Kocherlakota Explains Why Trump Is Driving the Stock Market Higher

A trader works on the floor at the closing bell of the Dow Industrial Average at the New Y
(BRYAN R. SMITH/AFP/Getty Images)
John Carney

Whenever President Donald Trump appears to take credit for the stock market’s record highs, financial journalists, economists, and Wall Street analysts are quick to deny that it has anything to do with the guy in the White House.

But a few tweets by former Minneapolis Federal Reserve President Narayana Kocherlakota Wednesday show that there is much more to Trump’s claims than these folks think.

The story starts with Dean Baker of the Center for Economic and Policy Research complaining about Trump’s taking credit for stock market gains:

That needs a bit of translation since most people do not think in terms of “risk premia.” What Kocherlakota is saying is that to our best approximation, what really drives the stock market is the return investors demand for taking risks. When investors are more willing to take risks–that is, when so-called risk premia fall–the prices of stocks go up.

And under Donald Trump’s presidency, risk premia keep falling. So BOOM goes the stock market.

And why would the risk premia fall under Trump’s election? The quick answer is simple: MAGA. Voters pushed back against conventional wisdom and voted for the candidate all the Very Responsible People told them was too risky. The American people were just less risk adverse in voting, and, not surprisingly, financial markets reflect this increased comfort with risk taking. It’s the Flight 93 Market.

There is also a more technical answer. But before getting to it, it is worth asking why so many economists, analysts, and journalists cannot admit that Trump’s presidency has something to do with the raging stock market.

It is partly social. A lot of these people travel in circles where one simply does not give Trump credit for anything positive. Even more than that, however, it is psychological. A lot of economists and market analysts predicted Trump’s election would herald doom and gloom for markets. And then when markets first rose, they said it could not last. Just like the political pundits who spent 2016 serially announcing that this time Trump’s campaign was over, market pundits have pronounced the end of the Trump trade over and over and over again.

In short, the ongoing bull market is a continuous rebuke to their forecasting skills. And when Trump takes credit for the rise–well, they cannot help but be triggered.

That is not to say the Trump Trade deniers do not make some fair points. Many of the policies that could help boost corporate profits have not yet materialized. So far tax cut proposals look more like plans to have a proposal than actual legislation. Trade policies are under-review, but not much has moved yet. How much could Trump have boosted the market with a few executive orders?

After Trump’s first one-hundred days in office, Morgan Stanley’s investment management team put out a note claiming that Trump’s effect on markets had been a “very modest negative, but largely not relevant.” Morgan Stanley’s Andrew Slimmon said the rise in the stock market was all about “the earnings recovery.”

At the time, that sounded vaguely plausible because a lot of people think that stock prices represent the present value of expected corporate profits. But if that were the explanation, the stock market should have run out of steam months ago. In fact, Slimmon thought it probably would. After all, it is not as if earnings optimism has kept growing in the second hundred days.

But the award for Most Creative Anti-Trump Stock Market Theory belongs to economists Lubos Pastor and Pietro Veronesi. Instead of asking why the market kept going up, they asked why it was going up in such an orderly manner. In addition to reaching record highs, the stock market has been setting record lows for volatility. Even after Trump’s “fire and fury” remark about North Korea, the CBOE Volatility Index, or Vix, did not rise above 12.

This sustained period of very low volatility is made all the more puzzling by the perception that we are mired in political chaos and uncertainty. Periods of uncertainty are also supposed to be periods of volatility. The VIX usually goes up alongside an index of economic policy uncertainty called the Baker-Bloom-Davis (BBD) Index. The BBD Index is calculated by counting the frequency of newspaper articles that reference economic uncertainty, the number of federal tax code provisions set to expire in coming years, and the extent of disagreement among forecasters about inflation and government spending.

As you can probably imagine, the BBD Index has been running high and hard since the election (although it has come down in recent months). After all, it is in large part a measure of how the mainstream media are reporting on things. So it is picking up all chaos, all the time:

This is a bit awkward for Pastor and Veronesi. Two years ago, they developed an influential model of why uncertainty and volatility move together. So they set out to rescue their theory by figuring out why things are different this time.

The simplest explanation for this is probably just that the mainstream media are creating a misleading picture of reality. Actual uncertainty as experienced by individuals, households, and businesses is nowhere near what you might think it was based on news stories. It is very hard to see much uncertainty when looking at measures of consumer and business confidence. The reason the BBD Index and the VIX parted ways is that the BBD Index largely measures subjective perspectives, while the VIX represents actual financial decisions. As Nassim Taleb might say, the BBD Index does not have skin in the game.

Unfortunately, that is not what Pastor and Veronesi think is going on. (Good economists hate Occam’s razor and love adding factors to explain things.) They argue that volatility is composed of two parts: policy uncertainty and how clear the signals coming from policy markets are. What’s changed, they say, is that the political signals have gotten less precise. NATO is obsolete one day; then, it isn’t. Anthony Scaramucci ousts the White House chief of staff; then Scaramucci gets ousted by the chief of staff. What has happened is that investors are simply tuning out the noise because the signals are so confusing and contradictory.

“We argue that the contradictory nature of the political signals in 2017 has reduced their informativeness,” Pastor and Veronesi wrote. “Markets continue listening to politicians, but they pay less attention than they used to. The result has been a weaker link between uncertainty and volatility in early 2017.”

In other words, Donald Trump’s Twitter account is keeping market volatility down.

That sounded like a stretch when Pastor and Veronesi wrote it back in May. Could Trump really confuse the market into a calm and orderly march ever upward? Even they seemed to scoff, warning that even if this was happening, it would not last. “Sooner or later, political signals will regain their informativeness,” they said.

Strangely, Pastor and Veronesi ignored a different theory of theirs that does a lot better job of explaining why stock markets are up–and why risk premiums are down. In February, the pair put out a paper arguing that political cycles are driven by changes in risk-aversion over time. When risk aversion is high, people elect the party promising economic redistribution and an expanding government–Democrats. When risk aversion is low, they vote for freer markets and low taxes–Republicans.

Donald Trump’s election can be looked at as an extreme version of this. It demonstrated not just a higher tolerance for risk, but an enthusiasm for plunging headlong into the unknown on a quest to Make America Great Again. MAGA politics is the opposite of risk aversion. So it is no surprise that it is producing MAGA Markets.

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