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SPEAKING FREELY
Bear's shadow falls
over financial markets
Jeffrey
L Ferguson
Speaking Freely is an
Asia Times Online feature that allows guest
writers to have their say. Please click here
if you are interested in
contributing.
The United States
faces a high probability of economic "Armageddon",
according to Stephen Roach, chief economist at
Morgan Stanley. "Balance the budget?
Fugitaboutit," says PIMCO's Bill Gross. Meanwhile
Warren Buffett has described financial
derivatives, with contracts totaling US$84
trillion in notional value concentrated among a
handful of large US commercial banks, as
"financial weapons of mass destruction" while
simultaneously moving $20 billion out of the US
dollar into foreign currencies.
To put it
mildly, some marquee names in the financial realm
sound cautious regarding the United States's
financial future. At the same time, today's
business news carries a continuing stream of
articles and commentary from experienced financial
professionals, which generally suggest that
although there may be room for concern regarding
oil prices, dollar weakness and debt levels, the
economy can be expected to continue expanding at a
moderate rate and financial asset prices, although
not at historically low levels, offer reasonable
value for the patient investor.
The
diligent investor, having taken the time to follow
what these professionals have to say, might be
excused for feeling concerned, confused and
frustrated. What hope do they have of untangling
contradictory views from some of the best in the
business? And, importantly, if the long-lasting
financial devastation of a secular bear market
(Roach's economic Armageddon) is a possibility,
what chance do they stand of determining the
likelihood of such an event? Fortunately our
financial future can be considered in a
fundamental and readily understandable, yet widely
overlooked manner.
Two secular bear
markets [ed: "secular" in the sense of "continuing
for a long period of indefinite duration"]
occurred during the past 100 years of US history.
1929 saw the beginning of a 90% decline in equity
values that transpired over the subsequent
three-year period. During the 1930s, the US
economy experienced the failure of thousands of
banks and unemployment of over 25%, with grinding
depression lasting until World War displaced
depression as the overwhelming economic force. The
Dow industrial index didn't regain its 1929 peak
until 1954, 25 years later.
The second
secular bear growled its way through the 1970s and
it was truly secular in nature. Contrary to a
common belief, equities didn't simply trend
sideways through the 1970s before moving to new
highs with the great bull market starting in 1982.
This illusion is caused by inflation that plagued
the period. Deflating the S&P 500 with the CPI
(Chart 1) reveals that the market peaked in 1969,
not 1973, before falling 64% over the subsequent
13 years, ultimately bottoming out in 1982. Stock
prices failed to exceed the 1969 peak until 1993,
24 years later, and didn't move convincingly
through the 1969 level until 1995. At this point,
the weary, and rather aged, investor still faced
capital gains taxes on a phantom 300% gain wholly
due to inflation. Covering this tax liability
likely extended the true recovery period to within
shouting distance of the bear market in stocks
beginning in 2000, the most recent peak in equity
markets.
Secular bear
markets must be avoided if an investor hopes to
enjoy expectations regarding their financial
future; the damage wrought is too deep and long
lasting for a buy-and-hold strategy. For older
investors, failure to stay clear of the secular
bear will result in financial devastation from
which they will have no realistic hope of
recovery. Unfortunately, the majority of investors
are bound to suffer this damage since the mass of
long-term financial paper won't conveniently go
away during a secular downturn. Somebody, meaning
most, must carry these financial positions all the
way down. To avoid this fate, one must understand
the force driving the secular bear so they have
some sense as to when to seek safe harbor, a
necessity they should face only once or twice in a
lifetime.
Implicit in contemporary
understanding of the business cycle is the belief
that cycles originate within our very nature. The
assumption is people simply become overconfident
during periods of economic expansion leading to
the overextension characterized by financial
bubbles, followed by periods of unreasonable
pessimism and attendant economic decline. Keynes
coined the term "animal spirits" in suggesting
this view of humans. The supposition that humans
are subject to spontaneous, coordinated bouts of
mania and depression supports the notion that
action should be taken to smooth the consequent
cycles through counter-cyclic intervention in the
monetary and fiscal sectors, easing credit and
expanding government spending during downturns
while tightening credit and reducing spending
during upturns in an effort to maintain high
levels of employment and low inflation.
