Dystopia: Rise of DJIA and Greenspan’s Utopia.

US stock markets are on the highs. Stock markets are supposed to be a barometer of investor confidence in the companies’ growth and profitability prospects, which in turn measure confidence in the larger economy. Financial Times Reported for 9 April, ^^^Overall, US equity markets moved higher after initial wobbles, shrugging off concerns over weak quarterly earnings and ahead of the minutes from the Federal Reserve’s policy meeting in March, due on Wednesday. The benchmark S&P 500 index closed 0.4 per cent higher at 1,568.60,after briefly breaking through the previous closing high reached last week. Seven of 10 main sectors finished in positive territory, with materials and financials stocks leading the gains^^^. Yet many other measures of US Economy’s strength fail short of expectations of  a broad consensus of economists,
Alan Greenspan was knocked off the cultish perch he once held as the steward of the US economy long ago. Yet he still has some traction as the talking head on TV channels. When asked on CNBC about the effect of sequestration [automatic spending cuts that kicked in on 1 March 2013] on Economy, he replied, ^^^…at the moment the critical issue is how does it affect the stock market. The reason for that is that stock market is a key player in the game of economic growth at the moment. Because there are two factors of the stock prices that have become important to understand. First is the so called “Equity Premium”, that is the rate of return on equity [should give] is a very high number, closest to the highest number in American history. This means it is very difficult to get stocks down… the price-earnings ratio is at a level at which it cannot basically go down very muchIf the stock market can hold through this then the effect [of sequestration] will be rather minorData shows that not only stock markets are a leading indicator of economic activity, they are a major cause of it… Statistics indicate that 6% of change in GDP is due to movements in stock prices and home… The wealth effect is probably the reason why consumers are holding up more than what payroll taxes…^^^.
The wealth effect is the increase or decrease in spending that accompanies the increase or decrease in perceived wealth. In other words, increase in wealth would trigger increase in consumption. Since the stock markets are high, the perceived wealth is high and we have the “assurance” of Greenspan that it is very difficult to get them down. So the only way US consumption can move is up and up. Greenspan’s notion that stock markets drive the economy finds no supports in the research done by Christopher Carroll and Xia Zhou: ^^^The “6 cents extra spending for every dollar increase in wealth” found in the research he alluded to was for the relationship between changes in the value of housing wealth and consumption, not stocks. In fact the authors, Christopher Carroll and Xia Zhou, argued that the wealth effect from stocks was “statistically insignificant and economically small”. If the stock markets do not drive the economy, then does the economy drive stock prices? The anaemic recovery in US economy hardly justifies at the moment the booming stock prices. Then what exactly is driving the DJIA and S ‘&’ P 500.
This is the question Steve Keen answers in his post, Greenspan’s Bullish, time to sell. To do that Keen analyses the relationship of Change in Margin Debt to Change in the DJIA and also the Acceleration in Margin Debt to Change in DJIA for past six decades and the past decade. Margin Debt is the amount put in an account with a stock brokerage to buy equities or securities. The amount of margin debt will change daily as the value of the underlying securities changes. Keen found a strong correlation in both these relationship, the former being the stronger of the two. ^^^The correlation of the change in debt with change in the Dow is stronger than the correlation of acceleration — 0.59 versus 0.4 — but both are pretty strong for correlations over more than half a century, especially since conventional wisdom asserts they should both be zero. The correlations have risen too as the level of debt has risen — both aggregate private debt and, in the USA’s case, margin debt which is specifically used to buy shares^^^.

The strong positive correlation between Change in Margin Debt and Change in DJIA is neatly captured in above graphs. But which one is the driver? The answer Keen correctly observes is a mix of both: rising Dow drives more investors to put more in margin debt, and more margin debt drives Dow higher- a positive feedback loop or seemingly endless leveraging [Scarily similar scenario to what happened to Real Estate Bubble]. What is the source of money that is put up for the margins? Federal Reserve has been pumping money into the banking system through the unabated Quantitative Easing. Sloshing money in the banking system is creating debt through loans that is wagered as margin money. Something conventional economists would never agree to because they have long “figured out” that level of debt has no impact on level of asset prices: ^^^But one can also make a causal argument that increasing levels of debt levered up the gap between asset and consumer prices. This assertion of course directly contradicts a famous proposition in academic finance — the “Modigliani-Miller theorem” that the level of debt has no impact on the level of asset prices^^^.  This is what Keen tongue in cheek refers to as “Conventional Wisdom”.

Briefly put:
Aggregate Demand = Gross National Income = GDP + [FL-DL] + NCI, where GDP = Gross Domestic Product, FL=Income form Foreign Labour, DL= Income for domestic labour, and NCI=Net Capital Inflow.

Aggregate Supply = Goods and services produced, add imported, less exported.

Keen and a few other economists [Michael Hudson, Dirk Bezemer and Richard Werner] -a bunch together with him he refers to as heretics- hold above relationship incomplete and misleading. They contend Aggregate Demand has an additional component of “Change in Debt” and as a corollary Aggregate Supply too has an additional component of “Change in Asset prices”. He adds, ^^^This implies a causal link between the rate of change of debt and the level of asset prices, and therefore between the acceleration of debt and the rate of change of asset prices — but not one between the level of debt and the level of asset prices. Nonetheless there is one in the US data, and it’s a doozy: the correlation between the level of margin debt and the level of the Dow Jones is 0.945^^^. In summary stock markets at the moment are neither a strong indicator of economic activity nor are driven by it; but are instead driven by rising Debt made possible through Quantitative Easing. Fragility, rather than sustainability is the message Keen takes from this data, and adds, Greenspan expressing confidence in the stock market is a reliable contrary indicator. Please read his excellent analysis here.
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