Coping in a Bear Market
[Presented at Boom, Bust, and the Future: A Private Retreat with Austrian Economists, January 20, 2002.]
In attempting an outlook for the year ahead--and Austrians firmly believe all such endeavors are an exercise in futility, given the complexity of the economy and the unknowable subjective valuations at work in human minds!--we will set out a brief theoretical framework. Then we will work from this to likely market phenomena and official policy actions, before listing a few factors that might derail our conclusions.
First, we have to base our theory on the premise that as a result of Man's expulsion from Eden, scarcity is a given, and thus the concept of generalized, rather than particularized, overproduction is a harmful nonsense.
Second, since we have no access to the staff with which Moses struck the rock, nor a ready supply of manna for the asking, we must realize that production is what creates wealth and that consumption, conversely, is what extinguishes it.
Thus, contrary to Keynesian and monetarist thinking, stimulating spending of itself says little about whether this will be a force for good or ill--though it may well manage to induce an increase in the aggregative statistical artifact which is GDP.
What spending does is not to create wealth, but to direct the form of its realization. Consumption is a vote, not some magic action-at-a-distance that automatically generates output, much less investment.
Spending--via its generation of price signals--tells entrepreneurs the overall ordering of preference for goods and services and gives them the starting point upon which they must base their own estimates of the price they can afford to pay for the inputs of land, labor, and other factors of production necessary for them to contribute toward the delivery of those goods and services most urgently wanted by consumers.
Once they come to expect to achieve this with a surplus--a profit--in hand, they will compete for those means they judge necessary. In this competition, they will further influence the array of prices of all raw materials, business services, rentals, and intermediate and capital goods in the market, and they will thus be continuously engaged in calculating and recalculating input-expected output margins.
A good part of these costs are associated with carrying the enterprise through time to its fruition: Goods do not appear instantaneously upon the shelf, no matter how insistent the desire for them (nor how wonderful the technology of inventory management, Mr. Greenspan). Here the interest rate--as the crucial, if derivative, determinant of the cost of capital on the market--plays its role.
In a market where the supply of money was fixed (or at least changed so slowly as to make no practical difference), that interest rate would, in turn, closely reflect people's time preferences--that is, their degree of impatience in wanting goods today rather than tomorrow.
This sets us up for what, in distinction to the fallacious Keynesian "paradox of saving," in fact makes for a "paradox of consumption": the more aggressive our demands for current goods, the less surplus we leave over from everyone's current round of labors, or, put another way, the less savings we make, the lesser the pool of both real capital (and, in this case, its corresponding monetary form) that can be made available to help produce the goods to be consumed in future.
From this extra current pressure comes a higher natural rate of interest which is a clear signal to entrepreneurs--through this most vital of prices--that means are scarce and of such long duration (or thinly margined) that more speculative undertakings are likely to fail. Thus, entrepreneurial efforts will be more narrowly based on more immediate production modes--in the extreme, on simple bilateral exchange, or even self-sufficiency.
As that last suggests, with its echoes of the primitive, this is not a route to increased prosperity.
The upshot of this is that rather than a negative feedback leading to a cycle of decline based on saving too much, we in fact have one based on saving too little.
But we do not live in that world; rather, we live in one where Alan Greenspan is merely the most egregious and unhappily influential player in his belief that he, by slowing or accelerating the swelling of the Fed's balance sheet (and, therefore, the system's most fundamental underlying monetary reserve assets) around its 30-year secular trend of 6.8 percent a year growth, can better set a rate of interest than can the interactions of a myriad of freely acting individuals.
Thus, the vital price signals are confused by the emphatic nonneutrality of money in its injection effects and in the amplification of these via today's hyperactive financial architecture--with its penchant for bringing unimaginable leverage to bear on tradable quantities deemed by the herd to thus be too low, or too high, in price at any given instant.
So, relative prices are distorted and may be made damagingly volatile and erratic in nature by monetary manipulation (even if some baskets of prices, selected for the composition of arbitrary price indices, appear more well behaved).
In this manner, interest rates are distorted by the impact of inflationary credit on financial market asset prices--and feedback strongly in the John Law spiral of monetized collateral in which we live. Thus entrepreneurs become confused, people misdirect their labors, and we keep misallocating our real capital, while piling up credit.
That, we feel, explains the business cycle, but this latest one had two new twists that helped it grow to an extent potentially more unbalanced than any previously seen. Understanding these extra rows in our matrix have an important influence on our attempts at prognosis.
