Trashing economic axioms

GUEST COLUMN

Conventional economic thought is unable to explain a lot of events in the global markets today.

We humans are strange beings--we love to trash what we create, wealth or peace. It's a harsh reality. Euphemistically we might call it a new age theory, or evolution. But the reality is that psychology is calling the 200-year- old economic thought as junk.

And guess what, Douglas McGregor (1906-1964) and Abraham Maslow (1908-1970) might just be laughing about how they might finally turn out to be the real contributors to modern economics.

McGregor whose work was based on Maslow's hierarchy of human needs coined the Theory 'X and Y' of management. The first psychologist ever to work at MIT, he talked about management styles and his Theory X assumed employees to be lazy, irresponsible and with little ambition on one side and with all the good traits on the other.

The good 'Theory Y' assumes that we humans as employees want to do good work. Research on behavioural finance concurs with 'Theory Y' and call humans nice and not selfish. The studies have proved that the economic belief of more money being better is not true. We humans are not motivated by more money. After a point happiness disassociates from money.

But behavioural finance does not end its recourse here. It adds that apart from being nice, we are also dumb. Putting it simply a majority of us are 'penny wise and pound foolish'. If majority of us are like this, it means either we love to lose the valuable pounds or the economics we have been taught is all wrong.

The latter seems more reasonable as behaviourologists have also pointed out that we humans are also loss averse. We cannot be loss averse and still lose, so there is definitely something wrong in the way we have been taught.

Economic axioms are not universal truths, some of them are far away from truth, it's just that nobody questions them. The big one is the interest rate axiom. The lower the interest, the better it is.

This seems logical, but it does not work. Higher the better, is what stock markets around the world suggested starting 2004. A two-year yield curve for Japan, the US and India exhibited similar results. India witnessed a falling interest rate scenario from 2001 till 2004, as the yields dipped from near 8 per cent down to 4.5 per cent. This was accompanied by a sideways Sensex till 2003 hovering near 3000 points.

Starting 2004 when the yields took off from 2004 back to 8 per cent, the benchmark quintupled. The Nikkei doubled and Dow moved up 63 per cent.

You might say, "This was an exceptional time for global prosperity, we all know that falling interest rates are positive for stocks." Wrong. The 1929 Depression happened in a falling interest rate scenario. The theory that rising interest rates kill stocks, or interest rate tool has predictive value, and central bankers are economic wizards is incorrect.

Alan Greenspan, ex-chairman of the US Federal Reserve admitted that the ability of people to think that central bankers can avert recessions is 'puzzling' for him.

Inflation and interest rates can be controlled be a central banker, but whether they will have the desired effect on the economy is doubtful. Globally, interest rates are seen to rise and fall together and there is an inflation cyclicality much beyond local tinkering.

Economic reasoning is not always unequivocal. Is rising currency good or bad for the market? The dollar-Dow correlation oscillates from positive to negative. Correlations are never permanent. Hence giving currency strength an axiom shape is inappropriate. We can extend the same argument to oil.

People say: "Oil price rise is not good for the economy, but this time it's different." Good and bad economic news is make-believe and convenient. "The same news was good yesterday, but today it has got diluted by the X factor."

Another axiom is making the 'Buy and Hold' strategy almost synonymous with investing. Well, if it worked for Warren Buffett, it may not necessarily work for us. Buffett started working at his father's brokerage in early 1940s. This was after the depression. Buffett bought when nobody was looking at stocks, so he was more of a contrarian and market-timer than a buy-and-hold investor.

Of course, he held on to what he bought for more than a few futures trading days. These days they say, "If you don't sell fast enough, you might hold for a long time."

Diversification is thought to be another way to mitigate risk. It is good if one understands that assets are not just stocks. And, that there is a difference between real estate and cash.

Understanding the sub-prime mortgage mess might shed some light on this. Also, the fact that if you really want to emulate Buffett, we need to have cash at the bottom, not eroded stocks, waking up to the harsh reality of earnings.

Markets can fall with or without earnings, as stock prices do not track earnings. The period between 1920 and 1929 was a period of rapid earning growth. Real S&P composite earnings tripled over that time and real stock prices increased almost seven-fold.

The S&P composite tripled again during 1950-59, but this time earnings grew only 16 per cent over the entire decade. There are many other bull market examples where one cannot illustrate the earnings logic to justify multi-fold increase in stock prices.

The argument can be extended to explain dividends and price changes. We ask for dividend at market bottoms and not at a market top. The relationship is inverted and the reasons are half-baked. They only explain why stocks go up, not why they come down. "They come down because of global risk and they go up because of real earnings." Yeah right!

After all the hard work, we are left with a portfolio in a local currency. How competitive is the local currency anyway? How convertible is it? Are we in a country which only sees currency strengthening? Does our central banker appease us with a managed float or a target zone currency management jargon?

If we become richer every year, as the local currency strengthens, then local exports may flounder. The companies we buy on the stock market might be thrown out of business, just because we can afford a longer vacation in Europe.

Richer in a quarter and poorer the next is all what currency plays are all about. Cross-border mergers are a reality, we pay and convert from our pocket when we bid for companies around the world. Individually we may not have a currency risk, but the stock we buy is in the heat of things. We wish currency crisis stays next door, but it is happening, every day. Ask a forex trader, it was never trickier.

Hence, the real currency is not the local paper, but gold, at least it's traded globally, is an alternate for money and it's rising. If there is a crisis "� the euro becomes the same as dollar or dollar halves against the euro, or the yen strengthens back to 80, we are left with only a few risk management strategies. One of them is gold. So how rich is our Sensex portfolio in terms of gold? If the real money was gold, then the Sensex portfolio is the same as it was in 2000. Real money has moved on and the Sensex is still back at the seven-year historical high. So, we are not as rich as we think we are.

The economics that we know cannot help us survive, leave aside making money. The market is not a conventional model. Bull markets have their own geniuses, successful corporations and stories, which disappear as the trend changes. We are at a historical juncture once again, this time it is bigger. How far new information and extraneous reasons help us remains to be seen. But what definitely cannot help us is the X in the axiom.

(The writer is CEO, Orpheus Capitals, a global alternate research company, and can be reached at mukul@or-phe-us.com)