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Guest Post: Trading on Yesterday's News – What Does the Stock Market Really 'Know'?

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Submitted by Pater Tenebrarum of Acting Man blog,

The Stock Market as a 'Discounting Mechanism'

We have critically examined the question of whether the stock market 'discounts' anything on several previous occasions. The question was for instance raised in the context of what happened in the second half of 2007.

Surely by October 2007 it must have been crystal clear even to people with the intellectual capacity of a lamp post and the attention span of a fly that something was greatly amiss in the mortgage credit market. Several sub-prime lenders had gone bankrupt back in February of 2007 already, and two Bear Stearns hedge funds speculating in sub-prime mortgage backed CDOs had lost all of their value by mid July and had to be shut down.

Both the ECB and the Fed had begun to take emergency measures to keep the banking system from keeling over in August – the former injected what were then huge amounts (close to €100 billion) into the banking system as a prominent French bank (BNP if memory serves) began to run into funding trouble. The latter enacted a 'surprise' rate cut in August – by October 2007, the effective Federal Funds rate had plummeted from 525 basis points to 475 basis points, by the end of December it stood at a mere 425 basis points.

It was impossible not to know what was going on. The Markit ABX.HE indexes that are used to hedge pools of mortgage debt had become a popular gauge for the health of the mortgage market, and the lower rated indexes were clearly in free-fall – this was the stuff mortgage debt insurers like MBI and ABK as well as AIG had written credit default swaps on, in amounts that exceeded their capital and reserves by orders of magnitude – contractual obligations that they could not in a million years have paid out if the guarantees were actually called in. For several quarters AIG's management even professed to be unable to determine the actual size of the associated liabilities!

And yet, in October of 2007 stock market traders paid nearly $70/share for shares of Fannie Mae (FNM) and more than $70 for shares in credit insurer Ambac (ABK), to name two of the more egregious examples (both are now bankrupt – ABK's shares trade at slightly below 2 cents at the moment).

 


 

The share price of bankrupt credit insurer Ambac. OK, so what did the market 'discount' in mid 2007 and October 2007?- click for better resolution.

 


 

What, if anything, were investors thinking when they drove up FNM's share price in 2007?- click for better resolution.

 


 

There is empirical evidence that the stock market works much better as a discounting mechanism during secular expansions than during secular contractions, according to data mining work performed by Bob Hoye of Institutional Advisors.  Hoye has found that while the stock market begins to decline up to six to twelve months ahead of recessions during secular expansions, it tends to top out and decline almost concurrently with the onset of recessions during secular contractions.  We will discuss the theoretical explanation for this phenomenon on another occasion, for the purpose of this article it suffices to be aware that it exists.

Is there anything we can immediately glean from the behavior of the stocks of soon-to-be-bankrupt companies on the eve of the GFC? We believe there is.

 

The Potent Directors Fallacy in Action

We have written an article on the so-called 'potent directors fallacy' (as far as we are aware credit for coining the term is due to Robert Prechter) in February of 2009, where the principle is explained by inter alia examining the crash of 1929.

In brief, the fallacy is the belief held by investors that someone – either the monetary authority, the treasury department, or a consortium of bankers, or nowadays e.g. the government of China – will come to their rescue when the market begins to fall. 

'They' won't allow the market to decline!' 'They' won't allow a recession to occur!' 'They can't let the market go down in an election year!' All of these are often heard phrases. Even many prominent economists who should really know better are fervently holding on to this faith in the magical powers of the central planners. In 1998 famous MIT economist Rudi Dornbusch wrote that there 'will never be a recession again', as 'the Fed doesn't want one'. Seriously.

In late 2007, Gregory Mankiw of Harvard was gushing in the New York Times about the 'dream team' in charge at the Fed and the treasury, which would surely keep us out of recession 'if only we let them work' (as if 'we' had a choice in the matter!). Mankiw often comes across as a pretty shameless panderer to power, which may have been the inspiration behind this inane remark, but reading his op-ed one did come away with the impression that he actually believed it.

Investors appear to be hostage to similar beliefs – and this is also what explains the odd ability of certain shares to levitate in 2007 in the face of the world obviously crumbling around them. ABK's stock did not reflect the almost inescapable conclusion that the company would be bankrupt in short order. It reflected only one thing: the faith of market participants that Ben Bernanke and the merry pranksters at the Fed would save the day.

