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.

Another market head fake

In the world of real bull riding, as opposed to nominal bull riding, or investing, the cowboy (investor) must anticipate the spins and leaps of the bull. Riders often study video of bulls engaged in previous games of cowboy tossing. A wrong guess sends the cowboy flying then landing awkwardly absent a score and without money.

So what can we make of the January plunge and recent recovery of the bull market? I am betting that the bull’s real intention is to plunge into a bear and that the latest rise in stocks is a head fake to trick the cowboys to overcompensate in anticipation of a continued ascent. Instead, the bull will reverse direction and slingshot the cowboy (investor).

Some of us are mystified by the recent rise in stock prices, but as the great Austrian economist Ludwig Lachmann wrote, moving the deeply anchored expectations of investors out of their comfort range for prices on the market requires extraordinary events. Some of us have seen indicators as early as two years ago, such as the hedge fund manager Mark Spritznagel, author of The Dao of Capital: Austrian Investing in a Distorted World.