Why Monetary Expansion Must Stop

By: MISES

The current problems faced by all the world's economies stem, primarily, from one source: the demise of sound money, whose quantity could not be increased without significant cost, and its replacement with fiat money that can be inflated to infinite amounts at almost no cost to the producer.

Expansion of fiat money makes it appear to all market participants, including financial regulators, that there are more resources available than really exist. Thusly, all participants, including governments, embark on programs that cannot be completed; there just are not enough resources in the economy.

Not only does fiat money create the illusion of greater wealth, it makes embarking on new projects irresistible. After all, does it not always appear that lack of money is all that stands between man and the fulfillment of all his dreams? Now, with unlimited quantities of fiat money, the day seems to have arrived when anything is possible. But this is an illusion.

Throughout my talk I will refer to economic laws that act as impenetrable barriers to achieving the goals sought by monetary expansion. These are laws of human nature — to ignore them brings serious adverse consequences.

Economics is a social and not a natural science, because man is a social being. His actions are not governed by physical stimuli but by preferences derived from subjective valuations, all of which are unknowable, undergo constant change, and therefore cannot be predicted. Nevertheless, we do know that man is rational; that he acts to attain goals which he believes will improve his satisfaction; that he employs scarce means to do so and that means imply costs; but since he expects to improve his satisfaction, he expects the costs to be less than the satisfaction to be attained; so man expects to profit from his actions. From this brief explanation of man as a rational being, we can derive irrefutable economic laws.

Two Evils of Monetary Expansion

There are two main evils of monetary expansion: (1) recurring financial crises and (2) expansion of the wealth-destroying welfare-warfare state.

I'll start with why we continue to have recurring and ever more damaging financial crises. Then I will discuss very briefly the expansion of the wealth-destroying welfare-warfare state.

No Societal Benefit from Monetary Expansion

Expansion of fiat money denies the irrefutable economic law that money is subject to the law of diminishing marginal utility. This insight was explained by Ludwig von Mises in his 1912 classic, The Theory of Money and Credit. Mises explained that money is not "neutral"; money is a good and is subject to all the laws of economics as are all other goods. Because each new marginal unit conveys less utility than all previous units, and because money is fungible — meaning that each new unit is indistinguishable from monetary units already existing — then the purchasing power of all money is reduced.

The first users of the new money benefit most from the newly created money. This is a tight circle nearest the event of the new money being created. Those furthest away from this event, who are in a wider circle of the general economy, all lose because this new money dilutes the value of each unit of money they are already holding. Think of it as pouring water into milk. Therefore, expansion of the money supply conveys no overall societal benefit.

Money Expansion Is Not Stimulative

Immediately we see that an increase in money cannot be stimulative overall. Although it can stimulate some parts of the economy (those who get the new money first), it can do so only at the expense of all other parts, violating another immutable law of economics, Say's Law, which essentially tells us that we can't get something for nothing. With the creation of new fiat money, wealth has been redistributed from the current holders of money — the rightful owners — to illegitimate new allocators who steal, without getting noticed, other people's money. The first or early receivers of the new money benefit at the expense of those who receive it later, through the market process, or do not receive it at all — for example, retirees living on privately accumulated wealth. The early receivers buy at existing lower prices, while later receivers pay higher prices.

As this newly created money dilutes the existing money's purchasing power, we see this as high prices — later and not immediately. Higher overall prices are the logical consequence of any expansion of money. The price level can be thought of as the result of total monetary spending divided by the total supply of goods and services offered on the market. If the numerator (total spending) goes up or the denominator (total market supply of goods) goes down, the price level increases.

Some may object to this explanation, saying that sometimes the price level remains relatively flat despite an increase in the quantity of money, because the total supply of goods increases enough to offset increases in total spending. My answer is that this is a justification for slow, planned inflation, which ignores damaging structural changes that still occur in the economy. I discuss these changes below.

The Prosperity Illusion Caused by a Rising Gross National Product

Unfortunately, increased spending creates the illusion of increased prosperity, because we measure prosperity by the growth in Gross National Product (GNP), a measure only of total spending, the numerator in the quantity-theory-of-money equation. Under sound money, GNP remains the same, because the quantity of money — and thusly, the quantity of total spending — remains unchanged.

