Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 4 April 2013

Stock Markets During Quantitative Easings - A Historical Parallel for QEasy Investors

In an era of “quantitative and qualitative” monetary easing, how do stock markets behave?

History may provide a lesson. Let’s look at the German experience post World War I when the circulation of the Reichsbank (monetary base) tripled in two years from 1918 to 1919 and went up ten-fold by 1921-end. Compared to Rudolf von Havenstein, Kuroda’s aims of doubling the monetary base are certainly more humble. And Ben Bernanke seems to be a paragon of tight monetary policy with M1 in the US increasing by only 78% since beginning of 2008.
The graph below shows that the real performance of German stocks was enormously different from their nominal performance which tracked the growth in money supply quite closely (The pundits who tout the ‘wealth effect’ should take note). While in nominal terms the index had returned in excess of 10 billion percent from 1918 to 1923, in real terms and in dollar adjusted terms it had lost almost 70% of its value.

The stock market was subject to considerable gyrations leading to fortunes being made and lost. Even though the present environment is currently deflationary, the rhymes of history lead to some startling observations. It is best to read some illuminating excerpts from Constantino Bresciani-Turroni’s masterful exposition of the German hyperinflationary episode (all emphasis mine, except where indicated):

…gradually the internal situation improved and a social revolution seemed more and more improbable. Also, towards the end of 1919 and in the beginning of 1920, the depreciation of the mark had given a strong stimulus to exports; the wheels of industry began to move round again, and the number of unemployed rapidly decreased.

The public once more began to have confidence in shares. Also, having learned from the very rapid depreciation suffered by…all securities with a fixed yield – the public began to consider shares as the representatives of an “intrinsic” value…whose price in paper marks must increase when the German exchange depreciated.

As the depreciation of the mark proceeded, this phenomenon began to be understood by the public, who, for a long time, assured by official explanations, had attributed the decline in the purchasing power of the paper mark, not to the continuance of note-issues, but to the rise in prices caused by the war, the revolution, and the economic crisis. The public now saw that the paper mark could no longer fulfil the function of the "store of value." In 1919 there began that speculative fury which characterized the Bourse during almost the whole of the inflation period.

Because of the dearness of living which lowered real incomes, many classes of people were forced to try to supplement their incomes by speculation on the Bourse. Also industrial and commercial firms considered the purchase of shares not only as a form of investment for reserve capital, but also as a temporary use for liquid resources – a use which guaranteed the preservation of the working capital which was threatened by the continual monetary depreciation.

It was observed in Germany, as also, indeed, elsewhere, that the circle of speculators was greatly enlarged. Shares were held by speculators in a much larger measure than formerly, when they were for the most part had been held longer by investors, who considered them as permanent investments.

Owing to the close connection between the dollar exchange rate and the prices of industrial shares, which was established in 1920 and 1921, the prices of securities had ceased to be the barometer of the general political and economic situation. Political events…had scarcely any influence on share prices, and what effect they did have often was exactly the opposite to what would have been expected under normal conditions. Events which were unfavourable to Germany, by causing a fresh depreciation of the mark, indirectly caused a rise in the prices of industrial securities.

After the ominous “black Thursday” (December 1st 1921) the public, badly hit by the fall of share prices, realised that not even the purchase of shares was a safe means of investing their savings. Until then many believed that the risk of buying shares was less…because they were able to judge more easily the conditions of this or that industry, rather than the whole political situation…

But another cause even more potent helped to depress still further the prices of industrial securities, and that was the alteration in the conditions of the money market. During the whole of 1921…[there was] an abundance of money in the market. But in 1922 a scarcity in the means of payment began to be felt…Deposits in the banks diminished rapidly…that obliged the banks to restrict credit. The new taxes, approved in the spring of 1922, helped to limit the liquid resources of industry.

Several other causes, besides the conditions of the money market, helped to depress the prices of industrial shares. Already in the spring of 1922 the Bourse began to discount the approaching end of the period of relative prosperity of German industry, which had begun with the depreciation of the mark and with the establishment of a great divergence between the internal value and the international value of the German currency. It was realized that the artificial stimulus given to German industry by the continuous increases in the foreign exchange rates could not act indefinitely.

It is certain that a great lack of confidence spread among the German people in the summer of 1922…Abroad for a long time the conviction was held – and manifested in the purchases of fabulous sums of paper marks – that the German economy would be rapidly revived. But in the summer of 1922 even foreign confidence…was at last shaken, after the collapse of the mark…

Together with the lack of confidence in the political and economic situation of Germany, the low income from shares certainly helped to keep the prices of them low during 1922.

Also the “invisible mortgage” weighing on German industry because of the payment of reparations contributed to the uncertainty of the future income from shares. It was known that in the end German industry would have to adapt itself to bearing its share of the burden. [Public debt and unfunded liabilities of government today can be considered akin to reparations that Germany was expected to pay]

Towards the end of October and at the beginning of November 1922 the situation in the money market once more changed rapidly. The rise in price of shares…was closely connected with the Foreign Exchange decree of October 12th, which fixed strict limits on the purchasing of foreign exchange. Numerous classes in whom was fixed the habit of investing their available resources in foreign exchange, could do nothing but return once more to the share market

As new decrees surrounded the purchase of foreign exchange with greater difficulties, the public bought shares, which they once more considered “real values.”

There was now no longer any curb on note-issues. The quantity of paper money increased with a continually rising rhythm…By such means certain classes of society secured an enormous amount of purchasing power, which they employed in buying shares.

In the first half of 1923 the prices of shares not only reflected the dollar exchange rate, but actually rose more rapidly than the latter…This was the first time since the war that there had been such a decided rise. And this occurred while the political situation created by the occupation of the Ruhr continued and while Germany was threatened by an economic crisis, the gravity of which was widely realized, and the onset of which was marked by the rising unemployment figures.

The paradoxical situation…is revealed in the following extract…“There have been extraordinary rises in the quotations for all shares, the chief cause being the catastrophic [original emphasis] change in the economic situation”

In the summer of 1923…The Ministry of Finance thought of changing the system of assessment and collection of taxes by putting the whole on a gold basis. The accounting of the entire economic system was thus rapidly revolutionised…The veil – thick for the majority, but transparent for the minority of shrewd people – which the inflation had cast over all economic phenomena, was now rent aside and it became apparent that the enormously inflated paper prices often signified, when reduced to terms of gold, prices much below those of 1913. And then the watchword for the securities market became: revaluation of shares, and speculation anticipated a rapid rise in quotations, which were thought to be much below the “intrinsic” worth of the shares.

The vicissitudes of share prices were the cause of heavy losses for some, and of conspicuous chance profits for others, during the inflation. The movement of share prices contributed very much to those serious displacements in the distribution of wealth which occurred during the years of the paper inflation.

And we all know what happened due to those “serious displacements”. Central bankers’ pretence of knowledge is likely taking us along the road to serfdom. 

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