A DISCUSSION OF ECONOMIC AND STOCKMARKET TRENDS, AND AN APPROACH

TO FORECASTING

by

P. T. JENKINS

(A paper discussed by the Society on I8 October I957 and subsequentlyrevised by the author)

INTRODUCTION

T H E aim of this paper is to illustrate in some detail a practicalapproach to the process of forming a judgment of the investmentscene as it is likely to be presented to the U.K. investor. It falls intofour parts, namely:

I.. Theoretical base.2. Survey of type of variations in stock markets and the factors

affecting them.3. Methods of diagnosing trends.4. An approach to forecasting.

The last part occupies only a small proportion of the space sincethe formation of a judgment in investment work, as in most otherfields, is only ' I 0 % inspiration'.

PART 1. PRELIMINARY DISCUSSION OF INTEREST,TRADE CYCLE AND MONETARY THEORY

The object of this part is to explain the author's view of that sphereof economics which may be considered fundamental to investment.The attempt to compress a large and controversial subject withina relatively few pages has obvious dangers. It nevertheless seemsworth while since, although obviously well within the actuarialpurview, these matters do not seem to have had much of an airingin our literature recently.

Interest is the price of money, and money is both a medium ofexchange and a store of value. In its first role, it is best thought of

I ASS I5

2 P. T. JENKINS

in dynamic fashion as so much cash or bank deposits changing handsper day. As it changes hands it will build fixed assets and stocks(capital formation) or merely enable consumption goods (currentor durable) to be manufactured and sold. This may be called theindustrial circulation of money. Money is also exchanged againstsecurities (which for present purposes include existing propertyinvestments) or may be held in idle balances; this constitutes thefinancial circulation.

These transactions may be compared with water swilling roundtwo baths, joined together by a pipe, and fed by a tank connectedto one of them.

Industrialcirculation

Financialcirculation

Bank ofEngland

/ F B

Fig. I

Money is inserted or withdrawn from the financial circulation bythe Bank acting as agents for the Treasury. Whereas the flow of' private' money from F to I is determined by the effort to equalizethe expected 'marginal efficiency' of capital employed betweenand within the industrial and financial circulations, that of Govern-ment money is motivated otherwise. The marginal efficiency ofmoney to hoard is, of course, its marginal value as a store, i.e. thevalue of the extra liquidity to the aggregate of hoarders, less theexpected rate of inflation-erosion, and may be negative.

A brief account of the trade cycle follows. Starting from thebottom of a slump, the initial rise in investment will come from:

(i) Final liquidation of surplus stocks of both consumer andcapital goods.

ECONOMIC AND STOCK MARKET TRENDS 3

(ii) Rise in real value of assets held in F owing to fall in pricesand flow from I to F (see p. 4).

(iii) Rise in real consumption consequent on fall in prices.(iv) Resumption of production of capital goods for mainten-

ance purposes.(v) Government deficit spending, if not consciously then

automatically due to the continuation of essential servicesonly partially met from reduced taxation income.

(vi) Investment for profit attracted by the fall of raw materialprices, wages and interest rates, etc.

Once started, the national income (which may for present pur-poses be defined as the product of the quantity and the velocity ofcirculation, or the 'momentum', of the money in I) tends to in-crease under the influence of the 'acceleration principle' (i.e. theoutput of capital goods varies roughly with the rate of increase inconsumption, with a time shift) and the 'multiplier': money flowsinto I from F to finance purchases of capital goods, and the nationalincome increases (after a time lag) by a multiple of the inflow whichis the number of times the extra money changes hands in a year.

(vii) In the initial uprising of consumption, its second deriva-tive with regard to time exceeds its first derivative withtime—i.e. the rate of increase in investment exceeds therate of increase in consumption. Later, however, therate of increase in consumption becomes steadier so thatinvestment stops increasing. This is reflected in nationalincome and consumption, causing investment to decrease,with further reactions in income and consumption,

(viii) Since increased real investment can only take place at theexpense of consumption when effective full employmentof labour and existing capital equipment is reached, areinforcement to the 'deceleration' effect discussed in(vii) arises. This is likely to be accompanied by inflation asa result of the continued flow of investment funds fromF to I, and the relative concentration of demand on capitalgoods, with the result that more capital and less consumergoods are produced. It then becomes evident that capital

1 - 3

4 P. T. JENKINS

goods are being manufactured at higher costs in order toproduce consumer goods whose quantum of sales is falling,particularly if there is a time lag before the newly createdincomes fully work their way through to the consumer,

(ix) Alternatively, the progress of investment may be moreorderly and get as far as yielding the new consumer goods,without any prior business reaction due to a falling off insales. In this case a recession may arise simply because thepublic cannot absorb the extra supplies at the producers''cost plus' price. This results in lower profit margins orlower sales. The producers' miscalculation may arise, forexample, from a determination to beat the other fellow outof the market, or because producers' costs have risen morethan the general level of prices and incomes since theoriginal investment decisions were taken.

(x) Profits may be squeezed because export prices cannot beraised enough to offset cost inflation,

(xi) Last, but not least, the boom may be stopped by creditrestriction.

Once the initial downward trend has started, the accelerator andmultiplier act in reverse, commencing with stock liquidation on amore or less severe scale. This results in a flow of funds back to thefinancial circulation.

To sum up, when the business outlook is good, money flowsfrom F to I, creating an inflationary situation in I and depressingfixed interest security prices in F, and conversely. Within F thereare broad divisions into idle cash balances, money stocks andequities. In an inflationary situation the demand for securities inF tends to concentrate in equities and in a deflationary situationit concentrates in money stocks and cash. This process is respon-sible for the market adage that gilts anticipate equities, which inturn anticipate business conditions.

It may be asked what is the place of savings and investment inthis scheme. Within I, saving is formally identical with investmentas defined by Keynes, but this is unhelpful. More useful conceptsare the flow of money from F to I for investment purposes, andthe net flow of money from I to F (i.e. after deducting the flow

ECONOMIC AND STOCK MARKET TRENDS 5

from F to I for consumption purposes). The connexion with theKeynesian savings and investment scheme is as follows: let

l=the net flow of money savings from I toF during a time inter-val Δt, which may be termed 'leakage'.

i' = deliberate or 'voluntary' investment in fixed assets andstocks from the circular income flow (i.e. from within I).

f= money flow from idle balances (i.e. F to I flow) for investment

purposes during the interval.

s = savings during the interval.

In this paper it is convenient to define investment (i) as repre-senting only voluntary investment. Then

s=i' + l,i=i+f,

s-i=l-f.and

Now referring to Principles of Finance and Investment, vol. I(Whyte), p. 40, we see that the difference between savings and'voluntary' investment is represented, in the Keynesian scheme, bythe 'involuntary' accumulation of stocks.

It will be readily appreciated that achieving the ideal of a pros-perous and steadily expanding economy over a long period is amatter of great difficulty—a sine qua non is an even development ofinvestment which will exactly meet the equipment requirementsof the consumer industries on a 'just over depreciation' basis. Thisimplies a steady rise in consumption, which again implies that'population times standard of living' should be rising at a main-tainable rate. This happy condition could be prejudiced by, forexample, a spontaneously rising degree of excess leakage. A failureof demand of this type can lead to ' under-employment equilibrium'—even if wages are free to fall downwards—because it is not worthwhile to invest at the rate of profit anticipated.

This may be summarized by saying that the expected marginalefficiency of investment may be less than the marginal efficiencyof money as defined on p. 2. It is a condition found at the bottomof a slump in normally progressive economies such as the U.S.A.,but endemic in countries such as India, where wealth has been

6 P. T. JENKINS

traditionally invested in gold and non-productive industries suchas merchanting and money-lending. It incidentally appears toexplain the prevalence of Socialistic attitudes among the progressivegovernments of such countries. A failure of the opposite typehas been manifest in the U.K. in the post-war period—i.e. toover-consume, resulting in a lower rate of investment and economicgrowth than might be wished.

An economic system may be represented by (k) functions, in(k) variables and an unspecified number of parameters, of the form

fi(P> r>y,s, c,i, ..., m) = o,

MP> r>y> s> c> h •••> m) = o,

fk (p, r, y, s, c, i, ....,m ) = ,where

p = index of prices in the industrial circulation;

r = rate of interest (i.e. an index of the general level of rates);

y = national money income;

s = saving in the time interval At (or 'propensity to save');

c = consumption in the time interval A? (or 'propensity toconsume');

i=investment in the time interval At (or ' propensity to invest');etc.

