"Financial Markets and Politics"
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.”
Seth
Klarman
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.
Labels: TOTD
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