The Low Correlation Between the Stock Market And Economic Growth

Analyst John Mauldin cites Crestmont Research’s Ed Easterling who argues “stock market is not correlated with economic growth”.

They say “secular bear markets even have higher nominal GDP growth than secular bulls”, with the chart below as proof…

And also say “34% of the years since 1950 with economic growth have experienced declining earnings per share (EPS) growth!” Again a series of chart below as proof…

I am puzzled.

If “low correlation” means economic growth has not functioned as a good indicator of the direction of the stockmarket price trends, then why the heck, do these experts keep talking about various aspects of “economic growth” at all? This is obviously a cognitive dissonance.

One factor for the insistence of the “economic growth” conversation could be that they don’t agree with the referenced opinion.

A second factor could be entertainment value. Experts write to entertain more than to disseminate positive knowledge.

A third factor could be to use of such contrarian evidence as cover to their earlier misdiagnosis of the markets and the attendant mistakes in prediction.

Finally this could all be about social signalling.

Yet this just goes to show how more and more ‘experts’ appear to be getting lost or confused about what’s been going on. In other words, traditional methodologies and metrics are becoming more dysfunctional.

And all this provides more credence to what I’ve been saying all along.

Stock Market Prices: Inflation versus Corporate Fundamentals

Even in the US the supposed causal relationship between stock prices and earnings appear headed for irrelevance. That’s especially a conundrum for experts whom are fixated with “fundamentals” and seem at a loss on how market cycles occur.

Writes Vitaliy Katsenelson in A Sideways View of the World [via John Mauldin]

(bold highlights mine)

The stock market seems to suffer from some sort of multiple personality disorder. One personality is in a chronic state of extreme happiness, and the other suffers from severe depression. Rarely do the two come to the surface at once. Usually one dominates the other for long periods of time. Over time, these personalities cancel each other out, so on average the stock market is a rational fellow. But rarely does the stock market behave in an average manner.

Among the most important concepts in investing is mean reversion, and unfortunately it is often misunderstood. The mean is the average of a series of low and high numbers – fairly simple stuff. The confusion arises in the application of reversion to the mean concept. Investors often assume that when mean reversion takes place the figures in question settle at the mean, but it just ain't so.

Although P/Es may settle at the mean, that is not what the concept of mean reversion implies; rather, it suggests tendency (direction) of a movement towards the mean. Add human emotion into the mix and P/Es turn into a pendulum – swinging from one extreme to the other (just as investors' emotions do) while spending very little time in the center. Thus, it is rational to expect that a period of above-average P/Es should be followed by a period of below-average P/Es and vice versa.

People’s random-like personalities can’t create excessively wild swings in the stock market if the stock market is solely funded by the scarcity of savings.

In other words, greed and fear is no less than a symptom of a structural underlying cause—“circulation” credit inflation.

Mr. Katsenelson adds,

In sideways markets P/E ratios decline. They say that payback is a bitch, and that is what sideways markets are all about: investors pay back in declining P/Es for the excess returns of the preceding bull market.

We say no more that this represents a manifestation of a credit driven boom-bust cycle where investors overpay during a credit driven boom cycle and vice versa.

More from Mr. Katsenelson

Mean reversion is the Rodney Dangerfield of investing: it gets no respect. Mean reversion is as important to investing as the law of gravity is to physics. As long as humans come equipped with the standard emotional equipment package, market cycles will persist and the pendulum will continue to swing from one extreme to the other.

Mean reversion is simply the product of unsustainable booms.

This reminds us of Fritz Machlup who once wrote,

-A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.

-Any decrease in the effective supply of money capital is likely to cause disturbances in the production process.

-An inflated rate of investment can probably be maintained only with a steady or increasing rate of credit expansion. A set-back is likely to occur when credit expansion stops.

In short, the Austrian Business Trade cycle explains more the workings of the dynamics of stock market prices than mainstream’s “corporate fundamentals”. Even celebrity "former grizzly bear" guru Jeremy Grantham observed of this phenomenon but had a difficult time explaining it.

Firecrackers and Social Signalling

Many Filipinos greet the New Year with a bang-literally.

During New Year’s eve, they turn the streets into virtual war zones, despite all the years of gory casualties from one moment’s fun.

