Are Stock Prices Real Any More?

One wonders if stock prices are real.  Consider the evidence.  Due to political obtuseness, the U.S. barely avoided defaulting on its debt.  The economy continues to expand at a disappointing rate.  Employment growth is tepid.  Middle class incomes are falling, on average.  Consumers are gloomy.  The Federal Reserve Board is gloomier.  Businesses hold back on investing cash.  But, last week, the S&P 500 reached record heights.  When you encounter cognitive dissonance in the financial markets, be careful.  Every time in the past 20 years when things seemed out of whack, it eventually turned out that, in fact, they were out of whack.  In other words, if it looks too good to be true, it probably isn't true.

Could investors be wearing their stupid hats again?  Their 401(k)'s got clobbered in the 2000-01 tech stock crash, and after adjustment for inflation, stocks still haven't recovered.  Investors' 401(k)'s and homes got clobbered again in the financial crisis of 2008, and many haven't recovered from those losses.  What does it take to move up the learning curve?

Maybe, however, the problem isn't investors.  Over 50% of the trading volume in the stock markets comes from high-speed computerized trading.  This activity isn't based on human judgments.  It flows from algorithms and formulae.  Some of the computerized trading is dynamic--it changes based on what it observes in the market.  Since the activity it is often observing is computerized, we now have computers reacting to the activity of computers, which could be reactions to activity by other computers. 

When stocks were valued by humans, we had some idea of what we were dealing with.  Even if things seemed irrational or even bubbly, we could understand what was happening, albeit with a frown.  Now, with stocks being priced by "thought" processes that are impenetrable to the average investor, the market not longer reflects the collective judgment of humans.  Instead, it is an amalgamation of valuation processes that often aren't based on human judgment.  The things that people are concerned with--lousy economy, sluggish jobs growth, falling incomes, dim view of the future--may not be finding their way into stock valuations, at least not in the ways that they historically did.  If so, we can't be sure stock prices are real because we have no idea what the computers will do next.  Caveat emptor.

Maybe the Retail Investor is Retiring

A persistent trend for the past three years is that retail investors have been bailing out of the stock market. Even now, with the market reaching new post-2008 highs, individual investors continue their exodus. Stock market pundits scold shrilly, pointing out that these wusses have missed out on the big rally of the past six months. The same wusses are deemed to be short-sighted for piling into bond funds at a time of historically low interest rates following a 30-year bond market rally. The pundits pronounce retail investors foolish, or worse.

But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.

The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.

Smarter Investors: a Problem for the Fed

Against all odds, there’s a possibility investors are a little smarter than they were three or four years ago. That’s unlikely. Investors have rarely managed to climb up the learning curve. The recent stock market collapse is near-conclusive proof that they remain as gullible and reckless as their grandparents and great grandparents in the 1920s.

Yet the recent sharp rise in long term Treasury securities yields and drop in the dollar suggest that investors fear the Fed. Specifically, they may be concerned that the Fed is printing so much money (and the Treasury is borrowing so much money) that another asset bubble is in the making. Ten years ago, investors didn’t worry about bubbles because, by all indications, the Fed in those days didn’t worry about bubbles. The tech stock bubble, the real estate bubble, and the credit bubble have administered painful lessons. Investors now worry about bubbles.

It’s unclear that the Fed worries about bubbles. It’s printing money like there’s no tomorrow. If it continues to print money like this, there won’t be much of a tomorrow. Investors have learned not to trust governments, not even the U.S. government. They’ve tuned into the fact that governments tolerate and sometimes even facilitate bubbles. It takes gullible investors to create a bubble, but it takes governments to grease the process with easy money. Investors have seemingly made some progress up the learning curve. But the government remains a one-trick dog.

In the last year, the U.S. government has dumped shiploads of cash into the economy. This cash is supposed to spur economic activity. But a policy of printing money requires true believers. People, and investors in particular, have to believe in the value of the currency. Evidence of apostasy exists.

The Big Money Dump has had limited effect. Banks aren’t lending if they have any alternative whatsoever and investors are staying away from the asset-backed securities market, which in the past decade was the true banking sector. Consequently, much of the Fed’s money is going into asset markets—Treasury securities for a while, now petroleum, gold, silver and so on. The Treasury bubble is bursting fast. Petroleum is the trade du jour. But the oil price rise counteracts the basic purpose of all the Fed’s money printing. Rising energy prices are tantamount to a reduction of consumer income, the worst outcome for an economy that depends on consumer spending. Rising mortgage rates have the same effect.

Thus, the markets are undermining federal policies. Backwards looking economic data shows that the economy is no longer sinking as fast as it was six months ago. But sinking is still sinking. Going from panic to malaise won’t feel good for long. The key question is when will the economy turn around and begin growing. The answer depends on the forward looking data. With gas prices jumping sharply, mortgage rates following Treasury rates upwards, unemployment still growing, and worst of all investors getting smarter, the federal government’s prospects for forging an economic recovery remain fogged in, at best.