Sydney M. Williams
Thought of the Day
“Financial Markets and Politics”
February 16, 2016
“The stock market is the story of cycles and of human behavior
that is responsible for over reactions in both directions.”
Founder, Baupost Group, LLC
Financial markets are humbling. After spending forty-eight years working in the industry, one would think I would have learned some, if not many, of the answers. Not so. In my late teens, I met the president of a regional brokerage firm based in Boston. He told me that he had been in the business for several years and claimed he knew less each year. That is familiar territory. Financial markets are akin to discoveries about space. Just as boundaries to the latter keep expanding, complexities to the former become more ubiquitous. Just when we think we know the answer, something else gets added to the mix.
One ingredient this year is the campaign for President and the possible nominees. A recent Barron’s article spoke to the “Bernie and Donald factors.” They included a chart which contrasted the spike in their respective polls, beginning late last year, with a collapse in the S&P 500. Coincidence? I don’t know. Isolationism is troublesome to markets. While neither man campaigns as an isolationist, they both advocate policies that lead that way. Mr. Trump talks of imposing tariffs on goods imported from China. Senator Sanders recently stated: “Unfettered free trade has been a disaster for working Americans.” While the odds that either man will win the Presidency may not be high, it is impossible to avoid the fact that the popularity of both reflect the thinking of millions of Americans. Voters should not ignore the positive contributions that free trade and globalization have brought to man’s well being. To the extent the policies of Mr. Trump and Senator Sanders have economic consequences, they will be reflected in financial markets.
Politics and financial markets are intertwined. Government’s role should be to set rules. Business should play the best it can within those rules, to the advantage of its owners, employees, customers and communities. Economies work best when free markets set prices and determine goods and services to be sold. There will always be risks. Creative destruction, an economic phenomena popularized by Joseph Schumpeter seventy years ago, destroys businesses that don’t adapt. While painful, change is necessary for progress. Cronyism is birthed when rules are established that serve to benefit an old (or favored) industry over a new entry. Consider the experiences today of Uber, Airbnb and crowdfunding.
Politicians are in the business of re-election. They do not necessarily operate in the long-term best interest of their constituents. Like us, their time horizons have shrunk – theirs to the next election. Businesses must have longer horizons. It may take a decade or more to recover the costs of a new manufacturing plant, oil well, mine or smelter. A fiduciarily responsible CEO must be confident of the future. He must believe government’s tax policies, rules and regulations won’t harm his business. He must be convinced that markets, foreign and domestic, will be open. Uncertainty breeds inaction. In a recent Wall Street Journal article, David Malpass noted out that total U.S. credit has grown by only 20% over the past five years, versus an average of at least 40% over previous recoveries. “To make matters worse,” he added, “80% of the increase went to government and corporate bonds, leaving only 20% for the rest of the economy.” Again, consequences are evident: According to a Gallop study, based on U.S. Census data, more small businesses in the U.S. are closing than opening, the first time that has happened since measurements began.
Over the past few years, the government agency that has had the biggest impact on financial markets is the Federal Reserve. This dates back to the financial crisis. The Federal Reserve can act more quickly than Congress. In 2008 they did, with an assist from Treasury and to the benefit of us all. In the subsequent seven years, however, their effect has been more questionable. Japan, over the past two decades, is proof that more than monetary policy is needed to perpetuate economic growth. Keeping Fed Fund rates at essentially zero in the U.S. has been good for financial assets (with the notable exception of savings accounts), but not for business investment, the economy, or even from preventing “too big to fail” banks from becoming even bigger. There are 25% fewer banks today than eight years ago, and the five largest banks control almost 50% of the $15 trillion in assets owned by banks. In 1990, the five biggest banks controlled 10% of banking assets. Negative rates should make people nervous. As the Bank Credit Analysis recently put it: “Negative interest rates do not generate growth; they destroy growth because they destroy capital.”
The reason we came to rely on the Federal Reserve was because the President and Congress refused to provide fiscal relief through a reformed tax code and more effective (and less protective) regulation. The clue that something was wrong was when President Obama ignored the findings of the National Commission on Fiscal Responsibility and Reform in 2010, a bi-partisan commission headed by Alan Simpson and Erskine Bowles that he had established a year earlier. Congress never addressed reform. The consequence: The Fed became the only game in town. And now central banks are running out of options.
But back to financial markets. “Mr. Market,” as Martin Wolf recently wrote in the Financial Times, “is subject to huge mood swings.” Stock prices reflect more than just revenues and profitability. They respond to behavior and confidence. There are those like Robert Shiller whose cyclically-adjusted price-earnings ratio concludes that current market levels have only been exceeded by those that peaked in 1929 and 2000. I am not smart enough to debate Professor Shiller, but I believe it is worth noting that ten-year compounded annual returns for the Dow Jones Industrial Averages (DJIA) are quite different today than they were in 1929 and 2000. In 1929, those ten-year returns averaged 11.9 percent; in 2000, 16.0 percent. When the DJIA reached its interim high last June 23rd, the ten-year compounded annual return was 5.9 percent. Today that ten-year return is 4.1 percent It is okay to be bearish, but perspective is needed.
A financial market that has been in bull mode for thirty-five years is the one for U.S. Treasuries. The yield on the U.S. 10-Year Treasury has fallen from 15.8% in 1981 to 1.7% today. Can rates move lower? Of course. Will they? I don’t know, but caveat emptor would seem to apply.
Assessing markets is difficult, not just because of the complexities of algorithms and mathematical formulas, but because markets also reflect human behavior – the nuances within each of us. As well, market participants confront myriad and conflicting government policies. Like baseball, there are statistics for everything in economics and markets. One can “prove” anything one wants. Person ‘A’ looks at a series of numbers and claim they mean X. Person ‘B’ draws the opposite conclusion. Norman Augustine, a businessman who served as Under Secretary of the Army from 1975 to 1977, once said: “if stock market experts were so expert, they would be buying stock, not selling advice.”
Age has few benefits, but one is perspective. It is based on one’s own experiences and from reading history, biographies and fiction – novels that deal with the human psyche. We know that tomorrow will not be “déjà vu all over again,” for history never repeats, though it rhymes, as Mark Twain allegedly said. We learn that not all questions have clear-cut answers, that events and individuals are unique, but we hope to have the wisdom to understand that human behavior is subject to emotions that are eternal. What history does say is that over the long term stocks have done well, and that investing is less risky than trading or market timing.