But fiat-money inflationary spending, caused by planned inflation of the money supply, is described as economic "growth." The more government inflates the quantity of money, the greater economic growth appears to be as measured by GNP. But this is an illusion. It is not growth at all. It is just a consequence of measuring higher prices.

So far we have seen that fiat money does not stimulate the economy overall; it merely rewards some at the expense of others and creates higher overall prices. But the main structural damage, to which I earlier referred, occurs in the structure of production as manifested by recurring boom/bust cycles. Here is where fiat money and credit expansion cause pure capital consumption, robbing the future productive capability of the economy.

Malinvestment and the Austrian Business Cycle

In the mistaken belief that the economy can be stimulated into a higher level of production by more money, central bankers lower interest rates below the natural, market rate. The ultimate result of such intervention is destruction of capital through what Austrian economists call malinvestment. Capital is devoted to lines of production, primarily into longer-term investments, that will never be profitably completed.

We must address this most pressing question: Why do so many businesses fail at the same time? Can it be that a mass incompetence spreads through the economy so that we experience a large-scale bust from time to time? Governments and central bankers focus on this bust and try to postpone it, thinking that this bust is the problem.

"Lower interest rates and increased government oversight provide nothing more than full employment for bureaucrats."

 

But, ladies and gentlemen, I am here to tell you that the bust is not the problem. The problem is the boom and what created it in the first place. Fortunately this business-cycle phenomenon has been very well explained by Austrian economics. For those of you who have the time, I will be happy to explain the details of this after my talk. Suffice it to say that it is the intervention of the central bank that puts into motion the culprit of "artificial interest rates." These are false signals to businesses that there are new, real resources for investing in longer-term, capital-expansion projects. But there are no new, real resources for the successful and profitable completion of all new boom-time projects.

Coercion Is No Solution

Rather than cease its monetary intervention, government counters these consequences with coercion in the form of increasing bureaucratic oversight of banks, mandatory increases in bank capital requirements, and the creation of bailout funds.

Increasing bureaucratic oversight rests on two false ideas — that bureaucrats can discern potential problems to which bankers are blinded and that, unlike bankers, bureaucrats are not greedy by nature, so they will not take on increased risk. But government bureaucrats can no more detect errors, culpable or otherwise, than can the financial community they are supposed to regulate. The normal economic cues are hidden by expansion of money and manipulation of the interest rate. Regulators and systemic-risk analysts are no more able to detect these errors than anyone else. All the oversight boards will accomplish is adding cost to the banking system and possibly creating what Wilhelm Röpke called repressed inflation (what we today call stagflation), whereby production declines and employment falls while prices rise.

Bailout funds are the culprits behind any increased risk taking by greedy bankers. These funds create moral hazard, whereby market participants know that some or all of the cost of increased risk will be borne by others but that benefits will not be shared. In addition, due to the law of diminishing marginal utility of money, the funds themselves continue, rather than cure, the problem initially caused by money expansion, for the funds are formed by even more money expansion.

All of this intervention leads back to the evils of redistribution of wealth, higher prices, and more malinvestment — a vicious and destructive cycle.

The Cognitive Dissonance of Money Expansion Followed by Increased Coercion

This entire process creates a psychological phenomenon called cognitive dissonance; that is, holding two conflicting thoughts in the mind at the same time. Expansion of the money supply and lowering of interest rates in order to stimulate the economy is not compatible with increased bank capital requirements and oversight boards to detect systemic risk.

The government expects that a lower rate of interest will promote more economic activity through increased lending. Yet the law of diminishing marginal utility applies also to lending . The only way to make more loans is to lend to less creditworthy customers. Yet this is the situation that more oversight attempts to prevent. Therefore, even if the government's oversight boards could detect less creditworthy borrowers, the very purpose of lower interest rates is to make loans to such people.

This makes no sense from an economic or financial point of view, but it does make sense from a political, command-and-control point of view. So lower interest rates and increased government oversight become nothing more than full employment for bureaucrats, who enjoy the perks of power and who bear none of the responsibility for their actions.

The choice is clear: either more of the same — that is, more fiat-money pumping and more regulation, with increasingly worse outcomes — or an abandonment of monetary expansion and bank oversight by government along with their replacement by sound money and the normal checks and balances of the free market.

Expansion of the Welfare-Warfare State

I'll now discuss the second main evil of fiat-money growth: expansion of the wealth-destroying welfare-warfare state.

