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Tilting at Windmills

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November 28, 2007
By: Kevin Drum

ME AND WALL STREET....I will never understand Wall Street. Here's the latest:

Fed Official's Remarks Send Stocks Soaring

Stocks soared on Wall Street today after a top Federal Reserve official appeared to open the door for additional interest rate cuts....In his speech this morning, delivered to the Council on Foreign Relations in New York, [Fed vice chairman Donald] Kohn pledged that the Fed "will act as needed" to address the volatility of the current economic situation.

"Uncertainties about the economic outlook are unusually high right now," he said. "In my view, these uncertainties require flexible and pragmatic policy making."

Now see, if it were me I'd be running for the hills at this news. Sure, Kohn was signalling that the Fed might cut interest rates, but he was only doing that because he thinks there's a danger that the economy might be tanking. So here's the difference:

Kevin: Economy tanking = bad. An interest rate cut is nice, but it doesn't nearly make up for a bad economy. I'm going to go hide in a cave.

Wall Street: Interest rate cut = good. Who cares if the economy is souring? Let's party!

Yes, sure, lower interest rates make stocks a relatively better investment than bonds, and that's good news for Wall Street. But the effect is small, and the stimulative effect of an interest rate reduction is both small and far in the future. A declining economy, by contrast, is bad news right now, and the vice chairman of the Fed just warned us that he was afraid the economy might indeed be declining.

And the market goes up 300 points. I don't get it.

Kevin Drum 5:58 PM Permalink | Trackbacks | Comments (43)

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Comments

How is the Fed cutting the interest rate paid by the Treasury going to help Citibank, which is going to be paying 11%!!! to some Arabs?

Posted by: Bruce Wilder on November 28, 2007 at 6:03 PM | PERMALINK

I agree re: the Citibank investment - "this is what passes for good news these days?" But someone pointed out to me recently that the housing implosion is good news for the stock market, as the insanely wealthy pull their money out of flipping houses and try throwing it around the market instead.

I'm so sick of this economy.

Posted by: Dan Ancona on November 28, 2007 at 6:06 PM | PERMALINK

The optimistic read would be this:

Most everyone on Wall Street knows, and has known for a while, that the economy is headed for serious trouble. That's bad enough, but these worries were compounded by the sense that the Fed was in denial and would be unwilling to do anything to mitigate the situation until it was far too late. Today's comments indicate that the compounding factor isn't there, and so people were relieved and scaled back from seriously frightened to just plain worried.

Not saying that's what's really happening, just that the market reaction might not be entirely nuts.

Posted by: Adam on November 28, 2007 at 6:12 PM | PERMALINK
But the effect is small, and the stimulative effect of an interest rate reduction is both small and far in the future. A declining economy, by contrast, is bad news right now, and the vice chairman of the Fed just warned us that he was afraid the economy might indeed be declining.

So? Serious players in the market have done their own analysis of what the economy is likely to do. What the fed vice chairman says probably doesn't much affect their view on the economy.

OTOH, a specific indication of an likely rate cut in the near future makes the expected future value of stocks greater than they would be without it, given the same perspective on the economy, and the increase in the expected future value is exactly matched by an increased willingness to buy now in anticipation of that value.

Posted by: cmdicely on November 28, 2007 at 6:13 PM | PERMALINK

To rephrase the previous comments: the economy tanking is old information and was already priced into the market. The fed being ready to cut rates is new information and therefore the market responds.

Posted by: vinc on November 28, 2007 at 6:16 PM | PERMALINK

Kohn's comments tell us his views on the economy - that it's bad - but that's something the market may know about as well as he does, and it's not news, so it does not send the market down. But his views on likely fed action is something he knows better than we do - and that does cause prices to change.

Of course, all explanations of such market jiggles are probably unreliable.

Posted by: Reid Hanson on November 28, 2007 at 6:20 PM | PERMALINK

Kevin,

sh...sh...sh...I'm selling out tomorrow first thing and putting it all into cash for short term. Don't send the market down quite yet. ;>)

Posted by: moe99 on November 28, 2007 at 6:21 PM | PERMALINK

The market declined 10%. It bounced a little. Managers feel some stocks have fallen too far too fast. They disagree as to which are the true bargains, so everything goes up a bit. I wouldn't read too much into it.

