by Gary North
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 shares.
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.
Despite 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 Fiasco
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.)
Argentina 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 loans later this year. I think the IMF or other agencies will lend this extra money. Japan Today (Jan. 8) reported:
The 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 defaulted on its debts.
Argentina 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 piece. 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:
The 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.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 warning.
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.
Losses 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. . . .
Market 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.
Whatever 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.
Greenspan 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.
Nevertheless, 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 loans.
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."
They'll charge three points for the extra $20 billion. These bankers are smart!
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.
After 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 down.
Somehow, 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 Board 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 ago.
Says Conference Board Economist Ken Goldstein: "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.
January 9, 2002
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