The quantity of money (m) may be regarded as a parameter.The system may be defined as ' in equilibrium during the time in-terval At' when the variables remain constant throughout thatperiod.

These k equations determine the variables if the parameters aregiven. It is, however, more realistic to regard the equations asrepresenting tendencies or 'tensions' in the economy. If one ofthe variables is pulled out of the equilibrium position the tensionswill work to restore the situation. If this process of adjustmentinvolves a time lag an oscillation is likely to be initiated round thevariables in the system, which may or may not eventually subside

ECONOMIC AND STOCK MARKET TRENDS 7in the equilibrium position, or remain in a cyclic condition. Inpractice this situation would probably alter the parameters.

The equilibrium position will in general not maximize, forexample, (i) or alternatively (y), as indicated in the discussion onpp. 5-6. The condition = o will limit the form of the/ ' s whose solutions in terms of (P, r, y, s, c, i, etc.) determine theseoptimum values of the variables.

In the long run, of course, the f's will change owing to theaccumulation of capital goods in the economy if (i) exceeds theminimum value (io) required for depreciation. For instance, if

(a, b = positive constants) owing to theacceleration effect. If apparent long-run equilibrium is to beattained, there must be equality between:

(i)

(ii)

(iii)

(iv)

Leakages (/ to F flow) and the F to I flow for investmentpurposes. This is equivalent to s = i (p. 5).Demand and supply of the securities traded within F (in-cluding money) at the going values of (p, r, y, s, c, i, etc).The quantity of capital equipment (e) and the amount re-quired for depreciation on equipment supplying the equili-brium value of (c).(i) and depreciation on (e).

Even this position seems inherently unstable. For leakagecauses a continual flow of money to F, all or part of which (accord-ing as the quantity of money is constant or increasing) must beexchanged for securities, the volume of which increases, if themoney is to be re-activated and so permit the maintenance of theinvestment F to / counter-flow. Thus, either (y) must be graduallyraised in order to provide interest and amortization for theseadditional securities, or wages will obtain a lower share of thenational product. Additionally, the accumulation of securities maybe expected to cause the rate of interest to fall in the long run.

Thus there may be no such thing as true long-run equilibriumunder capitalism. However, the conditions for short-run equili-brium are of more practical value. The following set of equations,which are a modification of those of F. Modigliani (Econometrica,

set out certain reasonable assumptions as to12, 1944, pp. 45-88),

8i = o or 8y

i=io + a, then c = co + bt

8 P. T. JENKINS

the interdependence of the variables defined on p. 6, expressedin real terms by the introduction of the price index (p). While itis not, of course, claimed that this system is comprehensive, it isa useful 'first approximation' to economic 'statics'. From thiswe can approach the more realistic ' dynamic' theory with a clearerunderstanding:

m/p = L(r,y/p) (m considered a parameter),s/P = S(r,y/p),clp = C(r,y/p),i/P = I'(r,clp) = I(r,ylp),s/p = i/p (if there is to be equilibrium in the

period considered).

(I)

(2)

(3)(4)

(5)

c/p

r2 < r\ < r0

y/p

Fig. 2

Usually, c\y will be a fairly constant proportion, but it isunlikely to be a decreasing function of (r) (e.g. consider the situa-tion at the extremes of slump or boom) (Fig. 2).

L is the 'liquidity function', i.e. the total demand for money(expressed in units of real value in I) in F and I: this division re-flects the two uses of money, i.e. as a store of value and a mediumof exchange. If real income (production) rises, more money willbe needed, at a given price level, for transactions in I, so that thesupply of money in F will tend to fall; causing (r) to rise, and vice

ECONOMIC AND STOCK MARKET TRENDS 9versa. If for some reason (r) rises initially, then the demand formoney to hold falls and people prefer to hold securities, thus re-leasing money for I, so that a higher real income can be sustained;but if real income is fixed, prices rise; and conversely. If prices riseinitially, then more money is required in I for a given real income,so that (r) rises; and vice versa. It follows that (r) is an increasingfunction of (y/p), if (p) is assumed constant, and that there is a

r(m/p)1<(m/p)0

(is) (/m)i (|m)o

ilp-slp mlp=L{r.ylp)

r2

0 YlP

Fig. 3

family of '(lm)' curves of equation (I), one for each value of (m/p)(shown in Fig. 3). Furthermore, (r) cannot fall below a minimumvalue r2 > o (the reason for the subscript will emerge later) since forr = r2 the disadvantages of holding money stocks in lieu of moneycease to be outweighed by the yield on the former. This clearly hasnothing to do with price levels in I or the quantity of money, sothat the (lm) curves have a common 'floor' at which the demandfor money to hoard becomes 'perfectly elastic' with regard to (r).Fig. 3 also illustrates the '(i's)' curve referred to by Cottrell{.S.S. I4, 235) which expresses the equilibrium condition

S(r,ylp) = I(r,ylp).

Savings and investment have here been expressed in real terms,by introducing the price index (p). The point ( , ŕ,y/p) which is the

IO P. T. JENKINS

solution of equations (I) and (2) is the equilibrium value of thevariables. It is not fully determinate, since it is a function of (p).This factor does not affect the (is) curves since the rate of interestat which savings equals investment may be reasonably assumedto depend only on real income, and not on the price level.

The (is) curve has a negative slope since, sooner or later, a risingincome must cause the propensity to save to rise more than thedesire to invest at the ruling rate of interest, and conversely, if theeconomy is to achieve stability. The (is) curve need not, in fact,have a negative slope throughout its entire length, but it simplifiesmatters to draw it so.

In order to determine the economy we must also have equa-tions for real output (x), employment (n) and the index of wagerates (w).

Thus x=yjp,

x = X(n),

wjp=W(dxldn).

(6)

(7)

(8)

Equation (7) expresses the relation between production and thelabour force, and depends on the capital equipment available,while equation (8) expresses the fact that employment will extenduntil the real wage equals the marginal utility of labour. The natureof W will depend on how much of dx/dn is required by capitalistsfor profit; W will vary inversely with the profit margin demanded.There are now eight equations and nine unknowns (p, r, y, s, c, i,x, n, w).

Case I. The ninth equation depends on the nature of the relationbetween the labour supply and the wage rate. If wages are flexible,we can write

n = N(w/p), (9a)

where N is a continuous function, and in general monotonicallyincreasing.

The three equations (7) to (9a) contain three unknowns (x), (n)and (w/p), so that output, employment and real wages are independentof money and interest in this case.

ECONOMIC AND STOCK MARKET TRENDS I I

The five equations (2) to (6) similarly determine (s/p), (r), (y/p),(c/p) and {Up), and equation (I) determines the price level (p), andhence (y, s, c, i, w).

Thus the rate of interest, real income, investment and saving donot depend on the quantity of money, which only determines the pricelevel.

Furthermore, there will be no involuntary unemployment unlessthe 'full employment' (in the sense that all wanting work areemployed) rate of interest r < r2.

Case 2. Suppose now that r = r2 ; in this case (2) to (5) fullydetermine (s/p, y/p, c/p, i/p), and (I) determines (p). Then (x) and(n) are determined from (6) and (7) respectively, and (w/p) from(8). The value of (n) corresponding to (w/p) in the supply oflabour equation (9a) will exceed the value obtained from (7)—i.e.there will be involuntary unemployment. Any attempt to lower realwages merely causes an I to F flow, and does not raise (y/p) or (n).Again, (r) and (n) are independent of (m), which only determines (p).This situation was analysed by Keynes. I t was described on p. 5above, and might be caused either by depression, or by a glut ofinvestment in a highly developed and prosperous country.

Case 3. Now suppose we reach 'absolutely full' employment,i.e. there are no further workers available at any real wage. Then

replaces equation (9 a). Equations (6) and (7) now determine(x) = (y/p) and (2) to (5) determine (r), (s/p), (c/p) and (i/p), while(I) determines (p) and (8) determines (w/p).

Again (r), (n) and the other 'real' variables are independent of(m),which only determines p.