 

 

Trading With the Help of the Rear-View Mirror

 

This brings us to today's markets. Nowadays, traders are not only not attempting to 'discount' anything, they are investing with their eyes firmly fixed on the rear-view mirror – they effectively trade on yesterday's news.

One example is the volatility usually produced by the payrolls report. This report not only describes the past, it is moreover a lagging economic indicator – and yet, traders seemingly regard it as highly relevant to the future.

Another example – an even more baffling one in our opinion – is the reaction usually observed on occasion of the delayed release of the Fed minutes.

First of all, it should be clear from experience that the Fed is one of the worst economic forecasting agencies on the planet. We have no idea why they even bother. Moreover, it too uses the rear-view mirror when deciding on its policy, which is a well known fact that is stressed in every single FOMC press release regarding monetary policy decisions. The stock phrase is: 'we will adjust policy according to incoming data'. In other words, policy will hinge on what has happened in the past – economic history is the major driver of these decisions.

So when yesterday the minutes of the August 1 Fed meeting  were released, the rational reaction should have been: 'so what'? It is completely meaningless that a 'majority of participants was leaning toward more easing measures'  three weeks ago. It tells us essentially nothing about the timing of the next iteration of 'QE'. What if all of the vaunted economic data prior to the next FOMC meeting come in much stronger than expected? What if the stock market keeps climbing? Will they then still implement 'QE3'? We strongly doubt it.

We don't doubt that eventually, there will be more money printing. However, just as the minutes of the prior meetings could not tell us anything about the likely timing, so does this latest release not really tell us anything with regards to that. Today, the markets are once again held aloft by a variation of the 'potent directors fallacy' – Ben and Mario stand ready to print (as does the PBoC of course), therefore nothing bad can happen.

 


 

A five minute chart of the SPX in yesterday's trading – the release of the Fed minutes was followed by a big spike upward- click for better resolution.

 


 

A five minute chart of GLD during yesterday's session – gold was one of the biggest beneficiaries of the release of the minutes- click for better resolution.

 


 

Precious Metals

In our update on gold, silver and gold stocks on August 13 we wrote that it was more likely for gold to break upward than downward from its recent consolidation – both the fundamental and the sentiment backdrop were strongly indicative of such a resolution. Moreover, the chart of gold in euro terms was clearly bullish.

At the time we also remarked that the positive signals were still 'tenuous' and that follow-through was required to confirm our view. We have now indeed received said follow-through, as gold has broken out above lateral resistance in yesterday's trading.

That said, we hate it that the release of the Fed minutes was what triggered the move. This sets gold up for the same kind of disappointment for which the stock market has been set up through the intense focus by market participants on more money printing and central bank promises of same.

From a tactical perspective, we think one should consider taking short term profits in gold related investments if gold should rise into the eagerly awaited speech by Ben Bernanke at Jackson Hole on August 31, unless upcoming major economic data releases until then are exceptionally weak. The speech may well prove disappointing. Alternatively, disappointment could become palpable after the next ECB and Fed meetings. We may even be cruising toward a 'buy the rumor, sell the fact' scenario (anyone remember the February LTRO?).

Strategically we continue to remain bullish on gold. For now, one should probably just let it run, but one would do well to be aware of the potential short term pitfalls that lie dead ahead.

 

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Fri, 08/24/2012 - 19:32 | 2735828 fonzannoon
fonzannoon's picture

In 2007 no one saw massive QE coming. Thats why the market crashed, and thats why there has been diminishing returns on every QE since.

Fri, 08/24/2012 - 20:39 | 2735958 Hype Alert
Hype Alert's picture

Who would have expected us to follow Weimar or Zimbabwe after their shining examples?  Doing it once maybe, but doing it time after time with diminishing results is insame.

Sat, 08/25/2012 - 04:31 | 2736440 AldousHuxley
AldousHuxley's picture

knowing the truth given current state of imperfect information and knowing the future predictions are different things.....

 

wall st. claims latter and taxes on human fear/greed, while market simply reflects the former.

Fri, 08/24/2012 - 20:50 | 2735971 Silver Bug
Silver Bug's picture

The fact is the market doesn't know very much.

