Why Won't This Market Do What It Is Supposed To Do?

With interest rates going the wrong way, down when just about every market guru has said they should be going up, and stocks going up when the economy is disappointing and we are overdue for a correction, market mavens are confused and many are asking, “Why won’t this market do what it is supposed to do?”

If markets did what the prognosticators say they are supposed to do, then a majority of participants would make money, but we know the opposite is true. The vast majority of participants do not make money. They account for the noise in the market, the day by day wiggles that cause the market averages to fluctuate above and below the longer term trend, and the sharper spikes and dips in individual issues as they respond to company or industry specific news. This part of the market is a zero-sum game with a minority of the luckier and more experienced traders having a small edge over the less lucky and inexperienced.

The direction of markets, the speed of adjustment and the price levels that they settle at during periods of consolidation is determined by a much smaller group of professional money managers working for investment funds, hedge funds, endowments, insurance companies, brokerages and other such financial institutions. These professional investors account for only a small part of the trading volume because they do not churn their portfolios on a minute by minute, daily or weekly basis, but rather tend for the most part to hold their investments for several months and some cases for several years. They may account for 10% or less of the trading volume, but they control at least 90% of the total assets held, and it is the weight of those holdings that determine the trends and levels of markets.

The forecasts made by economists are carefully studied by these money managers, and as we all do, they absorb into their thinking every other bit of news, business, political and otherwise. But they do not give much weight to the pundits and prognosticators of the popular media. In general they listen most closely to what colleagues and other members of their profession are saying and doing, partly because they speak the same language, using jargon and technical talk unfamiliar to most people outside the profession, and partly because there is security in being a part of the herd or fraternity. Being wrong along with most of their fellow managers is tolerable, but being wrong while at odds with the rest is catastrophic for one's reputation.

The best indicator of what money managers think of the economy is the behavior of the bond market. The stock market is far too diverse and subject to too many influences to be a reliable guide because there one must assess the impact of the economy on particular industries, and on the revenues and profit margins of particular companies, while in the bond market, especially the Treasury market where credit risk is totally absent, little matters other than the economy, fiscal and monetary policy. With fiscal policy immobilized by the political stalemate, and the economy limited by struggling consumers and lagging business investment, monetary policy is left as the overwhelming top consideration of money managers.

Money managers as reflected in the action of the bond market are clearly taking a less optimistic view of the economy than the Fed and most business economists have taken in recent months with their insistence that the weather was the main cause of the poor first quarter data when GDP fell by an estimated 1.0%, and that the lost output would be made up in an even stronger second quarter and remainder of the year. April was another weak month for the economy, tending to confirm the bond market's message. The anticipated signs of strength finally began to emerge in May, but the bond market's reaction was tepid, partly explained by anticipation that the European Central Bank's lower interest rates and aggressive easing would spill over into downward pressure on U.S. interest rates, as it apparently has.

Also influencing money managers is the growing chorus of academic economists led by Larry Summers, Brad DeLong, Joseph Stiglitz, Paul Krugman, and lately Noriel Rubini, reinforced by the appeal of Thomas Piketty's book on inequality, calling attention to the theory of “secular stagnation” which holds that the economy may be permanently locked into low growth and high unemployment by insufficient demand, insufficient spending by consumers and government, and hence insufficient incentive for business investment.

All eyes will now be on next Tuesday and Wednesday's Fed meetings, and the Yellen press conference Wednesday afternoon. Given the unusually large dichotomy of views on the economy, there will be intense interest in seeing how the Fed will characterize the incoming economic data, how far back they will trim their estimate of 2.8% to 3.0% GDP growth for 2014, whether they will stick with their prediction of 3%+ growth in 2015, and if they remain optimistic about improvements in the job market. Money managers, however, will be intensely interested in these numbers mainly for what they portend about future interest rates and not so much about the economy per se. The expectation remains for an end to QE by the end of this year, and for the Fed funds rate to begin being lifted in the middle of next year reaching 1.0% by the end of 2015. Fed optimism about the economy and an unchanged policy stance will be a net negative for both the bond and stock markets (sending interest rates higher), while any recognition of weakness in the economy and signs of dovishness on the part of the Fed will likely propel both markets higher (sending interest rates lower).

If secular stagnation is here, as I believe, then the Fed may be locked into a low interest rate policy and some form of QE indefinitely, despite the dangers they see in more QE. The Fed taper does not mean that it has stopped pumping in liquidity, only that it is doing so more slowly, and influential Fed Governor Dudley has already warned that an end to QE does not mean that the Fed will ever reduce its balance sheet, i.e. sell assets. So with the Fed continuing to pump liquidity into the economy, which asset prices will go up most? Stocks, bonds, commodities, real estate, loans, FX, derivatives, other alternative assets? Take your pick.

With the economy experiencing secular stagnation, it may be impossible for the Fed to tighten policy and raise interest rates in the foreseeable future because to do so would bring on a recession, or worse yet, the deflation that they dread so much. We will be looking for clues as to how the Fed balances the risk of secular stagnation with the risk of excess liquidity. A stagnant economy provides little incentive for investment in plant, machinery, equipment and software, and divided government keeps a lid on government spending, so there is no alternative to the Fed for keeping the economy afloat.

While economic news will have its temporary effect on market sentiment, the driving force for markets under these circumstances is the Fed, not the economy, and there is no reason that asset prices, especially stock prices, should not continue to rise even in a stagnant economy. Profits will be sustained via updated technology, wage suppression and by corporations using their vast cash hoards for stock buybacks and acquisitions that are accretive to revenue and earnings . The Fed liquidity pump will avoid the kind of cyclical downturn that depresses profits across a broad swath of the economy, and price-earnings multiples can rise substantially from present moderate levels.

Absent dangerous speculative bubbles (none have appeared so far) or severe imbalances in the economy (less prevalent these days because of far more effective tools for managing supply chain inventories), a downward spiral is unlikely -- just slow growth and persistently high unemployment. People are in general still very cautious and risk averse, which is a good thing. The time to worry is when animal spirits get out of control and we see speculative binges emerging, or when deflation causes consumers and businesses to defer spending in anticipation of lower prices in the future (no sign of that yet, inflation expectations remain well anchored).

The threat of a severe adjustment, a Minsky moment, is bound to emerge at some point as we continue pumping up the financial side of the economy at a much faster rate than the real side, but no one can know for sure when that will happen. It could be 5 or 10 years in the future, or even longer if the authorities are sufficiently alert and people remain cautious. It will be interesting to see how the Fed weighs this risk against the risk of recession or deflation.