Case 4. Now consider the consequence of money wage ratefixing by 'non-market' forces, e.g. trade unions. This consists ofreplacing (9a) by

wlp = w4|p (9c)Now I to (8) and (9 c) are nine equations in the nine variables(p, r, ylp, s|p, c/p, i/p x, n and w/p ). There are no 'short circuits' inthe set of equations and all the variables depend jointly on (m) and(w4), and the last eight simply on (w4/m).

n = n3 (9b)

w/p = w4/p. (9c)

12 P. T. JENKINS

Now compare Case 4 with Case I.. With flexible wages, thedemand and supply schedules for labour are in balance, i.e. theequations (8) w\p=W{dx\dn) and (9 a) n = N(w/p) are compatible.With fixed wages, therefore, we can strictly only use (8) if realwages (w4/pi)>(w1/p1); if (w4/p4)<(w1/p1) we should use (9a) inplace of (8) in the ' Case 4' set of equations. Otherwise, we assumethat the supply of labour is perfectly elastic at the (w4) money wagelevel, up to the point of absolutely full employment.

In the more familiar case where w4/p4/>w1/p1 it is clear that,in general, there will be involuntary unemployment if w4 /p4 >w1/p1

until increasing investment raises the demand for labour to the' Case I' level; i.e. until

or until, as a result of an expansion in the money supply (m), anda consequent rise in prices, w/p < w1 /p1 ; or until increasing in-vestment brings about the absolute full employment stage, whichcorresponds to

Any further rise in (w) is merely inflationary, and cannot infact take place without causing unemployment, unless employersaccept lower profit margins (p. I0) or there is a corresponding risein the quantity of money (m) which raises (p) in proportion andleaves real wages unchanged.

It is now proposed to discuss the results of certain furtherchanges in the equilibrium positions defined by Cases I and 4. Therelative equations may first be simplified as follows:

Case I

fixing x and n.

; fixing r.

; fixing p).; fixing w.

(I b)

(I C)

(I d)

(I e)

(I a)

ECONOMIC AND STOCK MARKET TRENDS 13

Case 4

(4a)

(4b)(40(4 d)

fixing r, x; and n.

; fixing p.

Case I. A fall in the marginal efficiency of investment or a risein the propensity to save causes a reduction in (r); (x), (n) and(w/p) being unchanged. Hence the new (is) curve is below the oldone. Since (r) is lower there is a greater demand for money tohoard in F, so that money income in I is reduced. Because realincome is unchanged, prices must be lower, so that the real valueof the money supply, (m/p), is raised. Thus it needs a lower rate ofinterest to maintain liquidity preference at the former level forany given value of real income. This means that the new (Im) curvemust also be drawn below the original one (Fig. 4).

Case 4. Now suppose wages are not free to fall. The positionof the new (Im) curve may not be much changed, as, although therewill be a downward shift in real income in comparison with theCase I position, there is also a lower value of (m/p), since pricescannot fall so much in view of the rigidity of wages. In otherwords, the ratio (y/m) may well be about the same in Case 4 as inCase I for all values of (r). However, the (is) curve is likely to belower in Case 4 than in Case I since the marginal efficiency ofinvestment falls even more, in consequence of the real wage raterising, instead of remaining steady as in Case I.. Thus, the newCase 4 position stabilizes with lower real income, employment andinterest rates. If the (Im) curve shifts upwards however, the in-terest rate could conceivably be the same or even higher than inCase I.

If, starting from the Case I position, wage rates are forced up byunion action, the tendency is to raise real wage rates, reduce realincome and employment, and, probably, reduce interest rates;unless the former level of real wages is restored by an inflationaryexpansion in the money supply.

I4 P. T. JENKINS

To summarize: in Case I (r) depends on the relative propensitiesto save (—) and invest (+) (the algebraic signs are those of thepartial derivatives of (r) in respect of the items in question) andon real income (x) (+) . This last ambiguity arises from the in-determinacy of the shape of the (is) curve (p. I0). In Case 4 (r),(x) and (n) are determined jointly by (s) ( - ) and (i) ( + ) ; by (m/w)

r

ro

Case 1, r1

Case 4, r1,

Case 1 (is)1

(is)o (Mo

(lM)1

Case 4 (is),

•x=y/px1 x1= x0

Case 4 Case 1Fig. 4

(probably +) ; by the shape of the liquidity preference curves(which depends on the relative demand for idle and active money);and by W and X. In either case the price level in the industrialcirculation depends on the ratio of the quantity of money to liquiditypreference. It will be seen that the (is)-(lm) diagram has no uniquesignificance in the determination of (r) and (x), but it is none the lessuseful for illustrative purposes.

Now consider the financial circulation. The prices of the fixedinterest securities traded therein vary primarily with the reciprocalof the rate of interest. Suppose the expected marginal efficiency of

ECONOMIC AND STOCK MARKET TRENDS 15

investment in I exceeds the going rate of interest. The consequentF to I money flow must result in a lower cash holding in F, andpart of the outflow will as a rule be financed against the creation ofadditional securities, which help to reduce the demand for moneyin F. Bank loans against sales of securities will transfer money tothose who wish to invest in I from those who do not. Finally,the price of securities will have fallen sufficiently to equate themarginal efficiency of investment in F and I once more.

This ignores any possible expansion of the money supply.Additional money is usually created by the Bank at, eventually, therate of about I2 times the value of securities removed from F inlieu. Thus a prolonged F to I flow usually entails an expansion ofthe money supply relative to the quantity of securities. This hasan effect on liquidity preference, since some securities are nearlymoney and form a ' store of value' together with money.

For example, suppose m= I00 and of this 90 is in I and I0 in F;and that securities = I00 in value. Now suppose that throughmoney expansion (m) becomes 200. Prices in I will double (withflexible wages) if liquidity preference remains unchanged and (r)and (x) remain the same. However, instead of a ratio of I0:I00 inthe cash: securities value store there will be a 20:I00 ratio, worthonly I0:50 in former real value. This will enhance the relativedemand for (income-bearing) securities, and cause a drop in the(Im) curve. Similarly, since the total 'value store' in F is nowworth only 60, instead of n o per I00 of 'real money' in I, the(is) curve will fall also. This will result in a reduction in the equili-brium value of (r).

This addition to the Modigliani theory shows that it is possibleto affect interest rates by a finite variation in the quantity of money,even if wages are not rigid. Another way would simply be for theBank to support the security market by a constant expansion of(m), leading eventually to runaway inflation, it being borne in mindthat there is a time lag before the extra money so created can drainawav into I.

Another amendment to Modigliani's exposition is in respect ofthe function W(dxldn), which Modigliani merely wrote as dx/dn.The point of the alteration is that business men often vary their

I6 P. T. JENKINS

profit margins and will, up to a point, sacrifice margins rather thanthrow their employees out of work as would otherwise be necessaryfollowing a fall in the marginal productivity of labour under asystem of rigid wages. This process must, however, eventually finda limit.

Next in this discussion of interest, the conditions controlling thesupply of money to F must be considered. The author pretends tono intimate knowledge of the techniques employed by the Trea-sury, using the Bank and the public departments as agents, butventures to suggest that there are three basic 'ploys' in monetarymanagement:

(i) Change in Bank rate. If Bank rate rises, the money marketcan be forced to lower its tender for bills by being driven toborrow from the Bank at the higher rate. This will lead to ageneral rise in rates, particularly at the 'short' end of theinterest 'spectrum', and cause an I to F money flow assavings increase at the expense of investment. The rise in(r) will also cause a flow within F from money into securities.Thus money will flow into the money market from twosources, so that it can be mopped up into the Bank with aconsequent reduction of (m).

(ii) Open market operation, whereby money is exchanged forgilts of varying date, with a direct influence on the volumeof money and prices in the gilt-edged market.

(iii) Funding operation, whereby money is extracted from thepublic in exchange for medium-long gilts, and either spenton public works (this is straightforward 'investment') orused to reduce the floating debt, i.e. reducing (m). Theconverse 'unfunding' operation may also be practised.

It is clear that the authorities are able to determine the shape ofthe interest rate spectrum, but that overall they must balance the'stability' level of interest determined as in the preceding dis-cussion if they wish to keep the volume of money constant. Itmay be concluded that the Bank may, at will, exact a rise in in-terest rates before parting with additional money, provided thatdemand is strong enough; and that if interest rates are kept high

ECONOMIC AND STOCK MARKET TRENDS I 7

enough, money will return to the Bank. Thus we may write the supply

There is also the relationship between short and long rates to beconsidered. The shape of the spectrum largely depends on theinstitutional set-up. If official action is directed mainly towardsinfluencing short rates, long rates will generally exhibit greaterinertia than the former owing to 'speculation' by institutions andothers. This tends to lead to an increasing progression of yieldswith term when short rates are low and to a 'humped' progressionwhen they are high (since, to make a sweeping generalization, thebanks want shorts and the life offices and pension funds want longs,and only the general public wants mediums). In recent years theauthorities have exercised a selective control on credit, ensuring thatenough is available for essential development schemes by thenationalized industries, etc. They have also exercised a directcontrol on market financing through the Capital Issues Committee.Had they not wished to discriminate they could simply have reducedthe supply of money. If a more drastic monetary policy had beenadopted prior to October 1957 to reduce (m) by open market orfunding operations it would presumably have had a relativelygreater effect in raising long rates of interest. The tougher policyadopted at that time did in fact tend to 'iron out the hump'.

