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.

 

Homer-Brain-X-Ray-the-simpsons-60337_500_375Image credit: Matt Groening

 

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 to enlarge.

 

What, if anything, were investors thinking when they drove up FNM’s share price in 2007? – click to enlarge.

 

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 to enlarge.

 

A five minute chart of GLD during yesterday’s session – gold was one of the biggest beneficiaries of the release of the minutes – click to enlarge.

 

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.

 

Charts by: BigCharts

 

 

 

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15 Responses to “Trading on Yesterday’s News – What Does the Stock Market Really ‘Know’?”

  • I don’t think the moves mean anything now except that is what the machines wanted. The stock market hasn’t been a valuation model for 2 decades. Instead it is a distribution machine. They will have all the stocks back when they get cheap. I wrote for several years about FNM going broke. Of course I had been taking a cue from Doug Noland. It was $70 a share because they could dump it on the public for that.

  • Belmont Boy:

    Two headlines, same day (August 23):

    Shares retreat on dim outlook for growth, Fed stimulus (Yahoo Finance)

    Price of gold surges on Fed stimulus hopes; is it headed for $2,000? (L.A. Times)

  • jimmyjames:

    btw…sent my donation in–

    thnx for the great informative site-

  • jimmyjames:

    What will be the signs that psychology is turning and markets will prospectively start reacting negatively to more money printing and government paper issuance?

    **********

    When we see gold go screaming past $10,000 ?

  • JasonEmery:

    The ratios I’m looking at are gold:silver and silver:hui. The latter has been consolidating a long time, about a year and a half, and I think we’re going to see a massive leg up, as silver outperforms gold and gold stocks. I’m not sure about silver stocks.

    The daily price gold chart looks like gold is on the right hand side of a parabolic move up, starting from late February. If you then look at gold:silver or silver:gold, the conclusion is there is at least a 50:50 chance that silver does another move like in late 2010/early 2011.

    Another interpretation of the gold chart is that it is forming the ‘cup’ part of a ‘cup and handle’ pattern, with an implied target of $1800/oz.

    I think you want to be overweight silver for the next several months or so, or until the charts say otherwise.

    • jimmyjames:

      Jason-

      Silver sort of spooks me yet-i think it still has a heavy industrial weighting attached to it-
      If the markets stay lofty it will probably continue higher-but it usually seems to get whacked when a fight to safety pops up-at least initially-

      Today’s trading had all the elements of a flight to safety other than the $ and silver-
      Usually/most always the $/gold and treasuries are up and all other commodities and markets are down-
      Maybe silver is decoupling from the base metal group-
      I like silver and bought it a long time ago-i would like to buy some miners back-but towards the end of today the miners were diverging in spite of the big gains in the silver price-so a bit bearish-
      The problem with trying to time silver is-she can be wicked fast- both ways-

      • JasonEmery:

        Jimmy-Silver is overbought on the daily price chart, but not even close on the weekly. Look for this monster move we’re in to continue.

        Gold stocks looked like they were outperforming gold ($hui:$gold), on a very short term basis. But if you look at 3 years of data, it is more likely just a dead cat bounce off a double bottom. Today’s tape tells the tale. Gold and silver way up, and gold stocks flat.

        Quite frankly, I don’t know what gold price will be required to get gold stock PE multiples to rise. Gold stocks make their biggest moves when you get PE multiple expansion, just like other sectors.

        • jimmyjames:

          Jason-i agree with you that miners didn’t track gold or silver very well today and that’s the reason for my doubts about whether this last spike can sustain itself-we have good downside resistance so i suspect the metals wont crash-but whether there is a continuation is the question-
          If silver and gold does what you expect-then the PE’s (with a lag) will/should improve and just maybe catch some fund attention-since not much else has any great earnings potential behind them-
          I don’t worry too much about overbought-because crashes usually happen in oversold and although silver is about neutral-it still gives me doubts in a general commodity sell off-
          The mid tier gold miners i bought back at the may/june lows are positive by 20-30%
          Profits have been good for most good producers this past while-if production costs start dropping that will also benefit PE’s –
          Anyway -I’m always bullish gold in the long haul and silver wont be left behind for long if it does get whacked and could easily outperform gold if any of the major currencies happen to start showing their true colors–

  • worldend666:

    Hi Pater

    I spend at least 30 minutes a day on your website so I figure I owe you at least a hundred bucks. Thanks for the entertainment and the daily summary of what really matters in markets.

  • RedQueenRace:

    “So when yesterday the minutes of the August 1 Fed meeting were released, the rational reaction should have been: ‘so what’? ”

    Pater, here’s my take on this type of stuff.

    Most of the moves within any one day are likely technical in nature.

    News acts as a catalyst. That is, it does not cause the market move, it is used to speed up what was going to happen anyway. Yesterday was a perfect example of that.

    The SPX had come down and tested support at 1407. This level had acted as resistance over a 7 day period on a closing basis. On the Yahoo message boards I had postulated that the market would come back and test former resistance as support.

    That happened yesterday. The SPX bottomed at 1406.78. It then traded sideways for along time and began working up before 2:00 pm. Although the futures and cash had pulled back a bit just before the release they were still off the lows. When the minutes were released the ES immediately took off. And I mean immediately. There is no way anyone could have digested the contents in 3-5 seconds and reacted. They simply reacted. Support had been tested and held. The market was going up whether or not the Fed minutes were released. The minutes just hurried things along.

    • I fully agree with your assessment in the context of short term moves. But in the medium to longer term, it seems to me that market participants are often swayed by their faith in government interventions to a very large (and quite unhealthy) extent. This is especially so since the beginning of the secular bear market period in 2000, but it is actually a phenomenon that could be observed again and again in history when ‘bad times’ struck.

  • ab initio:

    It would seem that central planners are in general reactive not proactive. As Greenspan said they could never identify any asset bubble and so all they could do was to mop up after a bubble burst. But never considering that it was their policies in the first place that create credit and other asset bubbles. The “potent directors fallacy” is commonly known as the Greenspan Put and now the Bernanke Put. Not that it worked in 2000 or 2008. But the belief continues in this omnipotent technocrat that can turn knobs and dials in a global economy with human participants who can behave emotionally.

    At this juncture policy is stuck on more of the same as there is nothing else policymakers are willing to try as nobody wants to deal with hard structural issues. That means more money printing and more circular accounting schemes and more government issuance of paper. This will continue in reaction to events until the charade can no longer be sustained – when we reach the Emperor has no clothes moment!

    My belief is that markets have got ahead of themselves and could be disappointed in the timing of the next money printing and will react negatively at which point the liquidity gusher will be turned on. The question is what will be the strength of the subsequent rally and for how long will markets keep rising before they need the next liquidity injection ad infinitum. What will be the signs that psychology is turning and markets will prospectively start reacting negatively to more money printing and government paper issuance?

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