Because the wealth-generating sector of society has nothing to gain and everything to lose by the expansion of the welfare-warfare state, under a sound-money environment these wealth-destroying activities would be vigorously opposed. But under a fiat-money system, many of those who benefit from the unhampered market economy are blinded by the money illusion and believe that government spending does not come out of their own pockets. Therefore, it is no coincidence that the Progressive movement in the late-19th and early-20th centuries coincided with both increased government spending and an increase in the money supply to be provided by central banks.

Like all unsustainable enterprises, the welfare-warfare state depends upon ever-increasing injections of fiat money; otherwise, its programs collapse rather quickly. Ever-larger increases in fiat money merely delay the day of reckoning, because the ordinary cues of higher taxes and higher interest rates are avoided for a time. So fiat money leads government to make promises that it ultimately cannot deliver.

When government finally becomes aware that it is limited in what it can accomplish, it is faced with a stark choice. If it scraps programs, it risks civil unrest from the program constituents. The alternative is to continue the programs in name only, resorting to price controls and rationing. National healthcare systems are the best examples of this phenomenon. Not only is demand for healthcare services greatly increased — a true tragedy of the commons, whereby commonly held resources are plundered to extinction — but the quantity and quality of services actually decline.

The Medicare system in America tries to solve this problem by underpaying for services and then forcing providers, via threats to pull their business licenses, to absorb Medicare losses in the hopes of making up the difference with private-pay patients. To avoid losses and remain in business, medical practices counter with lower service quality and delays. Our neighbor to the north rations care to those who can live and suffer long enough to advance to the front of long waiting lists. In a recent suit brought by a Canadian patient, a Canadian judge stated that "access to a waiting list is not access to healthcare."

The Long-Term Solution: Liberate Money and the Economy from Government Control

A free-market economy, which includes money freely chosen by the market, does not suffer disequilibria, periodic booms and busts, or high unemployment. The constant search of market participants to better themselves will result in cooperation, rather than confrontation, with all peoples everywhere. The liberal order, as envisioned by scholars such as Ludwig von Mises, can expand to encompass the entire world, resulting in peace and ever-expanding prosperity for all cooperating men everywhere.

Sound money is essential; therefore, the first order of business for Europe is to stabilize the euro. Stop inflating its supply. Stop purchasing sovereign debt. Anchor the euro in gold and/or silver. Try to gain international cooperation when doing so, in order to prevent large swings in gold and silver imports and exports when other nations see that they must emulate Europe. Nevertheless, if this is not possible, anchor the euro in gold or silver anyway.

Then begin the process of privatizing money by eliminating legal-tender laws. Let the market use whatever money it chooses, even multiple monies. Some Austrian economists believe that eliminating legal-tender laws is all that is required of government, that the free market will choose the money that it finds best suits its purposes. This may be the case; the attempt is certainly worth the effort. A practical step would be to relax legal-tender laws in one or both of two ways: the nonenforcement of legal-tender laws or the decriminalization of private money production. Nonprosecution would open the door to private, competing monies.

End all regulation of banking, including deposit guarantees, which only cause moral hazard. But enforce 100 percent reserves against money certificates and demand deposits. Reform the commercial code to provide legal protections for bank depositors just as is the case with any warehouse bailment.

But allow complete freedom of loan banking, whereby the banker takes legal ownership of funds for some set period of time, with a promise to return the funds, plus interest, at the end of the contract. This form of loan banking can be risk free, as when customer loans to the bank are less than the bank's capital account. It is also noninflationary, because the bank lends only funds that have been transferred to it and it alone — the depositor gives up his claim to the funds for the length of the contract. Undoubtedly, under such legal protections and known risks, the public would be better served than by the current, fractional-reserve system of constant expansion and contraction of the money supply via bank lending.

Rules for the Statesman

Those in positions of power, such as all of you here, must be guided by reason and not emotion. Adopt as your motto Immanuel Kant's categorical imperative. Pass only laws that are universally applicable — that benefit all men at all times and in all places. Treat men as ends in themselves rather than as means to other ends, such as national or regional pride.

Not many laws will meet these high standards. Certainly, printing money, which reduces the purchasing power of money already in circulation and benefits some at the expense of others, fails this test, as does buying sovereign debt at subsidized interest rates. Both of these practices lead not to freedom and security but to suffering and conflict. I ask you to lead as statesmen always do: based on principles that work, are true, and are real.