Another factor to be considered is the velocity of circulation.The operative equation is mI.vI=p.x, where (wij) is the quantityof money required for transactions and (vz) is the velocity ofcirculation in / . Since an increase in velocity is equivalent to anincrease in the quantity of money, an increase in prices can result;and vice versa. This means in practice that prices in / becomerelatively insensitive to variations in credit.

2 ASS I5

m/p = M(r,ylp). (I 0)function of money as

The shape of M depends on the monetary policy of the authori-ties. It adds an additional equation to our system, in which (m)may now be regarded as a variable rather than a parameter. Thisextension does not, of course, affect the conclusions reachedhitherto, or affect the determinateness of the equations. Theeconomy may accordingly be regarded as a tug of war for moneybetween I, F and B, with the rate of interest as regulator.

I8 P. T. JENKINS

Returning to the basic equations, it appears that they are notaffected in outward appearance by variations in velocity, sincevelocity is only one of the factors influencing the price index (p),which is a variable of the system. To take equation (2) as an ex-ample ; as has already been pointed out, it is a reasonable assumptionthat real savings depend only on interest rates and real income, andthat variations in prices, whether caused by changes in the amountor the velocity of the money in I, are immaterial.

However, in equation (I) there is a possible change in the shapeof the liquidity curves. For example, if real income rises, anincrease in velocity will offset the need for a greater volume ofmoney in I, so that either (r) will rise less than, or prices will notfall as much as, would be the case if velocity remained constant.Variations in velocity also occur in F. This may go some way toaccount for the close correlation between markings and prices inthe equity market.

Although the equations introduced in the foregoing discussionare formally concerned with static theory, they are not on thataccount inapplicable to the world of practical economics. In thefirst place there have been in the U.K. since the war periods ofseveral months at a time when interest rates and prices have beensteady, when it may reasonably be assumed that the economy hadreached a position closely approximating the equilibrium positionto which the equations are relevant. Secondly, their extension to adynamic scheme can be effected by replacing equation (5) by anequation of the type s/p — i/p =f(r, y/p). The system of equationscan now be regarded as a 'snapshot' of the economy at time (t),it being borne in mind that expectations of future changes in thevariables introduce a greater degree of interdependence betweenthem; e.g. savings will depend in part on expectations regardingprices, so that we should rewrite equation (2) as s/p = S[r,ylp,exp. (p)], and so on. A consideration of the static equations hasalready permitted some glimpses to be made of the operation ofcause and effect in the more general system: e.g. we have shownthat interest rates are likelv to rise if s< i.

It is also possible to use them to give a partial explanation(foreign influences being the most important omission) of two of

ECONOMIC AND STOCK MARKET TRENDS I 9

the more obvious trends in the U.K. economy in recent years,i.e. towards higher prices and interest rates. It is suggested thatthe typical series of reactions has been as follows:

(i) Increase in real income (x) as a result of past investment,or current excess of investment over savings; in the lattercase raising (r).

(ii) Consequent tendency of prices in I to fall frustrated by therigidity, indeed the constant increase, in wage rates;although prices need not be expected to rise as much aswage rates.

(iii) Hence there has been a drag on money to pass from F intoI in order to finance the greater money income needed ifunemployment is not to result from (i) and (ii); requiring agreater total quantity of money (m) in order to preservethe ratio (m/w) in equation (4 a) at the full employment'Case I' value; except in so far as compensated by anincrease in velocity or by an increase in W(dxldn), i.e.by a fall in acceptable profit margins.

(iv) Since prices have had to remain steady or rise, either (r)or (m), or both, have had to rise as a result of the increasein (x) (equation 4d).

(v) Notwithstanding that an increase in (m) would neutralizethe necessity for a rise in (r) in order to reduce the demandfor money in F and so raise supplies in I, it may neverthe-less be enforced by the supply of money function M(r, x),depending on the Bank's credit policy.

Appendix I gives figures in respect of I952-57 which supportthis interpretation. The yield on 31/2 % War Loan has been chosenas the index of (r), while the yield on 'shorts' is a convenient indexof credit stringency. It will be noticed that, when L was rising inI952-54 as a result of rapid monetary expansion, (r1) was fallingand (r2) was low; that as L fell sharply to July I956 with a reducedmoney supply, (r1) rose rapidly; that as L rose in January I957,(r1) fell; and that as it fell to a new low point in July I957, (r1) roseto a new high. If we accept px/m as an index of velocity in I (thecorrect expression being pxlmI) it is evident that vI has been

2 - 2

2 0 P. T. JENKINS

increasing rapidly throughout the period observed. It is alsonoticeable that (n) virtually stopped rising when (m/w) startedfalling; this reflected an unusual degree of unemployment, e.g. inthe motor industry.

PART 2. SURVEY OF VARIATIONS AND FACTORSAFFECTING THEM

Price charts (i)

This subject provides a convenient peg on which to hang thevarious topics to be discussed in this section, and will be dealtwith further in Part 3.

As may be seen from the chart of the Ordinary share indexgiven in Appendix II, there is very little regularity in the pattern.However, within the period for which the chart is shown it ispossible to distinguish two main amplitudes of movement, ex-emplified by those occurring during the periods

(i) July I955-November I956.(ii) October-December I955.

In addition, there are longer-term movements and also day-to-day fluctuations which do not appear clearly on the chart. In the

1805-10 1870-75 1920

It is impossible to say definitely what these' 50-year' waves weredue to, or whether they are still operative.

In investment work it is the intermediate movements corre-

Highs

Lows I785-90 I845-50 I895-1900

prewar period there were 'trade cycles' commonly of 7-10 yearsduration, and it would be premature to state definitely that thesehave been 'managed away'. Finally, there is the fundamentalupward trend in equities consequent on the depreciation of thecurrency and the expansion of the economy, which at companylevel means the increase in fixed assets. Even this very long termtrend has been reversed for periods of 25 years or so in the lastcentury, with interest rates, wages, commodity prices, production,etc. (after trade cycle variations have been smoothed away) all show-ing movements whose extremes fall in about the following years:

ECONOMIC AND STOCK MARKET TRENDS 2I

sponding to the prewar trade cycles, and since I945 what havebeen the I to 3-year 'foreign trade and political' cycles in the U.K.,that are of the most immediate interest, and these are usuallyreferred to in chartist literature as 'primary' trends. The shortermovements may be termed 'secondary', while anything longermay be regarded as a 'long-term trend'. This conveniently re-duces the number of types of movement to be studied to three.Movement (i) mentioned above was a downward primary trend,while (ii) was a typical secondary reaction.

There are some operators who apparently claim to be able toforecast the future trend of the share index from a scrutiny of the chartin conjunction with the index of gilt-edged prices and the numberof daily markings. It is more usual, however, for the charts to bestudied in relation to the various economic and political factors con-sidered likely to be influencing the market. It is hardly arguablethat, should a potent new factor arise suddenly (e.g. the Suez Crisis)the share index would be affected materially, and quite possiblyfalsify a judgment made previously.

Thus it seems clear that while charts may, and in fact do, tell usa good deal about the present anticipations of investors and thetechnical state of the market, they do not directly forecast themarket—this is a matter of inference and judgment from a largenumber of factors, of which the present state of the market is onlyone, and indeed a derivative item.

For this reason it is proposed to deal first with the 'external'influences on markets before passing to a consideration of the' internal' evidence. Since there is such a wide field it is proposedto divide it, perhaps a little arbitrarily, into factors tending toproduce each of the three types of movement mentioned above.

Long-term trends

There are a number of features which have become generallyaccepted as representing long-term trends in the investment scene.It is necessary always to bear in mind and continually justify thepremises underlying these assumptions and the case for investmentbased on them. In many instances, the investor can depend on thefact that the trend is unlikely to be disproved for a considerable

22 P. T. JENKINS

period of time—long enough, in fact, for him to have realized anyinvestment that he has bought on the strength of the assumption.In such a case it is of little importance to him if the assumed trendshould ultimately prove fallacious. Even so, it is unwise to relyexclusively on such long-term trends in selecting investments,since the short-term tendencies mav be at variance.

