Future Role for Banks Shrinking?

Historically the role of the banks was essentially to transmit the impulses of the central banking system. In that transmitting capacity, banks ran the risk of insolvency if and when the central bank decided to "tighten" money supply either through higher reserve requirements or higher interest rates or tightened lending standards. A conservative bank culture typically allowed the bank to survive a periodic tightening and expand during other periods. At the end of the day, it was a good job with a franchise on the money creation powers of an expanding economy. A good bank culture allowed a profitable ride on a rising economy with little loss of market share.

However, as the bond market revved up with the support of credit rating agencies such as Moody's and Standard and Poor's, the banks began the journey towards being disintermediated. Market share was diminished in the form of moving from the net interest spreads on large loans to investment banking fees to underwrite bonds. Gradually the outlines of a "bypass" of the middleman of banks occurred in the largest segments. This large debt market bypass was completed as the Federal Reserve, under the demands of the Covid-related lockdowns, purchased these bonds. 

At the same time, banks have increasingly standardized their loans to conform to be packaged into securitizations. This role, like that of the investment banking one above, does not necessarily require the powers to create currency to handle. Witness the proliferation of mortgage brokers. Again, as the Federal Reserve purchases these assets, the critical link of the bank becomes less critical. It appears to me that banks are increasingly losing market share in their primary function while the Fed's visibility and active role increases. 

The long term implications are such that banks need to reposition themselves. First Republic Bank is a particularly attractive model - driven by a financial planning know your customer lead and followed by lending and asset management. However, the lower end of the market is wide open and most critically to be determined by payment systems and technology. For this reason, payment processing companies have developed market capitalizations that dwarf those of banks.

Fed Lag Times

Yesterday marked a milestone as the wife of a friend of mine received the vaccine shot for Covid-19. With that milestone achieved, we move closer to the day of reckoning when the Federal Reserve starts to remove liquidity support and tighten. This will be an epic move.

The Fed's moves take about 6-18 months to show up in the economy. However, the responses in March were almost instantaneous as multiple approaches, both fiscal and monetary were implemented. In addition, market participants sharply changed with the visible engagement of the Fed.

With the market, especially in the technology sector (examples are too numerous to mention), experiencing unprecedented bubble characteristics, the Fed will have no choice but to remove support without impairing the real economy. To do this will require fiscal support to step up its pace. If the fiscal support does not show up, the Fed will have to wait.

The likely trajectory is that fiscal support does show up, however, both for small businesses and in the form of direct individual supports. This is reasonable as the Fed's actions have overwhelmingly been a "wealth effect" for the higher income and net worth segments of the economy. 

As this support shows up and the vaccine takes hold, likely pent up demand will drive a strong economic recovery. In the face of such strength, the Fed will have the opportunity to tighten while communicating that the Fed will be "measured" in its response. Given the Fed's typical lag time, the Fed can waste no time in implementing early actions - at the very least in the form of Quantitative Tightening to shrink its bloated balance sheet.

Beyond that initial point, the Fed must tighten until a blood-letting occurs in the technology sector - at the very least. Given the length of time it takes before the Fed begins its tightening journey and then the lag effect, 2021 could be a buoyant period. Beyond that though, bond buyers and Big Tech investors may have significant opportunities.

Bubblenomics

The Bubble is back. In a world of paper money, then Chairman of the Federal Reserve Alan Greenspan commented that part of his job was to make sure that paper money retained value as if it were gold. At that time, I took his comment to apply strictly to the framework of inflation. Yet since then, I have seen that his comments also referenced asset inflation or "bubbles." 

Although Chairman Greenspan claimed that he did not have the ability to spot bubbles, he did take action against the Tech Bubble of 1999. He consistently tightened money supply until short-term and long-term rates reached high levels despite a notable absence of inflation. What was he acting against if not the perception of a bubble?

Those actions contrast sharply with the current market. Despite similar bubbly valuations in a wide range of noticeably unprofitable companies such as Snowflake or Tesla, the Federal Reserve is forced to support liquidity and market euphoria. With political tension in rapid decline, people are able to turn their attention to the dramatic rise of the stock market and ask themselves, "does this make sense?"

I finally understand why the Fed always takes away the punch bowl when the party gets fun. It is not simply so that inflationary structures get built in. It is also to discourage speculation and gambling as activities that denigrate the fundamental concept of hard work as the way to build wealth. There is a moral structure built into the Fed's design. Further, the Fed has to be careful about how many "white elephants" get built with cheap capital combined with rosy projections. Those structures are sunk costs.

But as long as the Fed is required to support a Covid-impaired economy, it appears to me that the punch bowl is here to stay.  It will be taken away at the first opportunity. When that punch bowl removal happens or is perceived to be likely, the notion of a punch hangover will wreak havoc on valuations in these bubbly areas. Caveat investor.

What is the future of Health Insurance?

During this season of discord, the topic of health insurance arises frequently. US health insurance is unlike other systems in the world because it has a private enterprise core to it. With this type of incentive structure, various strengths and weaknesses emerge and are bitterly debated. Sometimes the best way to address disagreements is to start at the beginning. 

