Helping Bob Murphy Understand the Stock Market

Bob Murphy has decided to take me to task for using M2 nsa (with a three month lag) as a tool to forecast the stock market. Unfortunately, Murphy's look down from his ivory tower has missed how markets work. Further, he has decided to cherry pick from on up high, and while picking cherries from such a lofty position, he has landed on his head.

Now, I'm left to clean up the mess.

First, he quotes me twice when I have made (accurate, I might add) forecasts about the stock market. He fails, however, to quote my humbleness while I achieved these quite remarkable feats, since I also wrote, just recently:

Note: I want to emphasise that it is not always this easy to call trends. There are always many countervailing factors, but Bernanke's dramatic money printing shifts makes money supply the SUPER DOMINANT factor at this time. It won't always be this easy--even though money supply growth will always be the key factor to watch.

Note my emphasis on "countervailing factors".

Murphy writes:

I have several problems with all of this. First and most serious: How can you possibly argue that stock prices respond to money supply numbers with a 3-month (or greater) lag? I understand if you want to argue that measured CPI responds only slowly to injections of new money; fair enough. But surely it shouldn't take forward-looking investors three months to digest the implications of a change in Fed policy.

This is obviously written by a guy who has no familiarity with stock market activity. For him there is some kind of intravenous drip line that connects the Fed and the stock market. Uh, Bob, when exactly was the last time the Fed ever lent money directly to the stock market?Admittedly, it does get there since Fed money entering the system does push down rates at a specific point and eventually the system will eventually adjust by increasing the value of earning streams of publicly traded companies. But, Murphy is simply creating super-macro aggregation of something that is much more complex. Murphy's argument isn't correct Austrian methodological individualism, it is aggregation at a level that would make Friedman and Keynes proud of him.

Further, in addition to the simple time factor in a less aggregated model of money flows, you must break things down even further. Many investors have a mentality that if they are in a losing position they will sell when they break even. Good technical analysts have made fortunes knowing where this overhead supply of break even traders are, and trade around them. So if you have these break even traders, who knows how much money will be required "to take them out" before the stock market goes higher? Does Murphy think one hour of Bernanke money printing will do it? One day's worth? In truth there are many factors that enter into determining how many break even sellers are out there.Three months happens to be a good rule of thumb--nothing more. But if we were coming out of a years long depression, it might be two years. The only time I am aware of a near instantaneous reaction in the stock market to a change in money policy was in the summer of 1982, when Volcker shifted to an easy money policy in August of that year. The stock market took off like a rocket. However, at that time ,the stock market was in an extreme oversold position, the market had attempted many, many times (over years)to breakthrough overhead supply at 1,000 and EVERYONE was watching money supply numbers every week.

These days few watch money supply numbers, not even Deputy Treasury Secretaries.

And, yet Murphy seems to ignore (or really probably doesn't know) about overhead supply, methodological individualism and its importance in relation to where money enters the system. How else but through ignorance could he have written:

Yes, there is certainly a connection between Fed policy and nominal stock prices, but it can't be backward-looking and with a lag (let alone a variable lag!).

Then he makes this absurd statement:

I'm not claiming that the efficient markets hypothesis is correct; I'm just saying that it can't possibly take speculators months to react to unexpected changes in Fed policy.

Does he really think that the market is full of traders reading the monetary theory of the Austrians, Hayek, Rothbard and Mises, and that they will react at the first hint of changes in Bernanke's policy?

Earth to Bob, these guys lost billions, and billions and billions, and billions trading on the money expansion of Greenspan and the early Bernanke. Did they stop after Bernanke slowed money growth? Did Lehman or Bear Stearns start shorting the market in summer of 2008, as Bernanke tightened money supply even more? Did these two premier trading firms come up smelling roses in September 2008, as your instant market reaction theory would suggest?

Murphy really doesn't have a clue until he gets to the first sentence of his last paragraph:

A final note: I am sure that Wenzel is much more attuned to market movements than I am. If you had $1000 to entrust to either of our calls on market timing, you would do better to give it to Wenzel.

And as for the last part of his last sentence, I really must throw that back at him:

...I don't think he even sees when it [his theory] is being contradicted by actual events.