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Predicting the Market with Austrian Theory

By Howard Katz      Printer Friendly Version Bookmark and Share
Jun 1 2009 10:56AM

Austrian theory is known as theoretical economics and as an intellectual defense of hard money. However, I have also found it useful for stock market prediction. The old slogan says, “They don’t ring a bell on Wall Street? (to tell you when to sell). But in fact they do ring a bell, and to those who understand Austrian economics the signal is loud and clear. Using this signal the Austrian economists can take the money away from the Keynesian economists, making the good guys rich and leaving the bad guys poor.

The essence of Austrian economics is the time-preference theory of interest.  If you ask the question, “What is interest,? the Austrian school answers, “Interest is the price we pay for time.?

Now time is not something that one can put in one’s wallet or purse.  It is not a thing one can hold in one’s hand or drive around the block. So what do the Austrians mean when they talk about time as an economic good?  They mean that most everybody has a time preference.  If they are going to receive an economic good, they prefer to have it sooner rather than later. This can be made clear by the following example. A father promises his son, “Get straight A, and I will buy you a car.?

The son works hard and gets his As. “OK, Dad, where’s my car??  The father replies, “You will get your car, next year when you graduate.?


The son feels that he has been misled, that his father has not been fully honest. What is the problem here? He is getting the car he was promised. Why is he disappointed? The answer is that a car now is a greater value than a car next year. This is what the Austrian economist means by time preference. A good that you have in your hand right now is worth more than a good that you will not receive for some time.

And indeed, you come up against this problem when you go to buy a car in the work-a-day-world. The car man says, $20,000.?  You say, “I can save that over 5 years.?  The car man says, “If you are going to give me the money over 5 years, you have to pay 5% interest per year.  Money over 5 years is worth less to me than money right now.?

And this is what the Austrian economist means when he says that interest is the price we pay for time. We prefer present goods to future goods. The borrower wants to indulge his time preference.  He wants to use the good before he has earned the money to pay for it (e.g., a house or a car). So he goes to the saver and offers him extra money – interest. The saver sacrifices his time preference. He has earned money, but he does not spend it in indulging his needs. Instead he lends it to the borrower and receives interest. To the borrower, the interest is worth less than his time preference.  To the saver, the interest is worth more than his time preference.

It is a good thing for us players that there are many stingy Silas Marner types who hoard money and lend it out at interest so that we can borrow it and have a good time.  After all, tomorrow may never come.  In other words, people have different time preferences. The people with a short time preference become borrowers and pay interest to the people with a long time preference (who in turn become savers).

So when the Middle Ages put a ban on interest, they crushed the working of a free economy. Fortunately, John Calvin championed the legalization of interest. As his ideas spread through Britain, Switzerland and Holland in the 17th and 18th centuries, interest was legalized.  Here in America interest was legalized in the North by Noah Webster, who traveled through the 13 newly independent states in 1785-86 and convinced state legislators and other prominent people to support this measure (on the victimless crime argument).  In 1787, Jeremy Bentham did the same thing in Britain.

The effect was electric. Now that they could receive interest, people began to save.  They took their money to the savings bank or bought a corporate bond.  The savings were lent to businessmen, who started factories.  These factories employed the latest machines and dramatically increased production.  In both the American north and in Britain there was a large increase in wealth (which allowed Britain to win the Napoleonic wars and the North to win the Civil War).  This large increase in wealth is called the industrial revolution.

So if the Jimmy Carter types truly want to help the poor people of the world, they should speak out forcefully against the bans on interest which still exist in so many countries.  This is the key to a modern industrial economy.  We Americans can see this dramatically in the conflict between the North and South.  From 1793 (the creation of the first factory in Pawtucket, Rhode Island) to 1860 the North grew in wealth and population.  After the war, carpetbaggers from the North brought the elements of a free economy to the South, and the South began to catch up.  Arkansas still lags the rest of the country, and this correlates perfectly with an anti-usury law written into its state constitution.

Now Adam Smith proved that a free market maximizes economic benefit in every area of an economy (although Barack Obama has not yet learned this).  Most Americans understand this, and such institutions as rent control have pretty much died out.  However, there is one price which is severely regulated here in America.  It is the price of time.  Indeed, there is a special department of government called the central bank – in the U.S. the Federal Reserve -- which is charged with lowering the rate of interest below its free market level.  It does this directly by lending to the Treasury at low rates, and it does it indirectly by the creation of money, which depreciates the currency and lowers the real rate of interest.  Since the New Deal gave the power to create money to the Federal Reserve, prices have risen at just about the average rate of interest.  Thus the real rate of interest in America has been 0% for the past 76 years.

With (real) interest again banned, America is starting to get poorer.  In 1970, the average American working man had to work 3.6 years to earn the average house.  In 2006, he had to work 7.8 years.

When the Austrians looked at the way in which the manipulation of interest affects the economy, they found what is conventionally called the business cycle.  When credit is eased, we have what is incorrectly called a boom.  When the free market responds by tightening credit again, we have what is incorrectly called a depression or recession.  It is therefore possible to predict the business cycle, and the associated stock market ups and downs, by observing the machinations of the Federal Reserve to ease and tighten credit.  For example, the Fed was created in 1914 and immediate eased credit and printed money, causing a war “boom.?  In 1921, some of this money was taken out of circulation, causing the “depression? of 1921.  In 1922, the Fed eased again, causing the bubble of 1922-29.  In 1930-32, the remainder of the money was taken out of circulation, and prices in 1933 returned to their 1914 level (which happened to be the same level which existed under George Washington in 1793).  The clear and dramatic association of a rise in stocks with easing during WWI and in the ‘20s and of a fall in stocks with tightening in 1921 and 1930-32 illustrates the cause and effect relationship and can be used by the modern speculator to escape the general loss in wealth and put extra money in his pocket.

