The pur­pose of the stock mar­ket

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

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