This popular paradigm offers what appears
to be a logical, effective approach to economic
analysis and policy. Yet time after time through
decades of experience, the majority of economists,
financial professionals and policymakers have
failed to identify periods of excessive optimism
or anticipate subsequent declines and
counter-cyclic policy has failed to prevent
wrenching disruptions in financial markets and the
economy. As the Federal Reserve increases interest
rates following a period of credit ease, the
typical financial prognostication suggests a
controlled slowing of the economy, or soft
landing, as rates are moved to a neutral level. In
fact history demonstrates such rising rate
environments are generally associated with a
cascade in financial asset prices and economic
stagnation, or worse. The process is the same
whether the downturn is short term (2 to 4 year
cycle) or secular (30 to 40 year cycle), only the
magnitude and duration vary. This repetitive
failure of analysis and policy suggests the
popular understanding of business cycles may be
flawed.
If present understanding is
flawed, what alternative explanation might there
be for the business cycle? Interestingly, there is
a logical explanation, and it is based on one of
the most fundamental and powerful insights offered
in economics; an insight so basic that the concept
is addressed in depth in any text introducing
microeconomic theory and economists from all
schools of thought are likely to agree in
principle. No grand new theory is required to
understand the fundamental force driving the
business cycle.
Understanding the genesis
of the business cycle calls for little more than
understanding the key role prices play in
coordinating an economy; resolving the otherwise
intractable problem of how to best employ limited
resources to attain maximum satisfaction within a
society. Prices convey the enormously complex, and
sometimes otherwise unquantifiable, mass of
information that must be accounted for within an
economy (input availability, production
technologies, subjective valuations/preferences of
each and every consumer, etc). Prices guide the
economy by setting limits, signaling businesses
when they have reached the level of output
offering consumers maximum satisfaction relative
to alternative uses of inputs and limiting
consumption to that which will provide them the
greatest satisfaction given the resources
available and their preferences.
Price
controls of any kind lead to a mix of production
and consumption that fails to employ resources in
the most efficient manner relative to the total
satisfaction of members of society. For example,
forcing a price below the market rate will lead to
a quantity demanded in excess of the quantity
supplied, causing a shortage. Consider how readily
and happily we would consume oil at $5 a barrel.
Then consider how much oil would likely be
available to us if the market price was dictated
to be $5. Hopefully we would all have bicycles on
hand, since we wouldn't be driving our cars much
once the tanks run dry and bicycle makers might
soon reduce or end production for lack of energy
inputs.
We understand intuitively that we
would in fact enjoy a higher level of satisfaction
by paying more for oil, thereby supporting
creation of a larger supply. Further, we
understand that at the controlled price the supply
wouldn't be available since the below-market-price
actually indicates a low desire for the product
signaling producers to produce less. In short,
price controls diminish the well being of society
by promoting less valuable employment, or complete
unemployment, of resources available within an
economy.
What determines the extent of the
damage caused by price controls? The answer
depends in part on the size of the market in
question. If, for example, a small market such as
the market for hand-turned fruit bowls was being
controlled, the damage would likely be immaterial
to the economy as a whole with insignificant
subsidiary effects in other markets. On the other
hand, if a large market, such as the market for
oil, were price-controlled, the effects would be
extensive with impacts on any market dependent on
oil as a production input, along with direct
impact on end consumers who employ oil products
while driving cars and heating homes.
