Gavekal - On Market Stupidity 2

The Apex Of Market Stupidity
By Charles Gave
December 8, 2015

In some 40 years of watching financial markets, my dominant emotion has been a mixture of curiosity, amusement and despair. It seems the stock market must have been invented to make the maximum number of people miserable for the greatest possible amount of time. The bond market, meanwhile, has just one goal in life: to make economists’ forecasts for interest rates look even more silly than their other predictions.

Over the years I have often observed how most market participants are able to concentrate on only one set of information at a time. For example, in the 1970s, the only data release that mattered was the consumer price index. In the days leading up to the CPI’s publication, everybody dropped all other considerations to speculate feverishly about what the number might be. And then following the release, they would spend the next week or two commenting sagely on what the number actually had been. Eventually Milton Friedman convinced the Federal Reserve (and from there the markets) that there was some kind of relationship between the money supply and the CPI. So everyone stopped looking at the CPI, and instead started to focus on the publication every Thursday evening of M1 (or was it M2?). Inevitably each week would see an immediate rash of commentary on these arcane matters from the leading specialists at the time, Dr. Doom and Dr. Gloom.

This gave way to a period in which the US dollar went through the roof on the covering of short positions established during the era of the minister of silly walks in the 1970s. For a few years, the only thing that mattered was the spread between the three-month T-bill yield and the three-month rate on dollar deposits in London (an indication of the shortage of dollars outside the US). The beauty of this one was that the scribblers on Wall Street could comment on it twice a day or more, which of course had no discernible impact on reality, except for the destruction of the forests needed to print so much waffle.

That era came to an end in 1985 with the Plaza Accord. At that point the Fed, under the wise guidance of Paul Volcker—my favorite central banker of all time, probably because he was the only one without a PhD in economics, which may well explain his success—decided it was going to follow a type of Wicksellian rule-based policy under which short rates were kept closely in line with the rate of GDP growth. Of course, this meant the Fed paid little attention to the vagaries of the financial markets, so there was very little to comment on. The result of policymakers’ lack of interest in financial markets was that from 1985 to 2000 the US enjoyed a long period of rising economic growth, low inflation, low unemployment and high productivity; a period dubbed “the great moderation”. The trouble was that no one was able to make any money trading on inside information provided by the politicians and central bankers. As an advertisement for Sm ith Barney put it at the time: “We are making money the old way. We earn it.”

Naturally, that wouldn’t do at all. After nearly 20 years of economic success, the US budget was in surplus, the pension funds were over-funded, and the “consultants” in Washington were on the verge of bankruptcy, having nothing to say. Clearly something had to be done, and it was: policy shifted to accommodate Wall Street, with forward guidance, negative real rates, the privatization of money, and a lack of regulation. This allowed Wall Street to make money, but it created nightmares elsewhere through the ever-successful euthanasia of the dreadful rentier.

Still, the shift to an economy driven by the decisions of central bankers meant the market commentators were back in business in a big way. For the last 12 years, the only thing that has mattered has been to know whether or not the chairman of the Federal Reserve has had a good night’s sleep. Similarly in Europe, the dysfunctional euro, created by a bunch of incompetent politicians and Eurocrats, bred drama after drama. Since nobody wanted to admit it was a failure, the most important man in Europe became the president of the European Central Bank. 

In the last week, we have reached what is surely the apex of this stupidity. A bunch of algo traders programmed their computers expecting “Derivative Draghi” to be extremely dovish, as any proper Italian central banker should be. I am not sure I understand why, but some traders obviously decided that he had not been dovish enough. European stock markets plunged by -4%, while the euro went up by roughly the same amount in the space of a few minutes. What that means is simple: value in the financial markets is no longer a function of the discounted cash flow of future income, but instead is determined by the amount of money the central bank is printing, and especially by how much it intends to print in the coming months. So we are in a world where I can postulate the following economic and financial law: variations in the value of assets are a function of the expected changes in the quantity of money printed by the central bank. To put it in a format that today’s economists understand:

Δ (VA) = x * Δ (M),

where VA is the value of assets and M is the monetary increase.

What we are seeing is in fact in one of the stupidest possible applications of the Cantillon effect, whereby those who are closest to the money-printing, i.e. the financial markets, are the biggest beneficiaries of that printing. This is exactly what happened in 1720 in France during the Mississippi Bubble inflated by John Law. The end results were not pretty (see “Of Central Bankers, Monkeys And John Law” [above]).
What I find most hilarious is that some serious commentators have been pontificating at considerable length about what the market’s participants think. These days, some 70% of market orders are generated by computers, and many of the rest by indexers. And computers do not think. They simply calculate at light speed, which allows them to react to short term movements in market prices as they were programmed to do. And since they are all programmed the same way, the result is some big short term market moves. In essence, these computers act as machines that allow market participants to stop thinking. As a result, I cannot remember a time when less thinking has ever been done in the financial markets, which is why I find today’s financial markets infinitely boring.
We are swimming in an ocean of ignorance, just like France in 1720. It seems all the painful economics lessons learned over the last 300 years have been forgotten. I suppose that means we will just have to wait for another Adam Smith to appear. La vie est un éternel recommencement..