``This is how humans are: we question all our beliefs, except for the ones we really believe, and those we never think to question.” -Orson Scott Card
If I told you that the global financial markets have been simply looking for reasons to correct from its overbought position, would you buy this argument?
For many the answer is no. People look for news to fill this vacuum or what is known as a “last illusion bias” or “the belief that someone must know what is going on[1]”.
Because it is the proclivity of man to seek more complicated explanations, the Occam Razor’s rule[2]-the simplest solution is usually the correct one- is usually perceived as inadequate. Yet even if profit taking is a real phenomenon on the individual level, outside of the realm of statistics or news linkages, this is usually deemed as inconceivable by an information starved mind.
I would surmise that such a human dynamic could be a function of esteem based reputational incentives, or the need to seek self-comfort in being seen as “sophisticated”.
And stumbling from one cognitive bias to another, this camp usually associates cause and effects to “availability heuristic” or what we simplistically call “available bias” or the practice of “estimating the frequency of an event according to the ease with which the instances of the event can be recalled”[3]. And this is so prevalent in newspaper based accounts of how the markets performed over a given period.
Though we can’t discount some influences from news on a day-to-day basis, they may contribute to what we call as “noise”, since they represent tangential forces that are distant to the genuine “signals” that truly undergirds market actions.
In other words, people frequently mistake noise for signals.
And worst, for financial market practitioners scourged by an innate “dogma” bias, a characteristic seen among the extremes, particularly in the Pollyanna and Perma Bear camps, the attempt to connect the cause and effects of market actions and the political economy is largely predicated on spotty reasoning; specifically what I call as “Cart Before the Horse” reasoning - where X is the desired conclusion, therefore event A results to X.
This can actually be read as combining both logical fallacies (Begging the Question and Post Hoc Ergo Propter Hoc) and cognitive biases, particularly Belief bias or the “evaluation of the logical strength of an argument is biased by their belief in the truth or falsity of the conclusion[4]”, from which they apply behavioral decision making errors by selective perception or choosing data that fits into their desired conclusion (while omitting the rest), by the focusing effect or placing too much emphasis on one or two aspects of an event (at the expense of the aspects) and by the Blind Spot bias or reasoning that fails to account of their personal prejudices.
In short, the deliberate misperception of reality is a representation of distorted beliefs on how the world ought to be.
Clearing Cobwebs Of Cognitive Biases and Logical Fallacies
Let apply this into today’s market actions.
In the US equity markets, the bulls have fallen short of SEVEN CONSECUTIVE[5] weeks of broad market gains following Friday’s SEC-Goldman Sachs related sell-off as the week closed mixed for key US bellwethers.
The S&P 500 was the sole spoiler among the big three benchmark, where the Dow Jones Industrials and the technology rich Nasdaq still managed to tally seven straight weeks of advances (despite Google’s 7.59% loss prior to the Goldman Sach’s news).
Yet in spite of Friday’s selloffs, the week-on-week performance by the different sectors constituting the S&P had been also been mixed (see figure 1).
Figure 1 US Global Investor: Weekly Sectoral Performance and stockcharts.com: S&P 500 Financial Sector
This means that while Friday’s market selloff had been broad based, it wasn’t enough to reverse the general trend over the broader market, even considering the largely overheated pace of the ascent for the overall markets. Yes, we have been expecting a correction[6] and perhaps this could be the start of the natural phase of any market cycle.
Moreover, while the SEC-Goldman Sachs (explanation in the below article) news may have triggered the selloff on Friday, the largest loss over the week had been in the materials and telecom sectors with the Financial, where Goldman Sachs belongs, took up the fourth position.
Considering that the S&P Financial Index took a severe drubbing on Friday (down 3.81%-see left window), this only exhibits that the sector’s muted loss on a weekly basis had been an outcome of an earlier steep climb or an upside spike!
In short, in whatever technical indicator (MACD, moving averages, or Relative Strength Index) one would look at, the US financial sector has been severely in overstretched and overbought conditions which have been looking for the right opportunity for a snapback. Apparently, the SEC-Goldman event merely provided the window for this to happen.
Perma Bears: Broken Clock Is Right Twice A Day
Now for the Perma bear camp, whom have been nearly entirely wrong since the crash of 2008, seems to have nestled on the current hoopla over the SEC-Goldman Sachs as the next issue to bring the house down.
And like a broken clock that is right only twice a day, never has it occurred to them that since markets don’t move in a straight line, they can be coincidentally ‘right’ for misplaced causal reasons.
Their horrible track record in projecting a market crash early this year predicated on the US dollar carry trade bubble and the Greek Debt Crisis has only manifested events to the contrary of their expectation in terms of both the markets and the political economy. Instead, what seem to be happening are the scenarios which we have had pointed out[7].
Here is Oxford Analytica on the US dollar carry trade[8], ``As financial markets possess a demonstrable tendency to overshoot expectations, the carry trade probably is stoking market euphoria in certain places. However, this may only be partially significant, as underlying fundamentals still inform a large cross-section of investment activities.” (bold emphasis mine).