The
longer controls are, in effect, the greater the
damage. Not only is a lower level of satisfaction
imposed over a longer period but structural
capital changes occur as well. Using the previous
oil price control as an example, we can readily
sense that oil companies would cut back on current
capacity along with exploration for and
development of future supplies. Scarce capital
that would have been most profitably employed
maintaining or expanding the supply will be locked
into other less valuable uses in outside
industries. Over time, a considerable
misallocation of capital can be expected and a
longer recovery period will have to be endured
when prices are once again allowed to reflect the
preferences of consumers.
If all the
foregoing is accepted, one can see that the most
profound damage would be caused by perpetual
distortion of a price that affects all consumption
and investment decisions in all markets. Does such
a price exist? Yes: the interest rate! Every
consumption decision involves, although perhaps
not explicitly, the choice between consumption now
or saving now and consuming more in the future.
Depression of interest rates makes current
consumption less expensive relative to future
consumption with saving relatively less attractive
since earnings on savings are lower. Business
investment decisions are also affected by interest
rates. Every such decision, at least implicitly,
involves a valuation of discounted cash flows. A
lowering of the interest rate reduces the
discount, making business investments look more
attractive than would otherwise be the case.
Surely, one might reasonably think, given
our well-developed understanding of the importance
of prices in coordinating an economy and the
consequences of distorting prices, we wouldn't be
foolish enough to manipulate the price capable of
causing the most damage. Astonishingly, we do so
as a matter of policy! A primary function of the
Federal Reserve involves the setting of short-term
interest rates. Furthermore, institutional
practices within our financial system distort the
rate of interest to an even greater degree through
fractional reserves at depository institutions; or
most generally funding long assets with
shorter-term liabilities. Within modern day
financial systems the rate of interest never
develops through unfettered market action. All
markets, financial and "real", are continually
subject to distortion induced by the altered rate
of interest. There is no opportunity for a
market-determined rate of interest to provide
efficient, stabilizing coordination of resource
allocation across time.
How could we fail
to apply our understanding of the power of market
prices to a price as important as the interest
rate? Perhaps, in part, the answer involves the
abstract nature of the issue. Interest rates guide
the allocation of resources across time, a
particularly elusive concept. In the immediate
present, the frame of reference we all grasp most
readily, destructive misallocations resulting from
distortion of interest rates are not evident. In
fact quite the contrary is true. Depression of the
interest rate through expansion of money and
credit seems to offer a miraculous opportunity to
get something for nothing. As a consequence of
credit easing, we see higher levels of
consumption, business investment, employment and
financial asset values. How could any of that be
bad? Periods of declining rates generally precede
cyclic tops characterized by the best of
conditions in the economy and financial markets.
The problem is, a point will come when
rates must rise due to a shortage of saved
resources (unless overseas investors are willing
to supply a never-ending stream of saved capital).
As rates rise, consumers come to the realization
that their consumption was more costly than they
had thought and businesses recognize that
discounted cash flows are worth less than
anticipated. In other words, consumers learn they
consumed more than they could really afford early
in their overall consuming life and businesses
learn they've invested too much in early periods,
often into fixed assets which are not readily
reallocated. Faced with these realizations,
consumers will cut back on consumption and
businesses will reduce investment enough to
compensate for past misallocations resulting in a
greater reduction in economic activity than would
be suggested by the increase in interest rates
alone, leading to the conditions which
characterize a business cycle downturn. But this
is just part of the problem.
One key
sector of the economy is affected
disproportionately by expansion of money/credit
and distortion of the interest rate. The real
fireworks emanate from within the financial
system. The sector is the major player in this
drama as it embodies much of the credit expansion
while, due to inherent leverage, magnifying
consequences - good and bad. Although the Federal
Reserve controls base money, in our current fiat
money system it is the financial sector that
really picks up the ball and runs, creating a much
larger mass of credit while leveraging the
financial system through expansion of balance
sheets. This process is driven through the
creation of long-term assets (stocks, bonds,
mortgages, commercial loans, etc) which are funded
by short-term liabilities; a cycle which may
theoretically repeat over and over using the same
base of money.
