I keep having the same dream, like I’m in some kind of economic Shutter Island. It's 1954, and I am a U.S. marshal, assigned to investigate the disappearance of economic growth from Sado Island, which is supposed to be in the Sea of Japan but for some reason in my dream, it’s a mental hospital for the criminally insane in Boston's Harbor. I’ve been pushing for an assignment on the island so that I could brush up on my Japanese, but before long I start to wonder whether I haven't been brought there as part of a twisted plot by government officials whose radical treatments range from deficit spending to quantitative easing to downright zero interest rates. My shrewd investigating skills soon provide a promising lead, but the SEC revokes my license and I’m unable to access records I suspect would break the case wide open. As a Typhoon cuts off communication with the mainland, more dangerous socialists "escape" in the confusion, and the crazy, improbable clues begin to multiply. I begin to doubt everything - my memory, my partners, even my own sanity.
Every time, I wake up to a real world that seems somehow to make even less sense to me than my dream. Since May, the S&Ps monthly trading range from low to high has averaged 12% per month. August is not half-way over with yet, and already the range is 5%. For the past 126 years or so, the average gain per year has been less than 5% adjusted for inflation. A detached and unemotional analysis would have to note that hardly anything has happened since May that could have been construed as a difinitive change in direction or even mildly surprising, yet, the market has alternated between extraordinary tantrums and drug-induced euphoria for no clear reason on almost every day. If the market were a human being, it would have to be diagnosed with an acute bi-polar disorder.
Consider some of the recent non-events that moved the markets. As you read this, keep in mind that a 100-basis-point move in the space of an hour is equivalent to an annualized rate of 3-million percent.
July 21. Around 10:00AM, Ben Bernanke says that the outlook is “unusually unclear.” Markets immediately nosedive and are down 94 basis points within less than an hour. In the last hour of trading, without having recovered very much, the market suddenly drops another 175 basis points.
July 22. European PMI index hit 45.4, exceeding expectations of 44.3. The S&P 500 opens 145 basis points above its previous close and rockets another 123 basis points within the first hour of trading.
July 30. Chigaco PMI “reveals” that manufacturing production unexpectedly accelerated in the month, according to Briefing.com. The S&P500 index, having fallen 109 basis points in the first hour of trading, reverses and then jumps 152 basis points.
Aug 2. The national PMI index came in at 55.5 and the market opens 151 basis points above the previous day’s close and rallies another 230 basis points intra-day.
Aug 10. FOMC announces that it has decided to do absolutely nothing and makes no material changes in its statement or policies. For two days prior to this non-decision, the market rises 188 basis points on speculation that the Fed will do something radical. Then, on the day of the announcement, the market opens 80 basis points below its previous close because more learned analysts have started to explain why such speculation is unfounded. In the hour following the announcement that no changes in policy had been made, the market rallied 104 basis points.
11 August. Japanese machinery orders rise 1.6% from June, vs a consensus estimate of 5.4%. The Japanese equity market sinks more than 2%. The next morning, the S&P opens 157 points below its previous close and then drops another 211 basis points to close near the low of the day.
While it is possible to identify a specific event that triggered every crazed move, we can still discern from the trail of evidence that on any given day, the marginal investor, regardless of domicile, and whether it be a human or a computer, has lost site of the magnitude, and often even the most basic implications of the economic data that he or she or it is reacting to. The reason recessions happen, and millions of people’s lives are disrupted, is that assets are mis-allocated. Effective asset allocation within an economy is difficult to achieve without a properly functioning stock market. We need the stock market to function with a greater modicum of sanity if we are ever going to get any of these people back to work. We need to stop pretending that certain things are more important than they really are.
Post PMI Depression
Reactions to the various PMI data have been among the most un-measured. Following the announcement of the European PMI index hitting 45.4, we heard all over the world that concern about a double dip was over. Really? Does anyone out there think that it’s a good thing that the majority of European purchasing managers believe their business outlook is deteriorating, which is what any number below 50 would imply?
The PMI is a survey of the opinions of purchasing managers. These are the insiders when it comes to economic data, and readings below 50 have been shown to have a statistically significant ability to predict short term percentage changes in such real economic data as orders, deliveries, inventories, and in some cases even hiring. But small changes in the level of the index predict nothing and are wildly off the mark when used to predict the actual level of industrial activity.
The respondents to purchasing manager surveys give only three possible answers to a series of questions about orders, inventories, shipments and related data. These answers are either: 1) improving, 2) deteriorating, or 3) unchanged. There is no weighting given to their answers on the basis of enterprise size. On the other hand, the consensus forecast of the PMI is made by a handful of economists, most of whom have never met or talked with a purchasing manager in their life. They are forecasting what percentage of purchasing managers will answer positively as a percent of the total of those who answer positively or negatively. If you think about how one goes about making such a forecast, say, perhaps with a ruler and a compass or maybe a string and a thumbtack, then you can only begin to see how silly it is to invest money on the basis a beat or a miss in these numbers.
What the European data proved was that a small number of forecasters were less pessimistic than some other forecasters on one particular day. It has only a small bearing on the value of European companies, let alone the value of companies domiciled in any region where the currency has NOT just collapsed.
There is a predictor of the predictors that appears to be somewhat more accurate than others. In the United States, numerous regional PMI surveys are conducted, mostly by private consulting enterprises. Briefing.com has demonstrated that most of these are actually worse at predicting the national PMI than the Wall-Street economists, but the Chicago PMI has been rated highly predictive.
