"Kee" Points with Jim Kee, PhD.

Stocks are up around the world year-to-date, with US stocks in particular on a tear since the November elections. The S&P 500 is up about 11.6% since the beginning of the year, 8.5% just since the election. The Dow Jones Industrials index (30 companies), which is a little more heavily weighted towards “old economy” cyclicals (industrials, energy, materials) is up even more since the election, a function of its “old economy” make up. International stocks in general, and emerging market stocks in particular, initially sold off after the election but have since regained some (emerging markets) or all (world ex-US) of the lost ground. So far stocks are following election-year patterns, that is, selling off in October and rebounding in November and December. But don’t forget the BIG LESSON OF 2016: If you had sold your stocks and moved to cash in February of this year because of the “worst start for stocks since the Great Depression” (WSJ), or for the seemingly wise reason of “waiting out the election,” you could have 24% less wealth right now. That’s because stocks (i.e. S&P 500) are up over 24% since there February bottom. That would be an awfully hard pill to swallow in a year when markets are up.


University of Chicago’s Booth School of Business recently published an article entitled Why You’re Wrong About a Future Stock Market Collapse. It cites research by academics (including Nobel laureate Robert Shiller) that tracked the judgements of individual and institutional (professional) investors on the probability of a “severe” market crash, defined specifically as a crash similar to that of October 19th, 1987 (-22.6%) or October 28th, 1929 (-12.82%). The average estimate of the chances of a one-day crash over the subsequent six months, looking at data from 1989-2015, was 19 percent. In contrast, the actual probability of an extreme market collapse like either of those two days in any six-month period is actually less than 1 percent. The authors’ conclusion, and a great data point for individual investors to keep in mind, is that “investors gave estimates of the likelihood of a crash that were more than 20 times the historical precedent!” The authors’ conjecture that this pessimistic bias is probably due to the news media and journalists’ emphasis on negative outcomes.

Interest rates: US 10-year Treasury yields have increased (“backed up” as the bond folks say) to 2.5%, well above the 1.37% lows of last summer and right back where they were in the summer of 2015. Rising rates and rising stocks may seem perplexing but they need not be. Expectations are for the Federal Reserve to raise rates, but that is because underlying growth is expected to be stronger going forward. So higher rates reflect higher underlying real rates (and an end to deflation fears) as growth and profits warrant bidding up underlying real rates. This is called an increase in the demand for loanable funds, which is bullish (positive). You could also have higher rates that are driven by a reduction in the supply of loanable funds (a “credit crunch”), which would be bearish (negative). In both cases you have a rise in interest rates, but the implications are different. This is known as the “signal extraction problem,” and it is one of the most important and overlooked concepts in economics. You can’t extract a strong signal from a price change (like interest rates, which are prices) unless you know what is causing the price change. And it doesn’t just apply to interest rates. The implication of any price change, be it exchange rates (the price of currencies), oil prices, commodities, etc., depends upon whether the change is driven primarily by supply shifts or by demand shifts. The change in price itself usually doesn’t contain enough information.

Oil prices: The signal extraction problem is particularly relevant when it comes to oil prices. During the 1970’s, supply restrictions drove up the price of oil, which was bearish as higher prices reflected increased scarcity. But in the early 2000s as China joined the World Trade Organization (WTO), oil prices rose because global growth was increasing the demand for oil, which was bullish. Analysts unfamiliar with the signal extraction problem feared that oil prices above $50 would cause a global recession, but in fact the global economy kept on going through $150 oil, and we didn’t get a recession until the US housing-led global financial crisis. Recently the price of Brent Crude Oil (i.e. the global oil price) has risen to $55 per barrel, reflecting some agreement on output restrictions or caps by OPEC (particularly Saudi Arabia, Iran, Qatar, UAE) and non-OPEC (i.e. Russia) countries. In my opinion, this is welcomed primarily because it holds some promise of stabilizing the region somewhat, and that would be bullish. Output curtailment that drove oil prices back up to $100, on the other hand, would clearly be a bearish, supply-driven price “signal.”

International: IMF managing director Christine Lagarde is back in the headlines related to a negligence case that goes back to her French finance minister days before taking the IMF post in 2011. Lagarde succeeded former IMF Managing Director Dominique Strauss-Kahn, who resigned from the IMF in 2011 after being arrested by New York Police over allegations of sexual assault. Strauss-Kahn succeeded IMF managing director Rodrigo Rato, who was arrested last year for alleged fraud, embezzlement and money laundering.