary on how much the stock market has, in places, become a casino, and certain stocks no more than casino chips.
A second lesson to be learned is the ability of this short-squeeze trading to spill over into other parts of the stock market. If people buy GameStop at $500 a share, only to watch it go to $100, will such an investor have to sell other holdings to meet their own margin calls? This is how the events of 1929 cascaded out of control.
We have gone far beyond the Buttonwood Tree. If the market is to provide a place for investors to set aside funds for their retirement, it will need to address those who want to make it a casino. Brokers and speculators love trading, but investors need positive returns over time. There may be a way to accommodate both; if not, investors need to come first. Recall the original purpose.
Not surprisingly, economic data is now viewed with political overtones. With a $1.9 trillion COVID relief bill pending, such is to be expected.
The reality is that the economy is still hurting. People are still being laid off in higher numbers than pre-COVID, especially in the service sector that disproportionately employs women. One in 20 homes cannot stay current on their rent or mortgage. On the other hand, vaccination progress is material. COVID cases are going down. Depending on who is being quoted, some semblance of normality is 3-9 months off, assuming no significant mutations that current vaccines cannot handle.
What seems to be forgotten is that the funds being legislated can only be spent if people qualify for the same. If the economy were to recover quickly, the money would not be spent. Those who worry that the stimulus will go to those not needing it should consider surtaxing it. Someone of a higher income will repay the government more than someone in a lower tax bracket.
Embedded in the bill at this time is not only an increase in the minimum wage to $15 per hour, but an expansion of who is covered by the minimum wage laws. In the restaurant industry, hourly wages can be as little as $2 per hour if tip income makes up the difference to $7.65, the current base. If restaurants, hotels, and others who hire those who rely on tip income need to pony up the difference to $15 per hour, the effect on prices could be substantial.
Interest rates are going up. The combination of the sheer volume of government bond issuances and higher perceived returns in non-interest investments like stocks, Special Purpose Acquisition Companies (SPACs), and private equity are all eroding support for bond values. Depending on the decline, this could be a major theme of the next few years.
The ten-year Treasury yield is currently 1.40 percent, and the thirty-year is 2.25 percent. Both are up from the first of the year.
Inflation is becoming harder to explain away. The falling dollar and international economic revival are stoking commodity prices to their highest level since the last expansion. Even computer chips, once considered almost a commodity, are in short supply.
Add to this the inflationary implications of the higher minimum wage, and the stage is set for the first round of sustained inflation in a generation. What happens next is a matter of credit availability and mindset. There are those who believe that consumers, having been denied the ability to spend money on services during COVID, bought goods instead. They may be shocked at how much more the earlier services now cost.
The Stock Market
Since last fall, there has been a shift away from high valuation growth stocks to lower-valued value names. Depending on how high interest rates rise, this may be a trend with some duration.
Higher interest expenses will affect companies in proportion to their leverage. For the most part, the effect will not be felt all at once but rather over time as debt is reissued at higher rates.
An offset may be the stimulus spending and higher minimum wage, depending on how it is structured. Studies show that those on the lowest income levels tend to spend income increases disproportionate to those receiving at higher income levels. The ability of the economy to sustain itself is key to the market’s performance in 2021.
Warren Barnett, CFA