Why are stocks rising amidst riots and COVID-19?
Because people aren’t spending.
John Maynard Keynes laid out in The General Theory of Employment, Interest and Money a simple equation that sums up the current situation:
Income = value of output = consumption + investment.
Saving = income — consumption.
Therefore, saving = investment.
An Investment In Cash
During the COVID-19 lockdown, spending was thwarted by store closures and a lack of avenues to consume. Places where people could consume, usually had long lines, further discouraging those who ventured out; if the fear of becoming deathly ill did not discourage you from the get-go. Consumption is an interesting thing because, psychologically, people are driven to create utility out of their earnings. “Sitting in cash” is viewed as a wasteful use of earnings.
“It has been supposed that any individual act of abstaining from consumption necessarily leads to, and amounts to the same thing as, causing the labour and commodities thus released from supplying consumption to be invested in the production of capital wealth.” -Keynes
Absent the propensity to consume, people are pushed towards investment, or what Keynes describes in his formula as “Savings”. This accurately reflects data that retail investors are pushing the markets higher through ETFs and online financial services platforms such as Robinhood. Schwab saw “monumental volumes” with a record of 609,000 new accounts in Q1 and Robinhood saw daily trades up 300% in March year-over-year. Robinhood also told CNBC “over half” of its customers are first-time investors. Securities trading was among the most common uses for the government stimulus checks in nearly every income bracket. This is juxtaposed to the retreating interest shown from hedge funds and professional money managers that control large institutional dollars.
What makes this situation unique from ten years ago is the income part of the equation. Despite high rates of unemployment, most of the unemployed labor force previously made wages of less than $50,000/year. Below that threshold, the extra $600/week in federal unemployment benefits kicks in, essentially pushing income higher on unemployment than while working. Of course, an idle workforce, with higher income and less propensity to consume, increases savings (investment in risk assets).
Simultaneously, personal income in the US increased by 10.5 percent in April, while consumer spending sank by a record 16.4% in the same month and, which is evidenced by the retail index earnings down by retail sales expected to fall 12.3%. In sum, consumer spending collapsed, unemployment surged and yet personal income went up on average in April.
This has led to more money flowing into the traditional markets.
But why would retail buy the riskiest assets, such as stocks, and abhor defensive positioning such as bonds?
Primarily, stocks are easier to access and understand. Additionally, risk does not apply to the equation when money invested is found money. Even more importantly, memories of a stock market that bottomed in 2009 and subsequently rallied is a fond thought and hope of retail speculators.
The general position taken from talking heads of why markets and risk assets are higher is simply due to inflation, resulting from money printing. This satisfies Milton Friedman’s Quantity Theory of Money, which states that if the money supply doubles, prices double, therefore you have experienced inflation across all assets (such as the stock market). However, this theory has been disputed by Keynesians and proven otherwise through the last 20 years of monetary policy, due to the lack of velocity of money in the equation. Money velocity asserts that if you spend $100 at a store, $90 will be spent on other goods and services necessary to run the store, $80 will be spent producing the goods necessary to produce the product, or to sustain the lifestyle of the employee, and so on. We discussed this previously in Monetary Policy And Inflation: Is This Time Different?
We do not believe that inflation will be a direct result of money-printing this time, as it was not a direct result ten years ago. Money spent in consumption or direct investment creates higher money velocity than investment in the stock market or other speculative assets. Stock market investing is not giving money to a company to create and produce. Rather, it is purchasing shares from a previous speculator of the future value of the company. Additionally, the massive collapse in demand in the greater economy, as evidenced by the plummeting consumer spending and unemployment statistics, equates to lower prices for many goods and services. All of these together paint a picture of low money velocity. This matters because the lower the velocity of money, the fewer transactions are occurring between individuals, and therefore the weaker the economy’s health and strength are.
If the current trends continue then unemployment will increase, consumer spending will decrease, and the retail public will continue to use their savings as an investment (in the stock market). Until sentiment changes then, ceteris paribus, the technicals of the traditional markets will continue to be misaligned with the underlying fundamental systemic issues.
Of course, retail investors can only drive the market to new highs for so long. As discussed in “Negative Interest Rates are Coming”, large institutional managers began rotating out of risk assets long ago, and will not come back until more risk is off the table, and P/E ratios (today are equal to where they were October 2007) are once again attractive.