Transcript: A first look at the Market's serious but consistent misconceptions

513 Monetary Policy with Tony Dwyer

Today we try to explain the Market. Specifically why the market does well even as the economy skates along the edge and even bounces lower. We do it with the help of an intelligent market analyst: Tony Dwyer of Cannacord Genuity.

Listen to this episode

This is important. It is the health of the financial markets that is the apparent bright spot in the current stagnation. That and the apparent health of corporate balance sheets. If the stock markets were down here with the rest of us, things would be being done.

We begin with the full Monty: Here is Dwyer, speaking to Bloomberg.

At this valuation the market is reflecting .. and you can even look at the level of long-term interest rates ... it's discounting something more severe than a recession. Historically when the long bond drops over a ten-week period, when it drops more than thirty, er, more than twenty percent. and it dropped thirty-four percent from the May peak down to where we are now. When that happens it is pricing in more severe than a recession. You've never had a recession in the U.S. with money widely available.


And going back to kind of Economics 101, you go into recession when corporations need money and have no access to it. How do you get money? You earn it. You get it from a bank through C&I lending, Commercial and Industrial lending, or you get it from investors via the corporate debt market.


All of those are wide open right now.


People like me come on TV and we pretend we know what's going to happen in the next fifteen minutes. And that's a joke. Today we walked in, and it looked like the Market was going to break down. Now the futures are up 15 points. It was the opposte yesterday. What I think you have to do is maintain conviction in your long-term thesis.


What is stimulative to corporate profits and to spending by individuals and companies? It is interest expense. It's energy expense, and industrial input costs. All of those are much lower than when we started the quarter.


5 step.


The market correlates to the direction of earnings. The direction of earnings is driven by economic activity. Economic activity is dri8ven by the availability of money and the steepness of the yield curve. That's driven by Fed policy. And that's driven by core inflation. Now those are the facts.

Sounds plausible. I told you he was intelligent.

Let's play it again.

At this valuation the market is reflecting .. and you can even look at the level of long-term interest rates ... it's discounting something more severe than a recession. Historically when the long bond drops over a ten-week period, when it drops more than thirty, er, more than twenty percent. and it dropped thirty-four percent from the May peak down to where we are now. When that happens it is pricing in more severe than a recession. You've never had a recession in the U.S. with money widely available.

Buzzer

"never had a recession with money widely available." Ooops. We just had the mother of all recessions, and money was almost free.

If the market really is pricing in something more severe than a recession, maybe it is more intelligent than we thought. ... Nah.

But the point is that the activity of the Fed is to keep money widely available. Bernanke's thesis was that the Great Depression would have been avoided if we had saved the banks. It was a hypothesis that he has spent the last four years and trillions of dollars testing. Hypothesis rejected.

And going back to kind of Economics 101, you go into recession when corporations need money and have no access to it. How do you get money? You earn it. You get it from a bank through C&I lending, Commercial and Industrial lending, or you get it from investors via the corporate debt market.


All of those are wide open right now.


What is stimulative to corporate profits and to spending by individuals and companies? It is interest expense. It's energy expense, and industrial input costs. All of those are much lower than when we started the quarter.

Buzzer

Stimulative is investment and hiring. Cost reduction is not stimulative. Lowering labor costs is the route corporations have taken to keep up profits. Profits are, or were, higher. Likewise interest expense. Big boost from cheap refinancing courtesy of the Fed. Likewise energy costs. Yes, there may be more spending power, but unless that power is spent on hiring, no stimulus. If it is used to pay down debt, save against uncertainty, return cash to shareholders, or buy stuff in China, IT IS NOT STIMULATIVE.

Evidence: Record Profits, record low interest expense, dropping energy prices. NO STIMULATION. You don't need a PhD to see that. A PhD in economics would probably get in the way.

Notice we did not buzz the source of money. Not the stock market. We'll get to that later. The stock market is there to value the share price for the casino.

People like me come on TV and we pretend we know what's going to happen in the next fifteen minutes. And that's a joke. Today we walked in, and it looked like the Market was going to break down. Now the futures are up 15 points. It was the opposte yesterday. What I think you have to do is maintain conviction in your long-term thesis.


5 step.