 

http://ericsprott.blogspot.ca/

Sat, 08/25/2012 - 00:05 | 2736254 El Hosel
El Hosel's picture

These days "The Market"  is not a market, it is a tool. Markets reflect supply and demand, name any business where lack of interest and participation ( demand ) is a positive.... US "markets" have doubled in the face of record lack of interest and participitation. Big supply with no demand means game over, a true  market would decline. US markets are going up because the machine is pushing them up. A machine is a tool, a market is a market.

 

Sat, 08/25/2012 - 04:47 | 2736473 AldousHuxley
AldousHuxley's picture

the market is only a tool as long as it can sustain enough credibility that it reflects market prices.

these days with internet information, many institutions are losing legitimacy....

 

information revolution tend to deliver truth to masses efficiently and in the process uncover status quo's corruption....

 

Martin Luther used printing press garner support in challenging then most powerful structure...the church...that in terms of scientific truth it doesn't know what it is talking about and in fact corrupt and self serving.

internet is being used to challenge the most powerful structure today...the wall st....that in terms of economic truth it doesn't know what it is talking about and in fact corrupt and self serving.

 

yet even today ,masses still pay tax (aka tithe) to the roman catholic church and belive god is worth beliving.

500 years later, stupid masses may still believe in wallst. and the market....but many more will live wihout putting too much faith in it.

 

 

Sat, 08/25/2012 - 15:56 | 2737456 _ConanTheLibert...
_ConanTheLibertarian_'s picture

I think you got some things backwards here...

Fri, 08/24/2012 - 19:41 | 2735845 silverserfer
silverserfer's picture

can we please have peter tenerrabrarunum replace Graham Summers in the contributing articles. His dementia is MUCH more under control.

Fri, 08/24/2012 - 21:53 | 2736054 Ned Zeppelin
Ned Zeppelin's picture

Sorry, Peter's last name is to hard to spell.

Fri, 08/24/2012 - 19:43 | 2735852 REALTRADE
REALTRADE's picture

WHAT? that bitch tyler is not gonna come on here and bad mouth AAPL today after it won it's lawsuit against samsung?

lol yeah real unbiased reporting here tyler....all doom and gloom, yet the world marches forward...going on 3 years you've been bitching about the impending collapse, yet the stock market has all but retraced the entire move, you're a failed trader and even worst blogger....AAPL ALL TIME HIGHS JUST A FEW WEEKS AFTER YOU WERE BAD MOUTHING IT AGAIN....IT KEEPS MAKING YOU LOOK STUPID tyler..i bet you'll get a couple of your PM fanboys to circle jerk you while blowing your wad on a few ounces of gold

Fri, 08/24/2012 - 19:51 | 2735864 roadsnbridges
roadsnbridges's picture

Sounds like someone held SRS a little tooo long.

Shoulda gone with that 1 share of Craapl after all, eh?

Fri, 08/24/2012 - 20:10 | 2735910 Robslob
Robslob's picture

So REALTRADE help me understand, on a one basis, how your holdings of AAPL compare to my, one to one, holdings in physical gold?

Tyler relates the why behind the what and the what is clearly dictated by the last standing market maker (the Fed) and how by the way does that relate, in terms of purchasing power gained, to your holdings in AAPL?

Sorry forgot one small detail...my holdings are not backed by some form of debt...

Fri, 08/24/2012 - 20:17 | 2735924 fonzannoon
fonzannoon's picture

Rob don't bother. It's Friday. The real cokehead traders are at the steakhouse right now backslapping each other. They gotta hit the atm and piss on a homeless guy before hitting up some lounge later and purchase a $25 dollar bottle of ketel one for $850 dollars. That this guy is on here now bitching means he is not in that crew ,which means he stumbled on here, probably got caught in a trap set on here and is pissed.

Fri, 08/24/2012 - 21:22 | 2736008 Meesohaawnee
Meesohaawnee's picture

realtrade. dont you have a place to go like yhoo finance? thats were all the kiddies play. now go run.

Sat, 08/25/2012 - 00:29 | 2736275 joe6px
joe6px's picture

Interesting.  After reading the comments I'll talk about the emaciated elephant in the room..Volume.  Yeah, that's right.  Algo's trade the tape wherever they want.  Wait, Appl is beyond levitation by such lowly means.  So, let's talk slo-mo.  Why are so many hedgies buying Appl?  Why did some of the most influential traders invest in gold?  What is the history of over-bought tech's?

