Great Depression Economics 101: Keynes’ Take On A Roller Coaster Stock Market

Has another Great Depression begun?

The stock market does not appear to think so, at least not right now. As of yesterday, the stock market was only down from its peak by 17.6%, below the 20% cutoff characterizing a bear market.

Indeed, the reaction of the stock market to events in the labor market has been puzzling many. Yesterday, the S&P 500 rose by 1.45%, the same day that the Department of Labor announced that 6.6 million more people had filed claims for unemployment insurance. In the last three weeks, the S&P 500 has risen almost 25% , while at the same time more than 16 million Americans have filed unemployment claims.

In the 1930s, Keynes told us that the stock market was not always a rational reflection of what was happening in the world. In this post I highlight the relevance for today of what Keynes had to say about the stock market in his classic treatise The General Theory of Employment, Interest, and Money, a treatise he wrote to analyze the events of the Great Depression.

There is reason to wonder whether the current economic contraction will turn into another Depression. To put the unemployment claims figures into perspective, 16 million jobs comprises about 10% of the U.S. workforce and represents twice the number of jobs lost during the Great Recession a decade ago. These are big numbers, and suggests that the U.S. unemployment is now in the neighborhood of 15%, climbing towards the 25% unemployment rate reached during the Depression.

My previous post described how to use Keynes’ insights about the Great Depression to analyze the nature of the COVID-19 economic contraction. That post did not include a discussion of the stock market. In this regard, the economists who followed Keynes and developed Keynesian economics focused their attention on the debt market but not the stock market. They did so with good reason, as debt comprises the lion’s share of corporate external financing.¹ However, in The General Theory Keynes had many important things to say about the stock market and its role in the economy.

Keynes’ Perspective on the Key Factors Driving Stock Prices

Four concepts serve to describe the heart of Keynes’ message about the stock market: psychology, optimism/pessimism, confidence, and market sentiment. These are concepts used by modern behavioral economists, and without doubt, Keynes was a behavioral economist. In the discussion that follows, I will try to provide some authentic flavor by using Keynes’ own words wherever possible.

Keynes argued that investors often fail to base their decisions on principals I will call textbook finance. For example, textbook finance teaches investors how to use discounted cash flow analysis to estimate the “intrinsic” or “fundamental” value of a stock. Keynes used the term “enterprise motive” to describe what might motivate an investor to undertake such an analysis. However, he then argued that the enterprise motive would not be the primary driver of investors’ trading behavior. Instead, he asserted that another motive, which he called the “speculative motive,” would primarily drive stock trades. Investors driven by the speculative motive, Keynes said, would trade on forecasts of the future market price of stocks, rather than differences between stocks’ intrinsic values and market values.

Keynes was clear to say that investors might not believe that the future price of a stock will coincide with its intrinsic value. Referring to the U.S. stock market, he wrote: “In the greatest investment market…New York, the influence of speculation…is enormous…When he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation… ”

One of Keynes’ most important insights about the stock market is his idea about “conventional basis of valuation.” He explains this phrase to mean that the investor is ”anticipating what average opinion expects the average opinion to be.”² In other words, investors base their forecasts of the future price of a stock on what they estimate are the forecasts of other investors, rather than their own judgments of intrinsic value. Keynes described this concept by using a “beauty contest” metaphor, in which people are encouraged to submit entries for which contestant is the most beautiful, and rewarded if their entry is judged to be most beautiful by the most contestants.

Keynes used the term “trade cycle” for business cycle, and the business cycle lies at the heart of the economic issues we now face. Being the behavioral economist he was, Keynes was quite clear to identify biased expectations on the part of investors and firms over the course of the business cycle; and this takes us to the heart of what Keynes was trying to teach.

In the discussion that follows, I will draw on passages from Chapter 22 of The General Theory. As you read this part of the discussion, keep in mind the four key concepts I mentioned above: psychology, optimism/pessimism, confidence, and market sentiment.

Keynes focused on how psychological biases vary over the course of the boom and bust phases of the business cycle. He emphasized that during a boom excessive optimism would induce firms to engage in excessive investment in capital goods, and stock market investors to engage in excessive speculation. In his words: “The later stages of the boom are characterised by optimistic expectations as to the future yield of capital-goods sufficiently strong to offset their growing abundance and their rising costs of production…It is of the nature of organised investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital-assets.”