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VISUALIZING THE DESTRUCTION OF THE CLINTON SURPLUS

by Cullen Roche

Because I am an equal opportunity political hater – I bring you the counterargument of the Paul Ryan story. It’s unfortunate that I even have to write a story like this, but our world has become so divided down party lines that no one appears to be able to filter their economics without first deciding which side of the party line they stand on. It’s no longer about what’s best for America, but what’s best for the political party you back. But this is a good opportunity to lift the veil from some of the myths that surround the nasty politics of economics.

Many have accused me of taking a political stance when writing about the economy and Paul Ryan specifically. That’s simply not true. I often point to the Clinton years as clear evidence that this is not about politics to me, but pure economics. What do the Clinton years have anything to do with our current predicament? Let’s take a look.

The 1990′s were characterized by enormous prosperity in America. A multitude of factors combined to form one of the great economic booms in the history of modern economies. And our government used this opportunity to invoke some politics into the mix. In the late 1990′s our politicians started worrying about our national debt. The rhetoric about America going bankrupt became a persistent theme. And we took drastic measures to combat this supposed threat. Bill Clinton spearheaded the movement towards fiscal responsibility.

So, the government dramatically reduced the budget deficit and sent the US economy briefly into budget surplus. The government was saving money so they could spend it later! Unfortunately, that’s not how our monetary system works. The US government never needs to save in order to be able to spend. The government, as a monopoly supplier of the currency they require us to transact in, is nothing like a household, state, European nation or business.

What happened next directly contributed to the current malaise in the US economy. If we look at the sectoral balances we can see exactly what the Clinton surplus did. As the US economy was running a current account deficit in excess of 2% in the mid 90′s the US government began to shrink the deficit.

This wasn’t entirely misguided, however, it was taken to an extreme. As the current account remained steady near 2% the government’s balance continued to shrink and went positive in 1999. All the while the domestic private sector is being driven into deficit. Why? Because the government was not spending enough to allow the domestic private sector to net save. So what happens as Americans attempt to counteract this?

They fund their lifestyles in other ways. This means going into debt. As you can see from household debt levels Americans were taking on an increasingly large amount of debt in order to sustain their lifestyles. We all know what happened in 2000 as the dotcom bubble burst and the economy was thrown into a tailspin. The recession, in many ways, alleviated many of the excesses. This is the natural curing process of the business cycle and capitalism. It is a good thing. But I would argue that the Clinton surplus started the American public on the path towards a debt binge that would not end for another 7 years. It’s not a mere coincidence that the greatest debt binge in American history began during the end of the Clinton years. I believe this can be traced directly back to the Clinton surplus as the sectoral balances clearly show. Of course, there were more moving parts to it than just this, but the surplus played a key role in getting the wheels in motion. And so the seeds were sown for a much larger crisis.

The handling of the economy under the Bush administration is a different chapter in the story, but the moral of the story here is clear – this isn’t about politics. I don’t care for Paul Ryan’s or Bill Clinton’s politics. All I know is that their economics stink. And as we’re all finding out now, America is only as good as its economy and America’s economy is only as good as the people who formulate policy. Clinton sustained a good economy for much of his Presidency. Unfortunately, the wheels came off towards the end and his attempt to fix the US government’s fiscal “problems” played a key role here. Paul Ryan’s plan would catapult us towards the exact same situation. But again, let’s not allow the politics to cloud the economics at work here and like it or not, Ryan’s plan is bad economics given the current balance sheet recession. Just like the Clinton surplus was bad economics in the late 90′s.

Obviously, there are many more moving parts to the current malaise than just government spending and the squabbles between Republicans and Democrats, but I hope you’ll take one thing away from this story – the success of America isn’t about one party being right and the other being wrong. Most politicians don’t have the first clue about the workings of the monetary system so the odds are that they’re all wrong regardless of what they believe. But that doesn’t mean we should accept bad economics just because it fits with our personal political beliefs. Both parties have made enormous mistakes over the last 25 years. Ignoring good economics in favor of politics is no way to get this ship righted.

