The Dow lost 315 points last Friday — a nearly 2% plunge.
It is bound to happen sooner or later: US stocks will enter a bear market.
Nothing can stop it. Nature and the gods command it. The Dow will fall as much as 1,000 points in a day.
Then we’ll see if our analysis is correct…
We believe the Federal Reserve will be unwilling to stand back and let markets be markets. We believe it will step in with more stimulus…and probably bring on the wildest, craziest stock market extravaganza we’ve ever seen.
Whether that happens sooner or later, we don’t know. So let’s continue our discussion of the big picture…and why we think the Fed must stick with its game plan.
How to build a ‘margin of safety’
Endless discussion, books, reports, theories and blah-blah have been devoted to the subject of markets’ cyclical moves…and the role of human psychology in these cycles.
For our ‘crash course’ let’s just remember that markets don’t make it easy for us.
When markets look their best, they are often most treacherous. When they are forgotten, neglected and held in contempt, that is when they are most likely to give you ‘positive beta’ (the kind of investment return you get from being in the right market at the right time).
In that sense, markets are like individual stocks or bonds. You are better off buying them when they are cheap.
Your analysis of the company may be right or wrong, but the low price gives you what the father of value investing, Ben Graham, called a ‘margin of safety’.
The bigger your margin of safety — the gap between the price you pay and your estimate of intrinsic worth — the better.
But let’s now turn to the macro backdrop of today’s financial world…
Since this has been the focus of our interest for so many years we are tempted to write a book about it. But we already did. Four times. Readers warmly received the books; elite economists and policymakers have not so much as acknowledged them.
In the interest of full disclosure, our analysis of the macroeconomic situation is at odds with a long list of Nobel laureate economists and powerful opinion makers — Krugman, Summers, Bernanke, Yellen, Stiglitz, et al.
The list is so stellar that you will have to ask yourself at some point why you bother to listen to us at all. But we accept the question. We are in a small minority. And the burden of proof lies squarely — if a bit uncomfortably — on our shoulders.
The folly of central planners
This ‘crash course’ is too short for a full explanation of why the world’s leading economists are wrong and we are right.
For our purpose today, we content ourselves with a few important questions…
Economists of mainstream academia, government and the media believe they know how to fix an economy so that it does what they want.
Where’s the evidence?
In every example known to man, the more the authorities try to control an economy the worse it functions. More specifically, they believe they can boost output, making people wealthier than they would be without their interventions.
When did they ever do this?
From the beginning of time to the present, is there a single case in which this has happened?
Not that we know of.
These economists gain jobs, fame and prestige by claiming to improve the workings of free markets. We see that their theories have clearly worked for them. They have improved their own position…and shifted trillions of dollars to their cronies in the financial industry.
But is there a clear, undisputed example in which they have worked for anyone else?
Again, none that we know of.
But there are plenty of examples of economies that have been severely damaged by overly ambitious central planners. The most in-your-face example was the Soviet Union, whose seven-decade experiment with central economic planning was finally abandoned in 1989.
But let us turn our attention to the US. How has the economy evolved since the dark days of the Great Depression in the 1930s?
Guns and butter
World War II was the biggest stimulus program in US history. The economy boomed. Wages were high. But consumer goods were scarce.
When the war was over economists worried that the economy would fall back into a depression. Instead, the GIs came home, started families, got jobs, had children and set up businesses. The economy boomed again – this time with output that raised standards of living.
Increased prosperity led people to believe there was no limit to what they could afford.
Previously, politicians believed they had to make a choice — guns or butter (war or domestic welfare programs). President Johnson decided to focus on both.
The Vietnam War and the Great Society. These weakened the finances of the US so much that, in 1971, President Nixon was forced to end the direct convertibility of the US dollar to gold.
After the so-called ‘Nixon shock’, which ended the Bretton Woods currency regime, the world’s monetary system became elastic.
Because there was no longer any link between money and a scarce commodity, there was no longer any limit on how many dollars or yen or pounds you could create.
Commercial banks simply created money ‘out of thin air’ by creating new digital deposits.
A credit-dependent economy
Not surprisingly, this new money was popular.
The supply of credit (money) increased 50 times between the end of World War II and the onset of the global financial crisis in 2008.
Americans spent $33 trillion they had never earned or saved. That’s ‘excess credit’ — beyond the amount needed for a normally functioning economy.
This, and not real earnings, is what built — and what sustains — countless shopping malls, housing developments, Chinese imports, federal spending programs, wars in the Middle East and the standard of living we now take for granted.
Now, the economy — and the asset prices it supports — depend on continued expansion of credit.
Perhaps it is unnecessary to say so. But without expanding credit, today’s stock market is kaput.
Trees do not grow to the sky. Nothing lasts forever — certainly not a financial trend!
Credit is a claim on resources and output. When you borrow, you shift resources from someone else to yourself. But you have to pay your loan back. Or the lender will lose the wealth he thought he had…and stop lending to you.
This is why, earlier in this series, we looked at where capital really comes from.
Capital is real savings and real resources. It is the part of wealth you don’t consume on a current basis. Credit can be used to increase output…or it can be consumed. But if you consume it rather than invest it in future output, how do you repay your loan?
And what happens if the lender didn’t have any capital to lend in the first place?
$12 trillion in new money
Ah, this is starting to get complicated.
Sorry, not our fault. But let’s try to understand: Economies naturally breathe in and breathe out. They expand and contract. They make mistakes — bad investments, bad loans — and they correct them.
They increase credit and they reduce it.
Yes, credit is cyclical too. The more you borrow, the more you had better prepare to pay back. Sooner or later, every debt is paid, if not by the borrower then by the lender. And occasionally, when inflation reduces the value of the principal, by the whole society.
Since the 1987 ‘Black Monday’ stock market crash, each time the economy has tried to breathe out — expelling its bad credit, overpriced assets and oversize debt — the Fed has rushed to stop it.
Instead of allowing prices to decline — and accepting the losses, bankruptcies and defaults that usually accompany a credit contraction — the Fed has insisted on making the credit bubble bigger. It lowers borrowing costs, making more credit available at lower prices.
And now, having avoided many smallish contractions, the world economy now faces a biggish one.
Total world debt now exceeds $100 trillion. And the feds in almost every major economy are desperately trying to keep that number going up.
Many now judge the risk of a credit contraction unthinkable.
Financial author and analyst Richard Duncan of Macro Watch calculates that, over the last 12 years, the world’s five biggest central banks — the Fed, the European Central Bank, the Bank of Japan, the People’s Bank of China and the Bank of England — have expanded their balance sheets by the equivalent of roughly $12 trillion.
They create money to buy financial assets — typically government bonds but also mortgage-backed bonds, exchange-traded funds and REITs — to prop up asset prices, devalue their currencies and hold interest rates down to near zero levels.
So far, these measures have held off a credit contraction.
For example, in the US, since 2008, only the household sector has reduced its debt level. Business and government have more debt than ever. After 65 years, total credit is still increasing in the US.
But the real test of the Fed’s ability to stop the credit cycle is still ahead.
More to come…
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