And this comes despite repeated government intervention by prohibiting and or regulating the manufacture sale and use and media’s bombardment to show harmful effects of such activity.

Many Filipinos fondness for firecrackers, despite its high risks, I see as the following;

-It represents a form of informal traditionalism. It is somewhat like fiesta where New Year is annually commemorated but unlike fiesta where the means of celebration is not entirely accepted by the community.

-Exploding firecrackers could be seen as a form of sublime status signalling aimed at drawing upon public’s attention. The dominance of male usage enhances this ‘masculinity’ or ‘machismo’ syndrome.

-This activity can also serve as an expression of socio-political opinion, which had been used as signs to protest against the Marcos regime or even as opiate- an avenue to vent personal frustrations for some. In short, in my opinion, there are many psychological factors behind its persistence and not limited to a single dominant variable.

-With respect to social signals, I don’t share the view that firecrackers are representative of the flawed mentality particularly symptomatic on the ‘poor’. To what category defines poor? Will people earning $2 a day (moderate poverty as defined by World Bank) really sacrifice or exchange subsistence (food) for firecrackers? This defies logic.

The fact that the $16 million firecracker industry has reportedly been constantly growing reveals that such allegation is unfounded. The industry won’t and can’t grow if it had depended on the ‘poor’.

Alternatively, this means that it is the middleclass and the rich that has continually financed the industry’s growth.

As a side note, the local firecracker industry has turned international, with a local outfit partly hosting the World Pyro Olympics. The internationalization of the industry means a growing market for its ‘quality’ products abroad.

-It isn’t capitalism fault too. Some maliciously argue that manufacturers are out there to find new markets to sell. This is grossly misleading.

The fact that firecrackers have long been a part of this society (here is an article which links to the Pinoy ethos to Chinese origins), and the fact that government has repeatedly imposed different forms of restrictions (from bans to selective regulation) to the supply-side which has failed to curb the growth of the industry means that the supply side have only caught up with existing demand and not the other way around.

To repeat for emphasis, supply caught up with extant demand. As to whether demand constitutes as psychological or cultural or social expressions is actually beside the point. The fact is there has been demand for firecrackers.

Instead, what bans have nurtured have been an underground movement which has only weakened product quality and contributed to the statistics of injuries.

Some have used the Davao prohibition as a regulatory success story, which apparently many statists sees as a matter of implementing 'political will'.

Well, I am unsure of the veracity of the claims to the success story (to what degree is the success- 100% or absolute compliance???)

Yet even if true, Davao’s micro dynamics (1.3 million population 2007 census) would certainly be different with the NCR (11.5 million 2007 census) and with the rest of the nation.

Importantly, where Metro Manila is the political capital of the Philippines this implies that as home of lawmakers and equally lawbreakers (those who think they are above the law-mostly through patron-client relations), such diversity and inequality in the distribution of political power may translate to complexities in the implementation of such regulations.

One must be reminded that it does NOT take only political will (again strictly a supply side view) from political leaders but likewise the conformity of the populace with the regulation (demand side).

As 1923 Pultizer Prize William Allen White (1868-1944) wrote to his anxious friend, ``You can have no wise laws nor free enforcement of wise laws unless there is free expression of the wisdom of the people -- and, alas, their folly with it. But if there is freedom, folly will die of its own poison, and the wisdom will survive."

So people either choose to comply with laws (or regulations) or they don't. Think People Power Revolution. And that's the demand side which the opinion makers frequently forget to account for.

Have a wonderful 2011!

Presidential Inaugural, Traditionalism And Spending Other People's Money

People are enthralled with ritualism.

This would be evident today in the inaugural of President-elect Benigno “Noynoy” Aquino III and Vice President-elect Jejomar Binay.

And the pomp and pageantry attendant to this celebration comes with a cost; we learned that more than 10 million pesos (US $215,000) had been earmarked for this grand event.

My wife tells me to let this be (which I guess reflects the mainstream view), since this has been a tradition.

To heck with tradition! Money consumed from public spending extravagance is always lost productivity.

And the same reason holds why Philippine poverty rates has also been a tradition, the Australian government website notes that, ``In 2006, almost 27.6 million people lived below the Philippines' poverty threshold. This represents 26.9 per cent of Philippine families and 32.9 per cent of the population. According to international data, 44 per cent of the population subsisted on US$2 or less a day.”

