The Liquidity Theory of Asset Prices

For at least the last decade, there has been a growing sense of frustration among market professionals with the attempts by academics to account for the behaviour of financial markets. Very experienced practical people have become highly critical of traditional teaching in universities which is grounded in the so-called Efficient Markets Hypothesis.

Gordon Pepper has the unusual combination of an economics degree from Cambridge and actuarial training. Immediately after he finished taking examinations, he became a dealer on the Floor of the London Stock Exchange. His ‘postgraduate university’ was the market place, where he underwent the harshest of disciplines. Forecasts based on conventional theories were often wrong. The inescapable conclusion was that these theories were either incorrect or incomplete.
Pepper was the joint founder of W. Greenwell & Co’s gilt-edged business (that is, the UK government bond business), which arguably became one of the leading bond-advisory businesses in the world, the advice being about both the best investments and the optimum way to execute business. For more than ten years he was the premier analyst in the gilt-edged market and was often described as the guru of that market. He was the principal author of Greenwell’s Monetary Bulletin, which, in the 1970s, became one of the most widely read monetary publications produced in the United Kingdom.
Pepper is the author of three books and the co-author of a fourth: Money, Credit and Inflation (1990), Money, Credit and Asset Prices (1994), Inside Thatcher’s Monetarist Revolution (1998), and (with Michael Oliver) Monetarism under Thatcher – Lessons for the Future (2001). He is also chairman of Lombard Street Research Ltd, which is one of the UK’s leading independent firms carrying out investment research and specialising in analysis of money, credit and flows of funds. Summarising, Pepper’s particular strength is the combination of practitioner and academic. Above all, he writes with great authority from his knowledge of what actually happens in the marketplace.

Michael J. Oliver is currently Professor of Economics at École Supérieure de Commerce de Rennes and a director of Lombard Street Associates, UK.
He graduated in economic history at the University of Leicester and was awarded his PhD in economics and economic history from Manchester Metropolitan University. He has held posts at the universities of the West of England, Leeds, Sunderland and has been a Visiting Professor at Gettysburg College, Pennsylvania and Colby College, Maine.
He is the author of several books, including Whatever Happened To Monetarism? Economic Policy-making and Social Learning in the United Kingdom Since 1979 (1997); Exchange Rate Regimes in the Twentieth Century (with Derek Aldcroft, 1998) and Monetarism under Thatcher – Lessons for the Future (with Gordon Pepper, 2001). He has just finished co-editing a book (with Derek Aldcroft) entitled Economic Disaster of the Twentieth Century, which is being published by Edward Elgar in 2006. He has contributed articles to Economic History Review, Twentieth Century British History, Economic Affairs, Contemporary British History, Economic Review and Essays in Economic and Business History.

Foreword

xiii

Russell Napier

Acknowledgements

xvii

About the Authors

xix

List of Tables, Figures and Charts

xxiii

Introduction

1

(1)

Appetiser

1

(1)

Structure of the book

2

(1)

Language and jargon

2

(1)

Academic theories

3

(1)

Modern Portfolio Theory

3

(1)

The Efficient Markets Hypothesis

4

(1)

Forms of investment analysis

4

(2)

Fundamental analysis

4

(1)

Monetary analysis

5

(1)

Technical analysis

5

(1)

The intuitive approach

6

(1)

What the book is going to say

6

(3)

PART I THE LIQUIDITY THEORY

9

(40)

Types of Trades in Securities

11

(4)

Liquidity trades and portfolio trades

12

(1)

Information trades and price trades

12

(1)

`Efficient prices'

12

(1)

Expectations of further rises or falls

13

(2)

Persistent Liquidity Trades

15

(6)

Demand for money

15

(1)

Transactions demand for money

15

(1)

Savings demand for money

16

(1)

Interest rates and the demand for money

16

(1)

Supply of money

16

(1)

Printing-press money

16

(1)

Fountain-pen money

17

(1)

Interest rates and the supply of money

17

(1)

Monetary imbalances

17

(1)

Excess money in the economy

18

(1)

Summary

19

(2)

Extrapolative Expectations

21

(4)

Sentiment

21

(1)

Intuition

21

(1)

Decision-taking inertia

22

(1)

Crowds

23

(1)

Fundamental and monetary forces in the same direction

23

(2)

Discounting Liquidity Transactions

25

(12)

Speculation

26

(1)

Timing

26

(1)

Short-term risk versus profits in the longer term

26

(11)

Appendix: Speculation and market patterns

27

(10)

Cyclical Changes Associated with Business Cycles

37

(6)

Introduction

37

(1)

Direct and indirect effects of money on asset prices

38

(1)

Money, business cycles and inflation

38

(1)

Business cycles and fundamental factors: the `indirect effect' on asset prices

38

(1)

The combination of the indirect and direct effects

39

(1)

Strategy

39

(1)

Timing

40

(1)

Sequences

41

(1)

Triggers

42

(1)

Shifts in the Savings Demand for Money

43

(6)

The peak of a business cycle

43

(1)

Running down bank deposits

44

(5)

Appendix 6A: Some bond arithmetic

46

(1)

Appendix 6B: Government bond markets

47

(2)

PART II FINANCIAL BUBBLES AND DEBT DEFLATION

49

(10)

Financial Bubbles

51

(4)

Detection of a bubble

51

(1)

Phases

52

(1)

Chronically dangerous

52

(1)

The burst

52

(1)

Acutely dangerous

52

(1)

Crosschecks

53

(2)

Debt Deflation

55

(4)

The cure for debt deflation

56

(3)

Money supply policy

56

(1)

Fiscal policy

57

(1)

Appendix: Ignorance of Irving Fisher's prescription

58

(1)

PART III ELABORATION

59

(42)

Creation of Printing-press Money

61

(4)

The UK in more detail

63

(1)

Four policies

64

(1)

Control of Fountain-pen Money and the Counterparts of Broad Money

65

(6)

Control of bank lending

65

(1)

The teaching in textbooks

65

(1)

How central banks operate in practice

66

(1)

Bank capital

66

(1)

The UK in more detail

67

(1)

The `counterparts' of changes in broad money

68

(1)

Relationship between the counterparts

68

(3)

Modern Portfolio Theory and the Nature of Risk

71

(10)

Summary

71

(1)

Expected yield

72

(2)

Risk

74

(5)

Risk and the circumstances of the investor

77

(1)

Variation in risk -- life assurance funds

77

(1)

Investment managers' personal risk

78

(1)

Unacceptable risks

79

(1)

Exploiting skewness

79

(2)

Technical Analysis and Crowds

81

(6)

Trends and trading ranges

81

(1)

Crowd behaviour

82

(1)

Information

82

(1)

Trends and momentum

83

(1)

Approaching a turning point

83

(1)

Turning points

84

(1)

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The Liquidity Theory of Asset Prices

Summary

Author Biography

Table of Contents

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Summary

Author Biography

Table of Contents

Supplemental Materials

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