Before this market rout and from the safety of the World Economic Forum in Davos, hedge fund legend Ray Dalio talked about the coming bear market in bonds and likelihood that we were near the end of this cycle of economic boom. Sometime in the next two years, he remarked, we were likely to experience a recession and that would put an end to one of the longest periods of economic growth in the United States.
With the experience of the big market rout of January 26 through February 8 behind us–if it indeed is–when the Standard & Poor 500 stock index fell 9.03%, I’d like to make Dalio’s comments a little more explicit and apply them more directly to the stock market. (Since Davos Dalio has turned more bearish on the economy, putting us closer to the end of this economic cycle and describing the downturn as more difficult for central banks to manage.)
It may be clear to many of you reading this post, that no one has repealed the business cycle, the age-old guarantee that economic bust will follow economic boom and then itself be followed by economic boom again. But unfortunately, it’s not clear to the Trump administration, Congress, Wall Street, and a number of other global power brokers. In the face of evidence that the economic cycle is near or has passed its peak, and that the economy, if left to run its course, faces the real prospect of a recession sometime within, say, the next two to three years, these large institutional players have decided to take steps intended to extend the life of the economic growth segment of the cycle and to postpone, indefinitely if possible or if not certainly until after the 2020 elections, any move toward recession.
The historical evidence says that these efforts to put off the downturn are instead likely to exacerbate the severity of the downturn when it comes.
This pattern isn’t something invented by our current set of government and financial leaders. In fact, Hyman Minsky and the Austrian school of economists have posited that this pattern is inherent in capitalism as practiced in the real world.
There’s even a name for this pattern and for the economic downturn that results. It’s called a Minsky Moment, a name bestowed by Paul McCulley, in 1998, in honor of Minsky. (I especially like Minsky’s comparison of bankers and other financial players to arsonists, who set the economy on fire with the fuel of speculative cash.)
The Minsky cycle works like this: economic good times lead to two kinds of investment. The first is investment in tangible, wealth-creating capacity and in innovative new companies. This produces income for the mass of the population–the 99% in current parlance. The second is non-productive speculation (by the 1%) that uses cheap money to invest in asset bubbles, legal pyramid schemes, and high return/low probability schemes.
The problem is that much of the decision making in our current financial system is run by men and women invested in the gains, financial and otherwise, produced by this speculative investment. So it is especially hard to reign this speculative phase in short of a recession or a financial bust. It becomes even harder when a long period of asset appreciation, say, a bull stock market that stretches back to 2009, leads to a demand for more cheap money in order to keep the boom going and where the longevity of the boom leads to increased demand for speculative assets by smaller players who feel they’ve been left out of the game.
To me this sounds like where we are now in the economic cycle. I can’t think of a more appropriate example than the December tax cuts, which are forecast to add $1 trillion to $1.5 trillion to the deficit–borrowed money that can and will be used largely for speculative purposes such as stock buybacks that goose share prices upward without adding to a company’s productive capabilities–another $200 billion to $300 billion in budget busting deficit spending included in the February deal to keep the government open, an effort to leverage $1 trillion to $1.5 trillion in infrastructure spending by depending on alienating revenue from future government revenue streams to “incentivize” private investment, and the recently delivered Trump budget with its forecasts of red ink as far as the eye can see.
This speculative excess on the part of government wouldn’t be as damaging if it weren’t accompanied by similar efforts in the private sector. For example, while consumer spending remains healthy in the U.S. economy, in recent quarters it has been financed through an increasing use of consumer credit. After falling to a low in early 2016, the ratio of household debt to disposable income has started to rise again and hit 104.6% in the September 2017 quarter, according to Bloomberg. As you might expect that increase in debt has been accompanied by a decrease in the savings rate. The personal savings rate in the United States fell to 2.4% in December 2017 from 2.9% in November. Both months were conspicuously below the 5.9% savings rate in January 2016.
Depending on regulators and financial watchdogs such as the Federal Reserve and other global central banks to dash speculative excess would be foolish on the historical record as well as on recent events. The Fed’s decision not to raise margin requirements for stock traders using borrowed money to buy shares certainly contributed to the last stages of the great bull market run in 1999 that turned into the Dot.com bust of 2000 and after. Recently we’ve seen appointments to the Federal Reserve by the Trump administration of officials who believe in removing regulation from the U.S. banking sector on the logic the sector has now recovered from the excesses of 2007-2008. Minsky’s take on the capital markets would argue, to the contrary, that this is exactly the time when regulators should be looking to increase their intervention in an attempt to reign in the growth in speculative trends.
Unfortunately, for global capitalism, the Federal Reserve is the furtherest along among global central bank in removing some of the cash they poured into the markets in an effort to stave off the worst effects of the Great Recession. The Fed has, at least, started to reduce the size of its portfolio of Treasuries and mortgage-backed securities by not purchasing enough new debt to replace all the debt in its portfolio that matures. This has the effect of very gradually reducing the size of Fed holdings. The European Central Bank has not yet undertaken a similar move and the Bank of Japan continues to buy debt in the market as if there were no tomorrow–which, indeed, may be the case given the demographics of Japan and its aging population’s inability to generate enough economic growth to pay down the country’s debt.
The big challenge for the Fed at this point in the cycle will be to resist calls from Congress and the White House to goose growth at the first signs that the economy might be slowing. Those calls are likely to be very loud and insistent since so much of the justification for the recent tax cuts is that they won’t be as expensive as projected by outside “experts” since they will add to economic growth.
Now there is a financial market that goes along with this stage in the economic cycle.
It’s characterized by greater volatility as investors and traders slosh from one trend to another looking for gains and as they seek to anticipate–and avoid losses–by getting out of positions before the excrement hits the rotary air mover.
There’s a greater use of hedges of one sort or another in attempt to lay off anticipated but still vague future risk without giving up the gains from current and near-term speculation.
Perhaps oddly, given that everyone agrees on the increasing odds that something wicked this way comes at some point in the future, there’s no real drop off in speculation. Some people increase their speculative bets because, hey, the boom cycle will be coming to an end even if we don’t know exactly when so let’s make money while we can. Others increase their speculative bets because the greater speed of achieving gains in these speculative moves helps to offset the closing time window for the boom. Still others find obscure speculative bets where they think they’ve found a way around the more general problem for the markets.
And don’t forget the increasing power of denial as traders and investors try to find reasons that the good times will go on longer than expected–or that the warning signs aren’t actually warning signs at all.
We’ve seen all these at work in the drop in U.S. stocks between January 26 and February 8–a drop, I’d note, that seemed so much worse while it was happening than it turned out to be since we hadn’t seen even a 4% pull back in the S&P 500 in more than 400 days.
And we’re likely to see even more of these characteristics play out in the next few months. Who among us haven’t given a thought to playing the volatility futures market after reading that venture capitalist Peter Thiel had put $244 million on his own money into a bet that volatility would soar? Or isn’t thinking about buying junk bonds in the energy sector as a way to escape sub-3% yields on 10-year Treasuries now that oil prices are back near $60 a share? Or, as advice I saw in retirement magazine recently recommended, about putting part of a retirement portfolio into Bitcoin or some other crypto currency? (After all, why shouldn’t you get part of that 3000% or whatever percent gain? What could possibly go wrong.)
To take just one important trend that characterizes this late stage market, take a look at volatility. The swing in volatility has been shocking: The VIX, the CBOE S&P 500 Volatility Index, moved from 11.08 on January 26 to 37.32 on February 5 and then back to close at 19.46 today. I’d suggest that anybody who things that this is a signal that volatility is about to go back to its historical lows near 10 and stay there for a while is seriously misreading where we are in the market cycle.