Voodoo Finance for Sick Markets:
Stocks & COVID-19
Written for RealTimeCEO
Today, finance and economics have nothing to do with one another.
I deliberately open with this ridiculous statement, because financial markets in the last 12 months have behaved in ridiculous ways. In 2020, the real economy in the USA shrank significantly; yet, financial markets boomed. Some commentators have said that these trends defies logic and reality; others see how it mirrors the history of markets after the GFC. Either could be right; all we know, however, is that we must understand it immediately.
(I) Crash!
We’ll start with a brief history of our present situation — the COVID-19 lockdowns that have wrought economic havoc around the world.
In February, the World Health Organisation declared the COVID-19 outbreak a global pandemic, and economies around the world moved into an unprecedented lockdown. A massive shock rippled through the world’s markets as whole industries were pushed to the brink of ruin.
In response, respectable institutions began to issue dire GDP growth predictions. By March, Deutsche Bank said US GDP would fall by 12.9% in Q2 of 2020,¹ the largest quarterly fall since WWII. Goldman Sachs was even more pessimistic, predicting a contraction of 24% — an amount 2.5 times greater than anything in US history.² Both were wrong. GDP instead contracted by 31.4% compared to Q1 2020 — a period where economic activity already fell 5% compared to Q4 of 2019.³
Thus the US economy entered a dismal retraction, and financial markets responded accordingly. By mid-March, the S&P500 had fallen 30% from its historic highs, from 3379.45 pts on February 10th to 2237.40 pts on March 23rd. The signs were clear: 2020 was going to be a terrible year for investors.
But then, something remarkable happened. After the S&P500 hit its nadir in late March, it began a steep ascent, reclaiming 1000 points before June 30th. The New York securities industry doubled their usual first-half profits, taking home $27.6 billion before July.⁴ And on September 9th, the S&P500 reached its all-time high — 3580.84 pts. Investors rejoiced — somehow, despite the crisis, capital gains had increased.
Despite the dismal outlook, the S&P500 boomed in 2020. Share prices rocketed upwards, even while the real economy suffered incredible losses. So, I’ll reiterate: today, finance and economics have nothing to do with one another. Indeed, it seems like we’ve entered a system of what Joseph Stiglitz has called ‘ersatz capitalism’ — a land where share prices are divorced from real profits, and where markets behave like pale imitations of themselves.⁵ Even our markets, it seems, have fallen victim to ‘post-truth’ politics.
(II) “It Makes No Sense”
Faced with these facts, a good friend of mine proclaimed that these these movements contradict the logic that supposedly governs our economies. In his words: “It makes no sense.”
Like most others, he thought a) share prices should increase with demand, and b) demand for a firm’s shares goes up when we expect the firm to make more profit. He believed that prices are ‘rationally determined’ by a justified belief in future profitability.
To his credit, reality usually abides by this thinking: indeed, it is exactly why the stock market plummeted between February and March this year. People expected profits to fall, so prices declined.
But after the collapse in March, markets started contradicting these assumptions. Prices climbed even as the economy contracted. The demand for shares increased massively following the COVID-19 shock — even though the outlook for profitability and economic growth was dire.
If we believe share prices should depend on our expectations of profit, then we have to say: “It makes no sense.” And yet this our world today: we live in a time where economic reality no longer reflects the average person’s idea of economic theory.
(III) Making Sense, pt. I: Keynes
For this reason, we need a better theory. We must continue to make sense, even where reality starts to look unreal.
Luckily for us, a better theory already exists. All we need to do is abandon our idea that share prices are determined by considered, rational expectations of future profits. Instead — with thinkers like Keynes and Minsky — we must learn how irrationality rules markets, and how government intervention can distort prices.
To rehabilitate our ideas, we’ll turn first to one of the most important pieces of economic writing ever produced: Chapter 12 of Keynes’ General Theory of Employment, Interest & Money. In this short and brilliant essay from 1936, Keynes reveals the irrational behaviours that emerge when humans face an unknowable future. He has a particular interest in the unjustified conventions, beliefs and emotions we use to guide our decisions — that is, the human habits that make a mockery of our rationalistic pretensions.
Conventions
Keynes begins by discussing humanity’s tendency to rely on conventions for thinking when faced with uncertainty. As a trader himself, Keynes knew that humans have a habit of valuing stocks by assuming that the existing state of affairs will continue to prevail in the future.⁶ While this is irrational, the future is inherently uncertain; thus we have no alternative. Without a specific reason to do otherwise, we will usually believe that tomorrow will be like today.⁷
Beliefs
Compounding this problem, Keynes also saw that accurate forecasts of profitability don’t fully determine share prices. Indeed, these forecasts are often irrelevant to investors, who spend their time trying to pre-empt what ‘average opinion expects the average opinion [of a stock’s value] to be’.⁸ The demand for shares changes based on fluctuations in investors’ beliefs about other investors’ beliefs. For an investor, it’s often more important to correctly guess the market’s belief about what will happen to a stock’s value than to accurately estimate future profitability — irrespective of whether those beliefs are informed or rational. Being right about profitability is not the same as actually making profits.