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Tracking the Wall Cycles in Search of the Business Cycle Top in 2011

By David Knox Barker

One of the contributions to market cycle analysis by the late financial analyst PQ Wall was the discovery that there are nine dynamic market cycles in every business cycle. This cycle is widely known as the 20-week cycle. Investors and traders have been aware of this cycle for decades, although its exact length has been a point of disagreement. If there actually are nine cycles in a business cycle, it is a remarkable and important discovery, and has major implications for investors and traders seeking to understand current market action, and identify the market top expected in 2011. 

In The K Wave (1995), I rechristened the 20-Week cycle the Wall cycle, because it was PQ Wall who discovered the true importance of this cycle. Exactly how PQ made his discovery of the number of Wall cycles in a regular business/trade cycle is a rather lengthy subject. Therefore, the specific focus of this article is limited to the powerful evidence for the existence of nine Wall cycles in the last business cycle and the Wall cycle count in the current business cycle, which is likely to end in a global financial market disaster that goes down in the history books, trumping the debacle into 2009.

The Wall cycle is one of the most important cycles for both investors and traders, allowing them to identify important market turns using market price, cycle time and investor sentiment. Investors and traders ignore this powerful dynamic cycle at their peril. The evidence suggests that the global market decline that just occurred into March 16, 2011 was the termination of a Wall cycle #4 and the beginning of a new one in major developed markets. Wall cycles 3, 6, and 9 are typically the weakest in a business cycle, based on what PQ called third, last and weakest. One of the nine Wall cycles will usher in the top of the current business cycle, and begin a dive in the market cycles that will test investor and trader’s nerves with more gut wrenching global financial turbulence than the 2007-2009 global crash. 

It is important to recognize the basic cycle math used by PQ to determine that there are nine Wall cycles in every business cycle. Through his lifelong quest to unravel the mystery of market cycles, PQ discovered a regular divisibility by four and three built into all market cycles. To arrive at the nine Wall cycles in a business cycle you take a long wave, divide it into four seasons, divide the four seasons into four business cycles, divide the business cycle into three thirds, and divide again by three to arrive at nine Wall cycles in a business cycle. This math also means that a Wall cycle is a long wave divided by 144.

A healthy degree of skepticism is reasonable. The idea that every business cycle divides into nine dynamic Wall cycles, no matter what distortions central bank monetary policy and government intervention inject into the global system, is a rather bold assertion. I was also highly skeptical, until I did extensive cycle research and validated PQ’s rather stunning hypothesis.

This is where the Wall cycle story gets interesting. Although PQ did not describe it as such, what he was essentially arguing was that his cycle math represents a natural law in market cycles. How can human action pursuing purpose through buying and selling in global markets produce such cycles?

In the mid-1990s, I decided to take PQ at his word and test his theory. In order to test it, I concluded that there had to be an ideal length to all cycles, even if the “ideal” rarely occurs. This made sense because PQ proposed that the cycles of human activity in markets were essentially fields of human action in the global economy, with a corollary in the hard sciences and field theory in physics. Physicists have discovered that fields in the hard sciences are governed by degrees of freedom; essentially fields have some play in space-time.

If you have ever observed Fibonacci ratios of support and resistance in market prices you will readily understand how they act as degrees of freedom in the pricing mechanism of markets. It is clear that most market cycles are dynamic and not static. This means they fluctuate in length and are not fixed. This being the case, the search was on for an ideal cycle length and the Fibonacci degrees of freedom around the ideal lengths.

Without going into detail, when 42 months was tested as the ideal or “natural” length of a business cycle, a remarkable discovery was made. There is a strong tendency for the business cycle to hit date targets that are Fibonacci degrees of freedom around that ideal length. When you take 42 months and divide by nine to test for an ideal length for the Wall cycle, the evidence is even more convincing.

Recognizing the need for a tool to mine market data and prices to discover cycles in price and time, the Market Cycle Dynamics (MCD) software is in development and approaching completion. I now have a test version of the software, and I thought I should demonstrate to readers some of the early results.

The extremely long business cycle from 2002-2009 has been a challenge for all market cycle analysts. It was an unusually long business cycle, bloated by trillions of dollars during the global housing bubble, and late last year we learned that in 2008 and 2009 over $9 trillion dollars in loans from the U.S. Federal Reserve prevented the cycle from putting in a timelier bottom.

The MCD tool was used to analyze the 2002-2009 business cycle for its nine component Wall cycles. The tool allows analysis of cycles in price, time and sentiment simultaneously in ways that were previously impossible. What I discovered is remarkable. In our cycle work, stochastics are used to determine a full cycle, with 20- 80-20 in an appropriate stochastic marking the full turn of a cycle.

