Is it time to sell?

The two recent plunges in the stock market have investors’ knees shaking. Is this a normal, healthy correction that forces expectations to align more with reality, or is this the beginning of the big one, the aftershocks of which will take the market down 50% as happened in 2000 and 2008? I’ll be able to tell you in about six months. I only predict the past because forecasting the future is too difficult.

A recent paper by the University of Chicago Booth School of Business professor George M. Constantinides and McGill University’s Anisha Ghosh, “What Information Drives Asset Prices?” offers some insights. One is that the Consumer Price Index and average hourly earnings provide better guidance about the direction of the market than does consumption spending alone. In other words, Keynes was wrong.

But the best insight is that the phase of the business cycle we are in offers the best advice on the market’s future. The authors call the phases “regimes” and use just two, expansion or recession.

The consumption and dividend growth rates have higher means in the first regime than in the second one. Therefore we identify the first regime as the regime of economic expansion, with a higher mean of consumption and dividend growth rates and longer duration than the second regime...In other words, the investor is able to effectively forecast the regime in the next period...”

So the investors who accurately guess whether the next period will usher in a recession or continue the expansion will do better at predicting the market. The authors of the paper assume that investors use a range of macroeconomic variables, including Consumer Price Index and average hourly earnings, to guess what regime or phase of the cycle comes next.

Bank of England: mainstream econ is broken

It seems that the Bank of England has been feeling the heat from its forecast that Brexit would plunge the UK into a depression. Added to the failure of mainstream economists to predict the Great Recession, the public is losing confidence in its gurus, according to a story in the Guardian,

Haldane described the collapse of Lehman Brothers as the economics profession’s “Michael Fish moment” (a reference to when the BBC weather forecaster predicted in 1987 that the UK would avoid a hurricane that went on to devastate large parts of southern England). Speaking at the Institute for Government in central London, Haldane [Bank of England Chief Economist] said meteorological forecasting had improved markedly following that embarrassing mistake and that the economics profession could follow in its footsteps.

The bank has come under intense criticism for predicting a dramatic slowdown in the UK’s fortunes in the event of a vote for Brexit only for the economy to bounce back strongly and remain one of the best performing in the developed world.

Before the referendum on divorcing the EU, Bank of England governor Mark Carney had warned that that the split would cause a recession in the second half of 2016. Instead, the UK economy grew at an annual rate of 2.4% in the third quarter with no signs of a slowdown in the fourth.

The Fed is flummoxed – ABCT has the cure

Last week the Wall Street Journal printed a report card of Fed activity for the new millennium. The writers think the Fed failed most of its curriculum.

"In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal."

Part of the Fed’s problem is that it believed the media’s hyperbole about former Fed chairman Greenspan, referring to him as the maestro during the “Great Moderation” of the decade of the 1990s. Fed officials didn’t comprehend that the mainstream media is very socialist and will grossly exaggerate every apparent success by a government agency. The Fed and most mainstream economists took the praise from the media to heart and began to believe they were invincible. They even announced that they had slain the dragon of business cycles. Meanwhile, Austrian economists warned that the corpse resembled a wind mill more than a dragon.

Stock market forecasts better economists

After the stock market stumbling through the past two weeks, you will hear top mainstream economists repeat the old joke that the market has predicted ten of the last eight recessions. The point of the joke is to belittle the idea that the market can predict recessions and to convince investors to remain fully invested. Austan Goolsbee echoed the joke on National Public Radio recently then insisted the economy was fine and he saw no recession in the near future. When asked if now was a good time to panic, he said it’s never a good time to panic and people should just ignore what the market does.

It is true that the market has predicted more recessions than actually happened, but if anyone will examine the data they will find that growth slowed dramatically after major declines in the market even though the fall wasn’t deep enough for the National Bureau of Economic Research to declare an official recession. But even with its false positives, the market has done a better job of predicting recessions than have any mainstream economists.

Mainstream economists predict the past

Mark Twain once said,"Prophesy is a good line of business, but it is full of risks," and "It is difficult to make predictions, especially about the future." In the Bureau of Economic Analysis’ (BEA) recent statement that the GDP of the US grew by 2.3% in the second quarter of this year, it isn’t predicting the future, but the past. And Twain was right, even that is hard.

Initial GDP growth numbers are not actual data; they are the output of statistical models. That’s why the BEA has to revise them in a month and again years later. Most people pay attention to the first estimate, but the real interesting information comes from the direction of the miss. Most math models will miss on the high side as the economy heads into a recession and the gnomes will revise the numbers downward. In an expansion, they will miss on the low side and be revised upward.

