Posted on 05/01/2013 1:14:47 PM PDT by Kaslin
One of the first financial guys I ever met told me confidently “the economy and the markets have nothing to do with one another.” Recently I was interviewing potential new writers for a financial newsletter, which I’ve been asked to help launch, and one of them (a professor of economics) told me that “the financial markets and the economy are two different beasts entirely.” Where do people get such ideas?
One place they got them is from John Maynard Keynes who saw the movements of financial markets as being like a gigantic casino, moving randomly in response to people’s animal spirits which he believed were throwbacks to our animalistic instinctual forebears. His intellectual grandson Harry Markowitz applied that basic idea with more mathematical rigor while creating Modern Portfolio Theory, which Markowitz said was different from classical economics because it ignores supply and demand; in other words, the underlying economy.
First let’s look at the master. Here’s my friend Mark Skousen in his excellent book The Making of Modern Economics on the irrationalist stream in Keynes and his compulsion to sever economics from finance:
“Keynes complained of the irrational short-term ‘animal spirits’ of speculators who dump stocks in favor of liquidity during such crises. Such ‘waves of irrational psychology’ could do much damage to long-term expectations, he said. ‘Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate resources upon the holding of liquid securities’… According to Keynes, the stock market is not simply an efficient way to raise capital and advance living standards, but can be likened to a casino or game of chance. “For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs–a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.”
Instead of placing finance on a proper foundation of economics, Keynes grounded them both in psychology; arguing that the handling of money is a kind of neurosis. According to the definitive history of Keynes’ early intellectual circle, The Cambridge Apostles:
“In the early 1930s, Keynes became increasingly disillusioned with capitalism, both morally and aesthetically. The ideas of Sigmund Freud were fashionable at that time, and Keynes adopted the Freudian thesis that money making was a neurosis, a somewhat disgusting morbidity one of the semi-criminal, semi-pathological propensities which one hands over with a shudder to specialists in mental disease.”
Following his Freudian impulses, which according to the biographies were not often suppressed, Keynes reduced thrift itself (on which all investing depends) to a sexual neurosis, calling it ‘the fetish of liquidity’.
“Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate resources upon the holding of liquid securities.”
The origin of modern portfolio theory, really of almost all modern finance, is found in Harry Markowitz’s decision to take Keynesianism to its natural conclusion. Classical economics is about production, supply and demand. Markowitz threw all of that out. From his Nobel Prize acceptance speech:
“There are three major ways in which portfolio theory differs from the theory of the firm and the theory of the consumer which I was taught. First, it is concerned with investors rather than manufacturing firms or consumers. Second, it is concerned with economic agents who act under uncertainty. Third, it is a theory which can be used to direct practice, at least by large (usually institutional) investors with sufficient computer and database resources.The fact that it deals with investors rather than producers or consumers needs no further comment.”
In plain English: MPT acolytes are not concerned with firms (in which they invest) or in the consumers (from whom the firms in which they invest receive their revenues), but only in the economic agents known as investors. But don’t worry, they’ll have computers.
But what will the computers compute? For Markowitz and for the huge intellectual superstructure which is built on his ideas, they will compute based on price movements; what we call volatility. Markowitz called it ‘variability’. Again from his Nobel Speech:
“The basic principles of portfolio theory came to me one day while I was reading John Burr Williams, The Theory of Investment Value. Williams proposed that the value of a stock should equal the present value of its future dividend stream…It seemed obviousthat investors are concerned with risk and return, and that these should be measured for the portfolio as a whole. Variance (or, equivalently, standard deviation), came to mind as a measure of risk of the portfolio... These were the basic elements of portfolio theory which appeared one day while reading Williams.”
But why is variability the true definition of risk. Markowitz didn’t get the definition from Williams, whom he had been assigned to read. In fact Markowitz claimed that the reason he came up with the idea of variance as a risk metric is because Williams had provided no risk definition of his own. This is patently false: the second half of The Theory of Investment Valueincludes penetrating chapters describing the risks which arise from socialism or from Keynesian inflation. Perhaps Markowitz never finished his reading assignment.
One wonders how the history of finance would have been different if he had read and had understood Williams’ masterful application of free-market economics to finance. But instead Markowitz chose a purely emotionally subjective foundation for financial theory. Price movements make people uncomfortable. (As someone involved with managing portfolios, I can vouch for that.) With no objective economic criteria for risk such as low growth or high inflation, MPT defaults to the subjective: investors don’t like a lot of price movement, therefore a lot of price movement equals risk.
But is all of that right? Does the world of economics and finance have order and structure and act according to principles, or is it nothing at all but bestial, twitching, random spasmodic emotion? Is the economy really severed from markets? Is the brainstem really severed from the body? Our last couple of columns show that at least as regards the relationship between markets and economic growth, there is one which can clearly be discerned if one asks the right questions.
