Thursday, July 23, 2009

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.


  1. What were your accurate quotes about the stock market? One would have thought your warning meant, "Stock prices are going to go down," not "Stock prices will rise another 3 percent in the next 6 weeks."

  2. Wenzel,

    Murphy's argumnet isn't correct Austrian methodological individualism, it is aggregation at a level that would make Friedman and Keynes proud of him.

    At risk of being called a flame-thrower... I see Murphy and other LvMI types doing this a lot recently. I think they're spending so much time trying to interface with the Keynesians and monetarists that they've begun to adopt their lingo and methodology. I'm almost certain Bob will take offense at this characterization so I hesitate to make it and hope that time will prove me to be an absolute moron on this count.

    As for the rest of the post... I think you make some good points, especially about what kind of ideology/economics is guiding most people participating in the market. They're "believers" and pragmatists. They'll ignore the bus of reality until it literally runs them over, as it has done before and as it will do again. And they'll do the same thing... stand there and pretend it doesn't exist (I once had a fine gentleman from the Prometheus Institute 'libertarian' group tell me that he believed the bus literally doesn't exist. I challenged him to go walk out into the middle of the street and he mumbled something about how that wouldn't prove anything because I'd just perceive my own reality...). This is something that has been reinforced in my mind severely the last few months through various personal anecdotes as well as those shared by friends of mine. Numerous executives and investors we have collectively interviewed all agree things are fine, recovery is close, though none can explain why besides passionately believing it to be so. This can drive markets, temporarily, just as it did before the bubble burst and just as it will now.

    I don't know if you follow Dow Theory but I was quite disturbed to read that a "Bull" signal has been issued today with the close of the DJTA and DJIA, within this bear market rally. I am worried that this downleg will be another few weeks or even months away now and I am considering jumping completely out of my shorts that I've rode all the way (down) this up escalator. Really, really conflicted on this one though, as it's just absolutely miserable out there from every other possible indicator. And as KD mentioned today, HUGE Treasury issuance coming up in the next two weeks that you've got to think will sap some power from the stock market if the auctions don't fail.

    From the things I'd been watching, I was expecting capitulation. Instead, the market surged higher. Memories of Loeb's warning to heed a market that does the opposite of what you expect it to do come to the forefront of my mind...

  3. In the summer of 2008, I was jumping up and down that we were headed for serious problems in the stock market.

    Got that one right.

    In January 2009, I was clearly bullish.

    Got that one right.

    During any one of these periods you could have picked weeks and said, Bohohoo, you got that one wrong.

    But I got both forecast correct inretrospect.

    I can't forecast every six week wiggle, just the main trend. My current forecast is that we are headed for a major smash. Do you disagree? Do you think we are headed higher?

  4. RW,

    I don't have a particular forecast for the stock market, because I think Obama's moves are destroying future profits (stocks down) while Big Ben's policies are setting us up for large price inflation (stocks up). If a bunch of people read my book and saw the light, the market would crash because they'd realize how screwed we are. But since stock prices are based on forward-looking expectations, if 50% of investors are thinking, "Well, maybe when that stimulus money really kicks in, things will turn around" then stock prices can remain above where they "ought" to be based on more fundamental factors.

    And c'mon, I'm not asking you to forecast every week's wiggle. M2 has now been flat for about 4 months, right? So any day now, we should be expecting a crash, right? If the market dropped 2.5% today, instead of rising, wouldn't you probably have posted, "See I told you so"?

    Let me end with one final request (and then I'll go back to picking my apples up here in the tower): What would it take for you to admit you were wrong on this latest call? Suppose that by the end of 2009, M2 is no more than 2% higher than it is right now, and that the S&P 500 is at least where it is right now. Would you then admit you were wrong, and that watching M2 growth misled you this time?

  5. It easy in a morally hazardous world to ride the easy money. Nobody in the market does his homework. Maybe 2-4 percent. Thus the fairness in asserting Bob's secret Keynesian desire for aggregation on how rational people act. C'mon Bob- fear and greed, original sin.
    Now get back on the wagon!

  6. @Bob Murphy


    The market is really, really complex. Take for example your statement:

    ...if 50% of investors are thinking, "Well, maybe when that stimulus money really kicks in, things will turn around" then stock prices can remain above where they "ought" to be based on more fundamental factors.

    This is not completely true. If Bernanke drains the money dramatically, stocks will go down even if no one has read your book, and everyone is bullish. Market sentiment has some influence but is much overrated.

    For example, at the peak in the reak estate market, outside of Austrian economists, there were very few who did not think real esate prices were headed higher, much higher. Yet, with this, probably 90% plus, bullish sentiment, the entire thing collapsed.

    On another point, I think you are much too focused on exact predictions. We are Austrians we know there are no mathematical formulas to help us, and we all know the world is too complex for exact calculations, which doesn't mean we don't know anything, only that our knowledge is more limited than your attempts at the right versus wrong parlor game.

    At this time, Bernanke is not printing any money, zero. To me this looks like an incredibly negative thing for the stock market. By my warning readers about this, I am doing them a major favor of telling them that one of the most important factors is negative. Does this mean taht there are not other countervailing trends? No. Thedre are thousands of them big and small, can they push the market higher, short term? Of course. But longer term it will almost always money that rules.

    Timing is always tough, but as I posted in an earlier comment, we are headed into stock market hurricane season.This means stock liquidations for consumer purchases, winter clothes, school clothes, Thanksgiving and Christmas presents.

    If for some reason the market doesn't go down, while I am warning of all these negative factors, you could say "there must have been other factors in play."

    But if the exact same facts play out the following year, should I change my warnings? Absolutely not. As Austrians know, we live in a world of incomplete knowledge, you can only look at the major trends that are likely to hit the markets, but always being aware that the market is very, very complex.

    If the market doesn't crash by January 1, if you want to call this a mistake I am making now, well go ahead. But it isn't becasue "M2 is misleading me." I know what a halt to M2 money production does, it drains the markets of money, if the market does go up, it is simply because of the complex nature of the stock market, where other factors were stronger than money, as unlikely (but not impossible)as that may be.

    So with all these caveats, yes my forecast is that the market is headed much lower (Provided Bernanke doesn't turn around and start printing again). And I fully expect this too occur before 01-01-10.

    If it doesn't, by all means tell the world I am not Nostradomus.