The Stock Market Has Gone Barking Mad

No matter how many times you ask a dog what it’s trying to tell you, it’s always going to tell you the same thing: bark! The language of dogs is indecipherable. True, there are happy barking sounds and angry barking sounds. You can sometimes tell what it means by the tone of its bark. But the vocabulary of dogs is pretty limited.

We bring up the subject because the stock market is failing to communicate accurate information about the economy. The stock market is barking at investors. The bullish analysts are slobbering all over themselves. The ASX/200 briefly reached a 17-month high last week when it traded above 4,600. But the volume of the bark doesn’t really reveal the quality of the stock market, which to our mind OUGHT to be awful.

The stock market is under no moral obligation to perform in the manner we expect. It would be nice if it did. But investors have always thought this way. This is why the stock market is so good at humiliating the over confident and humbling the proud. Prices are what they are, no matter what you think they should be.

For what it’s worth, we think prices will eventually go lower. Two of the world’s three largest economies – the United States and Europe – are on the verge of another recession. But that is just a textbook definition. The reality is much worse.

The reality is that consumption in both economies is likely to remain low for years, as households deleverage. To the Keynesians, consumption (aggregate demand) is what drives GDP. If you want GDP to stop falling, you have to make up for the ‘lack of consumer demand’ by spending more at the government level. This textbook solution is complicated by the fact that most governments are already deeply in debt.

But a little reality should never get in the way of a good theory. Here in Australia, all the signs point to the government abandoning its pledge to deliver a surplus. The papers are full of quotes from anonymous MPs who worry that now is just the time the government should be spending money it doesn’t have, to make up for people who are no longer spending the money they don’t have.

This proves a point understood years ago by the French psychologist Gustave le Bon. When you take an individual and give him a decision to make, he usually makes it calmly, sensibly, and soberly. That’s not to say he gets it right, or doesn’t fall prey to fits of madness and irrationality. But a sane man on his own isn’t prone to doing crazy things.

Take that same sane man and put him in a crowd or a voting booth and all bets are off. Collective decision making takes on the same characteristics as the mob. It’s guttural, animal, and visceral. A person loses his sense of self in a crowd. The crowd becomes a living, dangerous thing that causes us to do things we’d never otherwise do.

Maybe this is what has happened to investors in the stock market in the last three years. They have ceased to be individuals. The stock market is now a crowded one-way momentum play, which is not a market at all. It’s a fix.

In a real market, you have a diversity of ideas about what companies are worth. Some investors are value investors. They believe that a business has an intrinsic value and you can apply a discount rate to its annual cash flow, identify a required rate of return, look at the return on equity, and then pick the best company and get the best price.

The technical traders and the quants look at the internals of the stock market. They look at volume, liquidity, moving averages, and relative strength. They’re neutral on what the stock market ought to do. They speak in the language of trends and maths and charts. Each to his own!

But we are all slaves to Bernanke now, and he has obliterated the differences between us. When you get the whole stock market hanging on every word the central bank utters, when prices become derivative of policy, it’s not a stock market anymore. It’s a crowd.

The crowd reacts to the magician on the stage. The magician on the stage is a fraud. But he’s a fraud with tremendous powers of misdirection and deception. And he can keep the audience in thrall longer than you can remain solvent betting against him.

This, anyway, is how we explain to ourselves why the stock market is not doing what we think it should. But you’d only deceive yourself by thinking this way if you left it there. What really matters is what you’re going to do with your money. And we reckon it’s possible to recognise the stock market as a fraud and still make money.


Dan Denning
for Markets and Money

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Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "The Stock Market Has Gone Barking Mad"

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David Johnson
Some people have a knack for accurately describing what others like myself see and understand but just can’t put into words. Dan, you and the staff at The Daily Reckoning have countless times put the economic world into what I believe to be an accurate and clearly understandable perspective. On a little different train of thought from the first moment I understood the ‘system’ had to grow to not fail I became suspicious; it just didn’t make sense to me that it could be possible for the system to forever grow. And once I started to realize just how fast… Read more »
However rational I rate myself, I would not dare a roaring bull by standing in his way. Don’t forget that in both Australia and the US, blue-chip stocks can be shorted. That is, people are allowed to bet on a fall in prices. When there is a big short position to liquidate, the obvious outcome is a swift move up, to the pain of the shorts. Every bettor has his limit and must pay margin to back his position, even if he is sure the market must fall at some time. However, speculators have their limits. Those who lose their… Read more »
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