Let’s take a look at this. Remember that this index rose to 62.3 in July, compared to 59.1 in June. Consensus called for the Chicago index to decline to 56.3. The uninitiated can be excused for thinking this is a big deal, but the stock market is not supposed to be run by the uninitiated. Since the Chicago index has waxed back and forth between 63 and 59 all year without any significant change in industrial activity, the difference between an index number of 62.3 and 56 is actually not as meaningful as it seems.
As it turns out, it is also not anywhere near as predictive of the national level as hoped for. Before the National PMI Index for July was released, the difference between the Chicago and National numbers ranged between -6.4 and +6.1. This leaves a 20% margin for error! In other words, based on the Chicago number of 62.3, I could have predicted that the national number would be anywhere between 55.5 and 68.4. Any number between these two should not really move the markets.
The national PMI index came in at 55.5, below the extremely wide range of reasonable predictions that could have been made based on the data made available only the previous business day. The National number clearly negated the strength that was evident in the Chicago number, but because Wall-Street economists, in their great wisdom, had forecast a number for the index that was wholly inconsistent with the known facts, instead of retracting the previous days misguided gains, the market read the National PMI not only as a confirmation of the previous days good news but as an additional positive. You could not make this up and be taken seriously.
The important point here remains that by reacting so violently to such minute differences between the actual PMI and the various forecasts of the PMI, the market is implying a degree of accuracy and importance in the forecasts that simply isn’t possible and was never intended by anyone creating or forecasting these indices.
Forget about the Fed. Please.
I do not want to delve as deeply into the Fed debate, because it really isn’t an important debate, but I do want to pose a few questions in closing.
- Has Ben Bernanke ever made an accurate forecast of the future in his life? I’m not saying he’s a bad person, but someone ought to ask this question before they react to his comments about the “outlook.”
- What exactly is considered “unusual” in terms of being “unclear,” especially since the answer to the first question implies that “clarity,” even when “normal,” is not of much use?
- This is a man whose primary responsibility during these sessions is to avoid saying anything that is even remotely meaningful. Whatever else you may think about the man, he is reasonably skilled at this particular task. So why do so many people attempt to impart such sagacity into such studied and intentional vacuity?
- So, unless Ben tells us what to think, we have no other way of knowing anything about the economy ourselves?
When interest rates are below the level of inflation and total credit in the economy continues to contract as it has, there is nothing the Fed can or should do about it other than stand ready to provide liquidity in case of crises. The market’s insane movements up or down, imply a degree of power that the Fed simply doesn’t have and a complete misunderstanding by the markets of the most fundamental economic dilemma of our time.
Typical of the next day’s response following the FOMC statement was the quote of one senior currency specialist at a large investment advisory firm:
Yesterday was a bit of a game changer. The Fed's actions yesterday realigned the stars and changed the narrative from one where people were relatively confident that the recovery was intact and didn't require much of a policy response.
Huh? The “game changer” being referred to was the Fed’s statement that it will reinvest maturing agency and agency mortgage-backed securities into "long-term" Treasury securities.” This is the equivalent of me saying that I will go to the men’s room when I need to relieve myself. It is not even a new play call, let alone a change in the game. And as far as changing the narrative, if you didn’t know there was something of a debate going on about the strength of the economy, then please tell me that you don’t have responsibility for managing other people’s money.
Leadership from the World’s Most Unlikely Place
Finally, we are left with the Japanese machinery orders, which is a bit of specialty for me. Ironically, this was probably the most solidly bullish data point to come out of any part of the world anytime in the last several months, and it seems to have had the greatest negative impact of all. This reminds me of the greatest frustration that most foreign fund managers express when it comes to Japan. Most complain that Japanese managers never answer their questions, but my observation is that the foreigners never ask the right questions. So it is with the machinery data.
First of all, excluding orders of mobile phones, the rise in orders was 6.1%, which was right in line with market projections. Intuitively, mobile phones don’t belong in the same data series with 60-ton earth movers and turn-key power plants and I don’t believe the global markets would have melted away so easily had the active players in the market paused to contemplate the subtle difference in the implications of a model-change in cell phones compared to any kind of shift in demand for heavy machinery.
On the other hand, for crying out loud, why is anyone even looking at or talking about month-on-month percentage changes in a series for which there is no meaningful continuity form one month to the next? The total value of orders was about 700bn yen, not meaningfully different than what it has been for each of the past 18 months. There was no meaningful change and before the data was released, there was no reason to expect any meaningful change. Never-the-less, a far more important data release that got over-looked was the continued rise in a key leading indicator of machinery orders that now indicates a rise of perhaps as much as 50% in orders during the next 12 months. I guess nobody asked about that.
Note: Wikipedia defines bipolar disorders as “a category of mood disorders defined by the presence of one or more episodes of abnormally elevated energy levels, cognition, and mood with or without one or more depressive episodes. The elevated moods are clinically referred to as mania or, if milder, hypomania. Individuals who experience manic episodes also commonly experience depressive episodes, or symptoms, or mixed episodes in which features of both mania and depression are present at the same time.[1] These episodes are usually separated by periods of "normal" mood; but, in some individuals, depression and mania may rapidly alternate, which is known as rapid cycling. Extreme manic episodes can sometimes lead to such psychotic symptoms as delusions and hallucinations.”
Disclosure: No positions
