Stock Market Dissonance

Stock Market Dissonance (10/22)

From Glimpse into the Future, via Market Shadows Newsletter

Also on this week’s MarketShadows Newsletter

  • Consumer habits, spending, staples and the housing market
  • Springheel Jack on AAPL
  • Chris Vermeulen on Gold
  • Pharmboy’s stock ideas, reports from Sabrient

The economy and the stock market are not in a direct cause and effect relationship; they are not indicators of each other.

(Updated) In Leading Economic Indicators, examining five common economic indicators, Mish observed:

“Time and time again I hear ‘The stock market acts six months in advance.’ Six months in advance of what? I fail to see how it is acting six months in advance of anything. If one is looking for leading economic indicators, the stock market is surely not one of them.

“Also note that if one wants a stock market indicator the economy is surely not it. Look at the plunging GDP in comparison to the stock market for recent proof. Look at the homebuilder chart above for recent proof. Look at the historic S&P 500 chart for proof. Seriously, the S&P is a hopeless leading economic indicator and the economy is an equally hopeless stock market indicator.

“Yet the myth (and the weighting) that the stock market is a leading indicator still persists.”

The economy is not a stock market indicator and the stock market is not an economic indicator.

There are many variables and confounding factors affecting the health (or appearance of health) of the economy and the stock market.

Examining economic indicators, there are also important problems in measurement – how do you measure economic conditions? Which factors matter, and to what extent? Which yardsticks are most meaningful? Which are not meaningful at all? And highs in the stock market may look good at a distance, but the measure is in money. Inflated money due to money printing is not an underlying signal of health, pretty chart patterns aside.

When trying to anticipate the direction of the stock market for purposes of making decent investments (in an environment where the value of the Dollar will likely decline), it is a mistake to get overwhelmed by long-term predictions that the economy is in a perpetual state of contraction. Even if you agree with those predictions.

From a psychological perspective, “cognitive dissonance” describes the state of holding two or more conflicting cognitions (e.g., ideas, beliefs, values, emotional reactions) simultaneously. According to the Wiki entry, “The theory of cognitive dissonance in social psychology proposes that people have a motivational drive to reduce dissonance by altering existing cognitions, adding new ones to create a consistent belief system, or alternatively by reducing the importance of any one of the dissonant elements.

“An example of this would be the conflict between wanting to smoke and knowing that smoking is unhealthy…”

Or let’s say, believing that the stock market should go up based on the Federal Reserve’s undeniable love of money-printing and the perennial Bernanke Put may conflict with the notion that our country has entered a long period of decline by measures such as wealth (for the 99%), equality and opportunity. Those beliefs might invoke uncomfortable feelings of cognitive dissonance. Similarly, in his book “When Prophecy Fails,” Leon Festinger (who coined the phrase “cognitive dissonance”) chronicled the thought processes of followers of a UFO cult “as reality clashed with their fervent belief in an impending apocalypse…”

Festinger found that “people have a bias to seek consonance among their cognitions… Dissonance is aroused when people are confronted with information that is inconsistent with their beliefs. If the dissonance is not reduced by changing one’s belief, the dissonance can result in misperception or rejection or refutation of the information, seeking support from others who share the beliefs, and attempting to persuade others to restore consonance.”

Recognizing that the behavior of the stock market and my beliefs about our country have conflicted, I’ve used the other common psychological technique, “rationalization,” to reduce the stress of clashing views. Thoughts on the market vs. the economy are not discordant when the cause and effect connection is abandoned.

Zero Hedge touched on the mistake of wrongful attribution of cause and effect while examining the wonders of perpetually rising government debt along with ever-expanding corporate profits. If at first the two appear connected, don’t be fooled – the alignment is not based on a cause and effect. Proof: Japan. (No, Soaring Deficits Do Not Mean Record Corporate Profits: In Fact Just The Opposite)

Zero Hedge: “Over the weekend there appears to have been more confusion about pretty much everything finance related by aspiring CTRL-V majors-cum-’market experts.’ In this specific case, the correlation between the soaring US deficit is magically supposed to imply the causation of surging corporate profits. Standalone this would be wonderful, because in a socialist utopia thought experiment, where one could hit infinite deficits funded by some magic MMT money tree, corporation would make, well, an infinite amount of profits, and would be an incentive for the government to spend itself to oblivion.

