"What gets us in trouble is not what we don't know. It's what we know for sure that just ain't so." ~ Mark Twain
Stock Market Boom
Economics perhaps is one of the most misunderstood disciplines in the planet. A faulty understanding of economics results in fallacies - which people don't seem to be able to get rid of. A fallacy that has bubbled over from economics to the field of finance is that a bull run on the stock markets are a sign for a strong economy. The case in point being that of India. India's GDP growth rate for the current fiscal is likely to be the lowest in a decade (with most analysts pegging the rate between 5-6%). However, the BSE Sensex index stands at around 19,900... the highest in 24 months and a shade under the all-time high of 20,827 (which it made in January 2008). So how do you reconcile stock market performance to solid economic growth?

In fact rising prices are no a sign of growth. instead the unmistakable sign of growth is falling prices. For example, consider how much laptops and mobile phones costed a decade ago... and contrast that is how much they cost presently. Laptops and mobile phones today are more sophisticated than they were a decade ago, and yet they are cheaper. And it is not to say that companies such as Apple, Dell and Samsung haven't grown in a decade. In fact they have gone from strength to strength. 

Specifically, the converse relationship is the more correct one: rising prices (including that of financial assets and equities) are a bad sign. So let's attempt to understand why that is so. 

So Why Do Prices Rise? 
Mainstream economists define inflation as a rise in the general price level of goods and services. For the time being lets put stock prices aside and first look at understanding how prices rise. The explanation for this comes via what is known as the quantity theory of money. In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level. For example, if the central bank were to print an additional $100 note, then it would reduce the value of all $100 dollar bills floating within the economy. This manifests as a loss in purchasing power of money, manifesting as a rise in prices. Almost all economists across the world agree with this relationship - though there is debate if this takes place in the short run or in the long run. 

Now here is where the Austrian School economists differ with mainstream economists (Austrians disagree with mainstream economists is almost everything).  The Austrians do not say than an increase in the money supply causes inflation. In fact what we  say is that inflation is the increase in the money supply. Without monetary inflation price rise is not possible since over time producers would be able to produce goods and services more efficiently resulting in reduced prices in the form of increased competition. A more detailed explanation of this is provided here by this great article by Frank Shostak (Frank is an economist who I respect a great deal - and I do suggest that you follow his writing). 

Now having established how inflation takes place in the economy, let's turn to the question of stock prices. 

Stock Markets and Monetary Inflation
Prices can only rise when there is monetary inflation within the economy. With monetary inflation all prices are affected - not only consumer prices as measured by the CPI and WPI. Why this effect goes unnoticed is because the common person does not associate rising stock and bond prices, rising real estate prices, rising services (such as education) cost and others.  Additionally even corporate profits would rise though monetary inflation (this is due to what we call money illusion given that cost components such as wages are slower to catch-up with rise in prices for finished products). 

Austrian economist Fritz Machlup stated this in this 1940 book The Stock Market, Credit and Capital Formation when he said: 

It is impossible for the profits of all or of the majority of enterprises to rise without an increase in the effective monetary circulation (through the creation of new credit or dishoarding).
Likewise it is not possible for the stock market indices to show sustained increase without constant monetary inflation. So what really happens? When the Central Bank creates money out of thin air by credit expansion, funds invariably enter the banking system and flows into the capital markets - including the stock markets. Hence any attempt to bring about credit expansion out of thin air results in a (temporary) bull run in the stock.

Specifically this is what Machlup had to say about how stock markets really work: 
Specifically it is neither possible for corporate performance to see additional gains in profits, nor for the stock market indices to show sustained increase without constant monetary inflation. So what really happens? When the Central Bank creates money out of thin air by credit expansion, funds invariably enter the banking system and flows into the capital markets - including the stock markets. Hence any attempt to bring about credit expansion out of thin air results in a (temporary) bull run in the stock. 
I would love to have written more to explain this further in more detail... but instead suggest that you look at a very good explanation of this here in this great article by Kel Kelly.

Unfortunately, as the Austrian Business Cycle Theory enables us to understand, credit created out of thin air is like heroin. As the physical body of a drug addict starts getting used to heroin, more and more heroin is needed to sustain the high. Any stoppage, or even a slowdown, in the dose of heroin would cause withdrawal symptoms. It is likewise for credit expansion out of thin air - as economic agents start getting accustomed to credit injections, more and more are needed at ever increasing rates to sustain the artificial boom in economic activities and asset markets. Hence if there were to be a marked slowdown in credit creation the music would come to a halt.

Now this is what the percentage year-on-year's change in India's money supply growth looks like (see chart): 
If there is anything called "noticeable slowdown" then this is it. India dodged the Great Recession brought about by the US housing collapse in 2008 partly because of the policy response of injecting more and more liquidity into the stock markets. There was a significant slowdown in the rate of monetary injections during the first quarter of the 2010 fiscal year. However, any changes in the money supply (or any other policy variable) do not have instantaneous effects on economic activity or the capital markets. As the effects of the monetary heroin starts wearing off the economy beings to experience financial convulsions as the economic activity starts to come to a grinding halt. This is a sense was witnessed in the form of a correction in the stock markets during the end of 2010 after it almost made a new high (see chart).     
As the growth rate of money supply tapered off the stock markets began to stagnate with a negative bias. Eventually the Reserve Bank of India (RBI) started inflating again - albeit gradually via Open Market Operations (OMO) which has again been observed in the form of gains in the stock market. 

My understanding of the current situation is that stock markets (and the BSE Sensex) is showing gains on account of a round of credit expansion in anticipation of RBI cuts in the policy rates in early 2013. Hence this is that i feel should happen: 
  • The stock markets should continue to rise a bit more over the next month. I would feel that the upside is fairly limited. 
  • I do not anticipate new highs this year... though this could happen if there is a surge in the amount of monetary inflation engineered by the RBI. Given current inflationary concerns, I do not expect any unexpected surge. 
  • The markets should start to give up their gains after another brief upward movement - possibly around the time when a triple-top chart pattern becomes evident. I expect this to happen by March 2013 (or earlier). 
  • I expect markets to be soft in 2013. I do expect a 20-30% correction (if not more). I expect corporate performance to disappoint. 
  • A fall in the stock markets would be signal for a long and extended bear phase in the market peppered with brief bull phases.  

While I am not a perma-bear, I find it difficult to remain bullish when economic bubbles are forming all over the world (including in India) as I have explained in by book Spot the Next Economic Bubble. I am personally reducing my exposure to the stock markets by using any higher levels to book profits. I do believe that you would get an opportunity to purchase stocks later in this year at a good discount.
  
Caveat: The use of any maths and/or empiricism in economics can be hazardous to your health (and to your wealth). 

Disclaimer: This article is my personal view on market trends. None should rely on this view for investment or trading decisions.
Poornima nagarkatti
20/1/2013 02:10:20 pm

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Saurabh Thirani
21/1/2013 02:01:21 am

Poornima - appears you have put in a blank message.

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1/5/2013 05:46:10 am

Excellent and logical analysis. Your reasoning makes a lot of sense. lets see how it plays out this year.

Subscribed to your blog.

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