The apex of mar­ket stu­pid­ity

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In some 40 years of watch­ing fi­nan­cial mar­kets, my dom­i­nant emo­tion has been a mix­ture of cu­rios­ity, amuse­ment and de­spair. It seems the stock mar­ket must have been in­vented to make the max­i­mum num­ber of peo­ple mis­er­able for the great­est pos­si­ble amount of time. The bond mar­ket, mean­while, has just one goal in life: to make econ­o­mists’ fore­casts for in­ter­est rates look even sil­lier than their other pre­dic­tions.

Over the years, I have of­ten ob­served how most mar­ket par­tic­i­pants are able to con­cen­trate on only one set of in­for­ma­tion at a time. For ex­am­ple, in the 1970s, the only data release that mat­tered was the con­sumer price in­dex. In the days lead­ing up to the CPI’s pub­li­ca­tion, ev­ery­body dropped all other con­sid­er­a­tions to spec­u­late fever­ishly about what the num­ber might be. And then fol­low­ing the release, they would spend the next week or two com­ment­ing sagely on what the num­ber ac­tu­ally had been. Even­tu­ally, Mil­ton Friedman con­vinced the Fed­eral Re­serve (and from there the mar­kets) that there was some kind of re­la­tion­ship be­tween the money sup­ply and the CPI. So, ev­ery­one stopped look­ing at the CPI, and in­stead started to fo­cus on the pub­li­ca­tion ev­ery Thurs­day evening of M1 (or was it M2?). In­evitably, each week would see an im­me­di­ate rash of com­men­tary on th­ese ar­cane mat­ters from the lead­ing spe­cial­ists at the time, Dr. Doom and Dr. Gloom.

This gave way to a pe­riod in which the US dol­lar went through the roof on the cov­er­ing of short po­si­tions es­tab­lished dur­ing the era of the min­is­ter of silly walks in the 1970s. For a few years, the only thing that mat­tered was the spread be­tween the three-month T-bill yield and the three­month rate on dol­lar de­posits in Lon­don (an in­di­ca­tion of the short­age of dol­lars out­side the US). The beauty of this one was that the scrib­blers on Wall Street could com­ment on it twice a day or more, which of course had no dis­cernible im­pact on re­al­ity, ex­cept for the de­struc­tion of the forests needed to print so much waf­fle.

That era came to an end in 1985 with the Plaza Ac­cord. At that point the Fed, un­der the wise guidance of Paul Vol­cker — my favourite cen­tral banker of all time, prob­a­bly be­cause he was the only one with­out a PhD in eco­nomics, which may well ex­plain his suc­cess — de­cided it was go­ing to fol­low a type of Wick­sel­lian rule-based pol­icy un­der which short rates were kept closely in line with the rate of GDP growth. Of course, this meant the Fed paid lit­tle at­ten­tion to the va­garies of the fi­nan­cial mar­kets, so there was very lit­tle to com­ment on. The re­sult of pol­i­cy­mak­ers’ lack of in­ter­est in fi­nan­cial mar­kets was that from 1985 to 2000 the US en­joyed a long pe­riod of ris­ing eco­nomic growth, low in­fla­tion, low un­em­ploy­ment and high pro­duc­tiv­ity; a pe­riod dubbed “the great mod­er­a­tion”. The trou­ble was that no one was able to make any money trad­ing on in­side in­for­ma­tion pro­vided by the politi­cians and cen­tral bankers. As an ad­ver­tise­ment for Smith Bar­ney put it at the time: “We are making money the old way. We earn it.”

Nat­u­rally, that wouldn’t do at all. Af­ter nearly 20 years of eco­nomic suc­cess, the US bud­get was in sur­plus, the pen­sion funds were over-funded, and the “con­sul­tants” in Wash­ing­ton were on the verge of bank­ruptcy, hav­ing noth­ing to say. Clearly some­thing had to be done, and it was: pol­icy shifted to ac­com­mo­date Wall Street, with for­ward guidance, neg­a­tive real rates, the pri­va­ti­za­tion of money, and a lack of reg­u­la­tion. This al­lowed Wall Street to make money, but it cre­ated night­mares else­where through the ev­er­suc­cess­ful eu­thana­sia of the dread­ful ren­tier.

Still, the shift to an econ­omy driven by the de­ci­sions of cen­tral bankers meant the mar­ket com­men­ta­tors were back in busi­ness in a big way. For the last 12 years, the only thing that has mat­tered has been to know whether or not the chair­man of the Fed­eral Re­serve has had a good night’s sleep. Sim­i­larly in Europe, the dys­func­tional euro, cre­ated by a bunch of in­com­pe­tent politi­cians and Eu­ro­crats, bred drama af­ter drama. Since no­body wanted to ad­mit it was a fail­ure, the most im­por­tant man in Europe be­came the pres­i­dent of the Euro­pean Cen­tral Bank.

In the last week, we have reached what is surely the apex of this stu­pid­ity. A bunch of algo traders pro­grammed their com­put­ers ex­pect­ing “De­riv­a­tive Draghi” to be ex­tremely dovish, as any proper Ital­ian cen­tral banker should be. I am not sure I understand why, but some traders ob­vi­ously de­cided that he had not been dovish enough. Euro­pean stock mar­kets plunged by -4%, while the euro went up by roughly the same amount in the space of a few min­utes. What that means is sim­ple: value in the fi­nan­cial mar­kets is no longer a func­tion of the dis­counted cash flow of fu­ture in­come, but in­stead is de­ter­mined by the amount of money the cen­tral bank is print­ing, and es­pe­cially by how much it in­tends to print in the com­ing months. So we are in a world where I can pos­tu­late the fol­low­ing eco­nomic and fi­nan­cial law: vari­a­tions in the value of as­sets are a func­tion of the ex­pected changes in the quan­tity of money printed by the cen­tral bank. To put it in a for­mat that to­day’s econ­o­mists understand:

where VA in­crease.

What we are see­ing is in fact in one of the stu­pid­est pos­si­ble ap­pli­ca­tions of the Can­til­lon ef­fect, whereby those who are clos­est to the money-print­ing, i.e. the fi­nan­cial mar­kets, are the big­gest ben­e­fi­cia­ries of that print­ing. This is ex­actly what hap­pened in 1720 in France dur­ing the Mis­sis­sippi Bub­ble in­flated by John Law. The end re­sults were not pretty.

What I find most hi­lar­i­ous is that some se­ri­ous com­men­ta­tors have been pon­tif­i­cat­ing at con­sid­er­able length about what the mar­ket’s par­tic­i­pants think. Th­ese days, some 70% of mar­ket or­ders are gen­er­ated by com­put­ers, and many of the rest by in­dex­ers. And com­put­ers do not think. They sim­ply cal­cu­late at light speed, which al­lows them to re­act to short term move­ments in mar­ket prices as they were pro­grammed to do. And since they are all pro­grammed the same way, the re­sult is some big short term mar­ket moves. In essence, th­ese com­put­ers act as ma­chines that al­low mar­ket par­tic­i­pants to stop think­ing. As a re­sult, I can­not re­mem­ber a time when less think­ing has ever been done in the fi­nan­cial mar­kets, which is why I find to­day’s fi­nan­cial mar­kets in­fin­itely bor­ing.

We are swim­ming in an ocean of ig­no­rance, just like France in 1720. It seems all the painful eco­nomics lessons learned over the last 300 years have been for­got­ten. I sup­pose that means we will just have to wait for an­other Adam Smith to ap­pear. La vie est un eter­nel recom­mence­ment...

is the value of as­sets and M

is the mon­e­tary

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