A Very Scary Finding

Articles From: Interactive Brokers
Website: Interactive Brokers

By:

Chief Strategist

Interactive Brokers

I’ve been doing quite a bit of head scratching recently – not because of poor work-from-home hygiene, but because I’ve had immense difficulty wrestling with the causes and character of the equity markets’ bounce from the March lows. Like many market veterans, I am concerned with the concentrated nature of market leadership and the seeming disconnect between fundamentals and valuations.

While I fully acknowledge that much of the recent rally could be explained by extraordinary monetary accommodation amidst a deeply oversold decline, there appeared to be an exogenous source of new money chasing popular, speculative names.

The following article identifies that source: Many Americans used part of their coronavirus stimulus check to trade stocks

I found that article to be quite worrisome. My concern is centered on these factors:

1. Equity markets digested a huge flow of new money in a short period of time.

2. Much of the money will eventually spent on necessities, meaning it will flow out of the markets over the coming months

3. Many of the investments appear to be coming from new investors.

Yes, over $1 trillion went into the pockets of ordinary American citizens and much of it found its way into the stock market. By definition, this raises a worry about money flows. One has to believe that much of the stimulus money that will be invested has already done so. Without a second round of fiscal stimulus, that flow is likely to abate – if it hasn’t already. It is hard to imagine a new class of buyers for equities arriving in the short term. Stocks need fresh money to sustain their valuations. That source ideally comes from economic growth, which is far off on the horizon at best. (Other sources could be a second round of stimulus or the Federal Reserve beginning outright stock purchases, but neither seems immediately likely).

It is reasonable to expect that some of that money would need to flow out of stocks for the recipients to pay expenses. After all, that was the point of the stimulus checks. It is also logical that many of the recipients sought higher returns for cash that wasn’t immediately necessary to pay bills. However, one of the tenets of finance is to match the lifespans of assets with liabilities. Doing otherwise introduces risk. Stocks are assets with an indefinitely long life. One’s rent or mortgage is due at the beginning of the next month. That is an enormous mismatch. Investing the rent money in stocks could indeed work out well, but it introduces a level of risk that is likely to be inappropriate. I certainly hope that those investors are seeing gains. I really hope that they are not using margin for those investments, because that increases their potential liabilities.

The linked article acknowledges the growth in new accounts seen at our firm and our competitors. I have nothing against new investors, especially because they are the lifeblood of our business and the markets on the whole. Over time, this is likely to be a wonderful thing for both the firms and their customers. But new investors often make mistakes. That’s not a criticism. It’s quite normal, and I have certainly learned expensive lessons along the way along with nearly everyone else. The risk that I see here is that there is inevitably some herd behavior behind this investment influx. In my experience, herd behavior works really well for a while but can turn very ugly quickly. This raises the risk level for all equity investors.

Let me be clear about a couple of things: we live in a free country where people can do whatever they want with their money, and I believe that everyone can and should be using stocks to help achieve greater wealth and financial security. This is neither a disdainful look at the government stimulus nor its recipients. This is instead about risk. I have spent a career managing financial risks, and consider myself attuned to them. There are risks here, and it is my duty to point them out.

I certainly hope I’m wrong about this one. But in the meantime, I’m very wary.

Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers, its affiliates, or its employees.