Political risk is the single biggest danger that stock market investors face today. And although this chimera has been steadily growing for year after year, it receives curiously little attention in the financial press.
What is political risk in the context of investing?
Simply put, it is the possibility that politicians will institute new rules, taxes or regulations that significantly reduce the value of publicly traded securities. And while it might be impossible to imagine the newly installed Biden administration taking any substantive steps toward disinheriting our current corporate overlords, I assure you that if the economy continues to fail the average person, a different, more economically populist administration will eventually be voted into office.
But why has political risk gotten so little recognition even as it looms gray and monstrous on the investment horizon?
I think we can all hazard a reasonable guess as to why financial media outlets such as CNBC, Bloomberg and the Wall Street Journal don’t want to have a serious discussion about political risk.
It spooks the muppets.
For those of you not up on the latest stock market lingo, muppet is a derisive term for a neophyte or unknowledgeable investor. It seems to have originated in the halls of that deeply corrupt institution, Goldman Sachs, where executives would often use it to refer to oblivious clients the company was secretly trading against.
In any case, you don’t want to be a muppet. Muppets involuntarily transfer their wealth to too-big-too-fail banks and other financial monopolists. Muppets are cannon fodder for hedge funds, investment banks, professional day-traders and other sophisticated financial players. Muppets perennially lose money.
Stock market participants, muppets included, are largely ignoring the gargantuan political risks that are steadily building in our economy. And that’s exactly why I want to talk about it.
Before we get started, I want to clarify that there are ultimately only a handful of ways to recover your money after investing in a stock:
1) You can sell your shares to someone else for cash.
2) The company can pay out dividends from earnings. Although it usually takes a considerable period of time, eventually you can recoup your initial investment. Any dividends paid out after your breakeven point is reached become a gain.
3) The company can be acquired by another company, which will pay via cash, shares or a combination of the two. If the acquiring company pays with cash, then you have crystallized your gains and truly gotten your money back.
But if the acquiring company pays either partially or fully via shares, then you really haven’t gotten all your money back yet. Instead, you’re left holding at least some shares in the new, acquiring company. In this case, refer back to items 1 through 3 to recover the rest of your money.
4) The company can be taken private. This is a lot like an acquisition by another company, except that the buyout is usually conducted by either a private equity firm or management. These are always paid in cash which is generally funded by debt. As a result, these acquisitions often go by the term “leveraged buyout”.
A major limitation on taking a company private is size; it simply isn’t viable beyond a certain market cap. The largest such privatization in history to date was the utility firm TXU energy, which was swallowed up by a leveraged buyout in 2007 for the sum of $32.1 billion. This might seem like a huge amount of money, but many, many firms that are household names are far too large to benefit from leveraged buyouts. For example, Walmart (market cap of $394 billion), PayPal ($283 billion), Nike ($214 billion), PepsiCo ($189 billion) and countless other well-known companies are much too large to be taken private.
In addition, market conditions must be just right (read: frothy) for most leveraged buyouts to occur. It is no coincidence that 7 out of the 10 of the biggest leveraged buyouts happened during the 2006-2007 timeframe (right around the peak of the housing bubble).
5) The company can voluntarily decide to cease operations and liquidate its assets. The proceeds must first be used to pay off any outstanding financial obligations (bonds, leases, salaries and pensions, etc.) before the remainder can be equally distributed to shareholders. In reality, voluntary liquidations never happen. As a rule, the management of a company will never willingly liquidate their firm as doing so would put them all out of a job.
Instead, almost all companies end their days with an involuntary bankruptcy filing once their financial condition deteriorates sufficiently. In this case shares end up being worthless.
So it should be clear from our above list that there are only a precious few ways to recoup an investment in common stock once you make it. And that finite number of possibilities shrinks even further when we strip out voluntary liquidations, which almost never happen. I would also like to note that selling your shares to someone else is only really viable if the recipient either believes that 1) the company will pay a strong dividend stream in the future or 2) that they will be able to sell the shares to someone else for even more money later (aka the greater fool theory of investing).
This is important because much like humans, corporations have finite lifespans. We all hope we invest in the next Coca-Cola or Ford – companies that have survived for more than a century. But such superlative firms are few and far between. Instead, we are far more likely to sink our money into pedestrian companies that will only survive a few decades at best. And if we want to turn a profit, we have to make sure we recover our money (and a little more as well) before they go belly-up.
And all this assumes that we live in a financially stable world, which we do not at the present. Instead, we are all swimming in a metaphorical ocean of political risk.
For example, it isn’t too hard to see a future where politicians looking to mitigate anthropogenic climate change levy a series of onerous carbon taxes. This would immediately endanger the viability of numerous companies in the oil and gas sector.
In fact, the coal mining sector has more or less experienced a similar outcome already. While the fundamentals had been moving against coal extraction for some time, implicit government hostility toward that most polluting of fossil fuels was the final nail in the industry’s coffin.
I would also like to point out that political risk for the energy sector is completely disconnected from the actual sensitivity of the climate to changes in atmospheric levels of carbon-dioxide. For investors, whether 450 ppm of CO2 signals imminent environmental apocalypse or not is ultimately immaterial. All that matters is that a future political administration perceives relatively high atmospheric CO2 levels as being an existential threat to civilization and acts accordingly.
