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Pavlov's Market

Submitted by Joseph Y Calhoun via Alhambra Investment Partners,

Stocks rallied strongly last week in response to comments by Mario Draghi that signaled a willingness, a determination in fact, to engage in more monetary stimulus. In fact, Draghi seemed to promise – once again – to do “whatever it takes”, offering to consider “a whole menu of monetary policy instruments” in saying that the ECB was now “vigilant”. One wonders why they were less than vigilant before last week but the market didn’t much care about that.  Apparently the use of the V word is code in Europe for more interest rate cuts – a minus sign by itself apparently not sufficient to revive the sclerotic European economy – something of which I was blissfully unaware until Friday. Stock market punters certainly got the message and bid stocks higher the world over, presumably in anticipation of better growth.

Why exactly more monetary stimulus now – after repeated applications of extreme policy in recent years – should be expected to produce more growth is a bit of a mystery. To date, there is no country one can point to and say that QE was an unmitigated success, that it restored a country’s economy to full health. And I doubt there ever will be since it only gets applied in countries or regions that are having severe economic problems, generally ones that are immune to monetary nostrums. You can’t fix fiscal and regulatory problems with more bank reserves and a cheaper currency.

Nevertheless, monetary stimulus in whatever form has become associated since the last economic crisis with rising stock prices and the mere hint of more stimulates, if nothing else, the algorithms that do most of the trading these days. Like Pavlov’s dogs, no actual stimulus is even required. A hint, a dog whistle or just weak economic data will do. Anything that rings the monetary bell triggers the risk taking salivary glands.

The connection between monetary stimulus and the stock market is a tenuous one that runs, ultimately, through corporate profits and therefore, to some degree, economic growth. In the past, monetary stimulus – rate cuts – was associated with weak stock market performance because it was applied when the economy was weakening and there was a presumed lag between a change in policy and its ultimate effect. Monetary policy works with long and variable lags as the economists put it. So, monetary stimulus was good for stocks but not right now; more stimulus was a sign of failure, that previous cuts weren’t sufficient, in the judgment of the central bank, to revive growth.

In the 2000 recession and bear market, the Fed cut the Fed Funds rate from 6.5% to 1% over a period of roughly three years and the stock market fell for almost the entire time. In the last recession and bear market the Fed cut the Fed Funds rate from 5.25% to the current 0 – 0.25% range starting in July 2007. The stock market fell, again, almost the entire time rates were being cut. In both cases, the economy eventually turned the corner, earnings improved and stock prices followed. Whether that was due to monetary policy or in spite of it is hard, maybe impossible, to determine.

QE supposedly works differently, through the portfolio balance channel, a mixture of wealth effect and forced risk taking. QE removes high quality bonds from the market and forces investors to move out on the risk scale to replace the Treasuries they sell to the Fed. The effect is to reduce corporate borrowing costs in the hope that the borrowers will find something productive to do with the extra cash. Further, because QE forces more buyers into the private sector bond markets it raises the price of those assets. The owners of those assets feel wealthier and will presumably spend more, further stimulating economic growth. The European version is slightly different but looks to accomplish the same thing – force capital into the private sector. That’s the basic theory anyway.

That it hasn’t really worked that way is apparently no impediment to those unconcerned with correlation and causation. The fact that stock prices have risen during periods of QE is not sufficient to prove that QE caused higher stock prices. It may have been something else that caused stock prices to rise and if so, it would seem pretty important to figure that out before acting – buying – on promises of more stimulus. One might also consider why Draghi and the ECB believe more stimulus is needed and whether policy really does work with long and variable lags.

Stock prices are ultimately about earnings and the discount rate one applies to them. Monetary policy can have an impact on the discount rate directly but its influence over earnings is much less. There are many things that affect profit margins and earnings per share, most of them having little to do with interest rates or even economic growth for that matter. And since rates have been at this depressed level since 2008 one would think that stocks are no longer moving on expectations of a lower discount rate. That leaves earnings as the primary driver of stock prices and for anyone buying on the ECB QE and China rate cut news that might present a problem.

The immediate effect, besides pushing up stock prices, was a rise in the value of the dollar versus the Euro and the Yen. It seems to have been forgotten in the hoopla, the conditioned response to more monetary cowbell, but it was only a couple of months ago that the world’s stock markets were reacting pretty negatively to a strong and steadily rising dollar. And for good reason if recent earnings reports are any indication. If stocks follow earnings – and ultimately they do – a rapidly rising dollar isn’t going to be a positive development for US multinational companies. It also isn’t good news – still – for countries trying to stem capital outflows.

Neither is it necessarily a positive development for the rest of the global economy. I have always been mystified that a strategy that drives capital away is considered stimulus. A more logical strategy would be to enact policies that attract capital not repel it. In fact, a cheaper currency doesn’t solve any problem; it is merely an acknowledgment of past economic mistakes. A cheaper currency doesn’t make a country poorer; it is a revelation of its true worth. It is the country’s other economic policies that made it poor, a falling currency and the policy that produces it being merely the market’s expression of that failure.

It was only a couple of months ago that a rapidly rising dollar was pushing the global economy closer to a new crisis. It seems unlikely that the conditions that made a rapidly rising dollar a problem in August have all been resolved by October. Those who bought stocks last week in response to hints of more easing from Draghi – and the rate cut in China – may find themselves in the same position as Pavlov’s dogs, wondering why no meal follows the ringing of the bell.