Besides, making stocks a little better investment than they were yesterday requires price adjustments immediately, not sometime in the future, even if the effects are in the future. Why wait until tomorrow to buy what you can buy today for less?

Posted by: tomboy on November 28, 2007 at 6:26 PM | PERMALINK

How about a little realpolitik to explain it -- everyone knows that everytime the Fed even whispers "rate cut" the market goes up. So as soon as the Fed says it, everyone buys because we know everyone else will -- driving the price up, and I can sell my stock tomorrow and pocket a short term gain.

I think this has a lot to do with what happened today, and my guess is sometime in the near future those same folks who bought today are going to sell for that short term gain and the market will post a correction -- not all the way back down, but probably in the neighborhood of 150 to 200 points.

Posted by: Tom Burka on November 28, 2007 at 6:27 PM | PERMALINK

Kevin, there's another interpretation. If you think that the Fed's move is going to make the dollar worth 2.5% less, but note that many of the Dow Jones companies market to the whole world, then the response should be for the Dow to go up, in dollars, by 2.5% (300 points) so that it will stay flat.

People keep asking why the market should go up while the dollar is dropping like a rock. Well, that's why. The Dow went from 12000 to 13000 this year. But the Euro was 1.30, now it's 1.48, so the Dow is down, not up, on the year by European standards.


Posted by: Joe Buck on November 28, 2007 at 6:27 PM | PERMALINK

Pretty much what these folks say (everyone already knew that the economy is tanking, so as long as it's not tanking more than analysts expected, the fed comment is all to the good). And of course the obvious cynical question about when stock price was ever linked to corporate performance, except in the most extreme (bankruptcy/reorganization) cases. Stock price is the present value of what the people think they can sell it to some other sucker for at some point in the future.

(OK, some stocks are actually bought by expected dividend return, but that's so 19th-century.)

Posted by: paul on November 28, 2007 at 6:28 PM | PERMALINK

Adding to the mystery is the fact that a drop in interest rate is questionable strategy for the Fed. The Fed's job is to prevent inflation. If they're focusing instead on economic expansion, there's a better chance that they will fail to prevent higher inflation.

Posted by: ex-liberal on November 28, 2007 at 6:36 PM | PERMALINK

Dead cat bounce. and bounce and bounc...

a few times

before it splatters all over the sidewalk

Posted by: degustibus on November 28, 2007 at 6:39 PM | PERMALINK

cmdicely, a lower interest rate makes stocks worth more all other things being equal.

but if the lower interest rate happens at a time when profitability is falling, then all other things aren't equal.

and yet the market reacted today as though they were: that's the puzzle.

i personally believe that ben graham said 70 years ago: in the short term, the market is a voting machine; in the long term, it is a weighing machine.

so right now, as several people have noted, market players voted yes for lower interest rates; whether the shares they purchased actually "weigh" what they think they "weigh" is another matter....

Posted by: howard on November 28, 2007 at 6:42 PM | PERMALINK

Either this is a case of irrational exuberance, or Wall Street is collectively hitting the crack pipe.

Posted by: Donald from Hawaii, & currently in Chicago on November 28, 2007 at 6:45 PM | PERMALINK

Tom Burka is exactly right. Wall Street responds to internal norms, which are overwhelmingly short-term, which in this case means the next trading hour or so.

Prices move mostly according to how traders think their colleagues will react during the next few hours. If I think everyone will think "market rise," then by definition I think the market will rise, and so I will buy. And since most of them are herd animals, and not really deep thinkers, a bet by one that his colleagues will think the same as he does is a good bet.

Thus bubbles, panics, the whole sordid and historically validated (and endlessly repeated) set of market failures.

Posted by: bleh on November 28, 2007 at 6:46 PM | PERMALINK

Cutting interest rates only helps if the economy is healthy enough to take advantage of them.

...But the loan fiasco has soured that market.

Posted by: Crissa on November 28, 2007 at 6:46 PM | PERMALINK

Yah, yah, up today, down tomorrow.
These gyrations are causing me motion sickness.