The chart demonstrates that in the business cycle from 2002-2009, using an 89 period daily fast stochastic (about 13 weeks), there are “exactly” nine cycles that ran from below 20 to over 80 to below 20 in those blue stochastics at the bottom. That on its own is a shocking and statistically relevant finding far beyond any mere coincidence, but it gets even better. Each one of those yellow arcs on the chart for each one of those nine Wall cycles are generated using a Fibonacci ratio of the “ideal” 141.9-day Wall cycle. The W3 cycle was not exact, but it was close.

It gets even more interesting. That arc that represents the second Wall cycle, labeled as W2, which includes one full trip from below 20 to over 80 to below 20 in the 89 period daily fast stochastics, is a Fibonacci ratio 261.8% longer than the ideal cycle of 141.9 days. Evidently, that’s what trillions in future bad mortgages during the early stages of a global housing boom will buy. The W3 and W6 cycles are 61.8% longer than the ideal, while W9, which received what we now know, was trillions in intervention by global central banks, including $9 trillion in loans by the U.S. Fed, is 161.8% longer than the ideal. These are abnormally large Wall cycles.

Those skeptical of the price, time and sentiment approach to cycles analysis should observe the price lines on the 2002-2009 chart. Those red line price targets and ratios are Level 1 Fibonacci grids generated by the 1982 low and the 2007 high. The green lines are Level 2 Fibonacci grids, i.e., the Fibonacci grid between the adjacent Level 1 price targets. Every one of the Wall cycles turned on a Level 1 or important Level 2 Fibonacci target. 

What this exercise in market cycle turns in price, time and sentiment exhibits is that even a business cycle distorted by trillions in central bank monetary and government fiscal intervention exhibited its nine Wall cycles in price, time and sentiment. If you are not tracking the essential market cycles in price, time and sentiment, you may be missing a big part of the picture Mr. Market is painting.

This brings us to the current business cycle. If you think that QE2 and trillions in deficit fiscal spending and policy are going to make the business cycle go away, and that this time it is different, then go ahead and follow the crowd wherever it leads. If you are interested in tracking the cycles, look at the chart below. It is tracking the Wall cycles in the business cycle beginning March 2009. The bottom in global markets on March 16, 2011 was the bottom of Wall #4. The top of the current business cycle will likely come in the current Wall #5, or even Wall #6, if Chairman Bernanke keeps his helicopter aloft for QE3. However, if that Level 1 1228 target is taken out, this final business cycle of the Kondratieff long wave is in its declining phase into 2012-2013, which conjures up visions of a flock of black swans.

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OIL PREDICTS STOCK MARKET DIP

by McClellan Financial

March 25, 2011

Just over a year ago, I looked at the 10-year leading indication that crude oil prices give for the stock market.  It is time to take another look at that relationship, especially in light of the trouble that it suggests is coming for stock prices.

This week’s chart shows again how the price plot of crude oil prices has done a great job of giving us a macro view of what the trend should be 10 years later for the stock market.  The periods when crude oil prices have moved sideways led to sideways periods for the stock market a decade later.  And the periods when crude oil has trended upward were followed 10 years later by big bull markets in the stock market.

So the fact that crude oil prices have gone from a low of $11/barrel in 1998 to now above $100 is an indication that we should expect a persistent uptrend for stock prices in the decade ahead.  But we should not expect it to be an unbroken uptrend.

When we zoom in closer, we see that oil’s price fluctuations can have important meaning for stock prices about 10 years later.  The timing is not perfect, but the dance steps generally get repeated.

The one caveat to that principle is that oil price movements that are based on supply and demand forces tend to matter much more than oil price movements brought about by governmental or quasi-governmental forces.  The Arab Oil Embargo in 1973 got the big oil price rise started, but stocks did not match the magnitude of that rise or the additional up leg caused by the Iranian revolution in 1979.  And the oil price crash of 1986 that came about when Saudi Arabia abandoned the production quotas similarly did not bring stock prices down.

The 1990 Iraq invasion of Kuwait caused oil prices to briefly double, but we did not see an exact echo of that spike in the stock market.  When governments put a thumb on the scale and nudge oil prices away from where supply and demand factors would dictate, it does not show up as much 10 years later in the stock market.

