The following are quotes on the course 'The Monetary Theory of Asset Prices', Module 3, Practical History of Financial Markets, Edinburgh Business School; managed by the Stewart Ivory Education Company (SIFECO) and jointly taught by Gordon Pepper and Michael Oliver. The mission of the Institute for Economic Affairs is to improve public understanding of the fundamental institutions of a free society, with particular reference to the role of markets in solving economic and social problems.
FINANCIAL BUBBLES AND DEBT
LIQUIDITY TRADES AND PORTFOLIO TRADES There are two basic reasons why someone purchases or sells a se-
The first type of transaction occurs when someone needs to raise cash or has a surplus of money to invest. The second type of transaction occurs when someone switches from one stock to another, or cash, in the hope that the transaction will improve the return on a portfolio.
INFORMATION TRADES AND PRICE TRADES Another distinction is between two types of portfolio trade. A trade can
If the price falls without any news to justify the drop, price traders will normally rate the stock as cheap and buy it until the price returns to the efficient level. If there is no news to justify the increase, price traders will normally view the stock as expensive and will sell until prices return to efficient levels.
EXPECTATIONS OF FURTHER RISES OR FALLS The analysis so far has been conventional. There should be no dispute
Otherwise, in the case of a liquidity purchase, the share price will initially rise. Why don't price traders who understand what's going on push prices back to the level warranted by the fundamentals.
DEMAND FOR MONEY
- Transactions Demand for Money
- Savings Demand for Money
- Interest Rates and the Demand for Money
Interest rates have a direct effect on the demand for money, but the effect is complex.2 Money comes in many forms: notes and coins, demand deposits (checking accounts), time deposits (deposit accounts), and the like (explained in more detail). in Chapter 19). Changes in relative interest rates affect broad money because they affect the demand for money for saving purposes (discussed in more detail in Chapter 6).
SUPPLY OF MONEY
- Printing-press Money
- Fountain-pen Money
- Interest Rates and the Supply of Money
Powerful forces other than interest rates affect the supply of both printing press and fountain pen money. The supply of fountain pen money depends on bank lending which is influenced by many factors other than interest rates.
MONETARY IMBALANCES
The overall effect is that the money supply increases as banks' holdings of government debt rise. For example, a government does not change its spending plans or tax rates because interest rates have changed.
EXCESS MONEY IN THE ECONOMY
It will be seen that in some years, the growth of M4 has been significantly greater than that of GDP, while in other years it has been lower. Figure 2.2 shows the relationship between money supply growth in real terms in the UK and a composite capital market index covering both stocks and bonds, as an example.
SUMMARY r Liquidity transactions are numerous and large
The third is largely outside the scope of this book (the effect of central bank intervention in the foreign exchange market is considered in Section 20.7).7.
SENTIMENT
INTUITION
On the other hand, if institutions have funds waiting to be invested, they are likely to look for bad news when prices fall, and the market may well bounce back. As explained in the Introduction, professionals who are close to a market observe how the market reacts to news.
DECISION-TAKING INERTIA
A market that tends to react to good news and ignore bad gives the impression of going up; a market that reacts to bad news and ignores good gives the impression of going down. Intuition is another reason why rising prices can lead to expectations of further increases, and vice versa to falling prices.
CROWDS
FUNDAMENTAL AND MONETARY FORCES IN THE SAME DIRECTION
Finally, an explanation is needed as to why speculators, who understand what is going on, do not, consistent with the efficient markets hypothesis, discount liquidity transactions in the same way that news announcements do and push prices back to the level of justified by the basics. Under the circumstances described, monetary analysts rightly judge that the market will most likely continue to rise in the short term.
SPECULATION
TIMING
SHORT-TERM RISK VERSUS PROFITS IN THE LONGER TERM
If everyone knows that the news has been widely anticipated, no one will sell at the time of the announcement. 3It is possible that no transactions will occur again because the price drop at the time of the leak prevents someone from selling.
INTRODUCTION
Harold Wilson, when he was Prime Minister of Britain, criticized the City of London for 'celebrating the misery of the masses' as the stock market rose to a new peak at the same time that unemployment hit a new record.
DIRECT AND INDIRECT EFFECTS OF MONEY ON ASSET PRICES
- Money, Business Cycles and Inflation
- Business Cycles and Fundamental Factors
- The Combination of the Indirect and Direct Effects
Therefore, the indirect and direct effects are in opposite directions for bonds, but in the same direction for stocks. In the opposite case, the indirect effect of slow monetary growth in a boom is low for stocks and, with a lag, bullish for bonds.