Since money is a scarce resource, public spending, which is always political, represents the priorities of political leaders. Therefore, traditionalism means “the heck with poverty, long live grandiosity!” Poverty, thus, is reduced to political convenience. They matter only during elections and when justifying policies to the public to expand government's role in society.

As the illustrious Milton Friedman precisely said, ``If I spend somebody else’s money on myself, then I’m sure going to have a good lunch!"

4 ways to spend money, table from Freedom Channel Blog

Thus, free lunch it is, at our expense.

How true, yet how unfortunate.

Unfortunate because, as Ludwig von Mises wrote in Omnipotent Government, "people lack the mental ability to absorb the principles of sound economics. Most men are too dull to follow complicated chains of reasoning".

In other words, the public's lack of understanding makes us all so easily manipulated by political leaders.

Desperately Looking For Normal-In Pictures

Here is another demonstration of how massively disconnected the stock markets are with conventional fundamentalism (e.g. economy or earnings)-which is the reason why many "experts" have been utterly perplexed.

Russia's RTSI had been one of the top world performers for 2009 and produced 129% in local currency gains!


The conventional thought have been that stocks function as forward looking indicators for the economy with about a window of 4 to 6 months ahead.

Yet the Russian economy has wobbled ALL throughout last year as shown below from US Global Investors.


According to US Global Investors, ``Russian GDP contraction is estimated to decelerate to -5.3 percent in the fourth quarter compared to -9.8 percent in the third quarter. The beginning of economic recovery as well as the base effect means a substantial upside to 3-4 percent growth estimate in 2010."

The RTSI spiked by another astounding 8% this week!

More.

In our recent post, Venezuela's Path To Hyperinflation we noted that despite the recent crisis-massive devaluation and electricity rationing-Venezuela's stock market benchmark, the IBVC, soared by a whopping 10.85% this week!

Chart From Bloomberg

No, it isn't that Venezuela is immune or crisis proof.

Instead it is likely that we are witnessing accelerated signs of the demonetization process or the trajectory towards hyperinflation.

Bottom line: the common denominator appears to be massive inflationism and how these has mangled economic calculation and has thus resulted to unexpected volatility.

Politics Ruled The Market In 2009

``Looking back, policymakers of all stripes missed their opportunities to make tough but necessary decisions in 2009. And now 2010 just doesn’t have the feel of a year that will witness a lot of decisive policymaking. In Washington, the focus will turn to the 2010 elections. The Fed will worry about its reputation and independence. Fearing for their jobs and fearful of mistakes, timid will win over bold. Bubbles treasure timid.”-Doug Noland, Issues 2010

At the start of the year, a friend asked, where I thought the local stock market is headed for in 2010. When my reply wasn’t in a definitive, I was asked instead where I FELT the market would go. Not satisfied in dealing with matters most- an analysis of the risk reward tradeoffs-I was expected to reply in the reductio ad absurdum or a confirmation of a preconceived bias.

And this is why Warren Buffett’s pejorative of stock forecasters becomes a reality, ``We have long felt that the only value of stock forecasters is to make fortune-tellers look good”. That’s because it has been a propensity for the public to reduce the role of financial market investments into intuitive based pulsating adrenalin based fortune telling “punts”, i.e. the euphemism for gambling.

Well, in dealing with markets most people deserve their fate.

Making New Year’s projection would have been evident from our notes of late last year. You can check out Following The Money Trail: Inflation A Key Theme For 2010, where we argued that inflation will be a concern for the year or How The Surging Philippine Peso Reflects On Global Inflationism where we argued for the case of a stronger Peso and a higher Phisix.

Nevertheless while it is easy to say or to get wedded to the notion or be overwhelmed by the bias that the Phisix will likely be significantly higher and that the Peso might be materially stronger, we might fall into a Pollyannaish trap without taking into consideration of what might preclude this from happening.

Market Extraordinaire

For starters, one must realize that last year, hardly anything that operated in the markets seemed traditional or conventional. Said differently, the market sailed in uncharted waters.

The fundamental distinction from the tradition market behavior had been the extent of concerted and coordinated inflationism engaged by global governments.