In reality, to the extent
that short-term liabilities are funded through
deposits of the banking system there is a limit
imposed on the expansion by reserve requirements.
Short-term funding outside the banking system
faces no such limit but short instruments will
need to be rolled over routinely in order to
continue supporting longer-term positions. With
interest rates falling or stabilized at lower
levels, this process can prove lucrative for those
adequately leveraged since the spread between
returns on short and long assets tends to be
rather large during periods of credit ease.
Furthermore, long asset values increase sharply as
rates fall and remain high with sustained low
rates since present values change exponentially
with moves along the time horizon. The process is
the same whether the expansion is conducted by an
individual, a medium-sized bank or a gargantuan
entity such as Fannie Mae. The result is creation
of an inherently unstable mass of credit supported
by a relatively narrow base of money with each
paper-backed financial instrument serving both as
an asset to one party and a liability to another.
Subsequent to the easing phase of the
financial cycle, stock and bond values are high,
credit is easy, business activity is strong,
unemployment is low, profits and income are high.
Consumers appear well able to meet their debt
obligations given strong asset values and income
while businesses seem well capitalized and
generate ample cash flow for coverage of
liabilities. As noted previously, depression of
the interest rate through credit expansion looks
and feels good within the context of the present
while concealing inherent resource dislocations
which will necessarily and painfully come to the
fore in the future; much as a substance-abusing
individual enjoys an immediate sense of
well-being, blissfully unaware of the withdrawal
to come. Such effects are magnified within the
financial system on the upside, and the downside.
What happens to the financial system as
rates rise? To begin the exponential increase in
values of long-dated cash flows (earnings on
stocks, interest payments on debt securities,
future wages, etc) that works such magic on the
upside now shifts into reverse. The decline in
values will be most evident in financial assets
considered speculative, generally because they
provide little or no cash flow in the present
while holding the promise of large returns in
distant periods. The value of these distant period
returns is much more heavily impacted by rising
rates than shorter-term returns. However, any
long-dated asset will suffer the irresistible
force of higher rates of discount as interest
rates climb, even those offering near-term income.
In short, equity and debt markets fall
first and often fast. With long-dated asset values
falling sharply, short-term liabilities remaining
essentially unchanged and the cost of short-term
funding increasing, investors quickly see profits
dwindle while their net capital contracts or
disappears entirely depending on their state of
leverage. Furthermore, early in the cycle, short
rates tend to climb faster than long rates. As the
spread narrows, the motivation to borrow short and
lend long diminishes, curtailing creation of the
new credit that might otherwise support the
system. Eventually short rates may rise above long
rates, providing a powerful incentive for outright
contraction of the financial structure.
As
the contraction progresses, long-dated asset
values, which are now loss-making to the leveraged
financial player, often prove inadequate to cover
stable-value short-term liabilities. Previously
credulous investors turn pessimistic, rightfully
enough, leading to expanding risk premiums,
diminishing long-dated values further still.
Eventually savers rush for liquidity, seeking
safety in very short-dated, high-quality
securities or even currency. The credit crunch
characteristic of financial declines reaches full
force. Bankruptcies surge among entities that
previously appeared sound as the failure to meet a
liability on the part of one player leads to the
loss of the offsetting asset held by another,
which, via chain reaction, leads to a series of
failures. The force of leverage working in reverse
overwhelms the system leading to a deflationary
implosion of the inherently unstable, leveraged
financial structure...unless the Fed can head the
dive off with another round of money expansion.
Contraction of the financial system
impacts the "real economy" as well, since the
system normally facilitates a critical process
within the economy, the process of intermediation
between savers and productive business enterprises
employing scarce saved resources to create the
products and services which, ultimately, provide
the basis for an increase in the well-being of all
members of society. When the financial system
suffers a systemic contraction, this much-needed
intermediation can break down, leading otherwise
productive, wealth-creating business entities to
shrink or fail entirely with predictable
consequences for employment and income.
