Robert Prechter Dispels 10 Popular Investment Myths, Part XI

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Robert Prechter Dispels 10 Popular Investment Myths, Part XI
The world's foremost Elliott wave practitioner tests myth #10: "Central banks and government policies control the markets” -- and brings you yet another surprising conclusion

By Vadim Pokhlebkin
Thu, 06 Jan 2011 11:30:00 ET

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This is Part XI of the series "Robert Prechter Dispels 10 Popular Investment Myths," where EWI president explains why traditional financial models failed in 2007-2009 -- and why they are doomed to fail again (and again). (Excerpted from Prechter's February and March 2010 Elliott Wave Theorists.)

Here are Part I, Part II, Part III, Part IV, Part V, Part VI, Part VII, Part VIII, Part IX and Part X; come back next week for the conclusion of this series.

The Socionomic Theory of Finance

The Conventional Error of Exogenous Cause and Rational Reaction

By Robert Prechter

Claim #10: “Central banks and government policies control the markets.”

Virtually everyone believes this statement; certainly most economists do. Keynesians and monetarists believe that authorities can control the money supply and interest rates, and most neo-Austrians believe that the Fed is all-powerful when it comes to inflating: Whatever inflation rate it wants, it simply manufactures.

Not long ago [in late 2008 -- Ed.] the U.S. government announced that it will fully back the debt of the mortgage companies it created (Fannie Mae, Freddie Mac); it pledged to use taxpayers’ money and borrow unlimited amounts to fund banks that it deems “too big to fail,” while pledging that the FDIC will fund shortfalls at all other banks. At the same time, the world’s top central banks offered unlimited credit at near-zero interest rates, in other words, free money.

According to the exogenous-cause model, these historic pledges and bailouts should have had immediate results. Take a look at Figure 20. Can you tell where on this graph of stock prices authorities took these actions?

According to the economists’ beliefs, the only rational place for them to have taken place would be at the bottom of the market. The minute the authorities began flooding the market with liquidity is the minute it should have turned up.

Figure 21 shows that in fact these actions took place in the early portion of the biggest stock market decline in 76 years. These actions did not push stock prices back up. The market finally bottomed months later, at a time when nothing along these lines happened.

It is no good to claim that these actions had results eventually. By that reasoning, any future turn in the stock market would prove the contention. Such reasoning is tautological, because the market fluctuates.

An exogenous-cause believer would do far better to explain this result by claiming that authorities’ actions of this type must be bearish, because every time they acted, the market fell; and when they finally stopped, it rose. Economists do not advance this argument, because they can’t make sense of it. Instead, they cling to their traditional cause-and-effect logic, while the markets just do what they want.

Over the preceding pages, we have seen that interest rates, oil price changes, the balance of trade, changes in earnings, changes in GDP, the onset or termination of war, peaceful times, terrorist attacks, inflation, a central bank’s monetary policy and a government’s fiscal policy have no reliable effect on financial market prices. Sixty-four years ago, a financial modeler named Ralph Nelson Elliott, after observing markets for some time, concluded, “Current news and political developments are of only incidental importance, soon forgotten; their presumed influence on market trends is not as weighty as is commonly believed.” According to our investigation, Elliott was too generous; they appear to carry no weight at all.

I am unaware of any exogenous-cause claim that holds up under scrutiny. An event that seems to affect stock prices one way in the present, when investigated in the past, fails to provide any consistently reliable relationship. Even claims that seem inescapably reasonable, if not irrefutable, fail the test of even moderately rigorous empirical observation.

I have tested every exogenous-cause statement or assumption I have heard, not all of which are included here. So far, none of them work. Many exogenous-cause statements contradict others, as we saw throughout this discussion. Proponents often adopt one argument and then the other, to fit market events. We still await exogenous-cause proponents to make any statement of stock-market causality -- or social-mood causality -- that holds up consistently throughout the historical record. ...

[Conclusion of this series is now posted: Prechter looks at attempts to explain what caused the 1929 market crash and the Great Depressioon.]

Latest from Bob Prechter: The current Elliott Wave Theorist updates you on the stock market, gold, silver and shows several stunning charts, one with a reading so extreme it hasn't been seen in 45 years. Subscribe risk-free now for instant online access.

Tags: bailouts, Ben Bernanke, Dow Jones Industrial Average (DJIA), earnings, Elliott Wave Principle, Fannie Mae, U.S. Federal Reserve (the Fed), Freddie Mac, inflation, investor psychology, market manipulation, monetary policy, S&P 500

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