Emotions
Lastly, Keynes also saw how our investment decisions can be based on non-rational, emotional forces. He rightly states that our decisions affecting the future ‘cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist’. That is, because we can’t see the future, we lack the ability to rationally calculate expected profits. Without the security of mathematics, we instead rely on ‘whim or sentiment or chance’ to make our choices. Thus, our markets are comprised of millions of people, buying and selling shares based on changes in their ‘spontaneous optimism’ rather than rational, knowledgeable calculation.⁹ Markets are driven by the heart — not the mind.
Implications
The truth about a firm’s future profitability can be irrelevant to share price. Our irrational taste for convention, belief and sentiment ensures that neither rationality nor logic determines share prices. Prices are irascible and maddening — much like the humans who try to control them. Accordingly, we must account for ‘the concealed factors of utter doubt, precariousness, hope and fear’ at play in our markets.¹⁰ Failing to do so will leave us entirely blind about the truth of prices.
(IV) Making Sense, pt. II: Minsky
From Keynes, we learn that prices are not determined by rational laws, but by emotion and belief. Prices behave irrationally; rational expectations have never prevailed. We must accept this as the first truth of our markets; doing so will allow us to move towards an understanding of the erratic behaviour of markets in 2020.
However, Keynes’ thoughts don’t fully explain our situation, where share prices rose even though we knew profitability would fall. Our society seems to have gone beyond irrationality into a collective defiance of economic theory altogether. At this point, it looks like we are more anti-rational than irrational.
To understand our anti-rational markets, we must go beyond Keynes, and try to understand the role of government intervention. As we will see, the government has the power to sculpt the future by fixing expectations. They can move us from irrationality into anti-rationality, because they can make us believe that shares will be profitable — even if we know this should be impossible.
The Financial Instability Hypothesis
Here, we turn to one of Keynes’ successors: Hyman Minsky. Like Keynes, Minsky was concerned with the surges and retreats of ‘spontaneous optimism’ that dominate the financial markets. But Minsky went a step further than Keynes: he saw how the mechanisms of the financial system could lead this optimism to snowball into ‘an explosive euphoria’.¹¹ He saw how euphoria could cause the economy to collapse into a heap of insolvencies. And he saw how the government, faced with financial collapse, could permanently distort market outcomes.
His theory — the ‘financial instability hypothesis’ — is complex and elegant. To put it simply, it says that booming economic conditions lead banks to loan money in increasingly risky ways. Essentially, the banker’s confidence improves with the economy. As GDP grows, his faith in the ability to profit from his loans also increases. The banker takes greater risks, meaning that debt repayments become more precarious as the economy booms. So, when a shock inevitably hits, and people are unable to meet their debt obligations, widespread default occurs. The financial system is inundated by a wave of bankruptcies, threatening the survival of the entire system.¹²
The unrealistic optimism of bankers has led to catastrophe — just like we saw in 2008’s GFC. But as society teeters over this economic abyss, the government then steps in. In the USA, Congress and the Federal Reserve now begin to enact policies that act as ‘circuit breakers’ against the recessionary forces: interest rate cuts, bailouts and quantitative easing (‘QE’). Following these circuit breakers are enacted, liquidity rises, banks avoid insolvency, and hopefully, bankers start lending once again. If so, investment increases, share prices rise, banking profits increase, recession is averted, and economic order is restored. At least, until another crisis hits, and the cycle repeats.
Moral Hazards
If the government is sensible, they then restrict the risky lending that caused the crisis. But if they aren’t, their decision to save the financial sector instead creates a ‘moral hazard’ — that is, they ensure that the parties who profit don’t bear the risks of banking.
Economists have long criticised governments for creating moral hazards after financial crises. Policies such as bailouts and QE teach bankers that risky lending merits no punishment. Indeed, as these policies tend to increase banking profits, they instead support and reward risky lending. So, if the government fails to tighten regulations after they prevent a crisis, their emergency support worsens the bankers’ risk-taking activities. Bankers will now have an implicit guarantee that they will be rescued if their lending causes another crisis in the future.
As ever, bankers remain unable to predict the future of financial markets. And for the most part, prices are still determined by irrational forces. However, by creating this moral hazard, governments can effectively give bankers a guarantee that the future will continue to be profitable — even in crises where real profitability is impossible.
