Efficient Markets Hypothesis Versus Ben Bernanke and the Fed

Efficient Markets Hypothesis Versus Ben Bernanke and the Fed

I’ve looked around for a transcript for Ben Bernanke’s press conference, and I can’t find one.  Here’s my gripe, and I mentioned briefly at the end of last night’s article.

But if the tightening is two years away, why did the market react so badly?  Markets are discounting mechanisms, and react to expected future changes, not the mistaken view of Bernanke that stocks of debt still affect the markets.  No, it is changes in the stock of debt, and changes in the expected changes in the stock of debt that affect the markets.

Ben Bernanke either does not get markets, or is hiding what he knows from economic illiterates.  He insisted that maintaining the purchased assets in the monetary base would continue stimulus, even if they slowed down the rate of purchase.

Really, I should have made it simpler last night, and said, “Market prices change when new information changes the views of economic actors regarding the future.”  Markets are discounting mechanisms.  If you tell the market that you will suck $85 billion of the highest credit quality assets out of circulation for as long as it will take to get the economy moving again, and then later you say that you will reduce that flow within a year, you think that won’t change the views of market participants?  It certainly will, and with violence, as we have seen over the last two days.  The market’s forward path for cost of capital has risen, and stocks have fallen as a result.

Not that I will ever meet Bernanke, but if I did, I would point him to the Efficient Markets Hypothesis [EMH].  He probably believes it.  I view it as a limiting concept, that is, EMH is partly true, but only when lots of people who don’t believe in the EMH scour the markets looking for information advantages.  For a funny take on EMH, you can read this.

The short answer to Bernanke is that what has happened in the past should have no influence on current market prices.  That information has already been incorporated into the price.  Only changes of future expectations affect the current stock price.  The same applies to asset prices versus monetary policy; asset prices react to changes in expectations.

But maybe it’s not so bad, or maybe it’s even worse.  What if the Fed is wrong about improving economic prospects, and we see GDP disappoint over the next two quarters?  I think that is likely, as do Bill Gross and Jeff Gundlach:

Going forward, however, yields are likely to start falling. And that means the place to make money in the next few months is “everybody’s most hated asset class: long-term government bonds,” Gundlach said. “There’s really no inflation, no sign of inflation.”

Gundlach says he’s uncomfortable with the term “tapering” to describe the Fed’s expected approach to winding down its bond-buying program, saying it wrongly implies the central bank can achieve “perfection” in its effort to wind down quantitative easing. While the Fed will eventually look to slow the pace of bond purchases, it could subsequently speed them up as well if economic data weakens, he said.

The Fed is wrong about how much power they think they have.  The more aggressive the easing cycle is, the harder the tightening cycle is.  There has been no greater easing cycle than this one.  Thus even the slightest hint of reduction in accommodation hits like a ton of bricks.  Now to hear from Bill Gross:

Gross and his colleagues have been skeptical about the U.S. economy’s potential for growth since the financial crisis. Gross said last week the Fed won’t raise rates in a “meaningful way” for at least the next two years and investors should be cautious when it comes to all risk assets.

As interest rates have climbed over the past two months, Gross has recommended buying U.S. Treasuries. In a Twitter posting June 18, he recommended buying five-year Treasuries and earlier, on June 12, he called intermediate Treasuries with yields above 2 percent a “buy.” The “Fed’s not raising interest rates for years,” he said.

and

“We simply think the real economy won’t follow the path that the Fed thinks it will because the Fed is based on a cyclical model that’s inappropriate,” Gross said in a Bloomberg radio interview today with Tom Keene.

When there is too much debt, we tend to get deflation, because we slowly realize that all debt claims will not be honored.  That leads to uncertainty and slow growth, as people try to preserve the value of what they have, rather than take risks to grow their assets.  I’ll be writing more about this in a future book review.  Highly indebted societies tend not to grow rapidly.

I’ve been adding some long Treasuries to bond accounts, and I may add more.  Like Japan, I think we are in the midst of a “bad policy” trap that restrains growth and leaves the economy to muddle, until enough debt is paid down, and fiscal policy looks sustainable.  That may not happen for a long time, so that leaves me a bear at present.

By David Merkel, CFA of Aleph Blog




About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.