What is the market discounting?

Bloomberg pulled no punches this morning:

“One of the toughest years for financial markets in half a century got appreciably worse Tuesday, with simmering weakness across assets boiling over to leave investors with virtually nowhere to hide.”

The strange thing is, even the media is struggling to explain the drop. Usually they have no trouble associating market crashes with some sort of narrative.

Trump’s trade wars, Brexit, Italy’s budget belligerence, higher interest rates in the US and emerging market debt are the default options for headline writers lately.

So which is it this week? What is the market discounting?

And what is discounting anyway?

It isn’t the idea that stocks are on sale at a discount. In fact, it’s precisely the opposite. If you believe in the theory of discounting, it suggests stocks are accurately pricing in a major risk of something going wrong.

Today, I ask what that risk is. But you need to understand discounting first.

Discounting is a seriously painful concept to grasp. The sort of abstraction that separates finance from accounting. But let’s try the intuitive explanation and leave out the math.

In the accounting world, a pound is a pound. In the finance world, they laugh most haughtily at this fallacy.

In finance, you introduce the questions of “when do I get it”, “what else could I be earning in the meantime” and “at what risk”. Discounting attempts to figure out what the promise of a future pound is worth today. And it depends on what answers you give to the sorts of questions I mentioned.

So the essence of discounting is simple. A pound today is not worth a pound tomorrow. Why? A pound today can be invested to generate a return, making it more valuable than the same pound in the future. A pound today is risk free, not a promise that might not be paid tomorrow. And a pound today hasn’t been devalued by inflation, yet.

The value of an investment can be calculated based on the cash it promises to pay you in the future. But each cash flow is worth less the further in the future it is promised because of all the things that could go wrong in the meantime. Calculating the value of the asset is called “discounting” because you have to adjust the value of the future payment by the risks.

The stock market is sometimes called a discounting machine. It does the job of analysing the future for you, and tells you what stocks are really worth based on the risks.

But you can reverse the process. If you take the price of investments (stocks) as a given, you can figure out what the risks are in the future.

When stock markets expect a recession, they fall. They’re anticipating the risk of lower profits leading to lower dividends, which means lower cash flows for investors. Incidentally, the year so far is an all-time record for dividend payments by companies on global stock markets.

The point is that investment prices are a signal about future risks, because they tell you about future returns. The process of calculating the right price based on the risks is called discounting.

So what is the market discounting when it tumbles? What risks does it foresee?

Could it be trouble in Italy?

That’s what I warned Zero Hour Alert readers about on Friday. I predicted turmoil to return to markets from Monday: “Which is why 19 November is the next crashpoint on the calendar.”

That’s what I warned Zero Hour Alert readers about on Friday. I predicted turmoil to return to markets from Monday: “Which is why 19 November is the next crashpoint on the calendar.”

I can’t reveal why Monday was the key. But given the tumbling stock market since, I hope readers positioned themselves to profit in the ways outlined in their supplementary reports.

I explain why Italy is in so much trouble here. And why the UK can’t avoid the biggest financial crisis in history.

Amongst the regular deluge of news about Italy, two new interesting developments featured. The first comes from Bloomberg:

“Fresh evidence of the damage done to market confidence came at a sale of inflation-linked securities, historically popular with Italian retail investors, which has so far seen less than a fifth of the demand at a similar offering in May. The poor response comes ahead of a European Commission report due Wednesday that could say Italy’s 2019 budget is in breach of European Union fiscal rules, raising the threat of fines on the country.”

The Italians are beginning to have their doubts about their government. Well, the Italians with money are. What’s left of them. And what’s left of their money inside Italy.

I’m still worried one particular news item due in two weeks’ time will trigger market chaos. It will reveal major capital flight out of Italy. The sort that triggered Cyprus’ financial implosion.

But I might be wrong. This morning, blogs and news aggregation sites are reporting that Italy’s minister of troublemaking Mateo Salvini told an Italian newspaper he is open to a compromise on the budget.

Is the news legitimate? We’ve had this sort of news before, but it turned out to be false. The Italian market is up this morning. Which could be another tremendous time to implement our Zero Hour Alert advice and profit from the coming plunge.

The stock market rally might not even last the day. There is a chance the EU Commission will reveal its intention to sanction Italy today. The European Commission’s report on Italy’s budget is due out. And that would form the basis of beginning the sanctions process. That would make Italian stocks plunge.

This story is closely related to my warning about what happened on Monday. I argued that the power and intent to sanction Italy rests outside the EU’s official channels. The Commission is merely a tool for the powers that be in Europe.

But Italy can’t trigger global stock market plunges, can it?

Well, an Italian default would be several times larger than Lehman Brothers…

There’s so much going on in Italy it’s hard to consider the other crises the stock market might be discounting.

Perhaps it’s Brexit that’s causing the carnage. The UK media probably thinks so.

But it’s unlikely given the FTSE100 is doing better than other key indices around the world.

Trump will be telling the world that the blame for falling stocks rests with the Democrats and the Federal Reserve. The former won’t pass more of his economic policies which goosed the US stock market until October. And the latter is threatening to raise interest rates. Interest rate upcycles always end in crisis somewhere.

The question used to be where. But perhaps all financial crises are now global anyway. And those hardest hit will simply be the financial centres. Like the UK.

Until next time,

Nick Hubble
Capital & Conflict

Category: Market updates

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