(V) Quantitative Easing 2020
Government power can fix the future, leading to a world where standard economic thought looks like nonsense. Artificial moral hazards can severely distort price behaviour. Already an irrational process, price determination can become absurd where the government commits to saving bankers, no matter what.
We know this; it is no secret. However, moral hazards in financial markets are abundant today. Indeed, in the US, the moral hazard created by the government is so well known that it has an ironic nickname: the ‘Greenspan Put’.¹³ In essence, the Greenspan Put is the Fed’s unbroken promise to save financial markets whenever a crisis hits, through measures like bailouts, QE and interest rate cuts.
In 2020, the Fed brought the Greenspan Put into play on March 16th, when they began a program of quantitative easing (QE) to support asset prices.¹⁴ Between March 9th and June 8th, the Fed purchased toxic assets from banks in earnest, and their balance sheet increased by 69%. In absolute terms, $2.75 trillion of liquidity entered the financial system, an amount than that exceeds all the funds injected by the Fed’s QE program between 2008 and 2012. Banks then used this cash to buy assets from other banks.¹⁵ Demand for shares increased, and the value of the S&P500 rose 43% while the Fed conducted their short but enormous program of QE.¹⁶
As such, the value of shares did not rise because investors expected profitability to increase: investors expected the Fed to enact the Greenspan Put once again. In February, investors should have expected liquidity to rise dramatically in the coming months. They should have expected share prices to increase as a consequence, leading to capital gains.
So, when the Fed began QE in 2020, the demand for shares rose because a) the money supply increased, and b) because ‘average opinion’ expected ‘average opinion’ to expect prices to grow in the wake of this liquidity injection. Accordingly, investors bought shares and prices rose, confirming their belief.
(VI) Ersatz Capitalism
To sum up the preceding arguments, we will say the following. If we want our expectations of the future to be correct, we have two avenues at our disposal. We can become impossibly good at prediction. Or we can enlist the help of institutions powerful enough to guarantee our profits — no matter what happens.
From this perspective, the share market’s behaviour now makes sense. A belief in future profitability has not driven market returns this year.¹⁷ Instead, the provision of liquidity and the expectation of subsequent asset-price inflation has caused the rise of the S&P500 throughout 2020. It was not rationality or irrationality that increased capital gains; rather, it was government-induced anti-rationality, the moral hazard that has once again given us profits without profitability.
Across the world, there has been over $6 trillion in QE throughout 2020 — more than half of the total QE seen worldwide between 2009 and 2018.¹⁸ Accordingly, we will probably see a repetition of the USA’s experience in many other countries. This includes Australia, where the Reserve Bank recently dropped interest rates to 0.1% and announced a $100 billion QE program.
In the months to come, we should therefore prepare ourselves for life in this system of ‘ersatz capitalism’. We should expect financial markets to behave like pale imitations of themselves for some time. Forever, perhaps — unless our governments reform the financial sector in favour of stability instead of this strange mode of capitalism.¹⁹
(VII) An Afterthought
While this is a dire conclusion, it doesn’t seem radical enough to me. What we have cannot be called a ‘poor imitation’ of capitalism, because it has nothing to do with capitalism at all. At its most basic level, capitalism is a system of privately owned, risk-taking firms, united by a commitment to generate profits through competitive, real production. The value of a company in a capitalist system, as revealed in its share price, should reflect their success in these regards.
But due to the Fed’s commitment to QE, for at least a few months this year, information about profitability and production became irrelevant to our financial markets. As the crisis unfolded, share prices were severed from underlying economic performance. The value of companies became disconnected from their successes as capitalist institutions. In 2020, financial returns were not based on ingenuity or skill: they were secured by the brute force of the government.
The government intervention that has produced this dangerous mode of moral hazard has completely changed the logic underlying asset pricing. Our expectations of profitability are divorced from those concerning volatility, capital gains, and returns on investment. Capitalist logic no longer governs our financial markets, and thus, one cannot even call them ‘ersatz’. Our language today proves insufficient to the task: we need a new word to describe our system.
Endnotes
³ See https://www.bea.gov/data/gdp/gross-domestic-product. When the BEA released this statistic in July, it also had no discernible effect on financial markets.
⁴ A recent report on New York’s securities industry confirms this reversal of fortune. Their profits between January and the end of June in 2020 totalled $27.6 billion — only slightly less than the total profits earned in 2019. See https://www.osc.state.ny.us/files/reports/osdc/2020/pdf/report-6-2021.pdf
⁵ See Freefall: America, Free Markets and the Sinking of the World Economy.
