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Sunday 25 September 2011

Blood on the Street

“The time to buy is when there’s blood in the streets”, Nathan Rothschild (attributed).
Micro or Macro?

Normally stock picking investors are interested in the microeconomics of firms; their earnings power, competitive advantage and so on. These factors will, over lengthy periods, determine whether companies outperform their peers or not. In recent years, though, a curious thing has happened: these self-same investors have become more concerned with macroeconomics; the trends and decision making processes within the overall economy.

It appears that investors no longer worry much about the fundamentals of investments or even the wiggly predictions of charts, because they have a much more basic way of assessing the likely trajectory of stocks: political analysis. And the result of this may be that we will have blood running in the streets. Again.

Political Incentives

Of course, politicians always affect markets and stocks. They levy taxes, often seemingly at random, they engage in trade wars, introduce market distorting subsidies, build bridges to nowhere and direct business development, invariably with unfortunate consequences. We usually watch politicians in the hope that they’ll do something truly interesting, like fall down a hole or walk into a lamppost or tell the truth, or something. Usually we’re disappointed.

Given that the average politician’s grasp of economics is on a par with a child’s understanding of quantum gravity, we shouldn’t be too surprised when they behave like any other person who’s been incentivised to spend other people’s money in order to make sure they personally continue to draw a healthy stipend. Investment bankers, CEOs, politicians … you get the idea. Incentives matter.

However, the past decade or so has seen markets become increasingly politicised. Central banks, led by the Federal Reserve, have acted to prevent economic declines and limit the impact of recessions but this has led to the unintended consequence of markets being continually lifted by a flow of government funds. This started on Alan Greenspan's watch at the Fed: the so-called Greenspan Put, which, whether by design or not, put a floor under market falls at the cost of raising moral hazard. This has had some odd, and extremely sad, consequences as we saw in Moral Hazard, But Thanks For All The Fish. Humans being the fallible creatures that we are, we’ve responded to this kind of pattern by learning to expect it, and this has been particularly true over the past few years as quantitative easing has been applied in order to stimulate moribund economies.

(Note that although there seems to be a straightforward correlation between QE and market rises it's not entirely clear that this implies causality: it could, for instance, be a psychological boost in confidence that causes share prices to rise rather than an increased supply of money.  The jury is (sort of) out - see, for example: The Financial Market Impact of Quantitative Easing).


Even in less straitened times markets are known to be procyclical (see To Predict the Next Bust, Ask an Austrian): they overshoot on both the high side and the low side. Psychology is, as usual, implicated, as described by Borio, Furfine and Lowe in this paper:
“Cognitive biases could easily generate perceptions of risk that move procyclically. As the expansion proceeds, the memory of the materialisation of risk diminishes and incoming data are interpreted as reinforcing the view that the economy is moving along a sustainable higher expansion path. What are short-run cyclical movements are perceived as part of a new, longer run trend. This process then moves into reverse, as actual defaults and other incoming information unambiguously contradict the prevailing paradigm”
For example, if house prices rise then people should buy less houses, all things being equal, and house prices should then fall to bring buyers and sellers into equilibrium.  Instead people tend to think that if they don't buy quickly they won't be able get on the property ladder so they buy more houses, not less, and push prices up until all young people can afford is a cardboard box, the market busts and everything goes into reverse.  That's procyclicality in action and, incidentally, why equilibrium based economic models all too often go wrong.

Political Paralysis

The trouble is, now that investors have become accustomed to being saved from successive economic downturns, it’s beginning to look as though the mechanisms available to the central banks aren’t working as well as they used to while politicians, who’ve long grown accustomed to unelected officials bailing them out, are markedly unprepared to make the difficult decisions necessary to resolve the issues: and the uncertainty and paralysis in both US and European administrations doesn’t inspire confidence that they have the wherewithal to address this any time soon.

So, many investors who’ve become used to investing based on macroeconomic factors are faced with a dilemma that often to seems to resolve itself in highly speculative and, frankly, pretty hopeless political analysis. Basing an investment decision on what you think Silvio Berlusconi or Andrea Merkel thinks might be possible isn’t so much irrational as utterly insane.

A Positive Bias

Invariably the positive discussions around markets are backed by microeconomic data but unfortunately a lot of this appears to be chosen specifically to support a positive investing case.  Most market participants are biased to the long side, so at some points in the economic cycle this has to be evidence of confirmation bias. It's just hard to know when.

Arguments abound about whether markets are currently expensive or cheap, but this is always the case. It's never safe to base such estimates purely on earnings forecasts because we know that analysts always lag the turn in markets.  They only bring down their forecasts slowly, in response to actual data.  See, for example, this paper by Peter Easton:
“A comparison of the estimates of the expected rate of return based on the analysts’ forecasts with estimates based on earnings realizations suggests that analysts tend to be more optimistic than the market even when they are not making “buy” recommendations”
We also know that quite a lot of firms have been achieving record levels of profitability:
“Of the 50 largest market capitalization companies that outperformed the S&P 500 in 2010, a great many recently reported net profit margins above 20%, and of the others many reported margins near or above historical peaks. The 20 largest companies in the S&P 500 with the highest profit margins, ranging from Amgen and Google (at around 30%) to Cisco and Altria (near 18%), comprise well over 15% of the market value of the index. If the average profit margin of companies that comprise more than 15% of the S&P 500 well exceeds 20%, how is it possible that the S&P will exhibit its historical postrecession expansion of profit margins and earnings?”
Herbert Stein's Law

Now record margins are, self-evidently, a good thing for investors. Unfortunately margins are governed by Herbert Stein’s Law: “If something cannot go on forever, it will stop”. French and Fama showed  a decade ago that profit margins are mean reverting:
"Mean reversion of profitability is highly non-linear. Mean reversion is faster when profitability is below its mean and when it is far from its mean in either direction".
So if profitability is at a cyclical high in historic terms for it to carry on improving something unusual has got happen. Now, look around. Do you see anything that’s likely to positively impact corporate earnings at the moment, especially in the absence of any more deep pockets of government money to throw at the problem? No wonder markets are trembling.

Into the Labyrinth

If on a microeconomic basis we ought to expect earnings to fall this means, all things being equal, that stock prices will also fall, on average. In a world where central bankers have exhausted the mechanisms at their disposal this leaves us to fall back on politicians; which is hardly the basis of a sound investment policy no matter how versed you are in the byzantine labyrinths of power.

Heaven forefend, of course, that we should make anything quite so vulgar as a prediction. This is the real world, where the only predictable thing is that unpredictable stuff happens all the time. But if you're relying on the whims of politicians to rescue your investments you’re not investing, you’re gambling. Unfortunately if it turns out that enough of us have been trained to do this by years of bailouts then we may yet really see blood running in the Street.


  1. outstanding post a lot more thought went into this than anything I have read in the journal in recent memory

  2. Excellent post, most insightful article I have read in months.

  3. I wonder if the "too big to fail" notion will be thwarted in this lifetime.