I feel sure that when reading the previous paragraph, you took note of Keynes’ phrases about “optimistic expectations” applied to “future yield” and “forecasting” applied to “the next shift of market sentiment.”

Keynes went on to emphasize that the result of this excessive optimism and speculative behavior would lead investors to be disappointed. Such disappointment would lead, he argued, to eventual reduced investment in capital goods, thereby lowering aggregate demand which would then result in a bust. In Keynes’ words: “[W]hen disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force.”

Is economic behavior rational? Keynes was quite clear to say that because of psychology, the answer is no. In his words: “[I]t is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world.”

In this last passage, Keynes was saying that excessive pessimism and a lack of confidence infuse the bust stage of the business cycle, just as excessive optimism and overconfidence infuse the boom stage. In his words: “It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism… When the disillusion comes, this expectation is replaced by a contrary ‘error of pessimism’, with the result that the investments, which would in fact yield 2 per cent in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment.”

In a nutshell, there we have Keynes’ major insights about the course of psychology over the business cycle, and the reflection of that psychology in the stock market.

Modern Twist to Keynes’ Perspective

Keynes’ concepts of “enterprise motive” and “speculative motive” for trading stocks are as valid today as when Keynes put them forward in the 1930s. Just as valid, I would suggest, are his views about excessive optimism during the boom phase of a business cycle. Indeed, during the last few years, I have consistently argued in my posts that stocks have been significantly overvalued on fundamentals. In this regard, I have focused on the role of FAANG, five technology stocks³ which together with Microsoft that have been dominating the value of the S&P 500.

There is a twist to the way enterprise and speculative motives play out in modern times. Today, sell side analysts provide forecasts, known as “target prices” for stocks. These target prices, which generally refer to twelve months hence, are communicated in analyst reports that often describe the forecasting methodology being employed.

In line with the enterprise motive, some analysts do use discounted cash flow. However, as I point out in my academic work, these analysts are in the minority. Most analysts instead rely on valuation ratios, such as price-to-earnings (P/E), price-to-sales, price-to cash flow, price-to-book, and P/E-to-growth (PEG).

Take P/E as an example. Analysts who use P/E to forecast future price, essentially estimate what is a plausible or warranted future P/E ratio for the stock, as well as a plausible forecast for future earnings. They then compute target price as the product of warranted P/E and their earnings forecast. Notably, textbook finance does offer a methodology for estimating P/E based on fundamentals. However, most analysts do not use textbook finance, but instead rely on the P/E values of comparable firms. In doing so, their behavior conforms to Keynes’ notions of the speculative motive and conventional basis of valuation, as they implicitly seek to forecast where other investors believe that P/E is headed.

As I mentioned above, a minority of analysts do use discounted cash flow techniques to arrive at target prices. As I have pointed out in my previous posts, my concern with these target prices is that they suffer from excessively optimistic assumptions. As a result, investors come to be lulled into thinking that stock prices are, or soon will be fairly valued relative to fundamentals, when such is not, or likely, to be the case.

My take on the modern version of Keynes’ perspective is that investors crave excessively optimistic stock price forecasts and supply side analysts feed that habit. Just as Keynes used a beauty contest analogy to describe the speculative motive for stock trading, I suggest using a drug dealer analogy to describe the biased valuations that sell side analysts feed investors.

Coming back to analysts and technology stocks, an issue I mentioned earlier: At the peak of the market, sell side analysts’ target returns for these stocks was 13.4%. Given that the average market beta for these stocks was 1.28 at the time, the estimated return for these stocks over the subsequent twelve months would have been below 10%.⁴ A return gap of 3.4% is consistent with excessive optimism. Fast forward to yesterday, after the market has had seven weeks of to absorb the impact of the coronavirus pandemic: sell side analysts’ target return is now 12.4%, with the 1% decline (from 13.4%) not even fully reflecting the Fed’s sharp reduction in the interest rate. All of this leads me to wonder whether analysts continue to feed investors excessively optimistic forecasts.

Conclusion

Keynes emphasized that psychology can prevent stock prices from correctly reflecting reality. In this regard, perhaps the stock market is simply telling us that investors are in a state of denial that the economy, or at least the labor market, is flirting with Great Depression dynamics in respect to the magnitude of the contraction, its duration, or both. More to come on this issue, in my next blog post.