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Market Myths

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Market Myths

© Martin A. Armstrong

There are numerous myths within the market which encompass everything from stocks and interest rates to gold and oil. Indeed, one could easily write a 1,000 page book on this subject, cataloguing all these “rules of the game”. By far the most widely hailed myth is the so–called relationship of stocks to interest rates. Ask anybody in the business and they will repeat the traditional dictum that stocks decline with higher interest rates and rise with lower interest rates. Then ask them why the Dow Jones Industrials stand near its 1987 highs after three hikes in the discount rate. The likely reply will be that the rise in interest rates is purely temporary and therefore of no concern since they will soon decline.

The true story behind these “rules of thumb” in market analysis is actually quite simple – they don’t work! The reason for this is simple markets and economic activity are non-linear. We have all heard of another rule or law of nature known as the “law of diminishing return.” This simplistic law means that an known effect eventually diminishes until it no longer exists. One example of this comes from medicine. Aspirin is widely hailed as a drug, which will help prevent heart attacks. But if you take aspirin in excessive amounts consistently, it will thin the blood so much that the end result will be heart failure. This effect of diminishing return is also described by another old adage “too much of a good thing.”

These laws or rules about economic and market relationships fail to hold up in reality on a consistent basis due to a very similar law, which we at Princeton have named the law of “reciprocal movement.” The basic assumption behind all market and economic laws is that the system itself is linear. This means that if government, for example, desires to lower inflation, it raises interest rates to hopefully reduce consumer demand and thus economic activity along with prices. If this law were indeed linear, then raising interest rates from 5% to 6% would produce the same effect as an increase from 200% to 210%. If we look at the current situation in Argentina, depending upon the bank, interest rates are being quoted at 240% up to 350% per month. This provides an implied inflation rate on an annual basis of somewhere between 20,000% and 30,000%. Prices on the street are rising at 1% every four hours at this time. Interest rates during this phase of hyper–inflation fail to act as an anti–inflationary measure as purported by today’s common market logic and instead act to propel inflation even further.

In reality, this is but one example of “reciprocal movement.” Everything evolves through a process, which can be plotted in a simplistic manner as represented by a bell curve. During the early phase of the bell curve, rising interest rates do act as a deterrent to inflation. But it is not the simple balance between interest rates and spending which is dictating the trend. The third component in this contango is confidence. Rising interest rates will induce greater savings and less spending, provided the consumer has confidence in government and banks along with a firm belief that prices are not going to rise more than the rate of interest return. However, if that confidence in government and/or banks declines, consumer spending rises even faster than before, as is the case in Argentina today and Germany during the early ’20s.

In the case of a gold standard era such as the Great Depression, the rate of spending declines but the hoarding of gold increases. Hyperinflation, such as in Argentina in the 1980’s and Germany in the early 1920’s, emerges when the consumer cannot hoard gold and thus he hoards tangible goods which causes prices to escalate rapidly. When gold is available, as was the case in the AS during the 1930’s, money supply contracts causing deflation as consumers hoard their gold by withdrawing their saving from the banks. In each case, the consumer’s lack of confidence in the system remains the common denominator and the effects of deflation and hyperinflation become indistinguishable in the final analysis. If interest rates and their effect upon the system were truly linear, then neither trend would be possible. Government could theoretically raise interest rates fast enough to prevent hyperinflation or lower them fast enough to prevent depression. Unfortunately, the Federal Reserve lowered its discount rate from 6% to 1.5% between 1929 and 1931, faster than at any time in history, with no effect whatsoever in relaxing the deepening depression. Interest rates rose rapidly during the hyperinflation of Germany and Argentina, again with no effective change in trend.

We all prefer to think in a linear manner. If we do X then the result will be Y. But this is far too simplistic in our real and complex world. Each action taken today has far-reaching effects, which we cannot foresee. The sheer level of complexity is difficult for us to conceive and thus we inevitably try to avoid such chaos by the use of neat and clean linear thinking. Unfortunately, reality does not oblige.

Our law of “reciprocal movement” is reality, not theory. Everything will display some effect on the left side of the curve and produce exactly the opposite on the right side. In Australia, for example, government continues to raise interest rates in an attempt to squeeze out inflation and reduce its current account deficit. The higher interest rates go the greater the incentive for offshore borrowing. This merely increases the current account deficit as greater amounts of interest payments leave the country.

When we look at inflation in raw materials since 1986, government’s attempts to curb inflation through raising interest rates at this time reduces the incentive to expand production. Hence, shortages prevail and prices rise. Raising interest rates to curb inflation only works on the left side of the curve when hoarding and speculation prevail. But at some point in time, higher interest rates cause higher costs and lower production which fuels inflation. This is the “reciprocal movement” effect.

No matter what we look at, the system is non-linear. Any rule of thumb can produce the desire effect in the early stage of the curve. But take that same tool too far and the effect is no longer linear at all.