A month ago everyone was sitting on the edge of their seats, waiting for the Fed chairman’s speech at Jackson Hole. Memories of Jackson Hole 2010 were resounding for investors. Were they going to leverage themselves to the hilt to buy as many risk assets as they possibly could (with hints of QE3), or were they going to have to liquidate all their holdings with no mention of QE3?
Well, Bernanke did not give the market what it wanted, and even went so far as suggesting that there would be no more QE at this time. Based on this statement, one would have thought people would be out selling. Yet, the market rallied from that point, causing some to scratch their heads.
Prior Government Interventions
This past week, we all did it again. This time, Bernanke gave the market exactly what it was expecting, with $400 billion in Operation Twist. One would have thought the market would rally when it got what it expected. Yet the market sold off hard, causing more head-scratching.
If we take an honest look at the timing of all of the government easing action from the start of the financial crisis in 2008 until today, you will see that these actions were not nearly as effective as the public is led to believe. If you simply take a cursory look at all the actions of the government during the decline in 2008, you would almost have to come to the conclusion that the government action of bailing out Fannie, Freddie and the financial institutions, as well as the Fed’s announcement of QE1, caused the resulting decline in the stock market. In fact, one can argue that the announcement of QE1 caused the largest and fastest part of the decline that shaved off 400+ points in the S&P 500 within a period of several weeks. All these actions were initiated at the beginning of, or during, one of the largest declines in history.
If all these government actions seemed to have caused these massive market declines, can we, from an intellectually honest perspective, deem further and similar government action as the cause of the market rally in 2010? Can the same action by the government honestly cause one of the largest market declines in history, but yet also be the cause of the more recent rally in 2010?
Of course, this is not what I believe. Rather, I believe that the government was ineffectual at changing public perception, no matter what it did, during a period of negative social mood.
As I personally view the news as following the cycles, any seemingly good news that is announced during a negative sentiment period seems to be discounted, as was the case with QE1 during the 2008 decline. In the same way, since the announcement of QE2 was made during a period of a social mood upswing (albeit in a counter-trend upswing), it would seem to have caused the rally, when it in fact had no such causal effect. It was simply announced at the proper time during the cycle, which made it seem as having caused the rally, while QE1 was announced at a time when it can be viewed, in the same manner, as having caused the decline.
The only conclusion that we can derive from these facts, based upon an intellectually honest approach, is that neither QE1 nor QE2 had any causal effect upon the markets, since the same action will not have opposite results.
Rather, it is public sentiment and mood that is the primary driver of markets and not some exogenous news or event.
Market Studies and Observations
Bernard Baruch, an exceptionally successful American financier and stock market speculator who lived between 1870 -1965, identified the following long ago:
All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking ... our theories of economics leave much to be desired. ... It has always seemed to me that the periodic madness which afflict mankind must reflect some deeply rooted trait in human nature – a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea ... It is a force wholly impalpable ... yet, knowledge of it is necessary to right judgments on passing events.
During his tenure, and in several hearings in front of the Joint Economic Committee, Mr. Greenspan noted that the idea that the Fed can prevent recessions is a "puzzling notion.” Rather, he postulated that the stock market is driven by human psychology and waves of optimism and pessimism.
Social experiments have actually been conducted which resulted in price patterns that mirror those found in the stock market. In 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili and Zhang, in which subjects simulated trading currencies, however, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology “in the absence of external factors.
One of the noted findings was that the trading behavior of the participants were “very similar to that observed in the real economy,“ wherein the price distributions were based on Phi (.618).
Their ultimate conclusion would surprise the most avid trader today:
In spite of the simplicity of our model and of the strategies of the single participants, and the outright exclusion of economic external factors, we find a market which behaves surprisingly realistically. These results suggest that a stock market can be considered as a self-organized critical system: The system reaches dynamically an equilibrium state characterized by fluctuations of any size, without the need of any parameter fine tuning or external driving.
Marsili was quoted as saying that “the understanding that we got is that the statistics of price histories in financial markets can be understood as the result of internal interaction and not the fundamental interaction with the external world.
In August 1998, the Atlanta Journal-Constitution published an article by Tom Walker, who conducted his own study of 42 years’ worth of “surprise” news events and the stock market’s corresponding reactions. His conclusion, which will be surprising to most, was that it was exceptionally difficult to identify a connection between market trading and dramatic surprise news.
Based upon Walkers study and conclusions, even if you had the news beforehand, you would still not be able to determine the direction of the market only based upon such news.
Robert Prechter Jr., in his book The Wave Principle of Human Social Behavior, in which he cites many of these instances, concludes “once you realize that even if you got [the news] in advance, you could not forecast the stock market. Though these facts are counter-intuitive, it does not take a dedicated market student long to observe the acausality of news to the stock market.”
Many investors/traders, until now, view this issue as another form of the “chicken or the egg” argument. Most even believe that the market is driven by the news. However, in truth, when you take an honest look at the facts, you should come to one conclusion: Social mood is what drives markets and not the news. In fact, it is negative social mood that usually is the cause of negative events later reported in the news. Furthermore, since the best barometer of social mood is the stock market, when we see the market action suggesting negative social mood, we should actually expect negative news, and vice versa.
R.N. Elliott, in his 1946 publication of Nature’s Law, probably puts it best when he said “At best, news is the tardy recognition of forces that have already been at work for some time and is startling only to those unaware of the trend.”
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.