As you can see the deepening lack of correlation, which highlights on the glaring lapses in causality linkages, from which the 2008 crash became a paradigm for the mainstream, is now being accepted as “reality”. The rear-view mirror syndrome or the anchoring bias is becoming exposed as what it is: A fundamental heuristical flaw, which cosmetically had been supported by misleading reasoning.
And as for the Greek Tragedy, the resolution is increasingly becoming a bailout option. Writes the Businessweek-Bloomberg, ``The euro may receive a temporary boost to $1.38 when Greece accesses a 45 billion euro ($61 billion) bailout plan before traders reestablish bets that the shared currency will decline, according to UBS AG.[9]”
And Morgan Stanley’s Joachim Fels, who among the mainstream analysts we respect, decries the prospective action, ``The bail-out and the ECB's softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time.[10]” (bold highlights mine)
The difference between us and Mr. Fels is that we look at the political incentives that impels the decision making process of policymakers-where the default option or the path dependency by any government, in a world of central banking, has been towards inflationism as recourse to any critical economic problem.
And Mr. Fels appears to be reading the market along our lines.
Price inflation, which Mr. Fels warns of, is starting to creep higher and becoming more manifest even in economies that have been expected to have lesser impact from inflation due to more monetary constraints, such as the Eurozone (see figure 2).
Figure 2: Danske Bank: Will Nasty Inflation Challenge the ECB?
The Danske team, led by Allan von Mehren, expects an inflation surprise[11] to challenge the European Central Bank (ECB) based on 3 factors, rising oil prices, rising food prices and depreciating Euro.
For us, these factors are merely symptoms of the political actions and not the source of inflation.
And for those plagued by the said dogmatic biases, they keep repeatedly asking the wrong question-“where is inflation?”-even when (corporate and sovereign) bonds, commodities, stocks, derivatives and most market signals have been pointing to inflation, across the world.
The fact that inflation is in positive territory for most economies, already dismisses such a highly flawed argument.
Yet, the narrowed focus or the ‘focusing effect’ or excessive tunneling on business or industrial credit take-up or unemployment rates or on rangebound sovereign yields (particularly in the US) purposely disregards the fact that inflation is a political process.
Government which resorts to the printing press as the ultimate means to resolve economic predicaments can only reduce the purchasing value of every existing currency from the introduction of new ones.
Tea Parties As Signs Of The Reemergence Of The Bond Vigilantes
In addition, such outlook neglects the fact that
-inflation has existed even during high period of unemployment rates as in the 70s,
-consumer credit isn’t the principal cause of inflation but intractable government spending and
-as argued last week, governments will opt to sustain low interest rates (even if it means manipulating them-e.g. quantitative easing) as a policy because ``governments through central banks always find low interest rates as an attractive way to finance their spending through borrowing instead of taxation, thereby favor (or would be biased for) extended period of low interest rates.[12]”
Moreover, for a population with a deepening culture of dependency on government welfare programs, the inclination is to accelerate government spending[13] in order to keep up with public demands for more welfarism. And this can only be funded by borrowing, inflation, and taxes in that pecking order.
Why taxes as the lowest priority? Because to quote Professor Gary North[14], ``Politicians fear a taxpayer revolt. Such a revolt is unlikely until investors cease buying Treasury debt. For as long as the government can run deficits at low interest rates, that is how long they will continue.”
The ballooning Tea Party in the US, for instance, which reportedly accounts for 15-25% of the population is relatively a new spontaneously organized political movement that has apparently emerged in response to the prospects of significantly higher taxes.
For the politically and economically blinded progressives to demean this as “superficial” accounts for as utter myopia. How superficial is it to resist a runaway government spending spree, which should translate to prospective higher taxes and or lower standards of living via inflation?
As author and Professor Steven Landsburg rightly argues[15], ``Once the money is spent, the bill must eventually come due—and there’s nobody around to foot that bill except the taxpayers. We are locked into higher current spending and therefore locked into higher future taxes. The president hasn’t lowered taxes; he’s raised and then deferred them. To say otherwise is—let’s be blunt—a flat-out lie.” (bold highlights mine)
Instead, the superficiality should be applied to the fabled belief that government spending and inflationism will account for society’s prosperity. Name a country over human history that has prospered from the printing press or inflationism?!
Hence, the emergence of the Tea party movement appears to sow the seeds of a taxpayer revolt, or as seen in the market, the soft resurfacing of the long absence in the bond vigilantes, who could be simply waiting at the corner to pounce on the policy mistakes based on the delusions of grandeur by charlatan governing socialists and their followers, at the opportune moment.
Until the tea partiers gain a political upperhand, the deflation story is nothing but a justification to undertake more inflationism.
The Siren Song Of Inflation
Going back to the naïve outlook for deflation, the lack of borrowing from both domestic and overseas savings doesn’t close the inflation window, in fact it enhances it. This will entirely depend on manifold forces as culture, habit (or addiction)[16], time constancy of political sentiment and political tolerance and etc...and importantly, the attendant policies in response to the political demands.