First, the easy factor: technological geewhizzery.
Like kids with noses up against the toy shop window, we are always impressed by shiny new gadgetry, and we lapsed into Discovery Channel syndrome as we steeped ourselves in the trading card mentality of bytes and bauds and hits and Hertz. Judgment became suspended in favor of novelty; to some extent, it still is: Cisco, Intel, Oracle, Microsoft, and their ilk still dominate both financial news and daily trading volumes.
Second, the external factor. This could be looked on as the Western fruits of globalization, of Dollar Imperialism.
Somewhere between the fall of the Berlin Wall and the Tequila crisis, a major external shift began--one that accelerated after the events of the Asian Contagion. Foreigners started to build up official reserves, a tendency which swelled to the tune of $400 billion worth of extra seigniorage from 1997-2000, and they also began to accumulate other forms of U.S. debt in an inordinate manner.
The figures here are sobering: 74 percent of all corporate bond inflows for the past 50 years have been concentrated into the 1995-2001 period, as has 79 percent of all GSE paper buying.
True, foreigners have been less than astute in also buying 85 percent of all their U.S. equities in these most overpriced of years, but net equity flows were actually negative, and even adding in FDI (often financed with expensive stock) only contributes $230 billion, whereas bonds made up $1.930 trillion gross, $1.690 trillion net. In fact, 68 percent of all portfolio and FDI net inflows to the U.S. since the Korean War have been made since the Bubble began, and these are essentially all bond liabilities.
This trend has been absolutely key to preventing America's Ponzi-scheme inflationary finance and its yawning trade deficit from igniting the sort of price inflation that has short-circuited more typical expansions. It is also, clearly, America's Sword of Damocles.
Private foreigners have built up balances in exchange for their cheap goods, official foreigners have expanded their reserve bases, and hence their money supply, on the back of their accumulation of surplus dollars. This has helped depreciate their currencies, which, while pushing up locally counted export earnings, has also represented an extra channel of implicit taxation on their peoples via inflation.
That tax has largely gone to subsidize Atlantic Consortium consumers.
For as long as it lasted (with the aid of the odd monetary collapse in the nations that supply the Consortium), this seemingly costless expansion of credit unfortunately served to tune everybody's production at once toward Anglo-American consumers and to the high-tech fallacies of the Atlantic business model.
Meanwhile, the homegrown credit bubble has driven a huge wedge between savings and investment--to the point that, over the last three years, for the first time in the record, U.S. gross nonfinancial business investment has not been matched by a combination of household savings and businesses' internally generated funds.
The reason this has not torn the system apart in a civil war of consumers and producers battling for goods is that Johnny Foreigner has been pleased to provide them liberally on demand.
Even so, add in the fact that corporates have been using much of what they have made in retiring arguably the most expensive equity in history (something their 1920s predecessors were NOT dumb enough to do), and we have had a $1.14 trillion hole blown in the accounts since the LTCM Panic.
But no matter, for an exponential growth in credit extension and financial leverage has helped filled this chasm. If we look at the growth of financial market debt over the last three years, we find an extra $1.20 has been conjured up for every $1 of cumulative combined household savings and nonfinancial corporate internal fund generation. For a sense of scale, compare this to the previous cycle's 1989 high of only 48 cents to each dollar, and the intervening 1992 low of 28 cents.
At the same time, outstanding derivatives contracts, used to cut, paste, bundle, and gamble on moves in underlying economic quantities, have burgeoned from $56 trillion to $120 trillion, fully six times U.S. GDP, during the six years of the Bubble, with interest rate derivatives growing 140 percent, or $50 trillion, within that total. Interestingly, fewer than 10 percent of these contracts are conducted with nonfinancial customers.
This is what Greenspan--without understanding it--has to attempt to unwind, by giving the patient more of what made him ill to begin with.
Now, a monetary expansion works essentially by changing prices (upward) once more, though this is much more haphazard and random than homogeneous goods thinkers like standard monetarists and Keynesians believe, and so is hardly guaranteed to be of any overall benefit, once we jump through Bastiat's window.
What is more certain is that it can unlock that portion of productive capacity that has been frozen up and prevented, by the existing costs and refinancing imperatives of its debt load, from not repricing its output to better suit the market.
Unfortunately, this means that firms stubbornly attempting to sell goods at above clearing prices, with shaky balance sheets to boot, are being supported at the expense of the nimble, the well managed, and the innovative. Look at Compaq or IBM against Dell for an instance of this; without the Debt Machine, the first two would have surrendered the market to the latter long ago .
