Why the Market Has an Upward Bias

The Role of Innovation, Risk Premium, and Monetary Policy

Last time we talked about the impact of external shocks, and how geopolitics and crises can influence the market. But what would happen if we exercised abstraction and isolated the regulated market from such external shocks?

We would have a constant upward pressure. A market that rises slowly with low volatility

(We will analyze the movement of the SP500 on another occasion, deepening the concept of variance ratio). The fact that there is a constant upward pressure is justified by the following factors.

1. Technological macrocycles: Different industries drive market innovation in cycles. The first cycle started with the industrial revolution (spinning machines, manufacturing, water power, etc.). The second cycle began in the late 1800s with the train and steel industry. The third cycle involved electricity, chemistry, and automobile. The fourth cycle was about electronics and petrochemicals. The fifth cycle was based on the internet and its applications. The sixth cycle, which overlaps with the fifth, is about digitalization and energy transition.

   Each cycle boosts productivity and quality, leading to dematerialization, especially in the last two cycles. This increases the potential and the economic growth for each process, while also creating monopolies for the leading industries.

   In the early 1900s, transport companies dominated the stock index according to the current macrocycle. Today, technology companies are the leaders.

   The stock market reflects this positive trend.

2. Microcycle of the listed company: A company goes public and makes profits. It invests its profits to grow its business. Its earnings increase and its stock price rises. This cycle repeats until the company is either acquired by a bigger listed company or becomes unprofitable and delists, leaving room for another successful company. As you can see, the stock indices are built to inevitably have a bullish bias by bringing in the winners and kicking out the losers.

3. RISK PREMIUM: There are assets with theoretically risk-free returns (e.g. US bonds). These assets provide the minimum return obtainable on the market.

   Other assets are riskier and their return depends on how risky they are (i.e. yield is uncertain). The stock market is made of risky assets, so investors need a higher return to hold them. The more risk and uncertainty, the more return. The historical return provides the basis for the expected return and ensures that there is a demand for such assets. The sustained demand for a limited quantity of goods like stocks increases prices, net of shocks, i.e. the stochastic component.

   We can use a formula to show this:

   Return of one stock = Risk-free rate + Beta * (Market return - Risk-free rate)¹.

   In other words, the expected return of the single stock is equal to the risk-free rate plus a multiple or a fraction of the expected return of the entire market net of the risk-free rate [e.g. 4% risk-free rate + 2*(9%return of the market-4%)].

   The greater the expected range of the single stock, the greater the beta. A stock with a large beta can have large increases as well as bankruptcy holes.

   The stocks that last the longest in the indices belong to sectors that can adapt to the changes from one macrocycle to another. They also have a low beta, which means they are less risky and less likely to go bankrupt. General Electric was the longest-lasting stock in the Dow, but it was recently removed. The stocks with the highest beta are those that benefit from the current macrocycle, but they are also the most vulnerable to the next one.

   They also face more idiosyncratic risks, which are the risks of failing for reasons unrelated to the market. The main point is that the market as a whole will always grow, but not every individual stock will.

   The financial system is designed to reward the winners and eliminate the losers.

When economic microcycles stall (like in the current Chinese balance sheet recession), the risk premium fails to attract buyers. As a result, the indices go down instead of up.

In the modern economy, the treasury and central banks can intervene to mitigate or prevent crises. This intervention is known as the Greenspan/Bernanke put and the Keynesian put.

They involve:

A) The Central Bank (especially the FED) which uses an expansive monetary policy. This policy acts like a protective put option that lowers the market risk when it drops by a certain percentage (usually 20%, which means a bear market). This policy was used in March 2020 and during the subprime mortgage crisis.

B) The central government which uses expansionary fiscal policies.

In this regard, using the NBER methodology as a reference², I developed a comparison between the S&P 500 and the economic cycles since 1971.

I chose this year because it marked the end of the Bretton Woods system and the semi-gold standard.

This change sparked globalization, as trade was no longer limited by each state’s balance of payments.

The former use of gold settlement led to rapid inflationary effects for net exporters and deflationary effects for importers, determining precise cycles of contraction and expansion.

Instead after the Bretton Woods break, the US became the privileged buyer of products on the world market in exchange for dollars and a deposit account for trading partners through the treasuries purchased mostly by the Japanese and then by the Chinese. These countries used the same dollars they earned from exports to buy these treasuries.

The log scale chart shows that the S&P 500 follows the trend of the perceived economic cycles but fails to anticipate effective recessions when monetary and fiscal policy intervenes to neutralize the transition from one phase to another, especially in low inflation situations; this is clear in the period between the Great financial crisis and the Covid.

It is worth noting that the only real flash crash in history, mostly unrelated to the economic situation, is the 1987 Black Monday.

1. The CAPM

2. https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions