The question of questions: Why did we have so much volatility in the financial markets in the Fall and early Winter? This was extreme volatility by any measure.
The fact that it happened while the U.S. was in an extreme growth spurt which took down unemployment, raised corporate profits, raised wages, and all of this without much if any inflation is one of the great economic mysteries of our age, paralleling in its own way the Great Depression.
I would respectfully like to offer a few possible answers, and if you see them as clearly mistaken, please do not be shy about questioning me about them.
First of all, the Reagan explanation: When, a short time after the terrible stock market crash of 1987, the Gipper was asked why the market had fallen so much, he had an amazingly smart answer. “I’ve heard it said,” the President pronounced, “that the market was just too high.”
Scoffers scoffed, but some of the great minds in finance, especially my dear friend and colleague Dr. Phil DeMuth, have found that a key metric for forecasting stock market movements is if the index is far above or far below its recent multi-year average.
That is, it’s not just a question of whether the market is high on a price-earnings basis or a price of earnings vs. a coupon, but whether it’s high just as a measure of an absolute price versus previous recent prices.
Yes, if stocks get far too high relative to recent prices, that’s often a signal that they are about to go down. It sounds too easy to be true and sometimes it is, but sometimes it isn’t.
So, yes, maybe stocks had just gotten too high in the period of mid and late 2018 and there was reason enough to sell. People and machines just wanted to take some money off the table and buy some shoes with it.
Second: Interest rates were moving up. Stocks are a way of earning money, either as capital gains or as dividends or preferably both. In the period from early 2017 to late 2018, the stock market had been fed like a stuffed goose. The Fed and the Treasury worked together to keep bond interest coupons ultra-low, still as a way of warding off the evil spirits of the financial meltdown of ’08-09. Corporate yields were also low and the junk market basically had slowed to a trickle once certain ethical and reporting flaws had been revealed — largely by me.
Stock market dividends were nowhere near as they had been in the prewar period, but they were good. And capital gains, especially in the high tech sector, were superb.
There was nowhere for money to go, in other words, than into the stock market: good dividends, no inflation, and the prospect of ultra-good capital gains told investors that there was only one place to be: the stock market.
Then, along came the spider, the eminently qualified Dr. Powell, who extended his stinger and said that it was time for interest rates to rise. He was, he said, concerned about inflation in the midst of such super high employment and wage gains as we had seen. The standard way to fight inflation is by slowing down growth, and that is done by raising interest rates. Interest rates are super powerful tools for slowing an economy.
When Dr. Powell and his colleagues began to do just that, the markets suddenly saw that (a) the economy might actually slow down, in fact that it might be a Fed priority to make it slow down. And arguing with the Fed is rarely a way to make money. A Fed driven slowdown would mean lower growth in dividends, lower growth in capital gains, and a much less frothy market for stocks. The markets also saw (b) that if interest rates rose, it might be a decent idea on an income producing basis to own bonds instead of stocks. Plus, if you buy Treasuries, you will eventually get your money back. There is no such promise with stocks.
People invest money to keep their money safe and to make money. If they see that Treasury bonds — usually described as “ultra-safe” — might throw off better yields than stocks, they may well reach for yield, abandon stocks for a time, and go for those ultra-safe bonds.
There were other reasons for a slowdown in stocks and extreme volatility. The President has fashioned a trade war with China. The U.S. exports a lot to China. If China stops buying or even slows down — just a tap on the brakes — it’s bad news for some low tech and some high tech exports. No one thought there would be prolonged government shut down either and that tapped on some government spending brakes.
Plus, some sci-fi type trading monsters had appeared. The media had learned that a great deal of the trading on the exchanges was now being done automatically, as one might say. The markets were told that if certain things happened, the machines would sell — and sell they did. The machines were like thermostats for the whole house. As the metrics were hit, the house temperature fell like a rock. That was machine intelligence at work.
But it was a kind of crude machine intelligence. The whole drama of last month reminded me very much of the first of the Terminator series. The machines had become self-conscious and began attacking the people who created them. Only this time, it was played with money and not with blood. It was a war of machine vs. man. Played out on the business channels all day long. Breaking people’s hearts and robbing them of their chances for retirement or a home for their children or college for those same kids. Those were extremely high stakes.
But it was a strange sort of man vs. machine drama. Because those super-smart machines, drained of human emotions like fear or sense of triumph, were losing as consistently and bitterly as if they were commuters taking the train home to New Canaan. They would lose, then bounce right back up again the next day. Which was the right direction? No one knew and certainly the machines did not seem to know.
The machines told us one day that all was gloom and doom. The next day those machines said that everything’s coming up roses. The machines had every flaw that human traders had and maybe then some — they couldn’t buy you a drink after trading ended for the day.
Or maybe the machines were just set up for the shortest possible time span of trading — to make money on the short side one day and then make it back on the long side the next day. Maybe not even the next day, but the next instant.
This was machine intelligence but maybe too smart for its own good. Or maybe not. Maybe that’s what extreme volatility is all about. To learn to shoot at someone who outdrew me, as Leonard Cohen, the great Canadian singer, wrote.
