An "Austrian View" Approach To Equity Prices

Take all you know about the formation of equity prices... and throw it out of the window, at least according to the following paper out of (fittingly Austrian) Erste Group, which applies Austrian theory to stock "valuation", by looking at a world in which the only determining factor for "fair value" is credit money creation. Indeed, the 2011 market, in which cross-asset correlations broke all records, and in which fundamentals were cremated once and for all, showed that the only thing that matters is who prints first, and more importantly, who frontruns said printing (it also means that most hedge fund analysts will soon be redundant). Here is Erste with a slightly less jaded view: "We come to the conclusion that it makes sense for equity investors to track monetary and, especially, debt developments closely. We believe that the changing dynamics of monetary as well as debt aggregates are often a good leading indicator for equity markets. Historic data shows that accelerating money and credit growth drives equity prices, while decelerating growth in the money and credit supply generally puts pressure on equity prices...Financial history shows that equity markets are ‘addicted’ to new money and credit creation. To keep rallies going, the equity markets need ever more fuel (faster rate of change in the money and credit supply). As soon as the rate of change is negative (decelerating money and credit supply) markets tend to become sluggish and lose momentum, even though in absolute terms the money and credit supply is still rising." And while this is not telling Zero Hedge regulars something they didn't know already, with the fiscal pathway of creating new money blocked in a (mock) austere world, the only other way to generate M1-X is by printing. Summary - much more currency debasement and devaluation ahead, only this time with a $100 base in WTI. Which most certainly means that very soon the world will need to find an extended source of cheap energy (read oil). And everyone knows what that will be...

Summary from Erste:

At the heart of this product lies the analysis of the development of historic money and credit statistics. It is called the ‘Austrian View’ because studying the theories of the Austrian School of economics (especially Ludwig von Mises’ book: ‘The Theory of Money and Credit’; which, by the way, will celebrate the 100th anniversary of its first publication in 2012) has inspired us to examine the relation between money/credit developments and equity prices. We have come to the conclusion that, indeed, there seems to be a connection between the two. However, it is necessary to have the right angle of vision when poring over the money and credit statistics, because otherwise they are pretty useless.


We have to admit that it has become very difficult to determine what money and credit actually is. Money supply aggregates like M0, M1, M2, M3, sometimes even M4, are being published. To complicate things further, central banks publish credit statistics as well. Finally, money and credit are just two sides of the same coin in today’s monetary order. Someone’s savings account (contained in the calculation of M1) is at the same  time the credit financing someone else’s project (contained in credit outstanding). We therefore believe that one should denote currency (apart from cash in your pocket) in savings and other bank accounts as claim, not as money. We believe that M1 and M2 are good short-term leading indicators for equities. In this publication we also track the development of debt as a supplemental indicator.


Apart from the question of which aggregates to track it is important to understand that the rate of change in the money supply is of interest. In order to drive a rally, the rate of change in the money supply has to increase. As soon as the rate of change is slowing down, equity markets tend to get sluggish and weaken. There is, however, a certain time lag effect involved. We decided to use the US stock market cycle 2001 - 2007 as a case study in order to demonstrate how the analysis of monetary forces can improve an investor’s decision-making process. The appendix  of this publication will track several monetary aggregates for the main currency areas.


The punch line is that this framework advises investors to establish long positions in equities (or overweight cyclical or financial stocks) as long as the credit supply is loose and accelerating; as soon as the credit supply becomes tight and decelerates, investors should gradually sell their positions or switch into more defensive sectors. [ZH: incidentally this is what we suggested back in May when recommending the QE unwind trade, which has returned about 10% over the S&P, or about in the top 95%-ile]


In this context, we would like to mention, that in December 2010 an interesting paper was published by Jordà, Schularick and Taylor, titled ‘Financial Crises, Credit Booms and External Imbalances: 140 years of lessons’. They have studied the experiences of 14 developed countries over 140 years and exploited a long-duration dataset in a number of different ways (application of new statistical tools to describe the temporal and spatial patterns). Their final conclusion confirms our interest in money and credit statistics, because the overall result is that credit growth emerges as the single best predictor of financial instability.


The overall framework has to be understood as an additional tool within the toolbox at the investor’s disposal. It is not the Holy Grail or something like that, but we believe that it can provide equity investors with an informative basis in times when fundamental analysis does not seem to be of any use.

Full note (pdf)