Who is buying?

The Dow is back over 17,000 and the S&P 500 topped 2,000 again this week. Who is buying at these nose bleed levels? According to Jeffrey Kleintop of LPL Financial the buyers are individual investors and corporations buying back their own stock (Hat tip to Christopher Rowe, Director of Investor Education at The Oxford Club). 

Currently, there are six notable trends in buying and selling in the stock market. U.S. stocks are being purchased by corporations and individuals; however, foreigners, hedge funds, institutions and insiders are net sellers.

According to data from FactSet, S&P 500 companies bought back about $160 billion in stock in the first quarter of 2014, and are on pace for an amount this quarter that is close to the all-time high of $172 billion set in the third quarter of 2007. Corporations have been decreasing the amount of shares in the market for 10 straight quarters. Over the past year, this has amounted to about 3% of shares outstanding in the S&P 500. 

Why does this matter? Individual investors tend to pile into the market near the top so that they buy high and sell low. Individuals are a small part of the market, so they function mainly as an indicator that the end is near.

Corporate buying is a much larger segment, large enough to overwhelm institutional selling and cause the market to rise. Corporations are borrowing to purchase their own stocks and pump up returns. This deflates the price/earnings ratio by inflating the earnings per share. So while I'm not a big fan of PE ratios as a guide to investing, corporate buy-backs make the ratio even less worthwhile.

But the main problem with corporate buy-backs is that the corporations are borrowing to buy. That pumps up the price of the stocks, makes management look better and in some cases triggers options and bonuses for them.

Kleintop expects institutional selling to continue. So what happens when profits go south and corporations have trouble making the payments on the loans? It will take out the largest group of buyers in the market this year. Most will have to sell the stocks they bought for a loss. That will accelerate any decline in the stock market that follows a bad earnings reporting season.

Forecasting Failure

The latest revision of GDP for the first quarter of this year caught most economists by surprise. A decline of 2.9% is the worst since the latest recession. Surprising most economists shouldn’t surprise anyone. The Laissez Faire newsletter alerted me to studies by the IMF economists Hites Ahir and Prakash Loungani on the abilities of private and public sector economists to forecast recessions. In short, their records are almost perfect, failure that is.

The photo of the Queen with the comment “Why did no one see this coming?” comes from a presentation at George Washington University on forecasting by the two economists. In a second photo, a London School of Economics representative responds, “Ma’am, to see this one coming would have ruined our perfect record of failure to see it coming.”

Stock market forecast Q3 2014

Here is the latest forecast of the S&P 500 average for the fourth quarter this year. The market made a head fake lower last year so it may turn around again depending on how well profits for the first quarter of this year turn out. But from the looks of things we have probably hit the high for this year and maybe for the bull market. This is a good time to think about gold and silver or possibly emerging markets since they have fallen so low.

Great Expectations part II

The previous post introduced the concept of elasticity of expectations as developed by Ludwig M. Lachmann and applies it to the stock market. Lachmann added that the velocity of price change is important as well as the practical range and break outs from the range: 

“‘Explosive’ price change is seen to be the main cause of elastic expectations, both in the sense of violent change, and in that it destroys the existing basis of expectations, the sense of normality, which provided a criterion of distinction between the more probable, the less probable, and the highly improbable. It does so by demonstrating that the highly improbable, which had been excluded from our range, is possible after all. Now, as we saw, a price will pass the limits of the range with difficulty. As it approaches them it encounters increasing pressure from inelastic expectations resulting in sales at the upper and purchases at the lower limit. To overcome the pressure of these stabilizing market forces the price movement will most probably have to be carried by a strong ‘exogenous’ force, i.e. one originating outside the market, unknown to it and therefore not taken into account when expectations were formed.”[1]

How to pick stocks

The Austrian business cycle theory suggest that investors buy stocks in the capital goods sector, or cyclical stocks, in the early years of an expansion and switch to consumer goods makers in the later years. Investors can do that easily with exchange traded funds (ETF) which cluster stocks in a dizzying array of industries, commodities and countries. For example, one of the better known tech stock ETFs is QQQ, which contains the stocks of a lot of capital goods companies.

But as happens with any grouping of large numbers of companies, most will be dogs. Only a few will be excellent companies whose profits grow well and whose stock prices reflect that growth. Most of the members of the ETF will act like an anchor on the value of the ETF. The only solution is to buy individual stocks, but analyzing thousands of individual companies takes more time than most part time investors enjoy.