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.
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.