Cover yourself with iPads, it will not help; unless the bloodless revolution/election leads to something like a Pixar film. (had to cringe at that myself)

Complaining about the film's ending on movie night a half hour before it happens...in this market..if you nail it, well, good on ya.  In this theater I think anyone nailing the ending is damn near impossible.  Good luck!  I'm sure you can trade a piece of paper for food or gas if it says Appl on it.  The results are in (MFG, etc.), if you don't hold it in your hand you have nothing.  Hedge accordingly.

Sat, 08/25/2012 - 09:33 | 2736646 sessinpo
sessinpo's picture

What? Another Apple bitch complaining about the neighborhood talking about his whore wife AAPL and how much she costs?

 

You know its only a matter of time before she puts you in the poor house. The question is, what will be the settlement when you divorce (price of the stock)

Sat, 08/25/2012 - 10:16 | 2736730 LG_Knight
LG_Knight's picture

I've got 20% in gold (physical). And 20% in Apple. Apple is going through a secular 10 X market growth from PCs to mobile devices, plenty of room to grow. Where is the problem investing in both for now?

I love zerohedge. Long-term, they have it nailed.

Sat, 08/25/2012 - 10:17 | 2736731 LG_Knight
LG_Knight's picture

I've got 20% in gold (physical). And 20% in Apple. Apple is going through a secular 10 X market growth from PCs to mobile devices, plenty of room to grow. Where is the problem investing in both for now?

I love zerohedge. Long-term, they have it nailed.

Fri, 08/24/2012 - 19:44 | 2735855 roadsnbridges
roadsnbridges's picture

Yesterday's news, as in the Berspanky letter from 2 days ago?

Fri, 08/24/2012 - 21:06 | 2735991 cosmictrainwreck
cosmictrainwreck's picture

"BERSPANKY" hahaha lol

Fri, 08/24/2012 - 19:55 | 2735882 q99x2
q99x2's picture

Maybe this time is different because there are no investors in the market. Everything is owned by the FED and company. If the FED can manipulate the markets higher after last quarters result and other expected gloom such as WWIII and a revolution in the US then WTF does the past have to do with today? As far as I could tell the FED direct manipulation of the markets circuitry did not get fully jacked into the exchanges until the end of last year. This time is different as concerns market indexes but not the economy.

Fri, 08/24/2012 - 20:00 | 2735890 stocktivity
stocktivity's picture

It's all Bullshit!

Fri, 08/24/2012 - 20:27 | 2735916 Yen Cross
Yen Cross's picture

  I've searched over the "Atlas Mountains", and parted the "Great Divide" for answers!

    I have watched the 'entire' "Hell Raisers series"(Clive Baker) , looking for that answer!

      I have gone to " Outer Space" and asked HAL , for answers!

         My Friends at the Fed. just gave me their "OUIJA BOARD".

              It is all  bullshit! ( 24/7 management works best)

 To the "Tyler Guest Poster". Thanks for the read.  Have you ever heard of " Back Painting Oscillators?"

Fri, 08/24/2012 - 20:33 | 2735948 FischerBlack
FischerBlack's picture

Some people dismiss reports of HFT market manipulation, PPTs, algo-driven ramp jobs, etc. as simple conspiracy theories. There is no organization, they say, behind the ups and downs of markets. The market just is what it is.

And these are the very same people who will then immediately say 'Besides, THEY won't let the market crash in an election year.' or 'They will keep stocks from dropping too far.' or 'Rates won't rise because they want them low.'

And who's the conspiracy theorist now, bitch?

 

Sat, 08/25/2012 - 12:17 | 2737047 Vampyroteuthis ...
Vampyroteuthis infernalis's picture

Cognitive dissonance

Fri, 08/24/2012 - 21:52 | 2736051 Ned Zeppelin
Ned Zeppelin's picture

The notion that the equities market are prescient is complete bullshit - no one is. Period. They reflect only current sentiment. Now add on the gross manipulation by the Fed and ECB and you can really kiss their furtune-telling abilities goodbye.

Fri, 08/24/2012 - 22:00 | 2736067 LMAOLORI
LMAOLORI's picture

 

 

"And yet, in October of 2007 stock market traders paid nearly $70/share for shares of Fannie Mae (FNM) and more than $70 for shares in credit insurer Ambac (ABK), to name two of the more egregious examples (both are now bankrupt – ABK's shares trade at slightly below 2 cents at the moment)."