Nevertheless, Morgan Stanley’s Spyros Andreopoulos enumerates why inflation is seemingly a siren song[17] for policymakers in dealing with a gargantuan and burgeoning debt problem.
From Mr. Andreopoulos (bold emphasis his, italics mine):
``Public debt overhang: The higher the outstanding amount of government debt, the greater the burden of servicing it. Hence, the temptation to inflate increases with the debt.
``Maturity of the debt: The longer the maturity of the debt, the easier it is for a government to reduce the real costs of debt service. To take an extreme example, if the maturity of the debt is zero - i.e., the entire stock of debt rolls every period - then it would be impossible to reduce the debt burden if yields respond immediately and fully to higher inflation. Hence, the longer the maturity of the debt, the greater the temptation to inflate.
``Currency denomination of the debt: Own currency debt can be inflated away easily. Foreign currency-denominated debt on the other hand cannot be inflated away. Worse, the currency depreciation that will be the likely consequence of higher inflation would make it more difficult to repay foreign currency debt: government tax revenues are in domestic currency, and the domestic currency would be worth less in foreign currency. So, the temptation to inflate increases with the share of debt denominated in domestic currency.
``Foreign versus domestic ownership of debt: The ownership of debt determines who will be affected by higher inflation. The higher the foreign ownership, the less will the fall in the real value of government debt affect domestic residents. This matters not least because only domestic residents vote in elections. Note that unlike domestic owners, foreign owners may not necessarily be interested in the real value of government debt since they consume goods in their own country. But they will nonetheless be affected by the inflation-induced depreciation. So, the temptation to inflate increases with the share of foreign ownership of the debt.
``Proportion of debt indexed to inflation: By construction, indexed debt cannot be inflated away. Hence, the higher the proportion of debt that is indexed to inflation, the lower the temptation to inflate.
``To these purely fiscal arguments we add another dimension, private sector indebtedness:
``Private sector debt overhang: An overlevered private sector may generate macroeconomic fragility and pose a threat to public balance sheets. Hence, high private debt also increases the incentive to inflate.
As per Mr. Andreopoulos perspective, there are many alluring technical reasons on why the political option is to inflate rather than adapt market based austerity or to allow market forces to clear up previous imbalances so as to move to the direction of equilibrium.
And combined with today’s prevailing economic dogma and direction of political leadership, the path dependency will most likely be in this direction.
Real Economic Progress And Deflation
None the less, real progress is characterized by increasing efficiency and technological advances that decreases costs of production and increases in output.
The result of which is a rising value of purchasing power of money or “deflation” (see figure 3) and not higher inflation which is the result of excessive government intervention.
Figure 3: AIER: Purchasing Power of the US dollar
This was mostly the case in the United States until the introduction of the US Federal Reserve in 1913, from which the US dollar has been on a steady decline or where the only thing constant today is to see the US dollar collapse in terms of purchasing power.
Going to the US government’s Bureau of Labor Statistics’ inflation calculator, $100 US dollars in 1913 is now only worth $4.55. That’s a loss of over 95%!
So aside from death and taxes, another thing certain in this world is that the value of paper money is headed to its intrinsic value-Zero[18]!
Yet it is funny how protectionists, who stubbornly argue about the “overvalued” currency of the US as the main source of her problem, have been only been asking for more of the same nostrums, instead of looking at WHY these has emerged on the first place.
Like in reading markets, belief in myths can be the greatest error that could lead to tremendous losses that investors can get entangled with.
As former US President John F. Kennedy once said, ``The great enemy of the truth is very often not the lie -- deliberate, contrived and dishonest, but the myth, persistent, persuasive, and unrealistic. Belief in myths allows the comfort of opinion without the discomfort of thought.”
[1] Wikipedia.org, List of cognitive biases
[2] Wikipedia.org, Occam Razor
[3] Taleb, Nassim Nicolas; Fooled By Randomness, p. 195, Random House
[4] Wikipedia.org, Belief Bias
[5] The emphasis on seven is meant to highlight the degree of overextension or overheating
[6] See US Stock Markets: Rising Tide Lifts Most Boats And Is Overbought
[7] For my earlier treatise on the US dollar carry bubble see What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?, and Why The Greece Episode Means More Inflationism for my discourse on the Greece crisis.
[8] Oxford Analytica; Dollar Carry Trade No Longer a Sure Bet, Researchrecap.com
[9] Businessweek, Greek Bailout in ‘Matter of Days” to Boost Euro, UBS Says, Bloomberg
[10] Fels, Joachim, Euro Wreckage Reloaded April 16, 2010, Morgan Stanley Global Economic Forum
[11] Mehren, Allan von; Euroland: Nasty inflation surprise will challenge ECB, Danske Bank
[12] See How Moralism Impacts The Markets
[14] North, Gary The Economics Of The Free Ride
[15] Landsburg, Steven; Tax Relief, Obama Style, thebigquestions.com
[16] See Influences Of The Yield Curve On The Equity And Commodity Markets
[17] Andreopoulos, Spyros; Debtflation Temptation
[18] See Paper Money On Path To Return To Intrinsic Value - ZERO
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