Observation of the United States while it was on the gold standard (1788-1933) shows that interest rates (on safe investments) averaged around 5%, and yields on blue chip stocks averaged about 8%.  This reflects the higher risk inherent in stocks.  The key number to watch is the yield gap, or the difference between the stock yield and the bond yield.  We write the equation:

           Yield gap = stock yield minus bond yield.

While America was on the gold standard, we have:

           Yield gap = 8% - 5% = +3%.

Now as soon as the Fed was created, as noted, it eased credit from 6% to 3%.  As soon as bond yields began to fall, the yield gap rose.  Investors in bonds sold out and put their money into stocks, and this extra demand caused a rise in stock prices.  Thus from 1914-1919 stock prices doubled.  In a similar manner, a fall in the yield gap predicts a decline in stock prices.  I have been using the yield gap since the late 1960s (when I first learned Austrian economics by reading von Mises) to predict moves in the stock market.

It is a beautiful indicator and predicts the vast majority of bull and bear markets.  (There are a few exceptions, the principal one of which is war.)  In theory, one should take a yield ratio (equal to bond yields divided by stock yields, which under the gold standard was 5/8).  However, Barron’s Magazine publishes the yield gap in its statistical section.  I fell into using it as a matter of convenience, and it has worked very nicely over the years.

A few adjustments are required.  The two numbers which are related are real bond yields and stock earnings yields.  To compute the real bond yield, one must subtract out the rate at which the currency is depreciating.  Conventional economists take the current rate of price increase from the U.S. Bureau of Labor Statistics and subtract it from the nominal interest rate on bonds to get the real bond yield.  However, bond buyers are not interested in how fast the currency was depreciating last year.  A buyer of the 30 year bond wants to know how fast the currency will be depreciating over the next 30 years.  This cannot be calculated precisely, and all we have is the market’s best guess.  Second, Barron’s uses stock dividend yields, not earnings yields.  In the old days, pretty much all earnings used to be paid out as dividends; now many earnings are reinvested in the company (and get to the shareholder by an increase in stock price).

These two factors change the level of the yield gap but not its behavior.  Back under the gold standard  the neutral point on the yield gap was +3%.  Today my observation indicates that it is -4%.  That is, a gap of -4% indicates a market where bond yields and stock yields are in a relationship the market regards as fair.

Right now the yield gap is telling a very interesting story:

The yield gap was bullish from early in the century.  Indeed, Greenspan leaned so far over to the easy side that the yield gap hardly ever got down to neutral, let alone negative.  Thus the panic in 2001 was due to 9-11-01, and the bear market of 2002 was due to Bush’s decision to invade Iraq.  Knowing that Austrian theory was bullish told me that the bearish force had to be the (impending) war.  Of course, when the news is out, the move is over.  Congress approved the war resolution on Oct. 10, 2002, and I turned bullish one day later for the bull move of 2002-07.

Along the way there was a mild tightening, from 1% to 5¼%  However, the tightening was not strong enough to have much effect on the yield gap, and the gap hung just about, or slightly above, the neutral level through ‘’06 and ’07.  The market, thus, was erratic in ’07 and early ’08.

Reading the long term chart of the yield gap, since Black Monday 1987, you get the impression that the Fed is in business to make the stock market go up.  A Fed chairman who gives Wall Street a nice bull market gets praise from the media.  A Fed chairman who causes a bear market gets condemned.  Greenspan does not know of the yield gap, but he always erred on the side of the bull, and it looks like Bernanke is imitating him.  Ease, ease, ease.  Of course, as any Austrian economist knows, this is the path to destroy the American economy.

In my economic letter, the One-handed Economist ($300/year), I use such tools as the yield gap to predict the financial markets so that you may exempt yourself from the general collapse which has already started.  I was the only gold bug of the 1970s to switch over to being a stock bug in the ‘80s and ‘90s.  Now I am a gold bug again, and this was very helpful to my subscribers in 2008.

Many gold bugs have difficulty knowing whether to concentrate on the metal itself or to be primarily in the stocks.  Here the yield gap is very helpful.  If both gold and the stock market are going up, then gold stocks will outperform the metal.  If gold is up but the stock market is down, then the metal will outperform the gold stocks.  This is one of my strategic tools in the current market.  If you would like to get a feel for my writing, then I recommend you visit my web site, (no charge).  I am currently doing a series entitled “A Strategy for Liberty? which explores how the modern pro-liberty movement can have the same success as the classical pro-liberty movement of the late 18th and 19th centuries.

Thank you for your interest.

Howard S. Katz



Howard S. Katz was one of the early gold bugs of the late ‘60s and ‘70s, turning bullish on gold in 1965.  His favorite gold stock, Lake Shore Mines, went from $3/share to $39/share over the course of the seventies (sold at $31).  Katz turned increasingly skeptical about gold as it mounted its final rise in 1979, and he called the top after the close on Jan. 21, 1980 (with gold at $825.50/oz.).  Katz traded gold in and out during the ‘80s and ‘90s and once again turned long term bullish in Dec. 2002.  His thoughts on commodities, stocks, bonds and real estate are available in a letter entitled The One-handed Economist and published every two weeks giving specific advice on trades in stocks and futures.  This letter is available (both electronic and paper copy) for $300/year with a 3-month trial for $100.  Send to: The One-handed Economist, 614 Nashua St. #122, Milford, N.H. 03055.  (Include both electronic and mailing address.)