Is it Suspicious that Markets Go Up?

Suspicious_fbbb44_1219122One refrain we hear from cynics is that investing in the stockmarket is a scam.

That we are idiots for thinking the market goes up forever when, everybody knows, “what goes up must come down.”

If you get your investing advice from Zerohedge or World Workers Monthly you’ll recognize this attitude. That optimists are suckers, they’re the pink slime fueling the Big Lie that markets go up.

Now, not to beat on the cynics — we need more, not less, critical thought in this world. Indeed, financial markets do house more hustles than a Tijuana streetbroker.

But the accusation that asset price appreciation is itself evidence of a Big Hustle is absolutely false. Asset markets don’t go up because CNBC and the Feds. They go up because of human nature. Specifically, they go up simply because humans are by nature impatient: they have “positive time preference.”

I know, not nearly as exciting as the conspiracy. But very important for deciding your exposure to financial markets.

Now, this doesn’t mean markets go up all the time. Since the 1970’s, for example, the S&P 500 has gone up 75% of the time. Which is not 100% of the time. Markets can go down for all kinds of reasons — a recession, slow-down in profits, higher taxes.

And keep in mind I’m not saying that stockmarkets are hustle-free. There are plenty of games played by everybody from Bernie Madoff to Janet Yellen.

But what I am saying is that the mere fact that asset markets tend to go up is not evidence of some grand hustle. Markets tend to go up simply because humans are impatient and this impatience makes them discount future payments. There’s no more mystery, no more witchcraft than that.

So let’s run through how time preference works its market-levitating magic. Time preference describes the fact that people prefer a dollar today to a dollar tomorrow. So let’s say I print up a bunch of IOU’s, guaranteeing you $1.05 in a year. How much would people pay for this IOU? Well, let’s pretend everybody has the same time preferences. 5%, let’s say, is historically realistic. Meaning they’ll give up a dollar if you promise them $1.05 next year.

How much would these people pay for my $1.05? Easy — they’d pay a dollar. What would the market value of my IOUs be? Again, easy — they’re worth a dollar. Precisely.

To see why, imagine I tried to flog my $1.05 IOUs for $1.01. People would be like, “Get out of here with your lousy 4% returns” and I’d go home with unsold IOU’s.

On the other hand, if I sold my IOUs for a dollar and the market price fell to 99 cents then some sharp-eyed speculator would scoop them up and pocket a free penny.

Wait a minute, so that means that you can stick a buck in the market and come out with $1.05? Pure witchcraft, that rising market. It’s a conspiracy.

So let’s carry this over to real-world markets: is a rising stockmarket evidence of the Big Hustle? Well, stocks fundamentally work the same way as IOU’s: you give Apple a dollar today, and they give you some money tomorrow — a stream of dividend payments.

Just like the IOUs, stocks are discounted today by time preferences. Meaning that, just like the IOUs going from a buck to $1.05, stockmarkets also tend to go up. Not because it’s a hustle by the CNBC talking heads in cahoots with Golman and Obama. Simply because time preferences mean the assets were discounted to begin with.

I’ll talk a lot more about the ups and downs of markets, and you can subscribe to my free Austrian Investment Newsletter here. But for now I want to lay down the marker that time preferences alone mean there is nothing fundamentally mysterious, nothing fundamentally wrong, about having an optimistic bias in the markets.