Further reading: Making sense of the upside-down

Fans of hit Netflix series Stranger Things will be familiar with the concept of ‘The Upside-Down’ - a parallel dimension to Earth dominated by unpredictable and often hostile forces, who in turn are governed by a malevolent superbeing. 

In 2020, investors should be able to relate to the idea of an upside-down world. Recent vaccine developments flipped the market on its head once more, with so-called ‘winners’ of the pandemic flying into reverse after a year of gains fuelled by unique trading conditions. Governments – our own superbeings – have shovelled capital into economies in order to keep companies and jobs afloat. O’Shaughnessy Asset Management’s 'Jesse Livermore' (a pseudonym presumably inspired by the father of day trading) has penned his own epic on upside-down markets, examining the case for bad news functioning as good news for investors, and vice versa.

At over 40,000 words, this treatise is by the author's own admission “very long”. It considers the idea that economic weakness, which is usually viewed in a negative light, can often form the basis for fiscal boosts, which in turn can benefit investors. The paper assesses the likely impact of fiscal policy on corporate profits, inflation and equity market valuations, and concludes that when certain economic policies allow, bad news can function as good news.

For example, in an 'upside-down market', a responsible government may seek to tackle aggregate spending at a time when the limited creation of new companies caps the recipients of fiscal injections. This serves as an advantage to investors, who may seek to capitalise on future earnings values at a great discount. Bad news, which has pummelled share prices and forced comprehensive change to the way we live our lives, acts as good news for the investor. Combined with loose monetary policy, such as negative interest rates (which make equities more attractive than bonds or cash), and crises could land a windfall for investors.

This doesn’t sound far from a promotion of Modern Monetary Theory (MMT), an economic concept that has become increasingly legitimate in recent years as a riposte to conventional economic doctrine. MMT expresses the view that currency issuers should prioritise leveraging fiscal policy to reach an appropriate level of inflation alongside other wider economic goals, instead of focusing on balancing the books. In other words, it’s a waste of time trying to slash budget deficits. Our superbeings should prioritise lifting the economy instead.

Mr Livermore acknowledges MMT in his report, arguing that as long as there are those who are willing to spend injected capital and provided that the economy has the capacity for this additional spending, inflation need not arise. “People on both sides of the aisle are increasingly coming to realise that fiscal policy is the ‘cheat code’ of economics,” he writes. “If you're willing to tolerate inflation risk, you can use it to achieve any nominal outcome that you want.” 

Not everyone is a fan of MMT, it must be said. Stephen King, a senior economic adviser at HSBC, dismisses it as “just fantasy” in a recent examination of the concept.

There are many lessons to draw from Upside-Down Markets, for fiscal doves, hawks and investors. The report plots a cautious trajectory for corporate profits using examples from the 1929 US stock crash and World War Two, illustrating the outcome of reticent fiscal policy in the former example and a spending boom in the latter, and arguing that withholding income represents a zero-sum game for economies. 

An examination of the causes of inflation follows, along with estimates of the inflationary consequences of fiscal and monetary reactions to the coronavirus pandemic. Mr Livermore concludes his paper with an estimate of the extent to which the price level and valuation of the S&P 500 would need to rise in order to restore average equity allocations to pre-pandemic levels. 

“The bullish asymmetry won’t last forever,” the author reflects. Go too hard on fiscal policy and inflation becomes a problem, potentially prompting tighter economic policy that increases the market’s downside potential. As valuations edge up in spite of the economic turmoil surrounding markets, one’s losses could be substantial. Upside-Down Markets is a creative thought experiment and an excellent economic history. It is worth reading alongside contrasting takes on ‘whatever it takes’ economic policy.

You can access Jesse Livermore’s ‘Upside-Down Markets: Profits, Inflation and Equity Valuation in Fiscal Policy Regimes’ free online, via this link.

For more on Modern Monetary Theory and what it might mean for your investments, here is Algy Hall’s quick overview and Neil Wilson’s deeper dive into MMT.