Data provider and research outfit Trim Tabs recently decomposed the buyers of the latest rally in the US markets and found little proof of mass public participation (see figure 1).

Figure 1: Fool.com/Trim Tabs: Who’s Buying This Rally?

This is why the “desperately seeking normal” camp has utilized myriad justifications for declaring the market’s unsustainable trend, such as a low volume or sponsorship (John Hussman), low cash levels of mutual funds (Claus Vogt), or even worst cycle for dividends (Floyd Norris) [But unlike the others, Mr. Norris makes a spin that a sharp plunge in dividends may translate to a sharp recovery] to many other issues mostly focused on valuations (e.g. Vitaliy Katsenelson).

Little have these experts noticed that government policies of printing colossal waves of digital and paper money would have an impact to the markets, had to go somewhere or find something to exchange for and would affect the markets and the economy unevenly. One analyst even called “inflation” as “secondary” concern.

In short, the basic flaw wasn’t only to underestimate on money’s neutrality but to greatly discount the incentives of the policymakers that prompted for such policy actions.

Value Scale Of Authorities: Banking Gets The Priority

Importantly, the obvious policy priorities of global authorities, especially in the US have been to rescue and ensure the survival of its banking system. The US and European governments have spent and guaranteed some $15 trillion (Bloomberg) of commitments or liabilities! This signifies as more than two fifths of the combined economy.

For anyone to argue that these governments have been devoting their efforts to mitigating economic woes (such as unemployment) have severely been misjudging the scale of values of those in power.

And this also has been evident with a shift in the model of the banking system from one providing traditional “loan services” to a “Banker as Trader” business model, where major banks have seen profit windfall from arbitraging financial markets that have been heavily massaged by the US government.

In 5 Reasons Why The Recent Market Slump Is Not What Mainstream Expects, we have discussed why most of the financial markets have been dysfunctional to price market based risks.

We said that…

1. By manipulating the mortgage markets and US treasury markets with the explicit goal of lowering interest rates, in order to ease the pressures on property values and to mitigate the losses in the balance sheets of the banking system,

2. By working to steepen the yield curve, which allows for conducive and favorable trading spreads for banks to profit and to enhance maturity transformation aimed at bolstering lending, and

3. By providing the implicit guarantees on ‘Too Big To Fail’ banks or financial institutions, this essentially encourages the revival of the ‘animal spirits’ by fueling a run in the stock markets.

Let me add that by implementing quantitative easing programs, the US government has fundamentally been subsidizing her banks by absorbing the toxic assets of the banking system allowing for the cosmetic enhancements of their balance sheets.

Next, by juicing up the equity markets, the US government has attempted to unleash the “animal spirits” in order for the market to abet on the financing of equity to the capital dispossessed banking and financial industry.

And like hitting two birds with a single stone, such unprecedented scale of market manipulations attempts to paint a picture of recovery and allow for the redeployment of stashed capital at the expense of savers.

In other words, the incentives to manipulate the financial markets to attain stabilization of the banking system appear commandingly superior to any other concerns.

Ergo, the markets of 2009 behaved in terms of the impact from political policies, as we correctly predicted in November of 2008 [see Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?], and believe that such dynamics will remain in operation for 2010, as we asserted in Investment Is Now A Gamble On Politics.

How does the US government manipulate the stock market? Perhaps through the Presidential Working Group On Financial Markets, an ad hoc group created in March 18, 1988 via Executive Order 12631 by President Ronald Reagan “established explicitly in response to events in the financial markets”, possibly channeled through the S & P futures.

As Zero Hedge’s Tyler Durden suggests, ``One way to manipulate the stock market would be for the Fed or the Treasury to buy $20 billion, plus or minus, of S&P 500 stock futures each month for a year. Depending on margin levels, $20 billion per month would translate into at least $100 billion in notional buying power. Given the hugely oversold market early in March, not only would a new $100 billion per month of buying power have stopped stock prices from plunging, but it would have encouraged huge amounts of sideline cash to flow into equities to absorb the $300 billion in newly printed shares that have been sold since the start of April.”

Of course, manipulation of the stock market would be speculation on our part. But the underlying incentive seems credible enough to suggest that such conjecture could be for real.