⁶ On page 152, Keynes writes: ‘In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention — though it does not, of course, work out quite so simply — lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.’ This convention allows us to attain ‘a measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.’
⁷ While this convention sounds ridiculous, it remains prevalent today. Popular financial models, such as the Black-Scholes model and the CAPM formula,(a) are usually implemented using historical data to estimate future prices. This means investors using these models like this assume the future will look like the past, even though crises like the dot-com crash, the GFC, and the COVID-19 recession show that this convention has failed dramatically on three occasions in under 25 years. Lacking clairvoyance, we have little besides this belief; hence, our meagre powers of prediction make asset pricing irrational.
(a) Studies show that financial analysts regularly use both formulas. A famous 2001 study by Graham and Harvey found that 74.9% of the 392 CFOs surveyed used CAPM ‘always or almost always’.
⁸ The General Theory of Employment, Interest & Money, pp. 154–156.
⁹ The General Theory of Employment, Interest & Money, pp. 161–163. See also: Brian Massumi’s 99 Theses on the Revaluation of Value.
¹⁰ The words are Keynes’, quoted in Massumi’s 99 Theses on the Revaluation of Value.
¹¹ Why Minsky Matters, p. 86.
¹² Wray explains it like this: High aggregate demand and high profits associated with full employment raise expectations and encourage increasingly risky ventures based on commitments of future revenues that are too optimistic. When the expected revenues are not realised, a snowball of defaults then leads to debt deflation (debtors default on their debts, which are assets of creditors) and high unemployment. See Why Minsky Matters, p. 86.
¹³ Named after former Fed Chair, Alan Greenspan, this epithet has an interesting history.
During the 1987 stock market crash, Greenspan affirmed the Fed’s commitment to ‘serve as a source of liquidity to support the economic and financial system’whenever a crisis hit. Here, Greenspan gave the market certainty: he would use all his powers to ensure the stability and profitability of an increasingly volatile and fragile system. From this point onwards, investors could rely on the Fed to bail out banks and refloat the financial economy if problems arose. Greenspan repeatedly lived up to his promise, so his commitment became known as the ‘Greenspan Put’.
Under Greenspan’s leadership, a financial crisis would always cause the Fed to buy assets at a good price. His successors have dutifully followed suit, starting with Obama’s Fed Chair, Ben Bernanke, who bailed out the banks during the GFC. And now, during the COVID-19 economic crisis, Jerome Powell has exceeded his forebears in every regard. See: https://www.federalreserve.gov/Pubs/feds/2007/200713/200713pap.pdf
¹⁴ In 2008, the Fed also justified their actions via a mode of ‘trickle-down’ economic thought. The argument is that QE depresses long-term yields relative to short-term yields. This incentivises the borrowing of debt, which is then used for investment, creating jobs, income growth, etc., supporting the wider economy. There is also a consumption wealth effect: investors who make greater returns will spend their dividends etc. in the economy, stimulating growth. Some economists were highly critical of this mode of argumentation, saying that it created a dangerous asset bubble that did little for economic growth.
¹⁵ In general, QE can only be used to buy paper assets from other banks. It cannot be used for loans, etc., and hence, it does not cause inflation.
¹⁶ Of course, the Coronavirus Aid, Relief and Economic Stimulus Act 2020 contributed to this rise: announced on March 28th, this package, which was three times larger than Obama’s GFC stimulus, pumped another $2.4 trillion into the economy.
¹⁷ If you are sceptical about this conclusion, you need not take my word for it. The price earnings ratio of the S&P500 shows us all we need to know. Historically, investors have used the P/E ratio to ascertain whether prices accurately reflect the underlying value of an asset. Mathematically speaking, the ratio rises when earnings fall or prices increase, and it declines when earnings increase and prices fall. If it is too high, this suggests that the asset is overvalued. Since 1926, the P/E ratio has risen above 25 only a handful of times. It did so in the early ’90s, again during the dot-com bubble, during the GFC, and now, during the COVID-19 crash. As of December 2nd, it sits at 37.14 — the highest it has been since the 2008 crash. The times that precede or follow economic crises see the P/E ratio increase dramatically. Of course, this is not because earnings increase during recessions; rather, earnings fall while prices are inflated by government intervention. Both factors conspire to raise the P/E ratio to unprecedented levels. Accordingly, the P/E ratio is not simply a measure of asset valuation: it is now a measure of government interference, and the overall health of financial markets. It is impossible to say what the future will bring; but from our vantage point, markets during COVID-19 look rather sick. Let us hope we can find a way to restore their health.
Gain Access to Expert View — Subscribe to DDI Intel
¹⁹ See https://www.rba.gov.au/media-releases/2020/mr-20-28.html