But if the moves are really that short, then maybe the market is not a place for pension funds and endowments and maybe the machines are hastening some day of eminent failure of stocks as an investment vehicle except for quick draw McGraw.
But then why is the richest speculator by far Mr. Buffett, whose ideal holding period — as he has often written — is forever? I wonder if anyone has data on how many years the machines have outperformed Mr. Buffett.
There is a lot of confusion swirling around the markets. Maybe there always has been. But what do the machines bring to the party except even more mixed-up confusion?
There is a great saying in a certain self-help program I know a lot about. The saying is that the smartest words in the English language are simply, “I don’t know.”
So let it be for the moment with the stock market gyrations of this Fall and Winter. What we do know is that if you pick great stocks — or let Uncle Warren pick them for you — and if you hold them a long time, you’re likely to get rich. There is a lesson there.
There’s another lesson: We are spending ourselves into an early grave if we keep on going as we are going. We have become a super debt-addicted country. Just beyond belief. Starting with the supply-siders — or maybe someone’s mistaken interpretation of the supply side (by the way, my super-smart father coined that phrase — supply side), we dug ourselves into the deepest debt hole that could ever be imagined — and beyond it.
We had as a nation often gone into debt, especially during World War II. But we recognized it as a bad thing and wanted to get it paid off as soon as possible. It was old fashioned, but the village elders told us that we really could get into trouble if we did not roughly equilibrate spending and taxing.
Then came the Supply-Siders who had a better idea. They said they had found out about a double rich chocolate ice cream that would actually make you lose weight. They said it was not just NOT a bad thing to lower taxes way below spending but was actually a very smart, healthy thing.
They promised that if the federal government drastically lowered taxes it would stimulate production so much that even with a much lower tax rate, the government would take in far more in taxes than it had before the tax cut.
There was no proof of this, but it sure sounded delicious. Eat all you want and never gain weight. Yum. The people who proposed this said their method would greatly raise the supply of goods and services, raising it enough to soak up excess liquidity in the system and lowering inflation. In fact, supply side was created explicitly to fight the inflation of the ’70s and early ’80s.
It had a sexy appeal to Ronald Reagan. It had a gigantic appeal to the editorial page of the Wall Street Journal. When Reagan won in 1980, he put through huge tax cuts right away and in fact the economy did well and deficits grew but not as much as some had feared. But that all came as Reagan was raising taxes for the following seven years of his time in office.
After that, the deficits exploded. Staring at roughly (very roughly) one trillion in 1980, by 2019, now, after all Presidents cut taxes, the accumulated national debt was roughly $21 trillion.
Yes, the economy had grown well, even very well. But that part of the supply-side theory that said we would get smaller deficits was a total bust.
It worked out so badly that we now face a genuine debt crisis. If we have a total federal debt of about $21 trillion, we are accumulating interest at the rate of roughly $800 billion a year. We are borrowing from the feds, the Chinese, and ourselves at the staggering rate of over $2.5 billion per DAY or over $100 million per hour.
This is a rate so high that it simply cannot be sustained indefinitely — and it’s growing. Not shrinking. GROWING.
It is simply impossible to contemplate how we are ever going to be able to service that debt forever. It may well be that we will be forced to have some kind of default — and fairly soon.
I hate to break this to Miss Ocasio-Cortez and her pals, but we cannot afford to have Medicare for everyone. We will be inhumanly lucky if we can still pay Social Security and Medicare at all within a few years. Already, urgently needed defense expenditures are going to have to be shelved even as the Russians and Chinese saddle up for a new cold war… or maybe a hot one in the Baltic States or the South China Sea.
And it gets worse. We all know that liquidity is everything in life. We came very close to a second Great Depression that would have been as bad as the first one ten years ago because of Fed and Treasury mistakes around Lehman Brothers and the housing boom that crashed in flames. We were rescued by a massive infusion of liquidity from the Fed and the Treasury and by TARP and by Bank of America buying Merrill Lynch.
I have sat at a table with Warren Buffett when he told me that without Bank of American/Merrill Lynch and TARP, even Berkshire Hathaway would have failed. If Berkshire Hathaway, probably as well-capitalized a company as has ever been, had failed, it would have meant that every decent-sized financial institution in America would have failed. This is the gun barrel we were looking down.
But we had plenty of room to grow in the liquidity department in 2008-2009. The deficit was immense, but not like today’s. What happens if we find ourselves in another financial meltdown occurring at the same time — or maybe even caused by — a major effort to reduce the size of the federal reserve balance sheet?
Will we have the intelligence and will power to spend and/or lend our way out of it as we did following 2008-2009? Or will we be paralyzed by fears about our growing deficits to show the financial muscle to get ourselves right side up again.
And meanwhile, what do we do about the deficit? I like Arthur Laffer a lot and would love to see him come up with a solution to the problem of his low taxes leading to high risk of insolvency. But will he? Will there ever be the will power to raise taxes on the rich to a level that really attacks the deficit? Or is it too late? It may well be.