STRATEGY
The indirect and direct effects are again in opposite directions for bonds, but in the same direction for stocks, and a substantial bear market for stocks is likely. They roughly coincide with the 'S' which mark significant increases and decreases in money supply growth.
TIMING
SEQUENCES
TRIGGERS
If the interest rate on bank deposits is high relative to the expected return on other assets, the amount of bank deposits that people want to hold for savings purposes will also be high. This can happen because the interest rate on bank deposits changes, or because the expected return on other assets changes.
THE PEAK OF A BUSINESS CYCLE
If interest rates on bank deposits are relatively low, the amount of bank deposits that people want to hold for savings purposes will also be low. If the interest rate on bank deposits changes according to the expected return on other assets, people will no longer be satisfied with the size of their old deposits.
RUNNING DOWN BANK DEPOSITS
With the fall in short-term rates, the pattern of returns in the bond market is changing. If interest rates are expected to fall significantly, the yield curve is downward sloping (that is, it is inverted).
Deflation
- DETECTION OF A BUBBLE
- PHASES
- Chronically Dangerous
- The Burst
- Acutely Dangerous
- CROSSCHECKS
- THE CURE FOR DEBT DEFLATION
- Money Supply Policy
- Fiscal Policy
The danger of a sharp disruption in the market turns from chronic to acute when monetary growth slows. The final result of the appropriate debt management policy can therefore be a decrease in the national debt.
Elaboration
THE UK IN MORE DETAIL
The government's (exchequer's) main need for finance is to cover the difference between its income from taxes etc. The main source of funding for the treasury is borrowing from the non-banking private sector, with the sale of gilt-edged stocks again being the main source. example.
FOUR POLICIES
This means that the banks' lending must be controlled if money laundering is to be controlled.
CONTROL OF BANK LENDING
- The Teaching in Textbooks
It should be noted that the central bank determines the level of short-term interest rates. There are other devices that appear to be intended to control bank reserves in one form or another, but which are, in fact, designed to increase a central bank's control over interest rates (for a discussion, see Pepper and Oliver, 2001, pp. 9–10).
BANK CAPITAL
Central banks try instead to control bank lending by influencing people's demand for bank loans by changing interest rates. Interest rates are not determined by market forces, i.e. the balance between supply and demand for credits. 2.
THE UK IN MORE DETAIL
In other cases, banks have ample capital, either because they have raised new capital in the market or because they are making significant profits that they are putting back into business. The difficulty with this proposition is that banks tend to be undercapitalized in a recession and overcapitalized in a boom, which is the wrong way to stabilize the business cycle.
THE ‘COUNTERPARTS’ OF CHANGES IN BROAD MONEY
RELATIONSHIP BETWEEN THE COUNTERPARTS
On the other hand, if discretionary fiscal policy remains unchanged, the PSNCR will tend to rise in a recession and fall in a boom, due to variations in tax revenues, unemployment benefits, and so on. The fluctuations in bank loans tend to be greater than those in the PSNCR and as a result broad money can fall when the PSNCR increases and rise when the PSNCR falls.
SUMMARY
EXPECTED YIELD
The expected return is the sum of the returns of all possible outcomes, each return multiplied by the probability of the outcome. If there are possible outcomes and the xth outcome has a probability of px and a returnrx, the expected return,r,ispxrx.
RISK
- Risk and the Circumstances of the Investor
- Variation in Risk – Life Assurance Funds
- Investment Managers’ Personal Risk
- Unacceptable Risks
An important difference between risk of loss and volatility is that the risk of loss depends on the investor's circumstances, whereas the volatility of a stock's price is the same regardless of who the investor may be. The odds of the ball landing on an odd number will be the same as for an even number.
EXPLOITING SKEWNESS
Many people are e.g. not prepared to risk a loss so severe that they would have to change their lifestyle – for example, being forced to sell their home and remove their children from private education. A significant gain in expected return will not persuade them to take risks of such magnitude.
TRENDS AND TRADING RANGES
The behavior of a crowd is different from the sum of the behavior of individuals if they act in isolation.
CROWD BEHAVIOUR
INFORMATION
A look at the other instruments shows if the explanation is a change in wind speed or angle, and corrective action can be taken. Similarly, in a crowd-dominated financial market, price behavior is the dominant information.1.
TRENDS AND MOMENTUM
APPROACHING A TURNING POINT
If a trend appears to be losing momentum, declining sales are evidence that the underlying buying or selling, as the case may be, is drying up, confirming that the trend is likely to end soon.