I think a better way for Kevin to divine stock market trends is if he rubbed Inkblot's fur with a ballon, then put Inkblot in a sack, and then noted which side of the sack the balloon would stick to.

Left side = market up, Right side = market down

Posted by: optical weenie on November 28, 2007 at 6:46 PM | PERMALINK

Yes, sure, lower interest rates make stocks a relatively better investment than bonds, and that's good news for Wall Street. —Kevin Drum

Kevin, the stock market is not the entirety of Wall Street, which also includes the bond market and currency traders. These people are sick and tired of almost a decade of historically low interest rates.

Posted by: JeffII on November 28, 2007 at 6:51 PM | PERMALINK

The market is only partly tethered to the economy because all the pension payments and insurance premiums that show up as fresh money everyday have to earn a return. Low interest rates mean Treasuries are that much less attractive vs. the long term return on stocks. Risk-adjusted returns on stocks are just that much better.
Plus, some of the hedges and derivatives are built around index funds. Propping up the indexes makes perfect sense. Until it doesn't.

Posted by: TJM on November 28, 2007 at 6:53 PM | PERMALINK

Yes, the falling dollar makes some companies easier to buy and so better bargains for euro investors. But it also seems like the market is over reacting to good news and deeply discounting the bad.

The Citigroup deal is not good news (11%!?!!). HSBC's move to swallow its subprime funds is not good news. Large on-hand US oil reserves really isn't good news either. The Home Loan Bank deal with Countrywide is very strange news indeed.

I think we are seeing trades by very large institutional investors who think only as far as the end of the quarter, and the yearend bonus. The small investor is nuts to play in waters like this.

Posted by: Will Divide on November 28, 2007 at 6:56 PM | PERMALINK

1) There may be some folks that are gambling that the housing bust won't be any worse than the 1997 "Asian Monetary Crisis" and that the economy will slow just temporarily and then resume like it did in the late '90s.

2) During the last two recessions (1990/2001) the federal reserve did lag by several months in response to clear warning signs. This time they appear to be more proactive.

3) Inflation worries may be exaggerated because banks are tightening up lending standards a lot. Can't create a lot of new money without new lending, and if buyers are waiting things out they aren't borrowing any money even if they can get the loans.

These are my most optimistic views.

Posted by: Doc at the Radar Station on November 28, 2007 at 7:03 PM | PERMALINK

It's called "short covering". It's interesting that only the Wall Street firms know real-time how much short interest there is in each stock. We, the average investors, are not privy to that information and receive information that is one month old. Just another example of how the game is rigged for those in power. By the way, level of short interest is absolutely the best indicator of stock movement.

Posted by: mrjauk on November 28, 2007 at 7:03 PM | PERMALINK

To paraphrase Hobbes (of "Calvin and...") :

I think we'd know a rational actor if we saw one.

Posted by: Frank Wilhoit on November 28, 2007 at 7:15 PM | PERMALINK

Ah, Kevin.

Stocks are up over 300 points today (uh, that's dollars to you financially comprimised liberal granola chomping types.)

Unemployment is on a record setting 6th year of expansion. Unemployment rates have never been so low so long (Compare President Bush's average unemployment rate with Bill and Hillary's sometime.) Finally, the market explodes for two straight days for huge gains.

Yet the liberals want to sift through the statistics nitpick with a couple soft areas and shout "See! Bush's economy sucks!"

THe hilarious thing is you guys don't even realize how silly and irelevant you appear to other people.

Posted by: egbert on November 28, 2007 at 7:33 PM | PERMALINK

"THe hilarious thing is you guys don't even realize how silly and irelevant you appear to other people."

The REALLY hilarious thing is that you're saying that is proof positive that that YOU don't realize how silly and out of touch you appear to the majority of Americans.

Gallup, Nov 11-14:
"How would you rate economic conditions in this country today.."

Excellent/Good 27%
Only Fair 44%
Poor 28%

The American people *know* that the economy sucks and all the phony numbers and happy talk from deadenders like Egbert are only convincing the same 27% that is unwilling to face ANY kind of reality.