Next week, Lord willing: the right questions…
Didn’t read the article but I understand that the market is being propped by the Federal Reserve.
I disagree with the general premise of this article that the stock market is a reliable indicator of the economy. Maybe in a perfect world where people only invest in companies they’ve researched and believe have long-term viability, or in a world where the FED doesn’t fiddle with interest rates and print money on a whim, or a world where people don’t feel compelled to park their money in publicly traded securities to eek out a slightly better return than bank accounts or by taking business risks. Keynes may have been a whack-a-doodle in some areas but he was pretty accurate in emphasising group-think and fadishness with the market. We only need to look at the dot-com bubble as evidence of this. Also the stock trade is subject to forces beyond the domestic economy. Saying the word “speculators” in a scoffing and derisive tone doesn’t negate the fact that speculators exist, and can wield considerable power with regard to spot commodity prices and market rallies.
One day it will and you better pray to God you are not anywhere near the road out of town...
Casino .... that’s the operative word.
Did I just get a basic intro to what NOT to think when investing ?
It is a house of cards, the fed loans money at zero percent interest to the banksters who then invest in the the market because them poring money in to the market drives up prices. This is true with commodities even more, oil, gas, copper, steel etc. We all know that the printing of lots of money creates inflation, the banksters are ahead of the inflation curve because they get the money first.
They then sell the stocks, bonds or whatever after the rubes, (that’s most of the other people) come in to the market and then the prices collapse, err correct.
Then they start the music all over again.
We have 25% unemployment now and and out of control inflation.
Foolish people who think they are "investing", worshipping the god of the Stock Market, which is a house of cards propped up with fictitious fiat money, based on nothing, and pumped into computer screens by more fools.
Invest in God, the real one, instead.
THE Berlin Stock Exchange still exists—as a building,
as an institution with large offices, with brokers and
bankers, with a huge organization for daily announcement
of stock and bond quotations. But it is only a
pale imitation of its former self and of what a stock
exchange is supposed to be. For the Stock Exchange
cannot function if and when the State regulates the flow
of capital and destroys the confidence of investors in
the sanctity of their property rights.
From the Vampire Economy
My take is Bowyer's like most bigots and he hides in a world full of convenient stereotypes but devoid of individuals --that's how he got a head full of crap like his "speculators" "movements of financial markets".
Reality. Let's consider how falling wages doesn't start idiots like Bowyer rambling on about the irrationality of the labor markets. The reason is we all know that individuals in the labor markets all have different needs. Some work where the pay's higher, others work for less so they can have more time with the family, and some prefer to work for free (say, a woman that quits a job to become a fulltime mom or a retired person doing volunteer work). Financial markets are no different. Some buyers want the price to go up (buy low sell high), others want it to tank (like folks hedging a major put or like the guy trying to buy up a majority share cheap), and there still are others who couldn't care less --they're in it for the long haul anyway.
Predicting long term general market trends is like predicting climate. Too many factors. The best we can ever hope to do is pick a niche and study.
The bubble will break, and it won’t be pretty. Maybe not this week, or this month, but it will break. When it does...40% drop in the DOW at least....
Further, even taking such considerations into effect, trying to measure of one thing as a means of estimating something else that's harder to measure only works if one does not use the information in a manner that affects the two things differently. For example, if a doctor notices that a patient has a fever of 101°F and prescribes a fever reducing medicine, the fact that the patient's temperature drops to 99°F would not imply the patient was healthy. A patient's temperature in the absence of explicit efforts to control it might be a good measure of health, but the accuracy of temperature as a proxy for health will be diminished by actions to control temperature.
I, too, think we’re getting closer.
A major problem with the stock markets is a result of the fact that dividends are taxed much higher than retained earnings. As a consequence, many people who buy stock expect to profit largely by an appreciation of their stock's value, rather than by the receipt of dividends. Such expectation severely undermines the usefulness of price as a means of allocating resources. In a properly-functioning marketplace, low prices will entice people to buy, and high prices will entice them to sell. It may be possible for a momentary spike in demand to cause prices to rise to irrational levels, but in a properly-functioning marketplace, rising prices will be a red flag to would-be purchasers. Unfortunately, bull markets' reactions to such red flags are often the opposite of rational market reactions.
