Heisenberg Report

‘Why Would Anyone Expect Stocks To Price Rationally?’ The State Of Exception Is Now Permanent

“Since the lows, the most frequently asked questions have been ‘Who is going bust?’, ‘When will we retest the lows?’, ‘Why is the stock market so divorced from reality?'”, BofA’s Michael Hartnett writes, in the latest edition of the bank’s weekly “Flow Show” series.

While market participants are justified in marveling at the rapidity of the rebound off the March nadir, it’s worth emphasizing that the scope of that rebound isn’t anomalous in the context of bounces after bear market plunges.

“Bear market rallies in 1929, 1938 [and] 1974 saw an average 61% rebound from the lows”, Hartnett reminds you. The visual below uses Bloomberg data to reconstruct historical bear market rallies. The chart makes a number of assumptions (as defined in the linked piece): the S&P 500 closes more than 20% below a record; a bear market continues until the index either doubles from a post-peak low or climbs above its pre-bear high, a rally is defined as the benchmark bouncing more than 15% before a retracement.

A similar-sized bounce to history’s larger bear market rallies “would take SPX to 3180 in this rally”, Hartnett goes on to say.

But aside from history, he flags two additional reasons for the apparent disconnect between stocks and economic “reality”.

Hartnett calls these “fake markets”, noting that “government and corporate bond prices have been fixed by central banks”. As such, he wonders “why would anyone expect stocks to price rationally?”

A snapshot of 2020 YTD cross-asset returns reveals a stark disparity with 2019’s “everything rally”. But when it comes to US equities this year, things could certainly be worse considering the circumstances. The same goes for IG credit.

Hartnett further suggests some market participants may have lost context. “2215 out of 3042 global stocks remain in bear markets”, he says, adding that the $15 trillion stock rally “must be placed in the context of the $30 trillion collapse” in February and March.

When it comes to “fake markets”, this is just a continuation of the ongoing debate around whether central banks have finally gone “too far” when it comes to administering prices.

In “Against The Gods: ‘Historically A Losing Proposition’“, I reminded folks that normative concerns aside, betting against central banks’ ability to corner markets, inflate asset prices and relegate price discovery to the dustbin of history, hasn’t generally paid off over the past decade.

The point wasn’t to glorify the power of the printing press or to otherwise suggest the current state of affairs is optimal. Rather, it was a descriptive piece more than anything else. The visual below is apples to oranges, and should be considered as such, but it nevertheless makes an important point.

In a note out early last month, Deutsche Bank’s George Saravelos didn’t mince words on the topic. “There is no such thing as a free market anymore”, he wrote. “All developed central banks have cut rates to zero and [are] buying trillions of assets”.

Saravelos went on to posit a situation where central banks utilize their “unlimited capacity to print money… to peg bond, credit and equity markets [thereby] stabiliz[ing] portfolio flows”.

Long-time readers may recall that Saravelos’s colleague Aleksandar Kocic presaged this years ago, in a classic piece on the possibility that we may have entered a “permanent state of exception” after 2008. The following passages (from a 2017 note) seem particularly prescient and germane today. From Kocic:

In its core, policy response to crises was an extension of what in a political context is known as the state of exception: Market laws had to be suspended to restore normal functioning of the markets. The intrinsic contradiction of this maneuver is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound. However, the accommodation has been in place for a very long time, during which traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics.

Engineering a state of exception comes with considerable risk. The Fed (and central banks in general) carries an implicit responsibility for orderly reemancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo — a permanent state of exception.

And with that, I’ll leave you with a few excerpts from something I published back on April 26, as this playful (but grim) glimpse into our possible future seems to fit nicely with the above.

Imagine the dystopian metropolis of the future. There’s a break in the rain. The sidewalks and streets are red-tinged glass as puddles reflect the city lights. You’re looking out from an alley. A girl walks by holding her umbrella. Above, today’s prices scroll across a ticker tape.

Videos of the daily price-setting press conferences play in a loop, as they do every night from 8 PM to 9 PM on every electronic billboard from New York to London to Tokyo.

They say it promotes “transparency.” It’s important, they say, for the public to understand “the process.”