It’s camping season. In fact, it looks like going camping is enjoying an incredible spike in popularity this year. After all, in the age of social distancing, what better getaway could a person ask for than to get lost in the wilderness?
One critical component of camping is building your campfire. As any good outdoorsperson could tell you, there is an art to building a good campfire that will stay lit and burn bright and warm until such a time that you choose to extinguish it. As I look forward to my family’s next trip into the woods, I find myself thinking about building a strong long-lasting campfire and my mind turns (as it is wont to do) to the investment markets.
I find that building a strong sustained stock market is not unlike building a proper campfire. There are certain key components that are necessary to get a good market started. There are different things needed to keep one burning strong. Lastly, there are certain items and tactics that can be used to revive one that may appear in danger of burning out. Just like with the campfire, improper application of overuse of any of these can lead to a cold and dark result.
Here some things you will need to build a roaring fire/market:
Oxygen/Buyers - Just like nothing can burn without oxygen, there can be no stock market without people/organizations willing to buy and sell shares. Technically, the only thing that can cause a stock price or a stock market to rise is the presence of more buying than selling. Just like a strong gust of wind can blow out a match though, a strong change in the behavior of buyers & sellers can quickly turn a market.
Dry Leaves/Low Interest Rates - There were about 4 months in the 47 years prior to September 2008 when the federal funds rate* fell below 1%. The current fed funds rate is one-tenth of one percent. Over the last eleven years, there have been less than 3 years when the rate was above 1%. This is all to say that in the past decade we have gotten far too accustomed to having dry leaves thrown onto our market campfire.
Throwing leaves on a fire makes perfect sense if it is in danger of going out. This is why FOMC* dropped interest rates so low when we were in the throes of the great recession. There is a danger to keeping rates at historical lows beyond when it is necessary though. It is not difficult for large corporations to increase their earnings when they can borrow at negligible cost. We saw a great deal of this by way of mergers and acquisitions, as well as corporate stock buybacks over the last decade. It doesn’t take a brilliant manager to increase profits by buying another profitable company using “free money.” What happens when interest rates inevitably increase again. Unlike in the forest, where there are a seemingly infinite number of leaves, there is a limit to how low interest rates can go and for how long.
Firewood/Good Businesses - Getting your campfire burning is always a bit “touch and go” until your first big log starts burning. Getting it going isn’t easy, but once it is on fire you can enjoy the knowledge that you will be warm for a while longer. It may be tricky to start, but a burning log won’t be blown out by a stiff breeze. Once that first log is burning, it creates an environment where other dry logs will catch fire as well and the resulting campfire can keep you warm for as long as you need it to. Well-run profitable businesses are a great deal like that firewood. It takes some effort, some favorable conditions, some patience, and maybe a little bit of luck to get one going. There is simply no substitute for good business however when it comes to building and sustaining a healthy equity market.
Lighter Fluid/The Fed’s Open Market Operations - In extreme situations, you may want something highly combustible to get your campfire to flare up immediately. Lighter fluid ought to do the trick! The tool of last resort for the investment markets is the ability of the Federal Reserve to engage in “Open Market Operations.” What this means is that the Fed can buy and sell securities on the open market. I won’t bore my readers with the details on this one, but will instead explain its similarities to lighter fluid. It is a good solution when you need a fire, but traditional methods don’t seem to be working. It is also not necessarily a good long term solution since the fluid may burn hot, doesn’t burn for long. Lastly, you’d better hope something else catches on fire before your fluid runs out.
There is a great deal of discussion lately about how our markets can be so seemingly detached from our economy. How can stocks appear to keep going up and up with millions of Americans out of work and countless businesses closed? The answer lies in the fact that there is more than one way to keep a campfire burning, and not all of them rely on firewood. The woodfires are just more sustainable.
In the campfire that is today’s stock market, there is no mistaking the fact that we are throwing leaves into the pit and are being rather generous with our use of lighter fluid. In addition to these factors, our oxygen supply has been boosted by the “Robinhood” investors who are using stimulus dollars to speculate on stocks. Even many businesses are seeing legitimate boosts in profits thanks to millions of Americans shopping with their stimulus money.
If you burn a pile of leaves and lighter fluid, you are going to create a great deal of smoke. The question worth asking as you look through that smoke is whether or not you can see any logs burning. That’s what it will take to make this fire last.
Related: When Good Advice Goes Bad
*The fed funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. The current federal funds rate as of July 28, 2020, is 0.10%.