A Pavlovian Response for Macro Tourism
An article by New York Institute of Finance instructor Jorge Martinez.
During his last years as a psychologist, Ivan Pavlov (known for his experiments with dogs and his studies on conditioned responses) reported that after a number of successful trials, the objects of his study were able to anticipate the stimuli, learning from past tests in which their reactions occurred post- stimuli.
Without going as far as Keynes (who considered that the market agents were possessed by “animal spirits” especially during the periods of high financial effervescence, i.e. large upswings or downturns), I would like to raise the possibility that Bernanke, as well as others central bankers, have based on Pavlov´s concepts to apply their own stimulus, obtaining on agents and the value of market securities almost the same results the Russian doctor achieved.
It has been said many times that these officials (meaning the central bankers) should consider monitoring, diagnosing, measuring and puncturing bubbles, part of their mandates. However, a task like that is not only misleading, it is also risky. By raising interest rates or cutting the stimulus (which would be the conventional way to deflate them), you give up all hope that the stimulus makes the noble and primordial work that it has, which is to encourage job creation, and enhance the productive investment in machinery, equipment, new inventory, networks and systems, as well as commercial and industrial infrastructure.
The applied stimuli has come in many forms, both as fiscal policy (tax cuts, direct spending and returns, that sum up about 3 trillion USD just in members of the G-20, plus another trillion from the rest of countries) or as monetary policy. Nevertheless, it is the quantitative easing (QE) which causes the most controversy and passionate views on both its arrival, and its eventual withdrawal.
Starting on August 2008, the central banks of the World's most powerful countries have added to its balance sheets a total of almost 8 trillion USD (to accumulate nearly 13 trillion USD in their balances) almost everything in the shape of direct quantitative easing on credit and bond markets. This QE has caused a tsunami of liquidity that has inflated the value of the global market near its previous peak of 2007 (United States has generated an accumulated return of 142 percent from its trough which equates to a 23 percent return per year, Europe has had similar returns, Asia a bit lower returns, and Emerging markets higher returns (almost 34 percent per year). In some countries, the market has already eclipsed its pre crisis high.
Kyle Bass, a fund manager, famous for using credit swaps to his advantage just as the 2008 crisis began, mentioned at a recent conference that central bank assets had grown at a rate of 17 percent per year since 2002. That growth compared to global GDP growth (3.9 percent), global bond markets (11 percent) and annual population growth (1.2 percent) seems excessive.
United States, by itself, has added almost 3 trillion USD to its balance sheet (which represents an increase of 240 percent versus the 860 billion they had before) with purchases of all kinds of bonds in the three different QE programs that have been deployed until now. Japan has added another 2 trillion USD (up 70 percent), England about half a trillion (an increase of 320 percent from its original amount) and China a similar increase.
So, what conclusions can be made? Is the entire increase in capital markets, the post-crisis bull market with cumulative returns of more than 140 percent, false? Has all of this been only a "nice but illusory trip" that will end once the stimulus ends -at some point in 2014 or 2015, or perhaps earlier, as these May and June swings have shown- just as fast as it began? Almost like a Pavlovian dog stopped salivating when the buzz ended?
I don’t believe it is, or at least not entirely. I think there is some real factors pushing this bull market, beyond the obvious bounce from the crisis trough (which occurred in March 2009), and one of these factors is corporate profits.
If you measure the earnings per share (EPS) indicator of the S&P 500, from the date the crisis ended, you will realize that they have grown in tandem with stock prices, at a cumulative rate of 123 percent. In fact, the P/E ratio of the S&P 500 (the amount paid for every dollar of profit) has grown 45 percent from its lowest point.
In short, what can be said from the arguments above is that behind this bull market, there is real economic power coming from the corporate sector and if this trend continues, the S&P 500 should follow suit. Stock market multiples probably benefit the most from the monetary stimulus, together –at least in part-, with increased demand for real estate assets especially at collapsed prices.
In conclusion, there is indeed a primitive conditioned response in the market for monetary stimuli (the most palpable right now is Japan), but there are also real elements to it. I think that by removing the stimulus (after previous QEs have ended, markets have fell only to bounce back immediately afterwards) there will be a short pullback that ought to be compensated with productivity and employment ratios if markets shall continue their upward trend.
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