More soberingly, look at Japan, or Korea, or China, where Keiretsu and Chaebol and SOEs rely upon infusions of dishonest money for survival, to the detriment of all. Look, too, at what dishonest money achieved through the equity channel in the West.
It is certain, though, that to the extent Greenspan has not simply stored up an even larger financial system crisis through his actions, a huge volume of easily mobilized liquidity is available for activation in spending.
If the private sector stops the purposeless exercise of piling up more debt with the right hand, while increasing savings accounts and money market mutual fund holdings with the other, in favor of spending the latter, rather than netting off the balances to reduce their obligations, the money relation is in for a potentially dramatic shift.
Given that we started this discussion by arguing that too much spending was further weakening the overly prolonged capital structure, there is a significant risk that this will mean increasingly insistent signs of price inflation, possibly as early as the spring, as a realignment is sought once more.
Note that this can take place even if unemployment rises, unless we either shift to a retirement or immobilization of money through private thrift, or extinguish it through default or deliberate central bank policy.
GDP may well rise in the absence of this last--and the Hosannas resound unto the Heavens--even though the economy is becoming inherently weaker as spending grows. This is especially conceivable for the services component (heads up, stock sector watchers), which accounts for 40 percent of GDP. At 4.7 times the dollar value of equipment and software investment, for example, this means that a mere 2.1-percent rise in haircuts and hotel meals would mask a 10-percent fall in face-recognition technology and human ID chips.
(No bad thing, perhaps!)
Don't forget, either, that government looms twice as large as such capital investment in the national accounts, and it is hardly likely to be in retreat in coming months. Bush is about to finance a six-year crusade (Deus Vult!), as well as a host of unnecessary domestic programs. LBJ, the last man to do likewise, didn't leave the world a better place than when he embarked upon the same course.
Lower down the pecking order, the National Governors Association has categorized state finances as "in crisis," and the large recent expansion of teaching staff, for example, suggests pressures on budgets all the way to the local level must be building, too.
There will plenty of government borrowers ready to squander the proceeds of bank credit creation in this coming year, even if the private sector becomes more reluctant to play.
Initially, this improvement in spending is going to be sold as a renewed Golden Age, and the Wall St. Herd will be out in force badmouthing the Euro to forestall the Denarius's Day of Reckoning. All this could just take us into early summer before the wheels come off.
Even at this point, however, the trade deficit will be widening and internal saving will be suppressed, so rates will be biased higher, if not overwhelmingly so, in what would be a mild bear market for bonds (absent the triggering of market feedbacks). Investment spending, too, and thus the loop between this and significant corporate revenue and earning enhancement, will be largely absent, so equities may not wilt, but neither are they likely to thrive according to the norms of recent years.
Again, in all this, the only escape route from an eventual deterioration in CPI seems to be the continuation of the U.S. dollar's attractiveness to less high-rolling foreigners. With no New Era, only Sunset Industry-style growth likely, together with another widening of the trade gap and with portfolios already overexposed, this looks like a challenge--however great the US military presence may be.
Here, too, lies a dilemma.
If the Fed does not act to guard against these effects, bondholders will become uneasy about the impact on portfolio values. The yield curve will steepen bearishly as long bond rates rise the fastest, and their foreign holders might compound both the market's woes and the macroeconomic effect through selling quantities of now-surplus dollars.
If the Fed does act--or, crucially, is credibly held to be on the verge of acting--the front end, with its still unprecedented speculative overhang, will buckle first, and we will suffer a sell-off led by the shorter maturities, flattening the curve. This, too, might hurt the all-important dollar and might require increasing Fed aggressiveness in an attempt to front-load the pain and "get ahead of the curve," in their parlance.
The first scenario may well be to equities' benefit--especially those of providers of personal services and consumer staples, possibly those of resource companies, and certainly also those with large offshore earnings components. What will have started as a portfolio shift out of bonds will, if inflationary perceptions become really entrained, metamorphose into the entirely natural recourse of buying real assets and then claims on them.
The second scenario is likely to be more malign. This implies tighter (or, at least, less easy) liquidity as well as higher bond yields, and a contraction of both earnings and multiples would then be in prospect, leading to yet more foreign liquidation--this time, of stock. This would be the eventual salvation of both bonds and the Fed's market standing, if not its political popularity.
