Wheeling and Dealing

What does a BMW M4 have in common with a BMW share? To the owner, both are assets that can be turned into cash at a known price. While I reckon you’d have more fun in the M4, you would fully expect to sell it for less than you paid. Not so with the share. This distinction between a tangible asset and a financial asset is clear. Other differences are a source of confusing and meaningless statements. For example, articles claiming that there is a stock of cash/bonds being “rotated” or about to “flow” into equities, gives the impression that the market for shares is like the market for the M4 – money being “rotated” into BMWs means that there will be more BMWs on the roads and BMWs will represent a greater share of total cars in use.

Applying this way of thinking to stocks is misleading since for every buyer of a share there is a seller, and on a net basis issuance of new shares is minuscule and possibly negative. The important factor to consider is not the amount of cash that a particular group may decide to invest in equities, instead it is the willingness to pay of that group relative to the willingness to receive of the prevailing owners of the asset.

If the new group has a higher willingness to pay for some structural reason, then the fact that they are “rotating” out of cash and into equities is an indication that prices will probably rise. But, markets are never segmented to that degree (even in the case of a short ban – see here). Perhaps retail investors have a reputation for being less discerning in the price they are willing to pay, but more often they delegate to a professional who is. So, an increase in flows into mutual funds from retail investors does not mean that, in aggregate, mutual fund managers (who operate in a competitive market) are going to change the price they are willing to pay for a particular security.

Ultimately, the prices of equities depend on discount rates and expectations of cash flows. Talking about those committing more of their money to mutual funds, for example, is not informative, since it is always only one side of the story. Similarly, statements claiming to explain why prices moved higher such as “there are more buyers than sellers” are equally useless. There could be hundreds of buyers willing to buy all shares of a company at $10, when a stock is priced at $11. Buyers and sellers have to be equal in terms of volume, always, and the price is a function of the willingness to pay/receive of each group. Price changes because the willingness to pay changes.

Willingness to pay is not an easy concept to think about. But it sits at the core of investing. It’s another way of thinking about the cost of capital. Vague concepts such as the “Great Rotation” and “net flows into mutual funds” are not instructive in determining the cost of capital and add little value to the capital allocation process.