“And everyone would be happy: infinite corporate profits means at least some trickle down wealth, and infinity even minus a big number is still infinity, meaning full employment for everyone. Hence utopia. Idiocy of this conclusion aside, the bigger problem with making the biggest rookie mistake in finance (and statistics), namely confusing correlation with causation, is that it is, as usual, 100% wrong when presented with one counterfactual. And when it comes to counterfactuals of soaring deficits, one always goes to the place that has ‘been there and done all of that’ before. Japan.

“Why Japan? Because just like the US, Japan has seen its share of soaring budget deficits in both absolute terms and as a % of GDP. In fact, since the 1960s, the deficit as a % of GDP number has gone up, up, up.

 

 

“How have corporate profits performed in Japan during this period of ‘deficit spending into oblivion’ utopia starting in 1960 and ending, well, never? Japan will surpass one quadrillion in sovereign debt this year, and well over 200% in debt/GDP. Well, as a paper by Jim Montier (dissected previously) showed early this year, corporate profits in Japan have done poorly to say the least. Below is the Bloomberg data for the ratio for Japanese profits to sales for all industries.

 

 

“In Japan, over the past 40 years, soaring deficits have actually resulted in collapsing profit margins. Which incidentally, is how one refutes amateurish correlation=causation CPM click magnets.

“But wait, there is more.

“Because the question still stands: why did Japanese profits decline for over 40 years during a time when the Japanese government was spending like a drunken sailor. We explained it previously in detail, but here it is again in a nutshell:

  • in an environment of soaring liquidity and free money, the hurdle rate on new investments collapses, as does the requirement to invest in Capital Expenditure (CapEx), both growth and maintenance. In fact, as we have shown over the past year, the age of the global asset base has hit a record high across the world, both in the developed and developing countries, leading to record low return on assets!…

“So why did cyclical (not secular) profitability in the US spike in the past several years? Two simple reasons: i) debt refinancings into an ever cheaper cost of capital, which however has now hit a floor as very little incremental balance sheet benefit is left for companies, both investment grade and high yield, and ii) SG&A reductions, as more and more companies lay off thousands, or merely replace their fixed cost structure with a cheaper employee base (converting from full-time to part-time workers is one example, and one we have documented extensively).

“Finally, as we showed last quarter, corporate profitability has already peaked, and in Q3 will post its second consecutive quarter of Y/Y declines. In the meantime, we believe it is unnecessary to demonstrate that US deficit spending did not decline at all in recent months, and in fact has at worst kept up at the same pace.

“The key point is that it has been the Fed’s easy money policies that have resulted in cyclical bouts of corporate profitability… Now, however, the Fed has no choice but to keep ZIRP for ever, even as corporate profits have once again started declining, and there is no lever the Fed, or anyone, certainly not the US Treasury, can pull to push them higher.

“In other words, an absolute dead end, and not to mention record deficits do not drive record profits, which was the original idiotic contention.

“So instead corporates get a 2-3 year profit boost benefiting shareholders who get to cash out, while in return America has a record debt load to show for it. Sounds like a grand exchange… if only one lives in a socialist utopia, as taught by the Columbia school of journalism or comparable, and has no idea how every single instance of socialism ends when the other people’s money runs out.” (No, Soaring Deficits Do Not Mean Record Corporate Profits: In Fact Just The Opposite)

Not a happy forecast for the economy or for the country for that matter, but will this unfortunate path take the stock market down with it (a stock market investor might ask)? The unlimited quantitative easing (QE-Infinity and Beyond) that is coming our way makes us question whether or not, or how soon, the negative economic effects will get displayed in stock prices. (Chart from ZH’s Bernanke Set To Unveil Number Larger Than “Eternity”)

 

Of course, the situation in the US will not necessarily parallel the course of Japan. Many different factors are in play: demographics, sociological factors, immigration, consumer habits, taxation, safety nets, etc. But it is worth watching, as we are now seeing corporate profits begin to weaken. Taking the other side of Zero Hedge’s argument, Phil of Phil’s Stock World wrote: “As you can see from the chart below, Corporate Profits as a percentage of GDP are taking a dip this quarter, but HAVE SOME PERSPECTIVE – they have never been stronger – EVER. The weakest thing now is confidence, and that’s no surprise given this incredibly depressing election season.” (A Little Perspective Does Wonders)

Links between the economy and the markets are not governed by readily identifiable cause and effect relationships.  While money-printing devalues a country’s currency, leading to higher stock and commodity prices, higher energy and food prices also stunt real economic growth. Adding the Fed’s ZIRP policies to the mix can highly distort if not negate connections that might once have seemed logical. We will watch how market forces eventually play out, but in the meantime, we are trying not to let our cognitive dissonant moments overly bias our conclusions.

 

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