Discounting Is a Two-Way Street

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When the
economic news is bad, an investment industry representative will
tell some TV interviewer that the stock market has already discounted
the bad news. By this, he means that the negative economic effects
implied by the bad news has been factored into the price of the

This analysis
is true, as far as it goes. The stock market’s prices respond
to the initial phase of the bad news before the bad news hits
the media. This market discounting phenomenon has been well-known
among forecasters and academic economists for at least 35 years.
The rule on news is this: “If you’ve heard about it, it’s too
late to invest on terms of it.”

On the other
hand, the glib experts never say in response to good news that
the market has already discounted it, too. If you have heard about
the good news, it’s also too late to invest in terms of it.

The experts
who get interviewed on TV are basically salesmen or the paid agents
of salesmen. Their job is to keep investor confidence high. They
get interviewed because the news media outlets make money by selling
advertising. If a TV financial news show were to cover bad economic
news as thoroughly as it covers good news, some viewers would
sell their shares, put their money in T-bills, or an insured bank
account, or in income-producing real estate. These investments
do not fluctuate very much day to day. Viewers without any stocks
would then not feel any need to tune in daily to see how their
stocks have done since yesterday. They would not need continual
cheerleading to persuade daily them that their money is where
it belongs. So, the show’s ratings would sag, its advertising
revenues would fall, and the network biggies might decide to switch
the time-slot to a talk-show format.

The theory
of efficient markets tells us that all news that relates to the
price of any asset is discounted before the news becomes public
knowledge. This is one of the great advantages of a free market:
its rapid assimilation of relevant information. The best and the
brightest investors assess the economic impact of news that has
yet to reach the general public, and their competing assessments
produce a market price.

To say that
someone should buy, sell, or hold based on recent public news
is to say that the person making the recommendation has better
information than full-time forecasters. Sometimes, this will be
the case. During market manias, a few forecasters will see that
the upward move cannot last, and that wise investors should sell
their holdings or buy puts or even short the market. But in manias,
few people will listen to sage advice. Also, few forecasters who
really do see that the mania is a mania will get the timing right.
They will identify the mania-like conditions early — too
early. The market will prove them wrong for a time. So, hardly
anyone will take their advice.

This is
equally true of market bottoms. Those forecasters who are familiar
with the effects of panic will try to persuade people to get back
in. But the panic may continue, as panics do.

So, when
you read or hear about bad news having been discounted by the
market, you should take this seriously. But good news is equally
irrelevant. The market has discounted all news.

So, should
you buy, sell, or hold?

Too Good
to Be True

You should
assess any company’s profit prospects, not in terms of the latest
news reports, but in terms of the long-term demand by consumers
for its output. Is this output still likely to be in demand on
the day that you decide to sell?

To answer
this question, you need two things: a timetable for selling that
you think you will stick with, and reliable information concerning
the likely alternatives to the product.

The more
likely that the product line will still be in demand when you
want to sell, the less likely that the company is a highly leveraged
investment that is going to soar in value because of late-comers
rushing to buy it, i.e., a supermoney stock. Proctor & Gamble
is less of a supermoney stock than Cisco. The likelihood that
new technologies for detergents — a really “new and improved”
product line — will be introduced by a rival firm is a lot
less than the possibility of a replacement for some high-tech
product line.

The U.S.
stock market is a supermoney market compared to other conventional
investment markets. This is because of the “buy and hold” policy
of the stock fund managers, especially retirement fund managers.
They have automatic retirement portfolio money coming in every
day. They have to do something with it. They assume that there
is no downside selling risk next month comparable to what will
happen when the baby-boomers start to retire at the end of this
decade. The fund managers have not yet discounted the retirement
fund withdrawals when the boomers start to retire, any more than
American politicians have discounted the effects of the retirees
on Social Security’s Trust Fund after 2010. In terms of allocation
of risk and assets, politicians and fund managers have paid no
attention to demographics. The mutual fund industry can no more
blow the whistle on the stock market’s vulnerability to retired
sellers who start cashing out in order to get access to liquidity
than a Congressman can blow the whistle on Social Security’s $10
trillion unfunded liability. The public does not want to hear
about obvious, inescapable bad news. The public will inflict negative
sanctions on asset managers who mention the obvious, or who allocate
portfolio assets accordingly.