Posted by: chaboard on November 28, 2007 at 7:50 PM | PERMALINK

Stocks soaring? If you price them in Euros you'll see that they're just a little less negative than they were before.

Posted by: B on November 28, 2007 at 8:06 PM | PERMALINK

Shortcovering ... market is "oversold"

Oil down $3

Trends trend...

Posted by: wren on November 28, 2007 at 8:07 PM | PERMALINK

That's because you're just one man, Kevin. How could one man understand something as powerful as The Market?

It's like understanding how Superman can fly. Would higher gravity on Krypton really give him the power to change direction in mid-air? It's best just to accept it.

Posted by: Sam L on November 28, 2007 at 8:25 PM | PERMALINK

Market down by 10% from all-time high.

Egbert's response: . . . [crickets] . . .

Market up to recover roughly 2% of the 10% downdraft.

Egbert's response: "Yet the liberals want to sift through the statistics nitpick with a couple soft areas and shout "See! Bush's economy sucks!"
THe hilarious thing is you guys don't even realize how silly and irelevant you appear to other people."

Send me your address, chump. I'll send you a quarter so you can buy a clue (and maybe more, so you can buy a dictionary and learn how to spell "irrelevant."

Posted by: Uncle Jeffy on November 28, 2007 at 8:35 PM | PERMALINK
cmdicely, a lower interest rate makes stocks worth more all other things being equal.

but if the lower interest rate happens at a time when profitability is falling, then all other things aren't equal.

Sure they are, if the profitability falling is already part of the calculations of the market players. Surely, you don't think the big Wall Street firms completely ignore economic trends until a fed official mentions them? No, the only news to them from a statement like that is the hints of what the fed will do: the only thing that is different after the statement than before, as far as Wall Street is concerned, is the perceived likelihood of a rate cut.

The comments about the economic trends themselves may be news to reporters, and people who don't pay close attention to economic trends themselves, but they aren't news to Wall Street.

Posted by: cmdicely on November 28, 2007 at 8:37 PM | PERMALINK

Of course, egbert, we have seen the most anemic job creation during a recovery in American history under George W. Bush. We have also seen the most debt run up in history under this nimrod.

Look, Wall Street is whistling past the graveyard. Any trader with any brains knows America is fucked economically and they are moving their money into Euros and foreign stocks. It's over - plant your garden and buy gold. A good water purification system ain't a bad buy either.

Posted by: The Conservative Deflator on November 28, 2007 at 8:43 PM | PERMALINK

Kevin: Play around with present discounted value formulas a little. A drop in long term interest rates of a tenth or quarter of a percentage point can increase PDV by 3-9%.

Set against that, how much do prospects of somewhat slower growth over the next couple years affect the *long term* growth rate over the next 30+ years? Probably not too much, I'd guess. Also, PEs are a pretty reasonable levels, relative to interest rates.

Posted by: Measure for Measure on November 28, 2007 at 9:04 PM | PERMALINK

If we all clap our hands and believe in fairies, Tinkerbell will live.

Posted by: thersites on November 28, 2007 at 10:02 PM | PERMALINK

A large part of how stock markets works is the idea of a self-fulfilling prophecy. If, as as whole, investors think that a stoelck's value will increase, they buy more of it then they sell. As the law of supply and demand would predict, this actually causes the value of that stock to increase.

To put it more generally, people have a belief; they act on that belief; the very action actually causes the initial belief to be validated. Self-fulfilling prophecy.

It'a easy enough to expand this to the market as a whole. It's also easy to see how fundamental human irrationality plays into this. Greenspan's 'irrational exuberance' observation is quite logical when seen in this context.

People believed that the stocks of companies with no history of making a profit, and no plans to actually make a profit, were going to increase in value, so they did. And they continued to do so, until people realized the obvious: that the Emperor had no clothes, at which time they began to sell. Voila- irrational exuberance becomes a bursting bubble.

Despite peoples' claims to the contrary, the stock market is one of the *least* logical aspects of society. It can, however, be explained, and perhaps even predicted, according to logical principles.