Many people seem to think that the value of a stock is substantially affected by its current market price. It's not. While stock prices may affect a company's ability to raise capital, and that may in turn affect the company's health and thus affect the value of the stock, I would suggest that every stock should be considered as having a "par value" which equals the present cash value of all future payments to which a person would be entitled if they held one share forever. Someone who buys a stock for less than par value or sells it for more than par value makes money. Someone who buys a stock for more than par value or sells it for less than par value loses money. Someone might buy a stock for more than par value and sell it for more money still, but such a transaction simply means the second purchaser lost more money on his transaction than the first did, and the first was able to take pocket for himself that extra money lost by the second purchaser. Note that if the stock changes hands many times at prices that go further and further above par value, what's happening is not that the stock's value is increasing, but rather that each person loses more money when buying a stock, which all but the last person recoups on the sale. The earlier people aren't profiting because the stock has become more value, but rather because each one managed to find a bigger sucker than himself.
To be sure, determining the par value of a stock for a company that's still in business would require a perfect crystal ball to know what dividends or other payments it would produce. On the other hand, if one defines "expected par value" to be the expected present cash value of all payouts from a stock that's held forever, the observations that are true about par value are generally true about expected par value.
As a parting note, I've sometimes seen "market capitalization", meaning the per-share market price of a stock times the number of shares outstanding, mentioned as though it were a meaningful figure. It isn't. The fact that AcmeCo has 500,000 shares of a stock outstanding, the fact that today's market price is $10/share does not mean that those shares are worth a total of $5,000,000. If there's no the company's assets could produce a combination of present and future payments whose present cash value is more than $1,000,000, then the total value of the shares can't be worth more than $1,000,000. If the per-share price drops from $10/share to $2/share, investors won't lose money when that happens. All they'll have lost is the ability to find someone else willing to take the loss for them.
Keynes was not an economist. He was a very educated contrarian who delighted in setting established theory on its head. He was welcomed only because the world was engulfed in the Great Depression and Mussolini, Stalin, and Hitler were much admired in the West.
He gave permission to would-be Fascists and Communists to plan the economy for the benefit of the masses. His theories have never worked but that fig-leaf of permission, couched in semi-economic nonsense, is still all the government class needs to justify its destructive policies.
The market is being “propped up” only because there aren’t many places to get a return on investment these days.
Your description of the difficulty in making predictions based on measurement almost sound like quantum mechanics, but I digress. The most leviathan-like socialist state on record is the former Soviet Union. They tried to twiddle the dials and micromanage something that, if left alone, would seek it’s own state of equilibrium. In a word, the way free markets are supposed to work. We now have politicians/policy makers who are thinking just like those misguided Soviets, but refuse to learn from history. In the immortal words of Ted Kennedy, the only reason socialism hasn’t worked in 6000 years of recorded history is because we didn’t have him to run it. That’s really how they think.
The author obviously doesn’t spend much time actually trading in bond, stock or commodities markets.
In the short term, the markets have little reflection of the economy, especially since 1998, when the Fed first started meddling in market valuations. I’d go so far as to say that the stock US markets have been decoupling from the US economy since about 1994.
Right now, we have the stock market making new highs, even as the regional Fed reports are showing us that the economy is falling down pretty quickly. If it were still true that the markets were predicting out two quarters, we’d see the market selling off, not reaching new highs.
The price of copper is showing the coming downturn in the economy, and perhaps some other commodities, but the Fed has no so viciously distorted the bond and stock markets that they are truly decoupled.
This is the #1 problem that conservatives have: The Fed is now engaging in fiscal policy. When interest rates go to zero, all monetary policy moves are, in effect, fiscal policy moves. If we want to reign in the outlandish federal spending, then we have to stop the Fed from subsidizing outlandish federal spending with historically low interest rates on Treasury debt. The Fed should be brought under control and told that they’re in the business of being the bank of last resort, not the manager of the economy.
In the last four years of trading, I’ve become more successful every year by ignoring the economic indications and trading almost solely on monetary policy announcements out of the US or Europe, and exogenous events out of the Euro-zone mess in particular. The last time I can remember making a big position move based completely on economic issues was back in December of 2007, when it was clear that we were going into a for-real recession that couldn’t be papered over and that the Fed wasn’t believing the indications (yet).
Predictions are always difficult, especially about the future, but I foresee that the capital markets will become even more disconnected from the economy, mostly because of the “rise of the machines.” Because none of the idiots on Capitol Hill give a rat’s rear end about retail investors or investor trust in markets (mostly, because idiots in Congress are too busy trading on insider information), the corruption of the markets and exchanges will continue to a point where only the very smarted and nimble of retail investors will be in the market any more.
The GOP damp dream of an “investor class” that aligns Main Street investors’ interests with those of business executives will die with a wimper as a result of the rise of corruption and maniac behavior by machine trading.
I read the entire article and still have no clue the premise or what it was trying to say.
I read your entire post and found it perfectly clear and readable and fully understand exactly what you said.
I wish you had written the article. Maybe I would understand it.
Bump
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