Like everyone else, I studied the "Efficient Market Hypothesis" in B-school. As time rolls on, however, the notion of market equilibrium is less appealing than theories of disequilibrium proposed by George Soros, Charles Kindleberger, Dean LeBaron, and others.
One of the pioneers of disequilibrium theory is Hyman Minsky. In 1992, Minsky outlined his "Financial Instability Hypothesis," which describes three phases of market development based on the degree of leverage employed: 1) hedge finance; 2) speculative finance; and 3) Ponzi finance. The three levels are described in a whitepaper published by the Jerome Levy Economics Institute, from which I have extracted three short paragraphs. (Bear with me, this is good):
The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.
Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.
The financial instability hypothesis is a model of a capitalist economy which does not rely upon exogenous shocks to generate business cycles of varying severity. The hypothesis holds that business cycles of history are compounded out of (1) the internal dynamics of capitalist economies, and (2) the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds.
Paragraph three conveys a most important point - perhaps even a profound statement. The market economy is driven more by internal dynamics than by exogenous shocks. As leverage increases, the financial system assumes a life of its own, influencing economic decisions and exaggerating the business cycle in both directions.
Financial causality, in other words, is mainly endogenous. The system is prone to self-feeding processes, which can run to extreme states of disequilibrium until eventually corrected by a crash or upheaval.
Compare this model of reality to mainstream thinking embraced by modern economists, including Janet Yellen, Mario Draghi and Haruhiko Kuroda. (Let's reserve judgement on China's Zhou Xiaochuan for now.) To these thinkers, the market economy maintains equilibrium until altered by an exogenous shock. This explains the Fed's obsession with "incoming data." It also explains the Fed's desire to build a cushion in the Fed funds rate in order to respond to the next downturn.
Don't believe me? Here's Janet Yellen from her August 2016 policy speech at Jackson Hole, Wyoming (emphasis mine):
Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy…. The reason for the wide range [of forecasts] is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted. When shocks occur and the economic outlook changes, monetary policy needs to adjust.
This is not to say that central bankers are ignorant of Minsky. They occasionally warn about excessive debt, and possible distortions from monetary policy. By and large, however, they don't acknowledge their own role in the Minsky process. The Fed's mission is to promote stability. It sees itself as a white knight, battling external shocks; not an agent of instability.
Financial disequilibrium is a fascinating topic, but what are the practical implications? While investors must ultimately draw their own conclusions, I'll offer seven observations, which I think apply to the current market environment:
- The Fed has become an agent of instability. It is attempting to bootstrap the economy by "priming the pump." This tactic is useful in arresting financial panics, but not as an ongoing policy.
- Don't expect the Fed to implement an exit strategy. The Fed cannot normalize because it has embraced the wealth effect, which also works in reverse. The Fed may tighten, but it will not tighten enough.
- Central banks around the world have committed to doing "whatever it takes," which is itself a moving target. Global monetary authorities are all playing the same game: competitive devaluation. But there is no free lunch. The world cannot export to itself, so the likely outcome is inflation.
- Expect an inflationary outcome, but don't presume the object of inflation. Inflation is a policy, not an exogenous force.
- The object of inflation is decided by the market, not by central bankers. The object of inflation might be consumer prices… but it might also be stocks, commodities, gold, real estate, or even bonds. Don't impose a rigid view on the market. Let the market tell you where inflation is headed.
- The Fed is wrong in presuming that CPI is the one and only guide to monetary policy. This flawed thinking is perpetuating the current state of disequilibrium. (One can argue that easy money is actually depressing CPI by encouraging excess capacity.)
- Trend-following strategies work well in periods of accentuated boom and bust. Remember the old saying: "Speculative markets rise to unimaginable heights, then they double." Markets in extreme disequilibrium, however, are likely to collapse once the leveraging process reaches a tipping point. Watch for signs of long-term exhaustion... and be sure to respect the major trend in both directions.
In a Minsky world, investors should expect dazzling bull markets and spectacular routs. The Dow might easily reach 30k… on its way to 10k, for example. Valuation is important, but may be useless over long stretches of time. While the market is ultimately a "weighing machine," it is also a "voting machine," heavily influenced by internal dynamics. Bizarre outcomes, such as negative interest rates, soaring P/E ratios, and market separation from the real economy, all make sense in Minsky terms.
Tired of the efficient market hypothesis? Try disequilibrium for a change, and see what a difference a presumption can make. Hyman Minsky had it mostly right, and the modern Fed has it mostly wrong. Central bankers are now trapped in an unstable, self-feeding reality of their own making.
For my money, this simple proposition is the key to financial markets for the next decade or longer.
But don't look for disequilibrium everywhere at all times. Though central bankers are the culprit du jour, the theory should apply with or without their complicity. Booms and busts have always existed. Human beings are the ultimate source of instability.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.