In the share chart, the principal long-term trend in the U.K.market is, of course, upwards, due largely to inflation. It is notdifficult to see why inflation occurs. In times of boom, credit,money and wages increase until checked, but in the ensuing slumpmoney is not drawn back into the Bank to the same extent, sincerigid wages compel easy money in order to reduce unemployment.Furthermore, inflation is a long-term medicine against depressionsince it keeps capital hoarding to a minimum.

A distinction must be drawn between an 'inflationary (or de-flationary) situation' and inflation (or deflation). The first is adynamic condition indicating that economic forces are out of lineand that pressure towards higher (or lower) prices is building up.The second is simply the static end product, so that, for example,inflation may be regarded as a cure for an inflationary situation.

Inflation is not always a boon to equities, as is sometimessuggested. Even if an inflationary boom does not collapse through'real' stresses (e.g. investment outrunning consumption) it will,sooner or later, be incumbent on the monetary authorities to restrictcredit and check the increase in money supply; otherwise, there isa danger that a runaway inflation will develop and destroy theeconomy. The resulting combination of high costs and tight moneymeans lower profits.

Inflation has proceeded at a rapid pace in the twentieth century,and received special impetus in the two world wars. Indeed, theunprecedented fall in prices over the nineteenth century was pre-sumably due to the vast expansion in production which tookplace at a time of limited gold supply. It is conceivable that'automation' may eventually have a similar effect.

A contributory cause of the long-term rise in equity values is theincrease in capital investment from company savings, which, inso far as the emerging benefit is not wholly absorbed by wages,

ECONOMIC AND STOCK MARKET TRENDS 23

tends to raise the real worth of the equity, provided that the law ofdiminishing returns does not gain too great a hold on the privatesector of the economy.

It may fairly be said that the most persistent feature in the U.K.economy since I946, apart from inflation, is the need for a highrate of capital investment in order to improve the productivity ofindustry and so raise the 'conversion factor' by which we live.This renders it a reasonable assumption that, subject to periodicalchecks when inflation or the balance of payments gets out of hand,Government policy will be directed towards the encouragement ofcapital spending by industry and the public boards.

Interest {long-term trends)

Some of the factors influencing interest rates have been dealtwith in Part 1. It is also clear that, within the body of securities,the relative volume of gilts and equities will affect interest rates.Thus, the nationalization schemes of the early post-war years werea 'long-term' influence of this kind. The aftermath of a great war,or an 'industrial revolution', will be likely to exert a relativelystrong demand for capital and so lead to relatively high rates ofinterest. These factors are 'long term' in the sense that they existindependently of the trade cycle.

The high tax rates associated with the Welfare State also tendtowards high interest rates, since interest payments can often beset off against tax. There is, however, a more subtle connexion. Ifresources are strained, the authorities can in theory raise additionalsavings by budgeting for a higher surplus, but if taxes are near theireffective limit, as to-day, this may be impracticable; the attempt toincrease the budget surplus materially would probably be offset bydissaving in the private sector. The promotion of a satisfactorylevel of overall savings in present circumstances would appear torequire relatively high interest rates. Since the authorities found it(in I957) inexpedient to 'destroy government credit' further byfunding, and it was considered imperative to keep short-term(inflationary) financing to a minimum, they were forced to reducepublic expenditure drastically in a number of directions previouslyconsidered inviolate.

24 P. T. JENKINS

Three other examples of long-term trends which seem of im-portance may be quoted:

(i) The economic expansion of the principal countries of the world.The beneficial effects of this trend on the corresponding equitymarkets has been mentioned when discussing the U.K. NorthAmerica, and particularly Canada, has been the most favouredoverseas home for U.K. funds owing to the rapid development ofthat area, coupled with its attractive political climate. The lowyield basis of Canadian shares is, however, largely due to the heavyinflow of American capital, which has permitted the dominion torun a large deficit on its foreign trade. It is therefore necessary tobear in mind (a) the possible emergence of economic nationalism,(b) the extent to which physical limitations may restrict the rate ofgrowth, (c) weakness on Wall Street, and (d) restrictions on U.K.investment. This paragraph was written some time before thesharp fall in the Canadian market which occurred in the summer

of I957.(ii) The constant increase in world energy requirements, with its

implications for the oil, atomic power construction and uraniummining industries. The case for investment depends on the viewtaken of the following points, among others:

(a) Whether the rate of increase in production will be matchedby profits (profit margins).

(b) Whether share prices are likely to be maintained or rise(yields, absolute and relative).

(c) Whether the investment is of the type required (expectedreturn, degree of risk, etc.).

(iii) The long-term expansion in demand for the principal basemetals (e.g. copper, lead-zinc, aluminium and nickel). These are thetypes of long-term trend which are unlikely to be disputed for atleast a decade. The Paley Report, published several years ago,forecast a substantial increase in world demand for base metalsduring the next 25 years. It could conceivably happen that owingto a thermo-nuclear war the consumption of raw materials mightfall away to a very low figure. The fact remains that investors willaccept relatively low yields on aluminium shares, for example,

ECONOMIC AND STOCK MARKET TRENDS 25

in the belief that the industry has an expanding future. It is amatter of judgment whether the discounting of expectations isexcessive.

It does not, of course, follow that just because demand fora commodity is increasing the price will increase—perhapssupplies will increase still more quickly. In the case of mostcommodities there is a continual race between demand and supply,with one or the other factor being temporarily in the ascendant—fluctuations which are superimposed on those resulting from thetrade cycle. Since reserves of any raw material are limited, andbearing in mind the trend to inflation, it is reasonable to hold theview in connexion with most of the strategic metals that over along period prices, or at least company income, is likely to riseabove the present level. The rate of discovery and exploitation offresh deposits is largely dependent on demand.

The moral of the last few paragraphs is that arguments on thelines that 'such-and-such investment must be right in the longrun' should be weighed very carefully. Should there be a markedreaction the private investor, at least, will often get tired of waiting,or, in market parlance, become a 'stale bull', and be glad to cut aloss and put his capital to more profitable use.

Primary movements and secondary reactions

These two types of movement will be considered together, sincethe same factors may cause either of them indiscriminately.

Interest rates tend to rise in a boom, owing to the increasingpropensity to invest, and to fall in the ensuing recession. Theseinterest movements will normally tend to antedate the corre-sponding reaction in economic activity, being a business regulator,activated normally, but not necessarily, by official action.

It is accepted by, at least, the present Government of the U.S.A.,that the best way to regulate the cycle is to curtail the boom, ratherthan to wait until the trough occurs and then to try and fill it up,on the principle that (a) ' it is easier to stop a horse" drinking toomuch than to make him drink', and that (b) attempts at reflationmay impede reduction of the excessive industrial costs which wereprobably the primary cause of the recession—short, that is, of a

26 P. T. JENKINS

general acceptance of currency depreciation, perhaps requiring adevaluation vis-a-vis competing foreign currencies.

In the U.K. the situation is bedevilled by our dependence onforeign trade and low currency reserves—compared with I938 weare conducting a far larger foreign trade with lower gold reserves,while in terms of purchasing power of U.S. commodities thecomparison is even less favourable—to say nothing of the increasein short-term sterling liabilities.

Thus in the U.K. the heart of the problem is the overridingneed to protect, and if possible to improve, the gold and dollarreserves, and, above all, to prevent the ever-present tendency to-wards inflation, arising from the desire for a high rate of invest-ment, armament and social services, coupled with aggressivewage claims, from getting out of hand. The last-mentioned featureis both a consequence and a cause of inflation, the vital statistic inthis connexion being the wage per unit of production, and asregards the balance of payments this should be compared with thesimilar index for our chief competitors, particularly the U.S.,Germany, Italy and Japan. It is noteworthy that, whereas theindex in question has increased by about 5 % a year in the U.K.,it has remained fairly steady in the United States and actuallyfallen in Germany during the post-war years.

There are thus three basic ' self-induced' dangers to which theU.K. is exposed, together with at least three ' external' dangers:

Self-induced(a) Slump arising from loss of internal purchasing power.(b) Balance of payments crisis arising from too high export

prices (e.g. through cost inflation).(c) Balance of payments crisis arising from excess internal claims

on production.