Buyers want
good news. No salesman sells death insurance. He sells life insurance.
No salesman sells sickness insurance. He sells health insurance.
He does not sell fire insurance or tornado insurance; he sells
homeowners’ insurance. The big exception is flood insurance; only
the U.S. government sells it, and almost nobody buys it, even
people who live in flood plains.

In the world
of direct marketing, it is well known that “you can’t sell prevention.”
You sell a cure after disaster has struck. You don’t sell thin
people a stay-thin lifetime weight-control program. You sell no-pain
diets to people who visibly lost control a long time ago.

When it
comes to TV shows on the stock market, prevention doesn’t sell.
So, we hear all about the stock market’s discounting of bad news,
but never about its equal discounting of good news. Good news
is a good reason to buy. Bad news is a good reason to hold. There
is never a good reason to sell.

As for selling
short, how many interviews have you seen on CNBC with specialists
in short-selling?

This is
why the stock market’s media-heralded opportunity for growth is
too good to be true. The S&P 500 index is selling for 40
times earnings
: very high historically. Yet we are being told
by some experts that this is the best time in 16 years to buy
stocks. But the past 16 years have produced the largest stock
market percentage gains in history. Apparently, the stock market’s
pricing system failed to discount the coming boom when it fell
in 2000 and again in 2001. But no one mentions this on TV. No
major brokerage house in late 1999 recommended shorting the market
for the next two years. The best and the brightest didn’t see
what was coming in December, 1999.

How bright
are the best and the brightest? Remember, these are the people
who did not send out any warnings in Argentina’s debt. You can
still find this forecast on Yahoo! It’s from an outfit that sells
special reports for $400
to $750

a difficult economic environment, there is little risk of parity
with the US dollar ending, as devaluation would lead to debt default
and insolvency on account of the large amounts of unhedged US
dollar liabilities owed by both the government and the private
sector. Consensus in favour of maintaining one-to-one parity will
therefore persist. In the event of a crisis caused by an external
shock, we would expect Argentina to respond by adopting the US
dollar, a proposal considered by the Menem administration, rather
than to devalue. (August
23, 2000

Too bad that
Menem went to jail.

The Argentinian

We are being
told today not to worry about Argentina’s default because its
negative effects have already been discounted by the stock market.
(My wife heard this on one of the morning talk shows.)

has had five presidents in one month. There was a default of $141
billion, or some portion thereof — nobody knows for sure.
The Argentine peso was devalued by about 30%. The government may
float the peso in a few months — a market rate of exchange.
The government is also expected to ask for $15 billion to $20
billion in additional
later this year. I think the IMF or other agencies will
lend this extra money. Japan Today (Jan.
) reported:

International Monetary Fund and G-7 officials said they stand
ready to help, but added that only Argentina, already in default
on its debt and apparently on the verge of devaluation, can take
the tough decisions about its future economic path.

“It is
too soon to expect that there has been an exchange of views
on policy,” said Bill Murray, IMF spokesman. “But we’re ready
to work closely with the new government to help it meet the
economic challenges that it faces.”

That sounds
to me like bureaucrats who are getting ready to deal. And why
not? It’s an old, old tradition: subsidizing Latin America’s deadbeats.
For over 170 years, Latin American countries have run up gigantic
debts to foreign banks located above the equator or above the
Rio Grande. Then they have defaulted. Over and over they do this.
Between 1825 and 1827, almost every Latin American government
on its debts.

defaulted in 1890, bankrupting
England’s Barings Bank
. Only a bailout by the Bank of England
restored Barings. (Barings went under permanently in 1995, after
a 27-year-old currency trader had lost over a billion dollars.
Nobody came to Barings’ rescue in 1995.) Yet by the mid-1890’s,
Western banks were lending
again to Argentina
. Gringo bankers just don’t learn. They
come back for more. That’s why the latest president could seriously
ask for an additional $20 billion in loans.

If you were
a football coach, and you kept scoring touchdowns with a particular
play, year after year, decade after decade, would you abandon
it? Of course not. You would wait for defensive coaches to adjust.
But what if the defenders suffer from the protagonist’s affliction
in “Memento“?
What if they keep losing their memories? You would keep running
the play.

The market
has now shrugged off a $132 to $141 billion default (nobody is
quite sure how much) by Argentina. It will not surprise me if
Argentina gets get an extra $20 billion. In fact, it will surprise
me if it doesn’t get at least $10 billion.

