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December 1, 2003

Rational Expectations

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Market action leads economic statistics, not the other way around

One of the key elements of our investment approach is the notion that market action conveys information. Market action is the result of millions of investors acting on their own information, including their personal circumstances regarding income, employment, and even their willingness to take risk. It is not necessary to drive this idea to implausible extremes (as the assumptions of the “efficient markets hypothesis” do) to have a firm respect for the idea that prices, trading volume, and other data generated by the market process must by their nature reveal some of the information held by market participants. Unfortunately, it sometimes seems that investors fail to respect this concept altogether.

Case in point is the circular reasoning that many investors take toward economic data. It's well accepted that stock market movements tend to lead economic movements (though even here, there is some disdain toward this idea, as reflected in jokes like “the stock market has predicted 11 of the past 5 recessions”). What is striking, however, is the extent to which investors also believe that economic movements ought to drive future stock market movements. The problem here is that these two beliefs create a feedback loop: investors observe stock market strength, and expect economic strength. Then seeing that economic strength, they turn around and expect stock market strength.

Let's clear this up right now. Strength in GDP, Industrial Production, Non-farm Payrolls, Capacity Utilization, and the Purchasing Managers Index are all negatively correlated with changes in the stock market during the same quarter, and are even more negatively correlated with stock market changes over the following quarter. In contrast, strength in the stock market has a positive correlation with growth in all of these economic measures over the following quarter. In short, market action leads economic statistics, NOT the other way around.

The same fact holds for corporate earnings, which have virtually no short-term correlation with stock market movements (see Bill Hester's article Corporate Profits Will Be Up Next Year). A handful of other analysts clearly understand the importance of market action, including Richard Russell (Dow Theory Letters) and the analysts at Bridgewater. But you'll get very little of this analysis in the popular media.

When investors observe strong economic data and use it to forecast strong stock market returns, they are essentially trying to use a lagging indicator to predict a leading indicator. This doesn't work well. Similarly, when investors observe Fed moves and use them to forecast bond market returns, the attempt is similarly misguided. Market action conveys information. Investors who don't respect this fact are at a distinct disadvantage to investors who do.

The Fed is still irrelevant

Another important fact for investors is that market interest rates lead the Federal Funds rate. In fact, changes in Treasury bill yields have several times the ability to predict changes in the Federal Funds rate than the other way around. At minimum, this suggests that market participants are generally able to anticipate Fed moves correctly (see Bill Hester's article on Forecasting Fed Moves). My own view is even stronger – except in instances where there is actually a constraint on the monetary base that can be eased by the Fed (such as bank runs or other financial crises), the Fed is irrelevant. Hikes in the Federal Funds rate follow, rather than lead, the credit markets. The general level of interest rates is driven by economic fundamentals, including the ability of output growth to meet demand, changes in monetary velocity, and the total quantity of government liabilities in the monetary system.

True, the Fed determines whether government liabilities take the form of currency or government debt, but since these are close portfolio substitutes, it hardly makes a difference except during financial crises (when cash is king). For instance, excessive bond issuance, by pressuring interest rates higher, also pressures monetary velocity higher, resulting in inflation just as if the government had issued currency instead. Monetary policy is powerless to change the total amount of government liabilities (which is the subject of fiscal policy). As I argue in Why the Fed is Irrelevant, the Fed is also largely powerless to cause bank lending to expand or contract. In short, the Fed follows credit market conditions, NOT the other way around.

It's certainly the case that rising short-term interest rates are likely to create new pressures on the U.S. financial system (see Freight Trains and Steep Curves), but it would be a mistake to believe that the Fed has substantial power to alter this outcome. Short-term interest rates are likely to increase purely due to the dynamics of supply and demand for short-term credit. The Fed will certainly follow (and to the extent that rising interest rates pressure monetary velocity and inflation higher, may be forced to follow). In my view, however, it would be a mistake to believe that the Fed has much choice in the matter.

