Sunday, November 23, 2014

Markets Misread the Medicine


Perhaps because of my cold I am more conscious than at other times to medicine. With all the wonders of modern science there is no sure fire way to cure the common cold, yet the market for cold remedies is very large and present in every country. We all want to get better quickly and will try any so-called remedies.

Wrong medicine sends markets higher

This week we have seen several examples of governments and/or their central banks prescribing the wrong medicine to the welcoming stock markets. The sugar pills that are being rammed down our throats are various forms of Quantitative Easing.

Perhaps exporting our problems helps

The US used to be accused of exporting our home grown inflation. At other times we were criticized for our declared strong but actual weak dollar policy. But now we are exporting a bigger fallacy. The recently retired chair of the Federal Reserve Board and mentor to the current chair in his continued advocacy of Quantitative Easing (QE) has quipped that in practice it worked, but in theory it shouldn’t. Further, he said “We were never concerned about [inflation]. Inflation was never a risk and inflation is not a risk now.” This is from a man that did not see the many precursors that multiplied and helped created the housing bubble.

The evidence of the lowering of underwriting mortgage standards was reported on within the Fed’s own documents. The comment about no inflation now is particularly inappropriate when using core inflation, the Fed’s preferred measure, which over the last twelve months has risen to 1.8%.  These mental lapses are acceptable for a busy ex-Princeton professor who was not challenged in the commercial world. His real crime against the US economy and now his followers in the central canks of the world is the belief that QE worked. There appears to be a loose correlation that the first dose of QE was stimulating. Those of us who follow the performance of securities prices have learned that correlation does not equal causation. The proof is that in this market additional doses have had increasingly less impact.

Japan’s experience revealing

Our Japanese friends have relatively quickly observed their own evidence when much stronger QE medicine was applied to their economy: it has led to them falling back into recession. On the weight of the evidence I believe we can conclude that QE is a poor if not bad medicine for economies, but not stock markets who need to believe. Thus this week’s Euro propaganda by the ECB buying bonds as they launch their latest QE attempt was good for their local stock markets, but is in and of itself unlikely to materially help the various economies.

The "Third Arrow" could really help

After fiscal and monetary changes in Japan, the “third arrow” was a deep and sustained reform movement which included removing many government imposed controls, including immigration.

Perhaps if the third arrow is successful, both the US and Europe could follow Japan’s lead. In the US, federal tax regulations are spread over approximately 79,000 pages. Renewed faith in the marketplace to provide much of the regulation with appropriate oversight would energize each economy. All one needs to do is to array the starting date of various industries along with the anticipated level of regulation to see where economic productivity is likely to occur.

What won’t help

Reliance on old economic theory and practice is not the answer to today’s problems. I won’t go on paraphrasing  Mark Anthony about coming to bury Keynesian thoughts. I am concerned more about an eighteenth century ghost of mercantilism. Today, as in the past, governments are trying to aid their exporters to earn increased amounts of currency.  The European governments of past eras were attempting the same maneuver by lowering the value of their own currency versus their competitors. This created an era of competitive devaluations. 

Both our Japanese and European friends are trying to accomplish the same thing today. This will set off a race to the bottom and deprive their homelands of more expensive imports. In terms of quality of life, cheaper goods often means items of less value to the user. To defend themselves, much of the wealthy classes are now exchanging their own currency for foreign luxury goods as a way to protect their own real wealth. Some of the preferred goods are securities. The $1 trillion dollar Japanese Government Pension Plan has doubled its commitments to both domestic and international stocks, each to 25% of their total responsibility. This surge is helping the Japanese market and I suspect is playing a role in the US as well.

What may be the root cause of the problems?

The as usual intriguing John Authers in the Financial Times has produced an article that may explain the unanimity of central bank thinking. In the article under the column head of “The Long View,” he has a title of  “Why we need to break the white male grip on the markets.” In the article he focuses on group thinking. The bottom line in the article is homogeneity makes a group overconfident. 

Most central bankers are learned economists. Most economists spend most of their time on macro-economic studies, in other words top/down. Coming from a securities analyst and race track handicapper my instinct is for micro- economics and focus on details that make something standout. I also learned at the track and in the marketplace to challenge the consensus thinking which is right some of the time, but wrong at other times. When right things go as planned, no problem; but when wrong they can be disruptive. Central bankers like most boards of directors and investment committees are made up of polite people that may occasionally question but rarely challenge the perceived truth. To have all the major central banks going the same way is an example of extreme consensus thinking which could well be risky.

Are good stock markets worrisome?

One of my individual high net worth clients reminds me that while he is delighted with the performance of his account, the pain of loss would be twice as large as the pleasure of his gains. He has his pleasure/pain calculus right even though over time a continuously invested stock portfolio has absorbed major market calamities with an average annual gain going back to 1871 of 6.8%. Nevertheless, if the medicine that we are swallowing is giving us sugar highs we need to be wary. The Lipper Balanced (Mutual) Fund Index is slightly elevated at 7.47% for the year-to-date. The index is benefiting from its ownership of large cap core equities that as a stand alone is up 11.42% in 2014. Neither of these numbers is of the nose bleed size, but after a remarkably strong 2013, we need to watch closely.

There are two indicators that we are watching. The first is the ratio of the purchase of call options as compared with the number of put options owned. This ratio is historically low and on this measure the market is not looking frothy. However, Friday’s stock price movements are a flashing cautionary signal. On the New York Stock Exchange 219 stocks hit new highs and only 15 hit new lows. This may show that the large amounts of institutional cash reserves are being committed. The reason for this belief is that on the NASDAQ there were only134 new highs, but 48 new lows. Often the NASDAQ is a more speculative market.

The patient is recovering

As my cold is leaving my body this evening I regain some perspective having recovered from the medicine I took. The issues in counseling my nervous client are the time horizons of his concerns. Clearly the US market could fall at any time in view of its long recovery. While the recovery has been long, it is not particularly robust. On a historical basis, we could see a possible 25% fall which could be recovered in perhaps five or so years. We are prepared for that potential. However, there is a bigger risk and it is on the upside. 

We may be in a period that many investors seeing the current gains and the popular belief in QE and other government remedies quickly re-enter the market and not in the large markets for companies like Berkshire Hathaway*, IBM, Procter & Gamble as recommended by Goldman Sachs*, but in much more speculative NASDAQ stocks and call options. This kind of surge could produce parabolic price patterns as we head to some predictions in the years ahead of 3000 on the S&P 500, but perhaps much sooner than expected. This kind of enthusiasm could set up my feared spike which could lead to a generational decline on the order of 50% like we saw in 2008. Normally the next big drop would be further in the future, but we can not count on it.
*Owned by me personally and/or by the financial services fund I manage.

The key for my client mentioned above is what level and duration is his discomfort. He could experience pain as those around him in the short run make a pile of money before they lose most or all of it. My task is to be conscious of his pleasure/pain calculus as well as his longer-term performance.

Question of the Week: Where are you on your Pain/Pleasure investor calculus?
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