Much-needed financial sector reform is another event that could suddenly and violently re-orient the capital markets to the great detriment of shareholders. Although it might seem fantastical today, I have no difficultly envisioning a situation where a future populist government resolves to nationalize the corrupt too-big-too-too-fail banks: Citigroup, J.P. Morgan, Wells Fargo, Bank of America, et al.
We can’t say exactly how it would happen, but it could be as straightforward as an outright seizure of bank shares without compensation by the government. And while I believe that depositors and CD holders would certainly be made whole, bondholders might find themselves dispossessed just like equity holders.
Make no mistake, if our venal mega-banks were nationalized, most working-class Americans would cheer the action on. In fact, it has been my longstanding supposition that the first American Presidential candidate who credibly promises to liquidate Goldman Sachs by any means necessary will easily win the highest office in the land.
Of course we don’t need an outright seizure of banking shares in order to create massive losses for equity investors. If the U.S. Federal Reserve should ever institute a fully-digital dollar, it would have the side effect of disintermediating nearly the entire banking sector in an instant. That would mean banks would enjoy dramatically lower levels of deposits, loans and, subsequently, profits.
Shareholders would be massacred.
Another area ripe for the bitter harvest of political risk is the technology sector. Google, Facebook, Twitter and Amazon have all proven themselves to be incorrigible monopolists. They apply suffocating control over key areas of the information economy, snuffing out lesser competitors on a whim.
It isn’t very difficult to imagine a future where a hostile political administration decides to vigorously apply heretofore neglected anti-trust regulations to these technology behemoths. In a best case scenario for investors, these companies would simply be broken up. But it is just as easy to see a future where the firms are nationalized or even turned into non-profits! In either case, shareholders would surely suffer great financial loss.
The healthcare sector is also horribly exposed to political risk. The price of both medical services and health insurance in the United States has been rising far above the rate of inflation for decades. At this point healthcare has become utterly unaffordable to the average U.S. citizen, making it a leading cause of personal bankruptcy. And although the Affordable Care Act (otherwise known as Obamacare) mandated health insurance coverage for nearly every citizen, the legislation did absolutely nothing to curtail skyrocketing costs.
If major healthcare reform were to pass congress and be signed into law, it could be devastating for investors in healthcare firms. For example, the popular idea of “Medicare for All” would more or less put the entire health insurance sector out of business overnight. Even if that doesn’t happen, it is easy to see a future where prices or profit margins for medical procedures are capped across the board.
I wouldn’t be surprised if a future administration, spurred on by an outraged populous, simply voided patent protections on all existing pharmaceutical products. If these political risks weren’t enough to frighten you, outright nationalization also remains a distinct possibility.
In light of the myriad political risks in today’s market environment, investors would be wise to demand a quick return of their principal. In short, it is vital to get paid back on your investments before political risk intervenes and flips the financial game board over.
Unfortunately, one simply has to casually examine the U.S. stock market to see that many people haven’t put much thought into how they are going to recover their money.
Despite being obscenely successful, tech giants Alphabet (Google’s parent company), Amazon, Netflix and Facebook don’t pay any dividends currently and have no plans to do so in the immediate future. Other corporate behemoths such as Microsoft, Apple, Johnson & Johnson and Visa do pay dividends, but do so at such a low rate that it will take many decades for an investor to recover his principal.
For example, as of February 2021 Apple has a dividend yield of 0.60%. If the dividend doesn’t change from its current level, it would take an investor 166 years to break even on an investment made today. Even if we assume that Apple grows its dividend at an unrealistically robust 10% annual rate from now until eternity, it will still take you over 30 years to get your principal back. And you will have to wait even longer (and assume perfect financial conditions persist for the entire time) if you hope to make a profit on your investment!
The bottom line is that you can’t expect to make your money back in a reasonable length of time on many stock investments made today. But don’t worry! Most investors implicitly believe they will just be able to flip their shares to someone else when the time comes – a classic hallmark of bubble psychology.
In fact, our current stock market mania is undoubtedly the most extreme in financial history. It exceeds the Japanese equity bubble of the late 1980s, the British South Seas Bubble of the 1720s and the infamous late 1920s DJIA bubble that preceded the Great Depression of the 1930s. Indeed, today’s speculative excesses in stocks, crypto-currencies and bonds are so extraordinary that they even make the hopelessly irrational Dutch tulip-mania of the 1630s seem downright sober by comparison.
Insanity doesn’t even begin to describe our dysfunctional capital markets these days.
And don’t think for a moment that you’ll be able to sell before things fall apart either. The suggestion that the average investor will somehow figure out the game is unraveling and head for the exits just before political risk manifests itself in portfolio-destroying nationalizations, patent cancellations or windfall profit taxes is just hubris. This is especially so when corporate insiders and connected political players will undoubtedly be tipped off about what is going to transpire long before you or I will get the memo.
In the end analysis, political risk isn’t simply one of the biggest dangers of a dysfunctional stock market – it is the defining risk of a global economic system that is rapidly spinning out of control. This is why I advocate for intelligent investors to carefully accumulate high quality tangible assets such as precious metals, antiques, gemstones and fine art. Hard assets will act as a hedge against the massive economic dislocations that are sure to rock the financial world in coming years.
Smart investors will own some tangible assets and avoid financial heartache; muppets won’t. Don’t be a muppet.
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