An outcome along the lines of the first prognosis is broadly conducive for diminishing corporate risk premia, while it lasts, and burgeoning federal, state, and municipal bond supply will play some part in this, but the alternative outlook--especially given foreign holdings of corporates--is anything but. Treasuries might suffer outright, but they would be unlikely to underperform in this event, as quality considerations would probably overcome any quantitative factors.
If you ask us, as betting men, which way the dice will fall, we can't imagine Greenspan doing anything so politically contentious as our second gedanken suggests and now that he's lost the nagging conscience of Governor Meyer (one of the few intellectually rigorous board members, though, naturally, a rigorous Keynesian), he has little opposition to look forward to from the placemen and the Bush-appointed tyros on the committee.
We should take a detour here and pay cursory attention to the wider world, making a swift obeisance to America's numerous and generous offshore creditors in order to estimate their effects on the U.S. cycle.
Europe also has its problems. Telecom-Tech mania did hit, as well as other foolish attempts to emulate the Yankees' and les Rosbifs' worst corporate misadventures. Iberian banks' failed attempt at a Peso Reconquista of El Dorado will hurt. But malinvestment has not been so widespread, given that much of Europe's extra credit creation was used to buy Anglo-American securities and companies.
Moreover, in most core European countries, private saving easily covers investment, so progressive impoverishment should not take place on the Anglo model unless the governments abandon all pretense of adhering to the budgetary stability pact and the mantra of "structural reform."
There also seems to be a firming resolve in the newly confident ECB councilmen that the old Bundesbank credo of "no countercyclical monetary policy" might actually work for them. We should also like to think that they will continue to be modest in their scale of reserve additions, once the new notes are bedded in over the next month or so.
Thus, barring dirigiste maladroitness, we might expect Europe to start the year looking worse than the U.S. but possibly ending up with a much better balanced economy at the end of it.
As for the UK, our pessimism should be well noted. Investment goods are in a 20-year slump; broader manufacturing is back at 1996 levels after a 1991-style fall. To reinforce this, note that private nonfinancial returns on assets fell threefold, from over 13 percent to barely 4 percent since Chancellor Brown and BOE Governor George presided over the UK's supposed end to "boom-and-bust" policies.
Bigger and bigger government--spreading industrial unrest, collapsing profits, scant saving and investment, a huge trade deficit, wild borrowing, a housing bubble, and a softening private-sector labor market--looks all horribly reminiscent of the '70s and '80s Lawson-Barber booms.
Japan now seems categorically trapped between its Asian neighbors and the importunate U.S. Bully on the weary old ploy of currency devaluation. Malaysia has threatened ructions; Korea has voiced complaints; now China is flexing its muscles.
Fortunately, bank reform is edging ever closer, and--if it is at last accompanied by ruthless extirpation of the deadwood--the Nikkei should recover and the Yen may strengthen as foreigners chase the elusive rebound once more. If it fails and stocks make new lows, at some point the surviving institutions may need their assets to shrink, or their dollar profits to be realized, in any case.
The one solution--the one nobody talks of but which could both trigger the inevitable crisis and pave the way for its resolution almost overnight--would be if government radically cut spending, not just slowing down its rate of growth, or even freezing it, but reducing it.
At a stroke, this would trigger all the bankruptcies we need; it would reinvigorate the private sector, giving command of their destinies back to the people, ending political peculation and all pretense at "stabilization" and terminate state-mandated mercantilism.
In short, Japan needs an Erhard and a Roepke to advise her. Instead she gets Rubin, Summers, and the Carlyle Group.
To recap, the core scenario is an increase in U.S. GDP as the optimists have it, but with much higher prices than most give credit to and with far lower corporate profits, except for those gaining windfalls from the effects of inflation.
We see the Fed being slow to react, politically tied by what is likely to be a continued upward march of unemployment, and worried about adding its impetus to the market's own imposition of increased debt service levels. Given the Fed's worldview, it will be bamboozled by low factory utilization and a possible double-dip in its precious inventory cycle.
Greenspan's latest speech showed he was still irresponsibly trying to promote the monetization of house price inflation to support consumption, but how far this can run has to be questioned. Can the main culprits, the GSEs, survive as bond and stock market favorites if we see any deterioration in the housing market? After all, their supernova-style expansion of recent years has led to the historically scant 55-percent cushion of equity which remains in the aggregate housing stock.
We shall see.
In sum, we currently hold that the vast monetary stimulus will push enough prices up, even amid stagnation in output, for cost-of-living indexes to deteriorate. Also, before too long, the yawning hole left by the evaporation of Bubble tax revenues and their replacement with Bust expenditures at every level of government will take effect, not only to add an underlying offer to bonds, but to begin to remind people of the bad old days of the 1980s.