Reduced consumption and business
investment along with contraction or collapse of
the financial system leads to all the painful
consequences we identify with a recession or
depression: bankruptcies, high unemployment,
diminished incomes, lower profits and lower
financial asset values. Naturally, such periods
are also characterized by a general pessimism.
Periods of general societal depression do develop
following periods of mania but the conditions that
foster such extremes of spirit are a direct
consequence of the distortion of the rate of
interest and misinformation conveyed by these
distorted rates to individuals acting in an
economy.
The interest distortion
explanation of the business cycle can only be
misconstrued if foundational concepts of price
theory are wrong, which is analogous to suggesting
to a physicist that the fundamental concept of
gravitation is wrong. Actually one need not be an
economist to understand the issue. Intuitively, we
know how we would react to an unanticipated
reduction in payments for that which we produce
(discounted value of future wages in the case of
labor), an increase in the cost of that which we
consume in the present relative to future
consumption, or how we would react, in our role as
investors, if our long assets were suddenly worth
less than our short-term liabilities with the cost
of carrying those short-term liabilities on the
rise. The distorting force comes from outside our
nature rather than within, which should come as no
surprise since we have long understood that humans
spontaneously, and miraculously, develop stable,
efficient markets via information conveyed through
market prices. There is no reason to think the
market-allocating resources across time would be
any different.
The investor who
understands the fundamental force driving business
cycles enjoys a significant cognitive advantage
over the majority of investors, including most
professionals. Contemporary understanding of the
business cycle may be the flat-earth misconception
of our age, and it is just as popular. In addition
to misleading investors, the misconception causes
monetary policy to be worse than ineffective in
moderating business cycles. Monetary policy may
delay painful adjustment for a time through
further credit expansion and reduction of rates
but such action causes distortions to grow in
magnitude ensuring even greater damage when policy
is ultimately overwhelmed and the process runs its
course. Rather than steer financial markets and
the economy clear of hazards, monetary policy
ultimately drives the ship up on the rocks, after
building up a head of steam, time after time
(note, past asset-backed monetary systems suffered
a similar process as a consequence of fractional
reserves/mismatching of maturities but the cycles
tended to be sharper and shorter).
What
can we say about present financial conditions
using this understanding of the business cycle? Is
a secular bear market inevitable?
Given
that distortion of interest rates constitutes the
fundamental force driving business cycles and the
fact that interest rates continue to be distorted
by the Fed and through conduct of finance,
combined with historical evidence indicating that
very long secular cycles - punctuated by interim
cycles - have previously developed as a
consequence, the answer seems clear. Yes, another
secular bear market is inevitable. Of course, what
we most want to know is, when is the beast likely
to bear upon us?
Predicting precise timing
of anything in an economy or market is a most
uncertain venture. Basic economic models typically
develop an understanding of concepts by
considering changes in one variable at a time but
real-world scenarios involve simultaneous changes
in many variables, some unquantifiable. Complex
economic models employing statistical methods may
attempt to account for many variables but they may
not be able to account for all pertinent
variables; they can suffer from ill-conceived
theory; the data is often lacking in some regard;
the models depend on statistical assumptions that
may be invalid; and there may not be any durable
constants to be discovered in any case. In short,
we must take any precise predictions regarding
timing and magnitude as they relate to markets and
the economy with a grain or two of salt...at
least.
A powerful fundamental concept has
been argued for here, but attempts to predict the
timing of cycles, even within broad time frames,
must include additional elements such as
application of an understanding of the roots of
financial fragility, the importance of spreads
between short and long interest rates and
consideration of inflation-adjusted interest
rates, among others. Even with consideration of
these issues, a short-term prediction may be
frustrated by such factors as an increased
willingness of foreign investors to provide saved
capital or, the ultimate imponderable, a general
shift in preferences (regarding resource
allocation over time in this case). Finally, keep
in mind we have no way of knowing what the market
rate of interest would be at any point in time
since the market never has the opportunity to
evidence this rate. Consequently we have no way to
accurately gauge the direction and extent of the
distortional force.
