Learning to Love the Pain
Board: Macro Economics
Pundits have proclaimed that Capitalism is the worst economic system except for all the others that have been tried. The reason for our mixed feelings about our economic system (besides the fact that it has been badly mislabeled) is its inherent instability. Free markets generate cycles, and the down cycles bring pain and suffering.
The market may be efficient but it is certainly not rational. It is very efficient at measuring the Wall Street’s current mania, but what it is certainly not measuring is the intrinsic value of the stocks being traded. In 1982 the PE of the S&P 500 stocks was 8. Then as the long bear market of the seventies turned into a bull the PE began to gradually increase until by 2000 it was 34. From this peak in 2000 it has decreased until today it is around 15. During this entire period corporate profits (ignoring the occasional recession) have increased at fairly constant rate of about 7% per year. If the market was efficient it would reflect this steady growth in earnings, but does nothing of the kind, what we get instead is a constantly changing view of the value of corporate earnings.
Long cycles are caused by the fact that capital markets are an exercise in mob psychology or the madness of crowds. The only way that we can eliminate market cycles, and make the economy more stable would be to find a way to fundamentally restructure human behavior. In spite of this obstacle, politicians and economists are fond of trying to find someone or something to blame for the cyclical nature of our system, and are capable of spending their careers in the completely frivolous pursuit of trying to fix the economy.
In fact it may be the pain that gives capitalism its edge. As with our bodies the function of pain is to send a message to the brain that we are doing something wrong. For the last thirty years the FED has felt that part of its job in supervising the big banks was to always ride to the rescue. In 1986, 1994 and 1998 when economic contractions treated the liquidity of the banking system Greenspan stepped in to pump money into the system. Bankers like Richard Fuld, Stan O’Neal and James Cayne came to believe that the FED always had their back, and expanded their leverage to completely irrational levels. By 2007 they had leveraged their equity by a ratio of $35 of borrowed capital to each $1 of their equity. Worse yet the quality of the assets that these banks had bought with their borrowed money (even though a lot of it was rated AAA) was junk. Looking back it is easy to blame management at the big Wall Street banks for the credit crisis, but how would these managers have behaved if the FED had not been so quick to intervene?
What if there had been a hard landing in 1994? In his book “The Age of Turbulence” Greenspan said that his proudest moment at the FED was his “soft landing” in 1994. I wonder he still feels the same way today? With a nice hard landing in 1994 would tech bubble have gotten as silly? What if the FED had not engineered a bailout for the Big Banks after Long Term Capital Management failed in 1998? Fuld, O’Neal and Cayne were all there to watch and learn. Clearly there would have been a lot of pain on Wall Street if the FED had not stepped in, but maybe the bankers would have learned something. Hard as it sounds, it has become obvious that when the government bails out the risk takers they create a “moral hazard.” That when the regulators seeks to relieve pain they just going to delay and turn a small crisis into a bigger one.
Unfortunately, when it comes to economic therapy, pain is often the best and most effective way to cure bad behavior, whether intentional or unintentional. In the same way that a positive result reinforces a behavior pattern, pain is the best way to encourage a change. Our market economy has a self-correcting system and that why it has survived, but the self-correcting mechanism is easily corrupted by inserting a moral hazard.
In a long bull market, the investor will tend to attribute positive results to his own personal genius and therefore learn little from success. As long as the price of its stock is going up, it easy for a company to ignore problems, and therefore, in a bull market problems keep getting bigger and bigger. On the surface everything looks fine because prices are going up, but in fact the economy is becoming more and more unstable. Although we don’t like to believe it bear markets are therapeutic. It is during a market correction that economic problems become obvious, and have to be dealt with. Businesses have to learn how to fix their problems or they cease to exist.
Popularity = Risk
It important to understand that the longer a positive trend in any market continues the more dangerous it becomes. The danger comes from the fact that the rising prices mean that investors (and bankers) are making money. These profits tend to make investors careless and overconfident. The more popular a stock becomes, the more the risk in owning it increases, even though as the price goes up it becomes more comfortable for investors to own the stock.
In the bull market following the end of WWII (1947-1965), our prosperity eventually grew lots of problems. It took a long time to solve the inflation that was the result of this post war prosperity. But it was what we learned from the pain of the seventies that drove the economic expansion of the eighties and nineties. Tight money eventually led to lower interest rates. Outsourcing, offshoring, and digital Technology dramatically lowered labor costs for American businesses. This helped to increase corporate profits and drove stock prices higher for seventeen years.
Today we have debt problems instead of inflation problems and there is no way these Problems are going to be easily or rapidly fixed. It took seventeen years in the eighties and nineties to apply the solutions for the problems that were identified in the seventies. It is not so much a question of have the problems been fixed, as it is have they been identified, and has there been enough pain so that real solutions will be applied. As always, pundits tend to have their crystal balls firmly focused on the rear view mirror, today as they make predictions they are not really looking at future but at the devastation and destruction of the last five years, and, as always, projecting that past into the future. A much better guide to the future will be to measure the pain we have experienced and project future economic growth based the amount and the intensity of that pain. For economists I suggest they dump their crystal balls and learn to love the pain.
We are probably not yet at the end of our secular bear market, but there has been a lot of pain and this raises the strong likelihood that somewhere in the not too distant future there lies the pleasant prospect of a long lovely bull market.