External(d) Deterioration in the terms of trade.(e) Non-availability of essential raw materials or fuel.(/) Excessive capital outflows.The interest weapon would legitimately be used to combat (a),

(b), (c) and (f) and, in so far as high interest rates are deemed help-

ECONOMIC AND STOCK MARKET TRENDS 2 7

ful to this end, they will probably tend to remain high, notwith-standing the additional cost of servicing the national debt. Apossible alternative line of action as regards (b), (c) and (f) re-spectively would be to introduce or strengthen import quotas ortariffs, export credits and exchange controls, except in so far as theseare not inhibited by foreign trade agreement or policy. Conversely,lower interest rates would normally follow (or anticipate!) a slumpor an improving balance of payments.

Since the U.K. lives largely by converting imports of rawmaterial into finished goods for export, an improving balance ofpayments depends partly on the sheer size of its foreign trade.If this is increased through expanding production, the imports willrise before the resulting (it is hoped) exports, thus temporarilyworsening the balance of payments. This healthy sign is not easilydistinguished in its early stages from (c)—it may even cause anunacceptable strain on sterling, e.g. through foreign fears causinga capital outflow. This is a consequence of the extremely low levelof the reserves.

Capital outflows are typically due to:

(i) deliberate net investment by the U.K. abroad.(ii) drawings on sterling balances by countries such as India

for development purposes.(iii) foreign speculation in sterling and sterling securities, in-

cluding the 'leads and lags' technique.

When foreign money flows into the U.K. as a result of an exportsurplus or a capital movement, the banks acquiring the currencymust replenish their sterling balances given in lieu by selling itto the Bank. The Bank must therefore create new money as a'counterpart' to the currency, which will, in the ordinary way,be an inflationary and interest-depressing influence. Similarly,an export deficit or capital outflow has a deflationary and interest-raising tendency. The effect of an inflow, for example, could, ofcourse, be neutralized by 'freezing' the additional balances issuedto the banking system, or by other more orthodox measures.

Under the old gold standard system, where changes in exchangerates were not contemplated, this movement in interest rates was

28 P. T. JENKINS

sufficient to restore equilibrium, but in view of the possibility ofexchange variations, high interest rates have, not unnaturally,proved of relatively little use in attracting capital to the U.K. inorder to combat speculative outflows, although the situation wouldbe far worse without high rates in view of their effect in keepinginternal prices to a minimum. Probably the most effective weaponin checking speculation against sterling would be a floating ex-change rate, which would permit speculators to make appreciablelosses on their transactions. It will, moreover, be realized that,once a devaluation has been made, there is scope for a lower rateof interest, in that export prices are once again competitive andthere is a less pressing need for internal deflation. This might alsobe the case with a floating rate, even if, in the event, the exchangerate were unaffected.

There is, of course, some scope for differences of view within agiven economic situation, and the apparent trend of official opinionmust be watched closely. However, the real situation is naturallyof even greater importance, and the main determining factor iswhether the economy is tending towards an inflationary or de-flationary situation, or whether there is, on the other hand, reason-able balance. The all-too-familiar signs of the former are labourshortages and constant wage claims, pressure on materials andrising prices. Our troubles since I955 have stemmed from causes(c), (e) and (f), in that order, with the threat of (b) lurking in thebackground (referring to p. 26).

Subsidiary and, usually, short-lived influences in determininginterest rates are 'independent' events such as strikes, politicalcrises and technical factors such as the date of the falling-in ofshorts and the incidence (not the volume, which is of more funda-mental importance) of new money which may be wanted for suchpurposes as development schemes by the various nationalizedbodies.

Fiscal policy

Besides monetary policy, the other main instrument of economiccontrol is, of course, fiscal policy, with which may be includedhire-purchase regulation. It may be judged that the two main linesof policy may receive different emphasis according to which

ECONOMIC AND STOCK MARKET TRENDS 2 9

political party is in power. In theory, it is possible to relieve in-flation by surplus budgeting, but, since the U.K. can hardly betaxed further without damage to the mainspring of economicaction—i.e. incentive—the only apparent scope for further progressin this direction is to cut Government expenditure. Another wayof relieving the strain on the Budget is by eliminating some of itsbelow-the-line responsibilities. Thus, in the I956 Budget local loanswere thrown on the market—this made no change in the strain onresources except to the extent that by charging realistic interestrates the demand for finance was reduced.

The Budget may, of itself, be considered inflationary if it hasan overall deficit above and below the line, except in so far as it issuccessful in attracting additional savings to cover the deficit.To go further, what is needed is a financial policy which will inducesufficient total savings to cover public and private investment, andthe export surplus, or surplus on current account, at presentprices. The current surplus should at least be sufficient to meetnet capital outflows, represented by net long-term investmentabroad and outward movements of speculative capital—any de-ficiency being a charge on the gold and currency reserves.

As Budget time approaches the likely changes in taxation mustbe considered. Apart from the points mentioned under ' InterestRates', some play may be made with the progress of income andoutgo compared with the estimates made in the last Budget,bearing in mind seasonal influences such as the late inflow ofrevenue. This may be done simply by referring to the last year'sfigures and noting differences. An analysis along these lines shouldenable an estimate to be made of the Budget out-turn in advanceof the end of the fiscal year, while it may also be possible to makea rough estimate of the effect of changes in production, etc., on thefollowing year's Budget if rates of taxation remain unchanged. Itmay then be possible to form a view whether an extra surplus willbe needed, or vice versa, in the ensuing year. This is rather aspecialized line of research, and in practice commentary on Budgetprogress may be found in the financial press. It will usually bepossible, as the Budget draws near, to judge whether it will bedrawn on inflationary, neutral or deflationary lines, and to make

3° P. T. JENKINS

some intelligent guesses as to the probable changes in taxation.For example, it did not require any great prophetic vision to fore-cast that some stimulation to capital investment by industry wouldbe introduced in the I954 Budget, although the precise form taken—the so-called 'new investment allowances'—could hardly havebeen foreseen. Similarly, a concession to the shipping industryseemed a distinct possibility in the I957 Budget in view of theevident need to improve the competitive position of British

Industrial trendsshipping.

These will broadly tend to follow the course of the economy,although profit margins and share prices may diverge from economicactivity for the reasons already mentioned. Some industries act asbell-wethers for the market. Since the war these have been themachine tool, radio, car, store and hire-purchase industries. Thecapital goods industries have, on the whole, maintained a high levelof activity and long order books, particularly for export. The patternwas, of course, quite different between the wars, when the heavyindustries were die worst hit in bad times.

In some industries prosperity is seasonal; for example, trampshipping freight rates usually fall in the spring and rise in theautumn, mainly owing to the incidence of the transatlantic coaltrade. When the shipping share market has been inactive, prices donot tend to fluctuate in sympathy with seasonal changes in freightrates nearly as much as when a substantial contrary movement haspreviously taken place—a point of general application.

Superimposed on these cyclical swings in prosperity, someindustries will be gradually diminishing in importance and somewill be growing. Some sections of the textile industry would appearto fall in the former category, while the oil and atomic engineeringindustries have already been mentioned as examples of thelatter.

Movements in share prices will generally anticipate industrialtrends, but the market may be caught by surprise—witness thesudden fall in shipping shares in March I957. A method ofchoosing a 'growth' industry sometimes advocated is simply tolook at the yield structure of representative shares. The present

ECONOMIC AND STOCK MARKET TRENDS 3I

writer considers that this is to be deprecated. It is easy to be wiseafter the event, but it may not be very profitable, particularly if themarket happens to be wrong.

Politics

There are few investments which are not influenced in somemeasure by political factors. While politics may have a long-terminfluence on a market or share, it is suggested that the movementswhich result are usually of a cyclical, i.e. 'primary' or 'secondary'character. In the U.K. the most obvious example of a long-termpolitical influence is in the steel market.

Obviously, the accurate interpretation of political trends is justas important as, although usually more difficult than, the anticipa-tion of economic trends {vide Middle East oil shares). So far,holders of Far Eastern rubber and tea shares have been sparedany serious interference in their companies, but this happy stateof affairs could cease with very little warning. No doubt share-holders' morale is bolstered by the knowledge of the substantialliquid assets held by many of these companies.

Until a few years ago South African gold shares were a widelyacceptable element in private portfolios, but on the change ofGovernment in the Union U.K. demand was much reduced, whichinitiated a major fall in the market.