Still, the background price pattern movements can clearly be seen as having been repeated in stock prices roughly 10 years afterward.  And now we are into the 10-year echo point of the big oil price decline from Nov. 2000 to January 2002.  So far, the Fed’s POMOs have kept the stock market going higher, so we have not yet seen the echo of that oil price decline being manifested in stock prices.  But given the decades of correlation between stock prices and oil’s leading indication, it is hard to imagine that we will be exempted from seeing some kind of echo of that oil price drop.  When the Fed stops doing POMOs in June, and when the stock market enters the part of the year when seasonality is much weaker, stock prices should finally be allowed to manifest an echo of that 2000-02 oil price decline.

The good news for long term investors is that later this decade we should see stocks echo the big rise in oil prices.  The bad news is that the most likely way for this to happen is not from stocks being worth more, but rather that the dollars needed to buy stocks will be worth a lot less thanks to the Fed inflating the monetary base.  So yes, in the late 2010s, your shares of stock will be worth more dollars.  But those dollars won’t be worth as much.

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ARE STOCKS MORE VOLATILE IN THE LONG-RUN?

by Cullen Roche

Traditional theory has often found that an investor will experience reduced volatility over the long-term.  The implication has led investors to buy into various long-term investment strategies that imply reduced risk.  This study (thanks to Abnormal Returns), however, from Lubos Astor and Robert Stambaugh of the Chicago School and Wharton, finds that stocks are more volatile over the long-term.  While volatility does not necessarily imply risk, the findings are interesting nonetheless.   I’ll expand on the findings in the coming days:

According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor’s perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties reduce desired stock allocations of long-horizon investors contemplating target-date funds.

We use predictive systems and up to 206 years of data to compute long-horizon variance of real stock returns from the perspective of an investor who recognizes that parameters are uncertain and predictors are imperfect. Mean reversion reduces long-horizon variance considerably, but it is more than offset by other effects. As a result, long-horizon variance substantially exceeds short-horizon variance on a per-year basis. A major contributor to higher long-horizon variance is uncertainty about future expected returns, a component of variance that is inherent to return predictability, especially when expected return is persistent. Estimation risk is another important component of predictive variance that is higher at longer horizons. Uncertainty about current expected return, arising from predictor imperfection, also adds considerably to long-horizon variance. Accounting for predictor imperfection is key in reaching the conclusion that stocks are substantially more volatile in the long run. Overall, our results show that long-horizon stock investors face more volatility than short-horizon investors, in contrast to previous research.

In computing predictive variance, we assume that the parameters of the predictive system remain constant over 206 years. Such an assumption, while certainly strong, is motivated by our objective to be conservative in treating parameter uncertainty. This uncertainty, which already contributes substantially to long-horizon variance, would generally be even greater under alternative scenarios in which investors would effectively have less information about the current values of the parameters. There is of course no guarantee that using a longer sample is conservative. In principle, for example, the predictability exhibited in a given shorter sample could be so much higher that both parameter uncertainty as well as long-run predictive variance would be lower. However, when we examine a particularly relevant shorter sample, a quarterly post-war sample spanning 55 years, we find that our main results get even stronger.

Changing the sample is only one of many robustness checks performed in the paper. We have considered a number of different prior distributions and modeling choices, reaching the same conclusion. Nonetheless, we cannot rule out the possibility that our conclusion would be reversed under other priors or modeling choices. In fact, we already know that if expected returns are modeled in a particularly simple way, assuming perfect predictors, then investors who rely on the post-war sample view stocks as less volatile in the long run. By continuity, stocks will also appear less volatile if only a very small degree of predictor imperfection is admitted a priori. Our point is that this traditional conclusion about long-run volatility is reversed in a number of settings that we view as more realistic, even when the degree of predictor imperfection is relatively modest. Our finding that predictive variance of stock returns is higher at long horizons makes stocks less appealing to long-horizon investors than conventional wisdom would suggest. A clear illustration of such long-horizon effects emerges from our analysis of target-date funds.

We demonstrate that a simple specification of the investment objective makes such funds appealing in the absence of parameter uncertainty but less appealing in the presence of that uncertainty. However, one must be cautious in drawing conclusions about the desirability of stocks for long-horizon investors in settings with additional risky assets, such as nominal bonds, additional life-cycle considerations, such as intermediate consumption, and optimal dynamic saving and investment decisions. Investigating asset-allocation decisions in such settings, while allowing the higher long-run stock volatility to enter the problem, is beyond the scope of this study but offers interesting directions for future research.