In 1998,
in the weeks after the near collapse of the world currency markets
in response to the failure of Long Term Capital Management (advised
by two Nobel Prize-winning economists), Milton Friedman wrote
a perceptive
. He told the truth. The 1995 bailout of Mexico was not
really a bailout of Mexico; it was a bailout of the Western banks
that had just been stiffed by Mexico. He wrote:

Mexican crisis in 1994-95 produced a quantum jump in the scale
of the IMF’s activity. Mexico, it is said, was “bailed out” by
a $50 billion financial aid package from a consortium including
the IMF, the United States, other countries, and other international
agencies. In reality Mexico was not bailed out. Foreign entities
— banks and other financial institutions — that had
made dollar loans to Mexico that Mexico could not repay were bailed
out. The internal recession that followed the bailout was deep
and long; it left the ordinary Mexican citizen facing higher prices
for goods and services with a sharply reduced income. That remains
true today.

The Mexican
bailout helped fuel the East Asian crisis that erupted two years
later. It encouraged individuals and financial institutions
to lend to and invest in the East Asian countries, drawn by
high domestic interest rates and returns on investment, and
reassured about currency risk by the belief that the IMF would
bail them out if the unexpected happened and the exchange pegs
broke. This effect has come to be called “moral hazard,” though
I regard that as something of a libel. If someone offers you
a gift, is it immoral for you to accept it? Similarly, it’s
hard to blame private lenders for accepting the IMF’s implicit
offer of insurance against currency risk. However, I do blame
the IMF for offering the gift. And I blame the United States
and other countries that are members of the IMF for allowing
taxpayer money to be used to subsidize private banks and other
financial institutions. . . .

The present
crisis is not the result of market failure. Rather, it is the
result of governments intervening in or seeking to supersede
the market, both internally via loans, subsidies, or taxes and
other handicaps and externally via the IMF, the World Bank,
and other international agencies. We do not need more powerful
government agencies spending still more of the taxpayers’ money,
with limited or nonexistent accountability. That would simply
be throwing good money after bad. We need government, both within
the nations and internationally, to get out of the way and let
the market work. The more that people spend or lend their own
money, and the less they spend or lend taxpayer money, the better.

This “moral
hazard” is a sufficiently great threat to have persuaded Alan Greenspan
to offer the following assessment to the House Banking Committee
in September, 1998, just after he supervised the rescue of LTCM
by persuading the lending banks to lend another $3.6 billion to
LTCM. He warned Congress of systemic risks to the international
banking system. He warned that lenders must take greater care in
making these huge loans. Nobody listened. Western money center banks
are now facing another massive default. Greenspan mentioned the
1998 Asian bailout. Today, Asia outside of China is in a full-scale
recession. Japan’s banks are facing a major crisis, for they have
all used Japanese stock market profits — long gone — to
provide their legal capital requirements. With this in mind, let
us review Greenspan’s

of lenders do on occasion evoke systemic risks, but it is the
failure of borrowers to maintain viable balance sheets and an
ability to service their debts that creates the major risks
to international stability. The banking systems in many emerging
East Asian economies effectively collapsed in the aftermath
of inappropriate borrowing, and large unhedged exposures, in
foreign currencies. . . .

pricing and counterparty surveillance can be expected to do
most of the job of sustaining safety and soundness. The experience
of recent years in East Asia, however, has clearly been less
than reassuring. To be sure, lack of transparency and timely
data inhibited the more sophisticated risk evaluation systems
from signaling danger. But that lack itself ought to have set
off alarms. As one might readily expect, today’s risk evaluation
systems are being improved as a consequence of recent failures.

Just as
importantly, if not more so, unless weak banking systems are
deterred from engaging in the type of near reckless major international
borrowing that some systems in East Asia engaged in during the
first part of the 1990s, the overall system will continue at
risk. A better regime of bank supervision among those economies
with access to the international financial system needs to be
fashioned. In addition, the resolution of defaults and workout
procedures require significant improvements in the legal infrastructures
in many nations seeking to participate in the international
financial system.