Rational expectations

To appreciate how market action conveys information, it's helpful to understand the concept of a “rational expectations equilibrium.” The legendary hedge fund manager George Soros coined his own term “reflexivity” to describe essentially the same idea. (That's no criticism of Soros - to arrive at an important insight of any field without formal training in it is always impressive.)

Suppose that individuals have some method of forming their expectations for the economy. Call these expectations X. These individuals then go out and act on those expectations, and produce actual economic data. Individuals look at that data, and revise the approach they use to create their expectations. We'll call that new method f(X).

Very simply, a rational expectations equilibrium is a “fixed point” where f(X) = X. That is, the beliefs of individuals and investors produce actual economic data that is consistent with those beliefs. In a one-shot world, a rational expectations equilibrium might be called a “self fulfilling prophesy.” But the concept is much richer than this. In practice, the problem is complicated by news, randomness, and the passage of time, so that we're describing a whole economic process (a “stochastic law of motion”), not just a single outcome.

When I was working on my dissertation at Stanford, I used to explain it like this. Take a birthday cake. Toss it out the window. Have a truck run over it. Scrape it off the pavement. Vacuum up the crumbs. Open the vacuum bag and pull out what's inside. If you pull out the original cake, you've got a rational expectations equilibrium.

It's also possible, however, for investors to form their expectations improperly. In that case, investors might start with expectations X, generate actual economic behavior, and fail to recognize that this data already prices in their expectations. In that case, f(X) isn't necessarily equal to X. You then get a situation where investors are constantly revising their expectations upward, and actual market behavior can detach from fundamentals. This is how bubbles occur, and it is the kind of "disequilibrium" that an investor like Soros seeks to act upon.

At present, there is a moderate bubble mentality in the stock market. That's clear from the combination of very rich valuations, but still generally favorable market action. This is a situation that we don't fight too strongly, but it's regrettable, because investors are almost ensuring themselves a painful re-education in the fact that valuations matter.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations but still modestly favorable market action. The Strategic Growth Fund remained fully invested in stocks that appear to have some combination of favorable valuation and market action, with an offsetting short sale in the Russell 2000 and S&P 100 indices equal to roughly 55% of that portfolio value. So we continue to be positioned in a way that will benefit primarily from further market advances, but our stance is respectful of the unusual valuation of the market as well as early deterioration in the quality of market action. For now, however, we do not have evidence to take a strongly defensive position in stocks. Historically, the current Market Climate has been reasonably kind to market risk, though again, the potential for early divergences to deteriorate further already holds us to a position that is less than aggressive.

The Market Climate for bonds remained characterized by unfavorable valuations and tenuously favorable market action. Frankly, we don't have much faith in market action remaining favorable, and even on the basis of current conditions, the Strategic Total Return Fund has a duration of just 3.25 years – meaning that a 1% (100 basis point) change in interest rates would be expected to impact the Fund's value by about 3.25%. Our eyes are firmly fixed on the behavior of short-term yields here. The Treasury yield curve already prices in a fairly abrupt increase in short-term rates, and my suspicion is that this expectation may turn out to underestimate the actual increase. As usual, we don't take investment positions on the basis of that sort of expectation, but suffice it to say that I don't expect low short-term interest rates to be sustained much longer.

In gold, our simple but effective 4-indicator complex (see Going for the Gold) has shifted to a fully unfavorable stance. Our more complex and proprietary models are no different. While I do believe that precious metals have long-term merit, I am concerned that short-term traders may be playing with fire, particularly given the high volatility of gold shares and a steeply overbought condition. We currently have no position in precious metals shares. That's not investment advice or a recommendation that other investors should sell, because we're very comfortable completely missing any further advance in gold stocks that occurs in what we view as a hostile Climate. Still, the potential risks are worth noting, and investors with substantial holdings in gold here should be certain that they have a long-term horizon and a similarly patient risk tolerance.


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