The United States elections periodically become a subject foranxious discussion both on Wall Street and in London. When theRepublicans came into power there was much talk that the marketwould fall owing to the dear money policy known to be favoured bythat Party. In fact, the market depression lasted for a few weeksonly, and was succeeded by an unprecedented boom. It is inter-esting to note that during the more recent U.S. elections it wasgenerally feared that Wall Street might fall if the Democrats werereturned to power. This is an example of the curious 'doublethink' which occasionally creeps into investment psychology, andin fact it is generally accepted amongst the more knowledgeablejudges that politics are likely to have very little long-term effect onWall Street, whatever the short-term results may be.

3 2 P. T. JENKINS

Technical market factors

These usually result in movements of secondary amplitudeonly.

(i) A great weight of new issues, particularly at a time of re-stricted credit, naturally tends to ease the market, if only by ab-sorbing institutional resources.

(ii) After a sharp market rise there will be a body of investorswho have made quick profits and, usually, a large speculativecommitment. Conversely, at a low point there may have beenpanic selling by investors who really wish to remain in the market,and a bear position. An 'over-bought' or 'over-sold' marketsituation may be liquidated gradually without disturbing thegeneral level, but may alternatively initiate or reinforce a contraryswing in the price level. Similarly, if a particularly good (or bad)company result has been generally anticipated, the shares oftenreact in the opposite manner to what might have been expected.

(iii) When the volume of dealings is relatively small, a situationusually associated with a temporary depression in markets, thejobbers will often mark prices down heavily in anticipation of smallsales or bear selling, and raise them again should 'cheap buyers'appear. Conversely, if the market has had a largely speculativerise, the jobbers will often take advantage of any trivial develop-ment which may temporarily restrain buyers to reduce pricessharply in order to scare speculators into selling them some cheapstock. In this way they gain more stock (of which they may wellbe short) by quoting lower prices than by maintaining them. Thisis known as 'banging the market'.

In the circumstances described, the prices of the leading stocksmay be quite artificial, and the market becomes largely a battle ofwits between professional speculators and the jobbers.

(iv) The end of a fortnightly (or three-weekly) account beforewhich speculative positions must be closed, contangoed or carriedforward, often causes a setback in the active stocks. At times ofhigh speculation, these facilities tend to become restricted, causingexceptionally wide swings in price. This may work in reverse atthe end of a dull account on bear closing, particularly if a 'bear

ECONOMIC AND STOCK MARKET TRENDS 33

squeeze' develops. The market, or more usually a particularmarket, may also rise at the end of an account on buying for ' newtime' if an improving trend is expected.

Speculation

This subject seems sufficiently important as a market influenceto merit a section to itself. Speculation may have several meanings;for example:

(i) Dealing with a view to reversing the transaction shortly(e.g. without having to pay for a purchase or deliver stockin the case of a sale).

(ii) Dealing in a stock concerning which the essential facts arenot yet all known, or which are unknowable.

(iii) Dealing in a stock which may be subject to wide fluctua-tions in price or yield.

(i) Speculative dealing may be based on special knowledge ofthe situation or simply on a market movement which has startedand which is expected to go further, or on expectations of atechnical rebound. The state of the market generally will affectthe issue—at the height of a bull market a whisper in favour of ashare will send it rocketing, while in a bear market the mostfavourable news will often fail to shift the price. The outcome willalso be affected by the market position being built up.

As an investment rises, it will be necessary to judge when tosell—this requires as much judgment as when to buy, and a usefulrule is to consider where the buyer of the shares is coming fromand to leave him something to go for. While market enthusiasmmay push the shares above the level which meets this requirementfor a while, it is unlikely to stay there for long.

(ii) In this case one man's speculation may be another man'sinvestment; thus the investor should at all times seek to broadenhis knowledge. On the other hand, a gold mine is necessarily aspeculation, in that no one can know what is below the grounduntil the first assays are confirmed or disproved by shaft develop-ment. The distinction between speculation and gambling is thatthe speculator will 'take a joy ride on prospects', while the gambler

3 ASS I5

34 P. T. JENKINS

will wait until the case for the shares is finally proved or dis-proved.

It is important not to be misled by the label on a stock intosupposing it may not be speculative. At the time when undatedgilts were yielding 21/2 %, Japanese Bonds were standing at about40 %. In retrospect, it may be seen that gilts were then a specula-tion on a fall in long-term interest rates below their already his-torically low level, while Japanese Bonds were a speculation as towhether the Japanese Government would resume the status as areliable debtor which it enjoyed before the war. There is no doubtwhich has proved the more successful, since the respective pricelevels have now virtually changed round.

(iii) This concerns the case where a stock is especially liable towide swings in price or yield which cannot, or which are not inpractice likely to be, anticipated. An extreme example would bea mine producing one of the minor industrial ores such as anti-mony, or a plantation share. Such stocks necessarily give a highreturn in a good year and are best avoided where capital is themain consideration. At times, however, there may be specialcircumstances which render appreciation sufficiently probable toreduce the degree of risk to a more acceptable level. The taxconcessions given to overseas trading corporations in the lastBudget are a case in point.

Market sentiment

In addition to matters of fact, which are ascertainable, andopinions, which may vary but which are based on fact, or whichwill be disproved by events, there are some factors influencingmarkets which may have little or no rational basis.

One of the most obvious market characteristics is the excessiveoptimism or pessimism to which it is prone, and which may applyto a market, an industry, or to a particular stock or management.In the short run—and by short is meant a period which may last ayear or two—what the public generally thinks is often more rele-vant than the 'scientific' view of the way markets ought to move.Although an institution can often afford to take a superior view ofthe situation, the private client will usually regard a heavy loss

ECONOMIC AND STOCK MARKET TRENDS

with alarm, and it may be of little avail for his stockbroker tocomfort him with assurances that there is every chance that thingswill be better eventually. To get out at the top of a prolongedmarket rise is as lucky as being the successful contestant in a gameof 'last across', and it is better to obtain a modest profit than to

35

continue to hold throughout the ensuing depression.It used to be true that when industrials were bad, gold shares

often improved. For some years now sentiment has been 'anti-Kaffir', and the Canadian market for a time took over the historicalrole of gold shares in absorbing the flow of speculative capitalaway from sterling. Now that the ready flow of security dollars toLondon has been stopped, this sentiment is directly reflected in the'dollar premium'. Gold shares now seem to be returning tofavour, although there must be many 'stale bulls' waiting tounload their shares on a rise.

PART 3. METHODS OF DIAGNOSISWe may now pass from a consideration of the factors liable toaffect markets to methods of judging the play of forces in-volved.

Apart from the investment press, possibly the most directmethod of estimating economic trends is by making use of the massof official statistics made available in the yearly National IncomeBlue Book and Censuses of Production, the Monthly Digest ofStatistics, the monthly Ministry of Labour Gazette and TreasuryBulletin, and the weekly Board of Trade Journal.

The indices mentioned below are among the most interesting.They are subject to a time-lag, which, together with the frequencyof publication, is given in brackets in most cases:

Index of Industrial Production (2 months: monthly). This is givenfor industry as a whole, and seasonally adjusted. There is also asubdivision into industries on a limited scale. The adjusted indexhas now been virtually restored to the level achieved at the end ofI955, when the economy was over-strained.

It is also necessary to keep an eye on the supply of essentialraw materials and fuels. It was a shortage of steel more than any-thing else which caused the Government to take action to reduce

3-2

36 P. T. JENKINS

the U.K. sales, and therefore the production, of the motor industryin I955-

(2 months:monthly) which is analysed quartely in great detailaccording to goods sold and type of vendor, in the Board of TradeJournal; to H.P. sales and car registrations (2 months: monthly).

The significance of the price and wage indices speaks for itself,and another test of an inflationary situation is when vacancies exceedunemployment by a substantial margin, as during most of I954-56.The credit squeeze reversed this situation in I957, but the twographs have now crossed again. The statistics of overtime working,published quarterly by the Ministry of Labour Gazette, are anotheruseful guide to the ' pressure' in the economy.

A recently introduced index of stocks held by industry and byother agencies (3-4 months:quarterly) is published by the Board ofTrade Journal. The recent rise in the industrial index may beinterpreted as showing high activity, while the fall in the indexof other stocks has apparently been due to the higher cost ofholding commodities in warehouses following the rise in interestrates.

Considerable light is thrown on the rate of capital investmentby three indices, namely:

Machine tool deliveriesNew factory approvalsThe quarterly sample

Periodical checks are made with the actual capital expenditureof the firms concerned, and in fact since the enquiry started theoutturn has generally exceeded intentions.