TURNING POINTS
FURTHER READING
Another example is that patterns can occur because the market fluctuates with reversals. The intuitive approach to asset pricing is another form of analysis mentioned in the introduction.
INTUITION THAT IS A REFLECTION OF MONETARY FORCES
- Biased Reaction to News
- Technical Reactions
- Market-makers
- Bulls and Bears of the Core Market-Makers
- Summary
First, they benefit from matching two-way traffic – that is, buying and selling the same stock. Knowing the level of the market at which large sales will occur is important information if caught with it.
INTUITION THAT IS NOT A REFLECTION OF MONETARY FORCES
In summary, the market's reaction to the news may depend on the proportion of loose holders versus tight holders, which may depend on whether or not there has been a recent technical reaction. It can also depend on whether the market makers as a whole are bulls or bears.
FORCED SELLING
DIFFERENT LANGUAGES
MACROECONOMIC MODELS .1 An Hydraulic Model
- Large Electronic Computer Models
The liquid level in the tank rose if the inflow was greater than the outflow. This was a vivid demonstration of the impact of the balance between the supply of savings and the demand for finance at the level of the stock market.
DISEQUILIBRIUM
INTENDED AND ACTUAL TRANSACTIONS The concept of intended transactions being different from actual ones
ACCOUNTING IDENTITIES
He analyzed the components of the supply of savings and the demand for financing in the American economy or, in American terminology, the 'supply and demand of credit'. Based on this analysis, he made predictions about the amount of credit each issuer would need in the year that had just begun.
Evidence and
UK MONEY SUPPLY AND A COMBINED CAPITAL MARKET PRICE INDEX, 1950–72
Further, close examination suggests that changes in the growth rate of the money supply preceded movements in the combined capital market price index. In the opinion of the authors, this graph is an intriguing proof of the importance of changes in the money supply to all investors.
UK MONEY SUPPLY AND THE EQUITY MARKET, 1927–72
The amount of the black card finances the rise of the stock market during the war. The most important factor is a change in the growth rate of the money supply, but the level is also relevant.
HEALTH WARNING
PREDICTION OF THE OCTOBER 1987 CRASH As the charts in the previous chapter show, by January 1987, the S&P
PREDICTION OF THE TOP OF THE US EQUITY MARKET IN APRIL/MAY 2000
In May 2000, one of the current authors, who had already retired, independently came to the same conclusion, and decisively acted on it by making a substantial conversion. The peak of the market was actually in September, when the great bear market began, as shown in Chart 17.2.
POSTSCRIPT
THE US IN THE 1930s
JAPAN IN THE 1990s AND EARLY 2000s Chart shows the Nikkei index and annual growth of broad money in
The above section illustrates how monetary signals can be clear when the future behavior of the money supply is known – that is, with the benefit of hindsight – but at that point one should bear in mind the possibility of a sudden reversal of the recent trend. It starts with current data for the monetary aggregates, followed by data for the supply of money and finally the various sectors of the economy.
ERRATIC DATA
WHICH AGGREGATE?
The figures for April 1973 and earlier have been corrected for changes in the number of contributors. An example is MZM in the US, used in Chapter 16, which is M2 plus institutional-only money market funds minus small time deposits.
A TARGET AGGREGATE
AN EXPERT APPROACH
If any of the aggregates behave in a peculiar way, the cause should be determined. Financial innovation must be monitored and taken into account when interpreting the behavior of monetary aggregates.
TIMING OF THE AVAILABILITY OF DATA There should be no doubt by now that monetary forces have a significant
- Timing of Publication
- Whiplashes
In general, when comparing the behavior of the aggregates, the different nature of the broad and narrow monetary systems must first be taken into account. In Chapter 16, the historical analysis for the US, the twelve-month moving averages were plotted at the end of the period.
UNDERSTANDING THE CURRENT BEHAVIOUR OF THE MARKET
Data is available for the current level of the money supply and its growth rate. In the long run, the behavior of the money supply must reflect what has happened to the demand for money.
PRINTING-PRESS MONEY
FOUNTAIN-PEN MONEY
THE COUNTERPARTS OF BROAD MONEY Together these six items comprise the counterparts of broad money. They
FORECASTS
MANAGEMENT INFORMATION
DISCERNIBLE TRENDS
THE PUBLIC SECTOR’S BORROWING IN FOREIGN CURRENCY AND FROM ABROAD
In short, control over the exchange rate is incompatible with control over the money supply. The largest part of the money supply is the bank deposits held by non-bank financial institutions, industrial and commercial companies and households (interbank deposits are excluded from the definition of the money supply).