None of
these critical improvements can be implemented quickly. Transition
support by the international financial community to those in
difficulty will, doubtless, be required. Such assistance has
become especially important since it is evident from the recent
unprecedented swings in currency exchange rates for some of
the emerging market economies that the international financial
system has become increasingly more sensitive than in the past
to shortcomings in domestic banks and other financial institutions.
The major advances in technologically sophisticated financial
products in recent years have imparted a discipline on market
participants not seen in nearly a century.

international financial assistance is provided must be carefully
shaped not to undermine that discipline. As a consequence, any
temporary financial assistance must be carefully tailored to
be conditional and not encourage undue moral hazard.

ended his grim testimony on this happy-face note: “It can be hoped
that despite the severe trauma that most of the newer participants
in the international financial system are currently experiencing,
or perhaps because of it, improvements will emerge to the benefit,
not only of the emerging market economies but, of the long-term
participants of the system as well.” Well, hope is cheap. Reality
is expensive.

It is now
a little over three years later, and what may be the biggest default
in history has hit us. It’s hard to say for sure if it is the
biggest; the Asian bailout in 1998 was in the same range.

the familiar word is, “The effects of the default have already
been discounted by the stock market.” Well, maybe the market has
discounted it. But it wasn’t discounted early enough: before the
business school graduates in the giant commercial banks made the

How many
of these defaults can the banking system take? More, we are told.
Always more. It’s all discounted. It’s all built into the risk-premium
component of the interest rate. All $141 billion? “Yes.” What
was the premium? “An extra percentage point. Maybe two. It doesn’t
matter now anyway.” Why not? “Because it’s all gone.”

charge three points for the extra $20 billion. These bankers are

The Peronists
have been ruining Argentina, on and off, for over half a century.
They believe in government-controlled markets, monetary inflation,
and welfare State subsidies. They are not defenders of private
property. They are to fiscal solvency what Madonna (who played
Evita Peron) is to moral purity.

the Fact

The experts
tell us that the bad news has been discounted only after the disaster
has become public knowledge. Somehow, they never know in advance
about discounting’s effects. The NASDAQ’s P/E ratio was 207 in
December, 1999. Was this cause for alarm? Of course not. Bad news
had all been discounted.

Then the
NASDAQ index fell from 5040 to 1500. Response? “Buy now! The bad
news has all been discounted.” But they told us that all the way

a dozen years of recession had not been discounted by the Nikkei
Index in December, 1989. But economists were not concerned. Neither
were investors. Nevertheless, all bubbles come to an end.

The trouble
is, when the bubble is in progress, everyone denies that it’s
a bubble. It’s just “public confidence about the future of [fill
in the blank].”

Today, it’s
high technology. Anyway, it was. Now it’s consumer confidence.
What about rising unemployment? Forget about it. The important
thing is that the public is confident.

Of course
the public is confident. All of the pundits and forecasters keep
saying that there is nothing to fear except. . . fear itself.
The Conference
reports that consumer confidence regarding six months
from now is up from 77.3 in November to 91.5. (1985=100) But,
regarding the Present Situation, it moved up from 96.2 to 96.9
— not much.

The Conference
Board also reported that the Help Wanted Advertising Index moved
down in November to 45 from 46 in October. It was at 75 one year

Conference Board Economist Ken
: “Even if the economy is slowly starting to turn
around, the labor market is still in retreat. In more than half
the country, help-wanted ad volume is about half of what it was
one year ago. The overall level of the Help-Wanted Index is as
low now as it has been in almost four decades. The trend in job
advertising suggests that new hiring will be kept to a bare minimum
through early 2002.”

Demand for
labor has to be a key index for the average Joe. Top executive
positions are not featured in help wanted advertising, but for
middle-class and working-class people, these ads are the most
obvious single indicator of actual business conditions. If businesses
are not hiring, then business is not expanding.


To say exactly
why the U.S. stock markets rose in the first week of 2002 is guesswork.
It may be that investors heard good news about consumer confidence.
It might even have been their faith in the stimulative effects
of inflation-driven low short-term interest rates. But investors
should be getting confirmation signals from business owners. Business
owners should be investing more money in new equipment, advertising
for more help, and buying more shares of their companies. Instead
we find the opposite, as far as the latest data indicate.

The lemmings
continue to ignore the rumblings of the economy. The whole world,
except for China, is in a recession. Corporate profits are still
falling. But investors remain optimistic. The bad news has all
been discounted.

When it
comes to bad news for this economy this year, there’s more where
that came from. This reality has not been discounted yet. But
it will be.


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