All this will provide a severe test for the dollar.
However, it is conceivable that the ongoing fall in income--in the sense of a remunerative flow of valued goods and services wrought by the distortions of the Boom--will mean that the inflationary currents become, in essence, hidden ones.
The lack of "earnings visibility," as the current vogue has it, and the political and financial impediments to entrepreneurial activity may--we emphasize the "may"--be too much for businessmen to respond to mere liquidity just yet, preferring instead to hold it on account and bide their time.
If this occurs, consumer prices could still rise, and they will certainly outstrip producer prices, but they will not rise as fast as we have in our main scenario; instead, they may decelerate. Of course, this would give central bankers even greater leeway to remain lax and fixed income strategists scope to sharpen off pencils and project even more new lows in yield.
It will be too late then for us to argue that we still have an inflation in a technical sense; that, in an honest world, prices would have fallen to bring labor, materials, and factors of production all back into balance; or that we are already sowing the seeds of the next Boom. Bonds would have gained significantly at the expense of equities, and pessimism would have abounded.
Moreover, in these circumstances, it is possible that people will begin to pay down debt along the way. The traditional view is that, assuming healthy banking capital, if the Fed keeps their provision up, no bank will willingly bear excess reserves, and so new money would be loaned as a replacement, even if only by buying existing securities.
But most liabilities are no longer subject to reserve, and, further, we would argue that nonbank finance and the close monetary substitutes in the Money Market Mutual Fund-Derivatives-Finance Paper triangle constitute an alternative sink (as well as a possible source) of nonreservable monetary holdings. Therefore, a contraction could easily make itself manifest here instead.
If housing cools, if the flow of receivables lessens, if businesses and consumers seek to discharge nonbanking debts, money supply might contract with or without the actions of a largely impotent Fed.
If we see evidence that this is becoming more probable, we are all in for some hard decisions concerning the investment outlook.
So far, this does not appear to be the case--not only is money supply still growing and the weekly MBA housing purchase index making new highs, but there are signs of life in nonenergy commodities such as metals and DRAMs, even freight futures, though much of this may be due to restrictionism, not demand. Asian export volumes, too, have begun to level off after often-precipitous falls.
Conversely, it is true that industrial production and capacity utilization were yet lower in December (albeit barely) and that production has now declined for fifteen straight months, to wipe out two years' gains, losing the biggest percentage since the slump of 1982 in the process.
Core intermediate goods prices fell faster in the last six months than at any time in the past 28 years; the core crude index is at the bottom of a 14-year range. NAPM prices are just up from November's 52-year low, and the Philly Fed's version is still only recovering from October's lowest in the 33-year record.
Orders may have done better, but as Tyco reminded us only last week, orders can be cancelled. Besides, some categories, such as nondefense capital goods--the highest of high-order goods--are still languishing at mid-1995 levels.
If there is little demand for producer goods, as these aggregates may suggest, there is likely to be no payment to production workers and suppliers and--once credit-led spending exhausts both itself and further free capital--the spiral into the depths well inside the production frontier would become all too real a possibility as consumer goods, too, began to lie unutilized at the price and the process of voluntary postponement of purchases set in.
Hayek's "secondary depression" could, then, be given an outing. It will be a shame, if it does, that the Fed has already expended so much ammunition trying for the mirage of a "soft landing" that it might be forced to resort to some real Monetary Crank methods, given the crushing indebtedness that obtains across all sectors.
We need, then, to see clear signs of reversal in these numbers, together with a restoration of corporate revenues (profits we can wait upon for a short while), which might signal that the productive structure is lengthening, or at least broadening, once more. Drawdowns in institutional money market funds would be another signal of an end to the scramble for liquidity, in favor of the activation of these balances.
Until then, we are in limbo, and, accordingly, we must invest with even greater than usual levels of deliberation and care.
In the end, this episode may simply come down to what we all know in our hearts is the crux: after a truly spectacular Boom and Bust, will secularly expensive bonds win out over historically expensive equities, or, in other words, will the damage done to the system spare us from inflation's ills, even if at the expense of a depression?
This is what we, traders, speculators--entrepreneurs!--must attempt to gauge in coming weeks, and, as Acting Men and Women, we, of all people, should know that as the data change, so must we.
That is the way to cope in a Bear Market, but it is, of course, the way to cope in a Bull Market, too!