On the financial side, useful figures are the total of bank deposits,the make-up of the corresponding assets, and cheque clearing, bothcountry and town—the former tends to reflect industrial turnover,while the latter affords some measure of financial activity. It has,for example, been noticeable that the banks have been permittedto keep a comfortable liquid position and that clearings have not

Other valuable indices are those relating to Retail Trade

and new orders (3. months.-monthly).and housing starts (2 months .-monthly).enquiry into firms intentions as regards

capital investment, recently instituted by thepublished quarterly in the Journal.

Board of Trade and

ECONOMIC AND STOCK MARKET TRENDS 37fallen with deposits during the credit squeeze, indicating that thishas been partly offset by greater use being made of the currencyavailable. It would appear from these facts that the credit squeezehas been (at least until October I957) a kid-glove application ofmonetary control whose main weight has fallen on the privatesector of the economy.

The items most directly geared to the balance of payments arethe monthly export/import figures published by the Board of Trade(about 2 weeks), the gold and dollar reserves shown monthly (nodelay), the half-yearly balance of payments figures (31/2 months) andthe monthly terms of trade (I month). The import/export figuresdiffer from the balance of payments figures published by theTreasury in that the latter include a greater element of invisibletrade, and also in timing, while the gold and dollar reserves areinfluenced not only by visible trade but by invisible trade and bycapital movements; thus the difference between imports and ex-ports usually affords but a poor guide to the monthly movementsin the reserves. There is no direct means of determining capitalmovements more frequently than half-yearly, but it is usuallypossible to judge their direction, if not their size, by watching theexchange value of the £ in relation to the dollar and the leadingContinental currencies. It is, for example, common knowledge thatspeculative capital was moving out of sterling into the D-mark inthe autumn of I957.

Finally, there are the National Income Statistics. Quite apartfrom their inaccuracy, they are of relatively little direct use onaccount of their infrequency of production. The provision ofquarterly national income statistics, as in the U.S., is currentlyunder consideration. While in the past the information on whichto base these was simply not available, it is apparently intended todemand further information from industry in order to make suchan analysis worth while. The Americans also have industrial in-put-output tables of over a I00 subdivisions, whereas the NationalIncome Blue Book matrix is too small to provide a satisfactoryanalysis.

38 P. T. JENKINS

Price Charts (it)

Chartist theory started with Mr C. H. Dow and has been de-veloped by Mr A. G. Ellinger in particular. Mr Ellinger's systemwas described by Haycocks and Plymen in J.I.A. 82, p. 333. Itemploys four indices, i.e. 'gilts', 'equities', 'activity' and 'con-fidence ' = (gilt yield)/(equity yield).

There is little doubt that the method gives notice of generalexpectations and the technical state of the market. The signs ofan impending reaction are:

(a) A fall in gilts and confidence, with activity failing to reachprevious 'highs'.

(b) High activity preceding the peak in equities.(c) A minor decline in equities followed by a rally which does

not reach the preceding high, and then a fall into new lowground.

A new bull market is conversely heralded by

(a) An improvement in the tone of gilts and confidence.(b) Rising activity.

For example, the lack of follow-through to the burst of activitysubsequent to the pre-election dullness in markets in May-AugustI955 (see Appendix II)* was a bear signal. It may be stated thatit was quite apparent, without recourse to drawing charts, that themarket was highly vulnerable—the excessive speculative activityfollowing the election result was a clear warning, together with theweakness in gilts and the beginning of 'balance of payments'trouble.

The present writer would, however (had he been a confirmed'chartist') have placed a bearish construction on the formationsduring February-March I957, which showed declining activity,gilts and confidence. However, about that time reference to the'higher production to be expected in the autumn' began to creepinto the financial press, with the result that, with the 'Suez'complex finally blown away, the equity market made a further

* This was prepared by Investment Research, Cambridge.

ECONOMIC AND STOCK MARKET TRENDS 39recovery. It would appear, therefore, that the chart is an extremelytricky instrument, to be interpreted with discretion.

Charts of individual share prices are probably more useful thanthat of the index, since they bring out the existence of ' resistancelevels', both upper and lower. Thus the pattern may show a'trend channel' or triangle, and a break out from this may be dueto all the shares on offer at the upper trend line having beenaccumulated, or vice versa, so that a substantial movement eitherup or down, as the case may be, can result.

Trend-channel Triangle Double top

Fig. 5

Then there is the 'double top' or 'double bottom', i.e. two'tops' or 'bottoms' at the same price in rapid succession—this isa frequent indication of a reversal of trend, possibly of minorsignificance.

Intelligence

Information is the life-blood of profitable investment, and it isnecessary to lay down lines of communcation by subscribing tovarious investment services, journals, government publicationsand the like, while personal contacts in as many industries aspossible are an invaluable aid.

The aim should be to have all the likely situations surveyed inadvance and watched for the moment when it may be particularlyprudent to invest. Thus, a rise in a stock believed to be under-valued may be sparked off by one further favourable item.

In addition to basic information and statistics it is often neces-sary to call on other expertise, as for example in connexion withestimates of future energy requirements. Much can be gleaned ofthe greatest possible relevance to the investor from Governmentpublications, the proceedings of industrial research bodies, etc.

4 0 P. T. JENKINS

PART 4. AN APPROACH TO FORECASTING

There seems no need to justify the method to be advocated, sinceit is that forming the basis of most investment decisions. It issimply to apply common sense to the situation emerging from theforegoing considerations.

A start may be made with the current economic-politicalposition. Now, clearly, an inflationary increase in money continues,for which wage claims must take the principal blame. The Govern-ment finally gave in to the claims presented last year (the railwayauthorities initiated the breach), and the reason may well be foundin the Suez crisis, which was then in being. Short of a really tightmonetary policy, designed to cause unemployment as a rewardfor higher wage rates, it can now only hope to prevent furtherrises by a directive to employers. Thus there seem to be only thestark alternatives of continued inflation or labour trouble on awide scale. This view stems directly from the analysis of Part I.It is clear that such inflation would be likely to be the reverse ofgood for company profits.

The figures in Appendix I show that with further wage claimsin prospect, there is no case for an early easing of the credit screw,to say the least. Production seems on the mend and money is stillcreeping into the economy. No real recovery in gilts seems likelyunless a business recession develops, and meanwhile pressure onthe pound continues. Allowing for inflation, the economic yield onundated gilts would be considerably higher than at present.

The pace of the U.S. economy appears to be easing off and thereis a world dollar gap once more. Much will depend on the U.K.'sability to overcome the more difficult export conditions which maywell be in store. There may be the seed-bed of a recession in thissituation.

On the political front, it may be expected that markets will startdiscounting the next General Election during I958. Whateverone's view on this, it is uncertainty which is the prime bugbear of'confidence', and its seems probable that there will be a good dealof liquidation of equities at some stage before the Election.

It is not the author's intention to proceed further than this, since

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42 P. T. JENKINS

the object of this section is simply to illustrate the type of con-siderations which must be borne in mind in attempting a forecast.It is his contention that, given an appreciation of the widespreadfactors in the situation, the conclusions to be drawn will oftenfollow with relatively little further cerebration. They will usuallyconsist of attaching subjective degrees of probability to variouspossibilities, and the secret of success is to understand whichconsequences are likely to follow which causes. It is to be hopedthat this paper has contributed something towards that under-standing.

REFERENCES

WHYTE, L. G. (1949). Principles of Finance and Investment, Vol. I.LANGE, OSCAR (I938). The rate of interest and the optimum of propensity to

consume. Economica, V, N.S. no. I7, I2-32.MODIGLIANI, F. (I944). Liquidity preference and the theory of interest and

money. Econometrica, I2, 45-88.COTTRELL, H. C. (I957). Economic policy. T.S.S. I4, 230.HAYCOCKS, H. W. & PLYMEN, J. (I956). Investment policy and index numbers.

T.I.A. 82, 333.

POSTSCRIPT

The paper was completed very shortly before the rise in Bank ratein October I957. While emphasis has been laid on the authorities'intention to prevent an increase in the quantity of money, it mayalso be desirable to offset an increase in velocity by reducing thevolume of money. The main usefulness of the new look in monetarypolicy lies in its success in combating speculation in sterling; inreducing domestic investment so as to make way for the greaterconsumption likely to result from last year's wage increases, andfor capital goods exports; and in its hoped-for effect in minimizingwage increases in I958.