What’s Missing?
February 3, 2018
Dear Friends,
First and foremost, periods of selling in the financial markets are normal. Frequent selling periods of 5.00%, 10.00% or 15.00% within a year are the rule.
What has been abnormal is the length of time that has transpired without a significant period of selling beyond 3.00%. During 2016 we experienced many days of up and down motion in the indexes of 1.00% or more. During 2015 we had a significant period of selling pressure and periods of declining indexes. In fact, 2015 was, overall, a slightly down year for the S&P 500 index. 2011 was a flat year for the index, which, at one point, was down virtually 20.00%. 2017 seemed to be a relentless increase in the indexes by which we measure markets. It was an unusual year. Good to be sure. But unusual.
Most of the market commentators were completely incorrect in their forecasts of what would transpire in the economy and markets with the election of Donald Trump. They allowed themselves to be conditioned by the political lens that seems to have infected our public discourse. This can be and was a significant error. The politics of our times surely affects the economy. But it doesn’t always affect it the way that our own political viewpoints suggest.
“The economy” is an abstraction, a conceptual construct employed for simplicity purposes. Our economy, not withstanding the attempt to isolate it from the rest of the world, is deeply embedded in the economic and financial realms of the entire planet. The economy is the sum of every financial and economic decision made on earth every day. Billions and billions of individual, sometimes interdependent decisions, by billions of people, accompanied by some collective decisions by governments and institutions. Every day, all day and night, no matter where on earth you are.
Each day, when markets close, here and in other places, economic activity and decision making continues, around the world, initiating trillions (yes, trillions) of dollars of constant circulation of money and the goods and services that are consequence of this process.
The selling in the U.S. markets the past few days is long overdue. When large profits are embedded in short term commitments, as opposed to long term investments in real companies, it is bound to be harvested. This often happens rapidly. Speculators have a role in the ecology of markets. But they are not investors.
As economic conditions change, the surface of the market changes to accommodate the developments. Conditions are changing, and markets are adjusting. We have had a growing economy for 9+ years. Even before the recent tax legislation, economic activity seemed to be accelerating. This is very unusual after an expansion this long. Unemployment is extremely low. The Federal Reserve has embarked on a course of gradual interest rate increases. The global economy has been rebounding. Markets will inevitably adjust as these conditions are observed, understood and incorporated into economic, investment and speculative decisions. This is natural and has always been the case through the many business cycles of our nation and the world.
So, what is missing?
In the market decline of 2000, it was a case of coming to see that “the emperor had no clothes.” Tech stocks were being valued by the number of “eyeballs” (clicks) that could be assigned to their websites. Earnings? Who cared about earnings! This was the future! It was the classic greater fool, intensely at work. As soon as the question was raised about actual earnings, the sector imploded.
In 2007-2008 it was mortgages. Who cared if folks could not afford the home they bought and could not sustain a mortgage with any actual interest rate, especially an adjustable rate. Banks were eager to make mortgages for marginal and unqualified buyers. “Hey, let’s just make it a no down payment, negative amortization!” Add the unsustainable interest to the principal of the mortgage and let folks pay forever! Equity? Who cares? You own a home! And, let’s also allow Fannie Mae and Freddie Mac to give these mortgages a AAA rating, package millions of them, slice them into billions of pieces and sell them around the world! I’ll guarantee that you don’t default. And when you do, I’ll default also, since I have no reserves set aside to cover the insurance I sold you! No one will get hurt. The government will save us all! (It did, primarily in the form of the Federal Reserve Board. Was that a good precedent? Someday, if we let it happen again, we will find out.)
So, what’s missing?
What’s missing is the economic dislocation of those earlier declines. It is inevitable that markets will go through “normal” selling periods. They usually happen very frequently. In fact, we usually don’t even remember them. This selling period, in my opinion, is a market event, not an economic event. Our economy and others, can function very well and grow with higher interest rates. We have almost always had higher interest rates than we have now and are likely to have for the next year or two. In 2018 we are likely to have record revenues, record earnings and very low corporate taxes. The current tax legislation has seen to that. If this is the case, markets will generally follow the economy. The markets may not go up at the unusual rates we have lately seen and they most likely will have more ups and downs, on an upward slope.
And it is quite likely we will have a recession eventually. Most recessions come and go before they are even recognized. The one factor that will be obvious and can undermine confidence is inflation. It is emerging. Will it be the factor that temporarily slows things down? Maybe. But we aren’t there yet. This is not that. Maybe in a year to two. Let’s save that for another communication!
For now, here’s to (Y)our Good Wealth!
Jerry!