US health insurance did not arise from the Federal Government. Instead, health insurance arose during World War II as a means of attracting and retaining workers. Wage controls had limited the prices that could be paid to workers, but "fringe benefits," such as health insurance, were allowed. The benefit of health insurance became enormously popular and due to wide adoption became a fixture in the average American's financial picture.

Clearly this structure meant several things. First, it meant that the people most likely to need health insurance - such as the elderly or disabled - were unable to attain coverage. Second, it meant that the health insurance premiums were exceptionally low with superior benefits, due to covering only the healthiest population. This meant that cultural expectations were developed for high quality coverage. Third, it meant that the identity of this high quality coverage at modest prices made it difficult to expand to expand it to the non-working population.

As a result, the working population became fiercely dedicated to the idea of such outsize benefits and loathe to give them up to some "universal health" plan. At the same time, the non-working population became increasingly frustrated with what was developing into an inordinately expensive system for its own higher utilization needs. 

The advocates of private insurance are correct in their perception of a superior system - for those who participate. However, I think that the issue of a general standard level of healthcare for all has to be made available. The legitimate fears of the beneficiaries of the current system are that such a general, standard level would either demand the diminution of current plans or an unmanageable expense load would occur by expanding such benefits to the entire population. 

The crucial discussion, then, seems to be how the U.S. could deliver a standardized healthcare plan for all - akin to the public school system - while protecting and allowing for the maintenance of the much more expensive system of employer healthcare - akin to the private school system. To some extent, it would seem the key is what is deemed "essential."

Ownership Impact

I have been amazed by the impact that ownership has on my thinking. Often I place a price on a security and am unwilling to pay more than this price. Yet, if I have the opportunity to purchase the security at my price and it rises in value on the following day, I am unwilling to sell it. This spread between my willingness to purchase and my willingness to sell is my Ownership Impact.

This Ownership Impact is the basis for a framework to "buy low and sell high." In essence, I am willing to be forced to become an owner if the price is lower than a specified amount and am forced to leave my ownership if the price is above a specified amount. However, this Ownership Impact is somewhat irrational in that if I buy something for $10 and am only willing to sell for $20, why wouldn't $11 be appropriate for new money added? After all, everything I own, am I not essentially repurchasing everyday (assuming frictional costs are negligible).

I discovered a recent article that discussed how deeply hard-wired these behaviors might be. Some researchers at Johns Hopkins focused on how our preferences for something deepen because we chose them. They brought 10- to 20-month-old babies into a lab and gave them a choice of objects to play with - two equally bright and colorful soft blocks. They set each block far apart, so the babies had to crawl to one or the other.

After the baby chose one of the toys, the researchers took it away and came back with a new option. The baby could then pick from the toy he or she didn't play with the first time, or a brand new toy. The baby reliably chose to play with the new object rather than the one they had previously not chosen, as if saying, "Hmm, I didn't choose that object last time, I guess I didn't like it very much." That is the core phenomenon.

It appears that this dynamic is working in reverse to drive my Ownership Impact - that once I have chosen something it is endowed with value. Conversely, once I have not chosen something, I develop an aversion to it. Such lurking biases are important to identify and overcome if good choices are to result.

You Can Only Sell It Once

I heard the phrase "you can only sell it once" from an astute real estate investor. I did not see this wisdom as applicable to the stock market because Mr. Market offers pricing everyday on every security. However, since that time, I have come to see it as partially applicable.

Most businesses are simply businesses. With an adequate amount of capital, these businesses could be replicated. Yet there are some businesses where no amount of capital can replace them. These businesses could be termed "irreplaceables" or franchises. My real estate friend's outlook is applicable to these companies because such franchises accrue value at a return on capital higher than the growth rate of their environment. "Buy, don't sell" could be the subtitle on these companies.

Examples from the past were brands like Coca-Cola or Hershey's. In today's world, the creativity and changing tastes of millennials has made these brands less irreplaceable. More of these irreplaceables are now in the tech world. The sheer scale of  Mastercard's reach or Facebook's address book makes them franchises. More importantly for the appropriate sale of such companies is the identification of a movement to being a replaceable from being an irreplaceable, as occurred to the Washington Post on the advent of the internet.

Financial Ratios: Signposts not Goalposts

Financial ratios are important to the investor and I group them into two categories: operating ratios and market ratios. The former address the operating characteristics of the business, such as "net profit margin." This takes the "net profits" (addressed in a prior post) and divides it by revenues. These ratios are important to understanding the business models itself. 

Market ratios, on the other hand, reveal the general assessment of the value of the business. There are several, but the most attended is the "P/E ratio," which means Price to Earnings. Like any measure, simplification has occurred and is important. Any time a "P/E" is discussed, an investor should ask does this mean Price to last year's Earnings or Price to Trailing Twelve Months Earnings or Price to next year's Earnings. I have seen all of these used almost interchangeably. 

As companies continue to creatively account for and present their results, the investor needs to use these ratios as a passageway to gaining greater qualitative understanding. For years, the "value" investor was simply focused on such ratios as a means of identifying a "margin of safety." In a world of change accelerating by globalization, the internet and cheap capital, such ratios may be misleading if they are not specifically connected to underlying qualities.