The Great Disconnect
It can't get any worse
I listened to one of those spaces on X last night about macroeconomics, the Fed, and capital markets. After about 30 minutes, I started wondering: are they just trying to impress me with fancy terminology? If you have been in the market for more than three decades, you would feel alienated listening to some of those people talking. The reason is that there is a great disconnect between what the Fed says, the economic conditions, and what market participants do. It has always been that way.
Market participants do not act based on what the Fed says unless there is a significant change in policy, a surprise, or some adverse development. Market participants focus on underlying market momentum and strength because this is all that counts. It is all clear from this market cycle: despite “higher for longer” interest rates and higher-than-expected inflation, the S&P 500 has rallied 50% on a total return basis since the close of October 12, 2022. This has been an “anticipatory process.” You can think of all the excuses you want: higher NGDP, disinflation, better earnings, etc. By the way, no one in the space I joined yesterday made a single reference to the exploding public debt. Why? Because there is no framework yet for fitting it into some narrative that can be useful in forecasting anything.
Reflexivity is the primary force that drives the market higher, not Fed comments during an FOMC meeting or even macroeconomic conditions. There is a strong belief, justifiable or not, that the US stock market has a solid long-term upward bias. Every time there is an upward move, this belief consistently updates to a higher posterior probability of an uptrend continuation. For this Bayesian process to stop, the market has to drop significantly, as during the 2020 crash. But then, the Fed and the government will step in and provide liquidity to restore market price stability. This restarts the Bayesian updating and translates to a powerful reflexivity loop.
This is also what we are witnessing at this point: investors are convinced that any losses due to a correction will be short-lived because the Fed and the government will step in and save the stock market. Any macroeconomic analysis is irrelevant and most of those who attempt to forecast the long-term path of the stock market using fancy terminology are probably confused.
The markets have changed in a significant way since the “original sin” of quantitative easing but even before that, there have been reports of an operation to “smooth” stock market returns via the use of S&P 500 futures (no longer traded and replaced by E-mini futures). Although we do not know whether those rumors were true, it is clear that the US economic system is pro-capital, and maintaining stock market price stability is of paramount importance. There are other countries where the stock market is of secondary importance. The stock market, however, is a key factor in the USA's economic and political dominance, necessitating the use of all available policy tools, including deficit spending, as the recent dramatic increase in public debt demonstrates.
Corrections matter for investors.
Stock market corrections are mostly due to unexpected developments, not economic policy, which has always accommodated higher prices. The risk for most investors is panic selling and then ending up chasing prices higher after a rebound. This is especially true for retail. Macroeconomic analysis cannot forecast corrections due to unexpected events; it is useless for that purpose. It is also not useful when there are no conditions for corrections because of the reflexivity loop. Macroeconomic analysis can be useful in fixed-income and forex markets. Additionally, it is largely irrelevant in the case of commodity markets because those are subject to random supply shocks. However, we notice that the focus of macroeconomic analysts has been on the stock market. Why? Because that is the largest audience. On the other hand, simple models based on momentum have provided a much more effective and tested method for realizing reasonable risk-adjusted returns. See this article for more details.
Well said