Nonetheless, at this
point in history the foundational concept may
provide much of what we need to reasonably
anticipate the worst of the bear. Consider Chart
2, a simple presentation of the data key to the
concept. This is the picture of a charging secular
bull about to hit the end of its chain. Beginning
with double-digit short rates in the early
eighties, we witness a clear downtrend
characterized by sequentially lower sharp peaks
followed by ever lower broad valleys. If one
delves back into the financial history of the last
two decades, one finds valleys generally marked
expansion periods and peaks were generally
associated with system quaking - events such as
sovereign debt defaults, currency crises, a major
institutional failure (eg, the Long Term Capital
Management crisis), interim bear markets and a
couple of relatively mild recessions; mild because
the Fed still had room to push rates lower and
overseas investors were increasingly willing to
absorb the flow of financial paper, providing real
saved resources in return. After each series of
rate increases, and subsequent financial crises,
the Fed ultimately lowered short rates to new lows
in order to reflate markets and drive the next
boom.
Consider where we
stand today. Judging by the trend the Fed would
have to drive nominal rates into negative
territory to reflate after the decline that we can
anticipate following the present series of rate
increases. However, logic suggests that nominal
rates cannot be driven below zero to any
substantial degree. Given a choice, potential
lenders would choose to hold cash and suffer any
inflation loss rather than lend cash at a negative
nominal rate resulting in a contractual loss in
addition to the inflation loss and default risk.
The only way for the Fed to reflate from this
point forward is to support price inflation,
driving interest rates below zero in real terms
(in fact inflation-adjusted short rates are
already negative).
The Fed will soon face
two dreadful options, either course likely
initiating the secular decline: a persistent
tightening that will cause the system to cascade
into deflationary decline or an attempt to fuel
the next boom while necessarily fomenting price
inflation, driving real short rates deeper into
negative territory. The deflationary scenario
isn't likely, due to political realities and
institutions that have been put in place since the
1930s to circumvent deflation (like the Federal
Deposit Insurance Corporation). We can count on
the Fed to use all means at its disposal in its
role as lender of last resort when time comes, as
has been promised by members of the Fed. Hence, we
should anticipate a secular decline characterized
by price inflation similar to, but worse than, the
1970s. Investors who take a defensive position
today (investing in T-bills, TIPS, real assets,
including some precious metals, and not paper
currencies) will have moved out of harm's way just
in time within the secular timeframe whether the
worst of the decline begins 6 or 18 months from
now.
After decades of conditioning, one
may well find a shift away from the popular
conception of business cycles to be discomforting.
This transition may be eased through review of the
repetitive real-world failures of analysis and
policy that are a consequence of the conventional
view. The popular paradigm, based on an impulsive
assumption regarding human nature, was doomed from
the start as it was built upon a faulty
foundation. The alternative, by comparison, is
consistent with robust, universally acknowledged
understandings fundamental to microeconomic theory
and insights available to any individual through
introspection.
The real mystery lies in
the fact that so many perfectly intelligent and
well-educated financial professionals, economists
and policymakers have overlooked the alternative
while holding fast to a logically confounded
concept evidencing a record of failure.
Regrettably, those depending on their expertise
have suffered, and will suffer, terrible
consequences during periods of secular decline. My
hope is that readers of this article will find the
insights offered compelling enough to serve, at
least, as a basis for rejection of the notion that
we are in a "new era" or that things will somehow
"be different this time", notions which have
proven ill-conceived time after time, cycle after
cycle, and that readers will be encouraged to
protect themselves from the inflationary secular
bear market which is inevitable - and now
imminent!
Jeffrey L Ferguson is
a private investor. He can be reached at
jferguson@centurytel.net
(Copyright
2005 Jeffrey L Ferguson)
Speaking
Freely is an Asia Times Online feature that allows
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