Hey guys, I wrote the below article for LinkedIn the other day but I thought you guys would find it interesting as well. I’d love to hear your thoughts on my thesis – especially given that we’re supposed to uphold ‘market integrity’ as CFA Charterholders…
Version with proper formatting, pictures etc: https://www.linkedin.com/pulse/markets-through-glass-darkly-babar-rafique-cfa
(The markets) through a glass, darkly.
As equity markets have become increasingly critical to the global financial and economic system, we’re actively subverting them into meaninglessness.
Equity markets are efficient, rational, and accurately reflect the value of assets, we’re told. Sure, there might be bouts of euphoria or panicked selling, but those are short-term anomalies in an otherwise rational system.
The simplicity of this idea is undeniably appealing – if we can trust in markets to broadly be an efficient allocator of value and accurately representative of short-term economic potential, then we can use it for a range of economic decision-making. An investor who wants exposure to a particular country can buy ETFs linked to that country’s stock market(s), for example, with the confidence that the investment outcome will bear a meaningful relationship with that of the economy invested in.
This requires, of course, that the price numbers on global stock indices mean something. The trouble is, to an increasing degree, they mean nothing at all. And we are busy creating more meaningless stock markets precisely because we need the ticker numbers to be more and more meaningful.
The equity market is a leading indicator for an economy, we’re told, and from TV talking-heads to academics to wealth managers, we all conduct ourselves as if that’s the case. A rising stock market thus means that confidence is improving and economic performance should shortly be rising as well. By that measure, the US economy should be doing fantastically well, matching or at least meaningfully correlated with the eye-popping performance of its major stock indices since 2008. Unfortunately, that’s just not the case – labour force participation remains appallingly low, wages remain depressed with lackluster wage growth, more and more wealth has become concentrated at the very top of the income scale, etc. In reality, while US markets have galloped ahead, the actual economy has been sleepwalking since the ‘Great Recession’.
This begs the question then – if US markets don’t meaningfully reflect the American economy, what do they reflect? To an increasing degree, they represent the fact and perception of central bank intervention into the markets. All major US indices share a meaningful correlation with the capital flows of the Fed’s successive QE programs, and speculation on the Fed’s future actions as communicated in various Fed meetings and press announcements move the markets in a big way. I’m certainly not saying that the Fed is all that matters for the US markets, but the market does listen to the Fed a lot more then it should and it sure seems like the Fed listens back. It’s worth noting here that the Fed’s dual mandate is to promote maximum employment and price stability, not manage market expectations – theoretically, they shouldn’t directly impact stock markets in the short term at all.
The story is much the same in the other major financial centres of the world, where the numbers on the big boards seem to be less and less meaningful as well. Broad European indices have been reaching for the heavens – after the ECB has reintroduced us to the pleasures of ZIRP and NIRP and launched a massive QE program of its own. Japanese intervention into their equity markets went even further, with the Bank of Japan directly buying ETFs to help keep the Nikkei going in the right direction.
The Chinese take the cake here though, with their level of intervention into their equity markets made abundantly transparent after the recent popping of the Shanghai SSE Composite Index bubble. After more conventional tools failed to stem the tide of panicked selling, the authorities deemed selling to be unpatriotic, halted trading in about half of the market, ordered companies to buy their own shares and generally made it clear that there was a preferred direction for the stock market to be moving in. Going against that direction would have you risk a lot more then what any definition of a halfway efficient market would suggest.
What has brought global equity markets to the point of becoming increasingly decoupled from their respective economies? I think it’s our need to have stock and stock index prices be meaningful that ultimately has driven the shift towards meaninglessness. From a top-down perspective, an example here is that politicians point to the stock market as proof of what a good job they’re doing in managing the economy and in some countries even derive their legitimacy from the continued performance of the local stock markets. Also, hundreds of millions of investors of all sizes have invested in stock markets through all sorts of financial instruments and stand to lose heavily in a market crash – that didn’t go over too well the last time around and we’re still struggling to recover.
From a bottom-up perspective, an example is company boards that partially link executive compensation to the performance of the company’s stock (which usually will have a positive correlation with the overall stock market). As a sidenote, Roger Martin, ex-Dean of Rotman School of Management (where I’m currently a student) has written extensively about this kind of executive compensation being problematic for the integrity of the markets as well – although he may not see it as a small symptom of a much larger threat to market integrity, as I do.
The stock market is just too important to leave to the vagaries of an actual market now. Too much depends on good-looking numbers now. It must be guided and controlled, or else the stilts on which our global financial system balances become shakier and more visible. The market must be rendered increasingly meaningless simply because it’s too meaningful to our current economic system.