The market correlates to the direction of earnings. The direction of earnings is driven by economic activity. Economic activity is driven by the availability of money and the steepness of the yield curve. That's driven by Fed policy. And that's driven by core inflation. Now those are the facts.

Buzzer

Here is what George Soros – see the Soros chapter in Demand Side the Book out on Amazon, by way of DemandSideBooks.com – what Soros calls a misconception.

Where are we? Page 81... the trend and the misconception in the boom-bust process.

Dwyer's five-step process is indeed what happens in the market, and has happened in the market. It explains why bad news makes positive markets and good news makes negative markets.

The misconception, or one of them, is that good news on hiring, for example, will create inflation, which means the Fed will raise interest rates, and tracking back down Dwyer's linkage to the next misconception, Fed policy affects the availability of money. This is a big misconception. See the Steve Keen and Hyman Minsky chapters, they're relatively short. The Fed does not create money. It validates the money created by lending in the fractional banking system. No lending, no money. Evidence: Massive Fed balance sheet growth, tepid money growth. Chart on page 93. Booms finance themselves. Busts ignore the Fed.

And back down further. Money growth creates economic activity.

Buzzer.

Exactly reverse. Economic activity creates money growth. The direction of earnings may correlate to economic activity, or it may not. Depends on which earnings you are talking about. We saw bottom line profit growth go through the roof in the past four years, as companies stopped capital spending and cut workforces. Helped out their stock prices. But when profits are driven not by hiring, expansion, investment, but by sacrificing the workforce, top line revenues do not do so well. But the market correlated to the bottom line, helped also by cheap money for refinancing and not incidentally the same cheap money available to market players to speculate with.

So the Market correlates to Fed money growth because Fed money is used to play in the casino market.

Real economic activity, money growth in the real economy. Inflation in the real economy. All these are outside on the street, totally unaffected by Fed policy except in a negative way, as incomes are hit by low returns on savings, for example, or as commodity prices go up thanks to increasing speculation.

The correlation between Fed policy and stock and bond market prices is as Dwyer describes. Used to be they operated in opposite directions. But now with all this liquidity, it looks for a home wherever it can be found.

But it is interesting that there is a closed loop here. Since the common error in normal times by monetarists is the Phillips curve connection, which is that employment and inflation rise and fall together, the common error in normal times is increased economic activity means potential inflation. Good news is greeted with higher rates by the Fed, which sends markets down. Bad news is greeted with lower rates, which sends markets up.

The bad news in this good news – bad news loop is that higher rates kill economic activity a lot more effectively than low rates revive it. Look at the data. Pushing on the string.

So the misconception is validated by the market. It becomes a trend-like thing. The financial markets operating for their own benefits and responding positively to Fed money. The Fed feeling validated by the financial markets responses. The real economy looking in the window.

Perhaps you think we fail to appreciate the virtues of capital formation generated by the Market. Here is somebody who likewise fails to find the game is worth the candle. John Bogle,the founder and retired CEO of The Vanguard Group. He’s the author of a new book “The Clash of the Cultures: Investment vs. Speculation.”

BOGLE

Let me start off by saying, give you a quote from Lloyd Blankfein of Goldman Sachs. He claims to be doing God's work, arguing that the financial industry, and I'm quoting him here, "Helps companies to raise capital, generate wealth and create jobs." Now we like all those, and it's true as far as it goes. But let's look at the facts. In a typical year, recent year, that total stock issuance including IPOs, comes to about $250 billion a years. But the rest of Wall Street is doing trading of $33 trillion a year.


So the amount of speculation, if you will, is 130 times the volume of equity capital provided to business. Or put another way, tradiing – casino activity – represents 99.2 percent of what our financial system does, and capital formation represents the remaining 0.8.

Of course, ultimately there IS a connection between the casino and the real economy. Bonds and debts come due that have to be ratified by earnings in the real economy. This is when the bankers look over their stacks of chips that have become worthless and say to the treasury, we need a bailout. Or to the Fed, won't you buy my worthless stuff? Actually, they have the power. They say, "You will buy my worthless stuff."

But cost-cutting that may help the bottom line and profits and CEO pay cannot continue forever with a shrinking top line. Ultimately we will need real demand.