-Z

Posted by: zorro on November 28, 2007 at 10:24 PM | PERMALINK

That's because it's the market with it's perfect information and invisible hand.

Posted by: anonamouse on November 28, 2007 at 11:23 PM | PERMALINK

cmdicely, methinks you are a little too optimistic about how realistically all corners of wall street discount information: otherwise, there wouldn't be earnings surprises.

more concretely, as we all know, a stock is worth the present discounted value of the future stream of earnings. The tricks are the discount and the future stream.

even if the fed cuts another 25 or even 50 basis points, the discount isn't going to change all that much, especially if you are using a longer-term piece of paper for your analysis; on the other hand, we've had years of record-setting profitability. that is unlikely to be the near-medium term future of the earnings stream.

or, to put it another way, stocks went up what, 2.5% today? do you really believe that the present discounted value of the future earnings stream went up 2.5% today? (do you really believe that a potential 25 basis points cut in the fed funds rate made citigroup worth $15B more today than it was yesterday? that's more than the entire writeoff they've announced....)

Posted by: howard on November 29, 2007 at 1:36 AM | PERMALINK

Here's the thing: These guys have a whole lotta money, which they don't really need anymore--their houses, cars, tuition, etc. are already paid for, they don't need it for gas, food, clothing, vacations, etc. because they have plenty to cover that.

So they have to do something with it, since, of course, they don't pay too many taxes either. Why not stocks? Why not bonds? Doesn't really matter, so they'll use any excuse to make more money from their excess money.

Posted by: KathyF on November 29, 2007 at 2:24 AM | PERMALINK

Also please explain to me how the average Wall St. employee now makes $17k per week, according to the NYT.

Posted by: bob h on November 29, 2007 at 7:21 AM | PERMALINK

about the stock market:

psychiatrists have a concept they call magic thinking. a magic thinker is somebody who believes that if he says the same thing, over and over again, long enough, loud enough,often enough and enthusiastically enough after a while, as if by magic, it will become true.

three almost perfect textbk. examples, of an extreme magic thinker, are:
1) george bush
2) mitt romney
3) rudolph giuliani.

what does this have to do with the stock market?

to get any business at all as a stock broker you have to be an extreme magic thinker(*).

(*)would you invest your money in somebody who didn't have absolute selfconfidence in himself?

Posted by: wschneid25 on November 29, 2007 at 10:21 AM | PERMALINK

about the stock market:

psychiatrists have a concept they call magic thinking. a magic thinker is somebody who believes that if he says the same thing, over and over again, long enough, loud enough,often enough and enthusiastically enough after a while, as if by magic, it will become true.

three almost perfect textbk. examples, of an extreme magic thinker, are:
1) george bush
2) mitt romney
3) rudolph giuliani.

what does this have to do with the stock market?

to get any business at all as a stock broker you have to be an extreme magic thinker(*).

(*)would you invest your money in somebody who didn't have absolute selfconfidence in himself?

Posted by: wschneid25 on November 29, 2007 at 10:23 AM | PERMALINK

cmdicely, methinks you are a little too optimistic about how realistically all corners of wall street discount information: otherwise, there wouldn't be earnings surprises.

I didn't say anything about "realism". I never said the perceptions were accurate, I just don't think Wall Streets economic perceptions (at least those of the big firms) are driven as much by public announcements like this as their perception of the Feds actions are driven by them. My comment was about how the statement effects Wall Street's collective perception (and how it doesn't), not how accurate Wall Street's collective perception is. I said that the statement probably didn't much effect their view of the underlying economic trends to which the Fed official suggested any action would be a response to, I did not mean to suggest that their view of that trend before or after that statement was necessarily accurate.

Posted by: cmdicely on November 29, 2007 at 10:40 AM | PERMALINK

Sam L,
It's like understanding how Superman can fly. Would higher gravity on Krypton really give him the power to change direction in mid-air?

Originally Superman could not fly. Remember able to leap tall buildings in a single bound?

He could jump around like some giant flea.

His ability to fly did not come from high gravity on Krypton. It came from Hollywood.

Posted by: Tripp on November 29, 2007 at 11:34 AM | PERMALINK




 

 

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