Submitted by ThetaGangThroweway t3_10oge5g in wallstreetbets
A lot of people are predicting a recession to match the SPY's 18% drop, and I have no doubt they'll all say "I told you so" regardless of anything happening. However, there's something much more fundamental the last couple years of market performance and Fed policy show.
Between the adoption of greenbacks and the 2020 Covid Panic, the Fed had a generous Federal Funds rate. That is the rate they both borrow and lend at, which was generally very low, generally roughly 1% above the expected rate of inflation. This was to allow people and businesses to borrow as much as they need, and was helped along by many subsidized lending programs. A great case in point is student debt, which is artificially cheap for people from middle class families and poorer families get literal free money in the form of pell grants. This vastly increased the number of people attending college, far beyond the actual demand among employers for degree baring persons. While we can excuse this because we think education makes for more refined and productive people, you also get absurd situations like mine where I have no intention of becoming a professor but I'm still in grad school for the fun of it.
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However, this spills over into stocks and bonds. Simply put, banks lend to each other at a rate proportional to the rate the Feds lend at. Obviously, if one bank is going to give the other an overnight loan, they must pay them a little more than an equivalent T-bill to make it worth their while. Likewise, all other loans are calculated at the rate of an equivalent T-bill plus the default risk.
Stocks are no different because equity funding simply shifts the risk from the lender to the borrower. Ergo, the value of a growth stock is calculated as the value of future expected earnings, minus the risk of missing that goal, minus the default risk, minus the payout of a T-bill expiring around the same time. You see why many companies choose to stay private, as the execs may have a great business model and want to keep all the money for themselves even if that means growing slower.
EVEN CALL OPTIONS have prices dictated by the Federal Funds Rate. This is because of options arbitrage where the dealers with their computers trading will buy or sell any option you like, but seek to do so risk free. A risk free option spread is to buy 100 shares, sell a call, then buy a put at the same strike. No computer will trade this spread unless the return is equal to the return of a T-bill over the same period, minus any expected dividends. This makes sense, as calls are naturally more expensive than puts because stocks can only lose 100% but they can gain any real number. The Federal Funds Rates only have a tiny effect on the price of short term calls, but add up to a lot with long term calls.
So, previously, the Fed's generously low-interest rates made it possible for anyone to borrow. This may be shown as a factor in the Housing Bubble, as a key point was that anyone could get a loan for a house and as long as you kept making payments and/or the value of the house went up then you can refinance a potentially infinite amount of times. BTW, refinancing is getting a new loan to pay an old one, and paying old debts with new debts is called a Ponzi scheme.
Accidental Ponzi schemes do appear to be a thing with the "blitzscalers." Simply put, since bonds return so little, there's tens of thousands of private equity firms and dozens of crowd funding websites where individuals seek out direct investments. This is how you get a lot of people whose net worth explode out of nowhere as these are fake rich people where private equity bought 49% of their firm at some arbitrary valuation, increasing the paper wealth of the execs overnight even though they were losing other people's money. However, if they did bring a marketable product, they could keep this going indefinitely using more and more equity funding to keep growing the business and allow previous investors to exit at a profit.
Most current allegedly self-made billionaires have done this, and for every one of them that made it, a thousand other equally talented men have failed. From Bill Gates to Trevor Milton, the latter illustrating how you don't actually need a profitable business to get equity funding.
We saw what the extremes of this will do 2020-2021, where near zero T-bill rates sent the value of everything up as any return was better than the Federal Funds Rate and people could borrow to invest. Just as in 1928 when even the shoe shine boy on the street was giving stock picks, in 2021 there were millions of sports fans and total amateurs on the internet giving their own stock picks. This produced the "everything bubble" where long-short strategies simply broke because everything was going up. Fortunately, the Fed burst that bubble by raising interest rates so they could delete all the money they printed during lockdown.
But you see a curious effect in the markets. First off we see the ousting of all the fools and frauds dependent on burning other people's money. China's housing market collapsed, crypto firms collapsed, and biotech collapsed. All private equity firms are no longer open to new investments, and voice of experience from the crowdfunding scene the place is dead. Whole countries like Egypt, Lebanon, and Turkey have become insolvent because they can no longer pay old debts with new ones. Retail trading has plummeted, as even the men who are still invested are trading less and putting less of their money into stocks. Likewise, interest in subs like this has plummeted even as the member rolls stay long people are simply not visiting trading subs so much.
Now, let us do a thought experiment with the extreme. What happens if the Fed offers a return on T-bills roughly equal to the return of the SPY (say 10%)? In this environment, there would be no reason to trade stocks at all. All stock exchanges would collapse and see vastly reduced trading volumes, with most smaller exchanges closing completely. The effect would be most extreme in developing countries with high degrees of correlation to the US economy, like India, China, Latin America, Africa, and other places. In these countries, not only would stock trading cease but many countries would have to enforce capital controls to stop the flow of money out of the country into the T-bills of the US and US-alligned states.
Most developed countries will see their own government borrowing rates drop immediately. In places like Europe, Canada, and Japan most investors are already invested in US stocks and will simply dump both stocks and their native T-bills in order to loan to the Fed. Stock prices will be so cheap that often the only buyers will be insiders taking their companies private at a good price, with many of these firms switching to selling thing to the government because the government suddenly has lots of money.
Of course you're thinking "Why on Earth would they do that, though?" Simple: A world war.
We've had a conspicuously long period of uninterrupted peace, with very few states ever committing more than 10% of their forces to any given war ever since the conclusion of WWII. However it starts, you can be sure that the Fed can obtain funding for such a war WITHIN WEEKS via the unlimited sale of bonds, and effectively militarize the economy within months. You might think government contractors would be the exception to this, but those are simply the men selling things to the government right now. During the World Wars, sometimes the government set up their own factories in order to meet demand. Also, there are few restrictions who can sell things to the government, and private corporations of all sorts will jump into the war effort, bring down the market share of current defense giants. But more importantly, mercenaries are the historic norm, not the exception, and these kinds of contractors and volunteer organizations can appear out of nowhere as gangs of men use their own gear and recruit their own subordinates (most countries use armed contractors to some capacity already).
But I guess the point is, corporate valuations are as arbitrary as the inflation rate because they can drop to near zero due to events they have no control over. Likewise, while it seems generous for the government to offer low-interest loans, doing so encourages high-risk behavior. Likewise, the government offering to borrow at high-interest rates encourages low-risk behavior. Niccolo Machiavelli himself said that while it would be wonderful for a government to be truly generous, spending tax money in such a manner can be irresponsible if there's nothing gained in return.
We're only a free market for as long as the bosses allow it. It has always been so.
Careless-Pin-2852 t1_j6eg9lr wrote
God dude when ever I post i have a rule 10 sentences max. I get posts knocked out because i don’t post all the minimums. Like positions etc.
You did not need to write all that to say the fed with help with national security.