They were Orszagged

Corporate Crime, Russia, Peter Orszag and Getting Away with Murder

snip

"Case in point: former Office of Management and Budget Director Peter Orszag.

Rosner said that the Orszag case is “one that I find most offensive.”

“It’s not on the level of Timothy Geithner or Hank Paulson, but it’s troubling,” Rosner said.

“Peter Orszag was co-author of a study paid for by Fannie Mae back in 2000 or 2001,” Rosner said. “It argued that Fannie and Freddie are incredibly safe and sound, that the stress test that was going to be employed by the regulator insured their safety and soundness. And that there was something like a one in 500,000 chance that they would end up imperiled. And even if that happened, the cost to the taxpayers would be a few million dollars. That’s pretty much what the paper said.”

“Orszag ends up as the head of OMB. And when the government takes Fannie and Freddie into conservatorship, he says – there is about a five percent chance that the government could be on the hook for more than $100 billion. Wrong again. No one calls him out.”

“Orszag is now the vice chairman at Citibank. I noticed the other day he put out an op-ed on Bloomberg which was clearly positioned to support his current institution. And nowhere does it say that he had anything to do with the government, the GSEs. And that’s just the way Washington works.”

“He obviously was in that position to add three zeros to his income on the other side,” Rosner said. “It’s not about public service. It’s about self service.”

Morgenson lamented the lack of criminal prosecution.

“I know proving criminal intent is exceedingly hard,” Morgenson said. “But if we don’t get some scalps, you will have left most people with the idea that you can get away with murder as long as it’s involving not a gun but a pen and a financial institution. That’s the wrong message we should send. It’s pernicious and damaging.”

“In the savings and loan crisis there were 839 criminal prosecutions that resulted in jail time,” Morgenson said. “And these were not just low level people. These were CEOs in some cases, CFOs – very high level people."

Fri, 08/24/2012 - 22:17 | 2736092 Ponzi_Scheme
Ponzi_Scheme's picture

What does the stock market know ?

Forget fundamentals. Forget declining metrics and expanding PE ratios. Forget growth and the global recession ...
Forget fiscal insolvency.

Buy the fucking dips.

Sat, 08/25/2012 - 00:28 | 2736274 JohnG
JohnG's picture

I miss those days too.....

:Sigh:

Fri, 08/24/2012 - 23:56 | 2736167 JR
JR's picture

Eventually, the stock market manipulation, without reform, will force the stock market to go out of business. You can't have a market if it is a trap.

Sat, 08/25/2012 - 00:03 | 2736252 fourchan
fourchan's picture

buy the fucking dip.

Sat, 08/25/2012 - 00:25 | 2736266 Yen Cross
Yen Cross's picture

fourchan   Unfortunately you missed the  boat.

Sat, 08/25/2012 - 00:28 | 2736273 Yen Cross
Yen Cross's picture

 J.R I was thinking reset @ 2030. I'll be down under.

  Blue hats/Red hats .  

Sat, 08/25/2012 - 08:19 | 2736582 Vince Clortho
Vince Clortho's picture

The "markets" are now nothing more than a toy, a tool for tptb to convince the public that everything is fine.  They cannot fix the real economy, unemployment, housing, the broken banking financial system, bankruptcies and massive debt.  Instead, they focus on using the media and the "market" to project a fictional reality that everything is OK, with the objective being to maintain their law and their order and their control for as long as possible.

This insanity will continue as long as there are people willing to trust and believe these vultures that are currently in control.

Sat, 08/25/2012 - 16:59 | 2737568 blunderdog
blunderdog's picture

"The market" is just an ongoing negotiation.

Some participants are bigger and have more power, that's all. 

This is how a capitalist system WORKS.  The guys with the most money decide how the world runs.

Is that a problem?  If so, why?

Mon, 08/27/2012 - 06:59 | 2740434 atoast2toast
atoast2toast's picture

http://www.weeklystandard.com/author/irwin-m.-stelzer

 

Recently released minutes of the July 31-August 1 meeting of the committee include this widely noted tidbit, “Many [how many?] members judged that additional monetary accommodation would likely be warranted fairly soon [when?] unless incoming information [which data?] pointed to a substantial and sustainable strengthening in the pace of the economic recovery." Of course, a “substantial and sustainable strengthening” of the recovery is in the eye of the beholder. The fog of Fed speak remains impenetrable. 

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