Dark Junk Epsilon
Epsilon is the difference between prediction and outcome. The stubborn call it error. Rather, it is the unexplained element of why things happen and where much of interest lies.
Ben Hunt calls his newsletter Epsilon Theory. It debates what happens behind the headlines. You can find the podcast here.
Ben was early to spot inflation and argues that it will persist. He expects central banks to raise target inflation to 3%. They must support financial markets with more money, particularly in the US ahead of the November election.
This is not part of any share valuation theory I was taught.
Popular science says we are 98% junk DNA. This is everything with no known biological function. It’s hard to imagine nature is that inefficient.
The vast dark regions of space are considered empty but what does that mean? Unobserved matter is still there and playing a role in the universe. One day humans will understand.
When commentators discuss markets they ignore epsilon. But this is where politics, narrative, behaviour and sentiment interact. Epsilon is why The Sniff Test is about finance, culture and politics.
They combine to create the grand vision of why things happen.
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Left-brained Logic
Psychiatrist Iain McGilchrist argues humans have become too left-brained. Traditionally, left brains are for logic, maths and verbal reasoning, while the right hemisphere is creative. McGilchrist explains it differently.
The two hemispheres have different values. The left wants to manipulate things, while the right seeks to understand. By becoming too left-brained we’ve assumed too much. By dismissing epsilon as error rather than the unexplained, our theories fail.
Here’s a chart of happiness versus income. There are three models represented by lines, with the blue one considered the best. Most dots are a distance from the line - that’s epsilon. This is where the explanation of individual happiness lies.
David Bahnsen wrote the book on dividend investing.
Barron’s, Forbes and The Financial Times list him as a top financial adviser. His theory is simple enough. Bahnsen states that the return of a stock market index is measured by:
Earnings per share growth + Dividend yield + Change in multiple
Let’s take a look.
Earnings per Share
Earnings per share are company profits divided by the number of shares. The more profits and the fewer shares, the more each share is worth.
Profits depend on sales and margins. Here margin is a catch all for operational profitability, taxation and capital structure. Other commentators dive deep into each of these. Bahnsen’s strength is saying only the net result matters.
Sales
In aggregate, company sales reflect economic expansion. This is stronger than many expected in the US and weaker elsewhere.
Pessimistic investors argue rising debt leads to falling growth. This is an article of faith. Bahnsen states it rather than debates it.
I discussed two views here and here. My conclusion, informed by
Michael Taylor
, is that debt alone does not topple empires. Assuming US debt is about to derail the economy is reverse induction. It’s arguing the sun won’t rise tomorrow because it always has done in the past.
For now, growth is positive and company sales keep rising.
Profit Margins
US company profit margins rose from 8% to 12% after the Global Financial Crisis. This moves money from labour to capital. It is why Trump is ahead in the swing state polls despite being in court.
Wages are rising at the fastest pace for years. This is because of inflation and workers may be keeping up, rather than becoming better off. Companies raise prices to pay higher wages and inflation rises. If not, margins fall.
What started this cycle?
Central banks are there to control inflation. The US Fed also worries about employment. Many feel its real purpose is to support the price of shares and bonds.
One way to juice markets is increasing the supply of credit. Banks prefer to lend to people who pay them back. Typically that’s richer companies and people with assets to pledge.
These same people own government debt and receive windfall income when interest rates rise. The combination of higher rates and continued flow of credit perpetuates the feel good of those invested in markets. How does credit boost margins?
Rising margins are a result of company efficiencies. But they are also because less competition makes it easy to raise prices. Biden has made this a political issue.
Investors are all-in on artificial intelligence boosting efficiency. The narrative is that its transformative power will keep markets rising. Technology enables companies to do more with less.
This means fewer existing jobs. But no technology to date resulted in fewer jobs in total. There is disruption in what and where jobs are, but the profits from technology determine spending and saving throughout the economy. New opportunities arise.
So margins go up? Not so fast.
For much of this century the world globalised. In practice, this meant shipping manufacturing to China. This is now reversing and the pattern of trade is changing. Russia reported the majority of its trade is now with Asia. Only Germany remains a top ten partner in the West.
The sanctions regime works when Russia depends on Europe, because Europe relies on Russian resources. The US imposes the regime and Europe pays.
Will Russia go back to supplying cheap raw materials to the West? Is China going to forget the technology embargo?
