The purpose of the stock market
When you’ve been around for as long as we have, you can’t help but come to a few conclusions—most of them unhappy. The first conclusion is that the stock market was invented to make as many people as possible as miserable for as much of the time as possible. In this sense, the stock market is a roaring success.
The second conclusion is that none of the explanations you hear advanced at the beginning of a fall in the stock market are ever the real reason for the market’s decline. There is immense admiration for all those commentators at Bloomberg and the Wall Street Journal who are able to declare each morning that “the stock market went down yesterday because…” . How can they be so certain? The stock market is one enormous game of bonneteau. The “house” whiffles around three upturned cups and a single coin. When the movement stops, the punter has to guess which of the three cups conceals the hidden coin. For the house, the name of the game is to trick the punter into concentrating on the wrong cup, so he—or she— misses what is really going on.
The stock market is a master at this game. In recent decades, we cannot recall a single occasion when the explanations advanced at the beginning of an incipient bear market turned out to be the genuine drivers of the market’s decline. Only much later did anyone piece together the real reasons for the market’s slump, usually far too late to be any practical use for investors wondering whether or not they should buy back in.
Armed with this knowledge, let’s look at the current market turmoil, and ask “What does this bastard want me to look at ?” The obvious answer is China and Greece.
So, deep down, we should be looking out for something else. And that something else is the US economy—which even as we speak could be entering a recession, probably with falling prices to boot.
Yes, yes, as Wimbledon champion John McEnroe used to protest: “You cannot be serious!” Perhaps not, but in our experience serious people seldom make money in the markets. More often it is those whom the euphemistic British like to call “characters” who come out ahead.
So here we go. When the US Federal Reserve first rolled out its “unconventional monetary policy”, fronted by its dreadful zero interest rate policy, we wrote a paper entitled The High Cost Of Free Money. The point was that the stock market was going to go up, but that the economy would not grow—or rather that growth would at best be anemic. The recommendation was for investors to be invested in shares, but to realise that they were skating on very thin ice, since the basic mechanism at the heart of economic growth—the process of creative destruction—was being suppressed. In a nutshell, the game was to remain invested in equities, so long as a recession was not looming.
Equipped with this knowledge, some time ago we set out to build a recession indicator for the US. Today the indicator is at zero, and one by one the economic signals are turning— in the wrong direction. If the past is any guide, continuous unemployment claims—which are going up—should be higher in three months time than they were two years ago. Since 1966, this has never happened without the US going into recession, except once in 1985-1986.
So the real issue in the markets may not be China or Greece, but the US. After years of false prices for interest rates and exchange rates, it looks as if the chickens are coming home to roost. We have never understood how serious economists could believe that by fixing prices they could stimulate growth. Now, reality may be about to teach them something they did not learn at university.
If we’re correct, there could be a significant impact on the 2016 US presidential campaign, the future role of the Fed and other central banks, and on the economic profession in general (the last being the least important, of course).
In conclusion: reduce the volatility of your equity portfolios by as much as you can, extend the duration of your bonds, and sell low quality bonds.