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THE SPECULATIVE PREMIUM IN OIL IS TOO LOW

by Cullen Roche

Interesting findings from Goldman Sachs with regards to oil prices.  This comes from a recent research report from their Commodities Research Team.  In July of 2008 Goldman Sachs famously said the price of oil was not being distorted by speculators.  After a 75% decline in prices they changed their tune and said speculators had in fact distorted prices.  Their retraction said:

“Conversely, speculators bring fundamental views and information to the market, impacting physical supply management and facilitating price discovery. As a result, speculators have a loose relationship with price. In other words, as speculators buy, prices generally tend to rise, and vice versa. Accordingly, speculators also contributed to the extreme price movements over the last two years. For example, new data suggests that speculators increased the price of oil by $9.50/bbl on average during the 2008 run-up. Thus, speculators exacerbated the volatility that was nonetheless rooted in the fundamental imbalance.” (emphasis added)

As I’ve previously stated, I find it hard to believe that there is not a speculative element involved in the price of commodities today.  This is perhaps best seen in “commercial” participants who are now speculating in the markets by hoarding or using various commodities as collateral for financing operations.  Given their 2009 retraction, it’s not surprising to find that Goldman says there is a speculative premium in oil prices currently.  Perhaps more surprising, is their statement that the speculative premium is too small:

“In such an environment, it is not surprising that net speculative long positions in WTI crude oil reached a new record high of 391 million barrels. In comparison, when WTI crude oil prices peaked at over $145/bbl in July 2008, the net speculative long position in the light sweet crude oil contract (future and options) was less than 100 million barrels. We estimate that each million barrels of net speculative length tends to add 8-10 cents to the price of a barrel of crude oil.

Given that net speculative length has been about 100 million barrels higher since the political protests spread from Tunisia and Egypt to Libya (Exhibit 2), this suggests that the oil market has been pricing a $10/bbl risk premium into the price of crude oil due to concerns over potential political contagion to other oil producing states in the MENA region. This is consistent with the fact that Brent crude oil has been trading near$115/bbl in the recent period, $10/bbl above our 3-month target.”

“Crude oil prices fell sharply in a broad liquidation on Tuesday as demand concerns raised by the unfolding events in Japan briefly offset the supply concerns arising from the MENA region. However, net speculative length only declined by 15 million barrels, highlighting the strength of the MENA concerns. Further, as we discuss below, we expect that the increased demand for oil due to the loss of nuclear generation capacity in Japan will far outweigh the demand lost to lower economic activity. More specifically, we estimate that230 thousand b/d of combined residual fuel oil and direct-burn crude oil will be required to offset the nuclear generating capacity lost in Japan. We estimate that to lose a comparable amount of oil demand in Japan would require an 8.0% decline in Japan’s economic activity due to the earthquake and its aftermath.

Consequently, we continue to view a containment of the threat to oil production from the political unrest in the MENA region as the primary downside risk to crude oil prices in the near term, with a downside risk from current prices of near $10/bbl. However, at this time assessing the threat to oil production remains challenging, with the ultimate impact of the initiation of airstrikes this weekend by a coalition including the United States, France, and the United Kingdom enforcing a UN-sanctioned “no fly” zone in Libya still unclear. Further,with reports of protests in Syria and Yemen, hostilities at the Gaza/Israel border, and Saudi troops in Bahrain, the risk of political contagion remains.

These developments suggest that the $10/bbl risk premium may prove too modest, and as the world focuses on MENA and Japan, events continue to unfold elsewhere. This weekend brought reports of a 100 mile long oily sheen spotted on the waters off the US Gulf Coast,20 miles north of the site of last year’s Macondo leak. In the wake of last year’s leak,another leak in the deep water would certainly increase the risk of a reduction in supplies from the US portion of the Gulf of Mexico. Fortunately, the initial tests carried out by the US Coast Guard suggest the “oil sheen” is likely caused by large amounts of sediment, and not fresh oil.

Consequently, the balance of risks to our forecasts remains clearly skewed to the upside,with the primary risk to oil prices over the medium term coming from higher oil prices and their potential to slow the pace of economic recovery.”

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