Where The Market Is Headed: An Austrian Perspective

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 |  Includes: DIA, QQQ, SPY
by: Edward Moseley

There is no question that since the 2008 housing crisis the Austrian School of Economics has received widespread recognition for its ability to identify asset bubbles based on empirical data within a unique theoretical framework. It is true that this recognition brought with it criticism; though Austrian rhetoric appears to be slowly creeping into mainstream investment articles.

As someone who identifies himself as an Austrian, but who is also a daily investor, it is sometimes difficult to reconcile what is in the long term theoretically bad for the economy with what is in the short term very profitable. Allow me to explain.

There was once a time when the term capital could refer to the magnitude of resources commanded by a definite amount of currency. Spending indicated the claim of one economic entity on a good in the economy in a magnitude proportional to that which otherwise would have caused the good to remain idle. Savings indicated that an individual had abstained from laying claim to that good such that another economic actor could claim it for productive or consumptive use.

Capital has historically been synonymous with money. When investors today discuss a capital injection into the economy, though, what is really being discussed is an injection of money or credit to the reserves of banking institutions. The most discussed capital injections today are the Federal Reserve's monthly $85 billion injections in the form of mortgage backed security and U.S. Treasury purchases. With these injections money ceases to be a measure of the capital it commanded prior to the injection, as simply adding to the monetary supply does not create an additional supply of capital equipment to be used for industrial output.

One must keep in mind the disconnect between money and capital when looking at the Federal Funds Rate, or the rate at which one bank lends to another. This rate, in effect, dictates the interest on a massive amount of interest bearing accounts. As it is the tendency of banks to remain as loaned up as possible, one bank will readily borrow reserves from another to lend out while still meeting the reserve requirements. Today banks are holding much higher reserves than in any other time in history.

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These reserves held by banking institutions ought to be a bullish indicator for the market. As these reserves are slowly lent out into the economy, upward pressure on many prices will occur. This is especially true in capital equipment, as well as oil and other industrial inputs. As the chart below shows, the money is indeed being lent out to commercial and industrial institutions in an increasing fashion.

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Even though this money is being lent out, monetary velocity, or the relative rate at which money changes hands in an economy, remains incredibly low. As monetary velocity picks up it would be likely to bring the consumer price index, corporate profits, and capital markets with it. This has historically been the case.

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Now we must look at the Federal Funds rate and why it is at all useful for investors to keep an eye on. Below is a chart of the Federal Funds rate, and there is a noticeable correlation between the Federal Funds rate and the capital markets as represented by the S&P500 below.

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What is clear from the above graph is that a recession comes nearly without fail each time the Federal Reserve raises interest rates.

As the Federal Reserve tapers the economy off of cheap credit, it also shines light on those investments which would not have been possible without low interest rates. Individuals and businesses come to realize their malinvestments as interest rates normalize, and they are forced to liquidate their positions all at once. A bust occurs.

Indeed, there are fluctuations as the market has up and down days, but it is clear that the most pronounced downturns come as a result of the raising of interest rates, during which time the Federal Reserve slashes interest rates again-and the cycle repeats itself.

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Conclusion

From an Austrian perspective, the empirical data presented above does indeed paint a bullish picture for the stock market over the next few years (allowing for normal corrections along the way), while at the same time setting the stage for an incredibly deep recessionary period thereafter after malinvestments are realized and liquidation occurs.

The capital markets should continue upward as bank reserves are loaned to businesses, monetary velocity picks up, and the CPI begins its climb upward. An increase in monetary velocity and the CPI will eventually prompt the Federal Reserve to step in to "cool down" the economy. Traditionally, the Federal Reserve's preferred market cool-down mechanism comes in the form of increasing the Federal Funds rate.

As an investor, once you hear that the Federal Reserve will allow the Federal Funds rate to rise, it may be wise to load up on puts of SPY, DIA, QQQ expiring several months in the future, or to simply exit the market and wait for the dust to settle.

If history and Keynesian prescriptions for economic woes are at all indicators of future action; if ever there is another significant market crash (which, in the opinion of the author, there must be) the Federal Reserve will simply jump in to provide the economy with liquidity, and the boom bust cycle will begin again.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.