A portfolio manager submits the following modest proposal on how to fix a centrally planned, and utterly busted and discredited, stock market.
We are all witnessing what happens when food inflation starts to affect the population in less developed countries: people react with violence. The sudden realization that basic staples have become unaffordable puts enormous pressure on households that rely on daily or weekly cash flows to make ends meet. In emerging markets, prices are surging for basic commodities. Basic commodities are what people consume. In developed countries we experience inflation in manufactured food products, as a result of the surge in basic commodity prices. That is to say, when the cost of cocoa soars, chocolate bar manufacturers will make sure that retailers accept an increase in list prices that is covering the spike in input costs for the manufacturer. All this is well understood. It is however less well understood what actions food manufacturers undertake to protect their profits when commodity prices soar. Historically, food companies have been for the most part very good at “recovering” input cost increases. What they tend to do as a basket of soft commodity prices start to increase, is that they would push through a list price increase to retailers, which tend to more than compensate for the increase in input costs. As an example, a chocolate bar might have direct cocoa cost of 20c per bar. It sells for a dollar. When cocoa prices go up by 50%, and the cocoa in the bar now cost 30c, the manufacturer will try to pass on a list price increase of 20c before negotiating with the retailer. Newspaper headlines generally help to create an emotional environment with expectations for further price increases… At that point, retailers will have several options: decide to accept the list price increase of 20c and pass it on to the consumer, negotiate a 10c increase in line with the spike in cocoa prices or, alternatively, pass on the 20c price increase and ask the supplier to give back the extra 10c in promotions, the good old buy one get one free that consumer love. Now, the latter is the most widely followed route, because retailers know too well that when consumers see promotions, they tend to respond, buy more and consume more, which means higher sales for retailers, higher profits, and bigger volumes for manufacturers, who benefit from this dynamic too. So, with the mere recourse to a marketing gimmick, consumers are led to believe that nothing really has changed, products are not really more expensive, because they are on promotions. So that they do not desert supermarkets, if anything, they do buy more. “Trading down” is a phenomenon that only partially compensate this dynamic. Staples in emerging markets cannot be promoted: street markets are already very competitive. Hence the need to price on immediately the surging price of inputs. Hence the lack of “consumer illusion”, hence the protest.
Now, why all this is relevant to the stock markets? Middle class consumers in mature markets are starting to wake up to inflation. Fuel prices are soaring, food prices are on the up again, rates are increasing, mortgage rates never came down. The massive outflow of mutual funds shows that the middle class is starting to access retirement money to fund short term capital outlays. As short term cash flow pressure mounts, very little income can be set aside to buy the equity market. Equities have become inaccessible for a large number of households. Households cannot afford to “BUY THE FUKCING DIP”. There are growing concerns in many areas about the stability and solidity of an equity market when popular support falters. Some may say that governments are manipulating stock markets to create the illusion of wealth and manipulate perception on the true
state of the underlying economy. If that was the case, then the very same governments should be the first one to worry about the viability of this so called “ponzi scheme”. I suppose they probably would worry, and I sense that they are worrying already. If we buy the argument that governments are already retailers of financial instruments (debt, currencies and possibly equities, if we assume that they intervene in the market), then I think that they could learn a lesson from observing how retailers and chocolate manufacturers cope with food price inflation, as this could be a good analogy to equity price inflation and the crowding out of middle class investors.
Here is my proposal. Starting from the assumption that the equity market is probably a tad expensive on fundamentals, like the chocolate bar that prices at $1.20 even if really it should only be priced at $1.10, then governments should introduce “sale periods” and stock promotions. Sale periods would attract retail buyers “en masse”, awakening in them their “bargain hunting” animal spirit. Exchanges should be able to organize these sale periods in pre-market trading hours, on a quarterly basis. If shoppers are forming night queues for Iphone 4s, I am sure that they would turn on their laptops at 4am for a heavily discounted stock sale. Shares should be allocated on a first come first serve basis, like ticket concers on ebay, for limited amounts only. Companies that allow their shares to trade in this sale windows, should be granted presidential mention and a medal for helping to build their nation wealth. Stock promotions would instead be managed by company directors on a discretionary basis, and could be associated to disposal of personal holdings in the stock by the very same directors. Stocks sold on promotion would carry the same voting rights than any other stock. There should be a collateral agreement in place that as soon as promotion ends, those market participants that have deep enough pockets to “BUY THE FUKCING DIP” should intervene to readjust market prices. One particular mention should be made for stocks that are integral to the perception of the value of a country as a function of the performance of their equity markets: they should never be promoted, but given for free to selected retail buyers belonging to the lower classes. Amounts should be very limited, but it would be as close as it gets to set up a charitable foundation, with the added benefit of limited potential for tax avoidance.
I strongly believe that this would broaden the base of marginal buyers for equities, democratize once again the markets, increase government popularity amongst middle classes and finally it would help to finally shut up all criticism on excessive corporativism.