A period of capital investment is required to rebuild Western manufacturing. Margins may be squeezed.
Number of shares
Ben Hunt distinguishes coyotes from raccoons. The former are smart and know the theory. The latter are grifters and understand the practice. Share buybacks highlight the difference.
The number of shares listed on stock markets is falling. There are around 4,000 listed US companies, down from the peak of over 7,500 in 1997. One reason is private equity, which finances new companies and owns them longer than in the past. This is a tax break for the rich.
Another reason is companies buying each other. Low interest rates after 2008 signalled economic uncertainty while making money cheap. Rather than invest in capacity, companies borrowed and bought competitors, pushing up prices to repay the debt. The falling number of shares is the flipside of rising margins.
Buybacks are a third, but weaker explanation. In theory, companies buy their shares when there is nothing better to do with the money. In practice, they enable executives to sell options and be granted more. The number of shares falls a lot less than the announced buybacks.
The US introduced a 1% tax on buybacks. There were over $1 trillion in 2022 and $795 billion in 2023. In the UK, the Liberal Democrats propose a 4% tax on buybacks to force investment. UK companies will list in New York instead.
In the last week, the boss of Peel Hunt has decried the lack of new companies listing in the UK. He fears the London Stock Exchange will follow the Irish into irrelevance. This may get worse.
Dividend Yield
Dividends are cash payments to investors rather than investing in capacity or buybacks. Traditionally they’ve been seen as a signal of low growth opportunities. What you gain in income you lose in capital gains. Bahnsen disputes this.
Without growth, high dividend paying companies are similar to putting money in the bank and living off interest. It works provided you have a lot in the bank.
Bahnsen argues that certain companies pay dividends to signal strength and confidence. As a result the returns to shareholders are more reliable. Imagine two companies’ shares returning 10% a year. One has 5% price appreciation and 5% dividend yield. The other pays no dividend and rises 10% in price.
If the economy or market turns down, the dividend yield cannot fall below zero. Hence, an investor in the first company misses out on 5% growth. An investor in the other loses all the upside.
The success of dividend investing depends on slower growth. This is a pessimistic view of the world. Stocks paying high dividends have not performed well in recent years.
Bahnsen’s timing may now be right. Whether it’s debt, deglobalisation or inefficient investment in domestic manufacturing, there is a lot of epsilon on the horizon.
Multiple Expansion
Share price rises are observable. So are earnings per share and dividend yields. The difference in stock price changes and those three things, is the move in the multiple of earnings.
There is no explanation for why stocks trade at 22x, just the observation that they do. Multiple is epsilon because it is what is left over after an explanation. It depends on narratives, preferences and the unexplained.
A lot of the recent rise in share prices is due to higher multiples. At the current level it takes 22 years with no growth to get your money back. The theory is that investors must therefore be expecting strong earnings growth.
With margins likely to have peaked and less support from share buybacks, that puts a lot on sales growth. In turn, that requires strong economic growth.
The higher multiple of earnings is a result of monetary expansion. By buying lower risk government bonds, central banks forced investors to buyer higher risk assets. Consequently share prices went up. There’s no magic here.
Ben Hunt expects monetary expansion to continue through to the election. Thereafter bets are off. In hindsight, it’s easy to see why shares rose so much in the US. But in the years following the crisis a lot of people were pessimistic.
Waiting for Godot
In Beckett’s play Godot never arrives. For some this symbolises a search for meaning in a meaningless world. A triumph of left brain over right.
When stock price rises are justified by multiple expansion then theories may be viewed this way. If so much is unexplained, what is the benefit of the explanation?
The alternative is to assign a direct link between Fed policy and stock multiples. This is to admit that governments control markets. Many equity fund managers are some form of free marketeers. Such an admittance is inconceivable.
Better therefore to keep arguing that tomorrow will be different. The change will come, with the election as the next possible turning point.
As the world divides into two camps there is less money flowing into US markets. China, Russia and their allies invest at home. Given this, I’d expect the US to keep priming markets to manage the transition.
For over 20 years fund managers have sold UK shares and invested internationally. If polarisation restricts their choices, they may funnel even more money into the US. The UK stock market may hollow out before the US collapses.
This is the dollar milkshake theory. In a gathering crisis, the US sucks in everything, as milkshake is drawn from the bottom of a glass. The theory was developed to explain emerging market performance. It might apply to the whole Western world.
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