Mean Markets and Lizard Brains Read online

  What is David’s secret? He summarizes it by saying, “I know when the buying is real and the selling is real.” David stands in the crowd, listens, observes, and acts. He capitalizes on emotional signals from his counterparts, and he uses little or no formal economic analysis.

  So is it possible to make money just by exploiting knowledge of sentiment, with no economic analysis? The answer is yes, but I believe it is possible to make even more money by combining economic analysis with the science of irrationality. That is the course that we will follow in the rest of this book, and it requires that we delve into the economic details.

  We begin with the economic evidence in favor of the worst of times, and then move to the arguments in favor of the best of times.

  Bear #1: Animal House Fraternity Goes National

  “Fat, drunk, and stupid is no way to go through life, son,” says Dean Vernon Wormer on his way to expelling the members of the Animal House fraternity. When learning of his expulsion, John Belushi’s character Bluto remarks, “Seven years of college down the drain!”

  The first argument against the U.S. economy suggests that an economic path that is the equivalent of fat, drunk, and stupid cannot have a good ending. The three “pillars” of the U.S. economy are: (1) government deficit spending, (2) the Federal Reserve’s easy money policy, and (3) profligate spending by U.S. consumers.

  Pillar #1: Deficit Spending

  When the federal government runs a budget deficit, it sells U.S. Treasury bonds to make up the slack. From the beginning of the 1960s up until the late 1990s, the U.S government generally spent more than it collected in taxes so the supply of bonds grew. By the late 1990s, however, the government was actually running a budget surplus and using the extra cash to buy back lots of its bonds. During the technology bubble, the government was raking in lots of taxes (often paid on stock market gains).

  Surprisingly, some economists thought that the U.S. debt was becoming too small! They feared that persistent U.S. government budget surpluses would lead to paying off the entire national debt and make U.S. Treasury bonds extinct. This could cause problems because some investors buy U.S. Treasury bonds as key parts of their financial strategy (e.g., insurance companies). As we see in Figure 4.1, the fear of government surpluses leading to a debt shortage was unfounded.

  In an amazingly short time, the fear of government surpluses evaporated and we have returned to the good old days of deficit spending. In just four years, the budget swung from a surplus of more than $200 billion to a projected deficit in excess of $500 billion.

  Pillar #2: Loose Money

  After the stock market bubble popped, the Federal Reserve cut interest rates dramatically to soften the economic pain. The popular press believes that monetary policy can come to our rescue. Alan Greenspan is often called the second most powerful person in the United States. Every statement by the Federal Reserve is scrutinized for the slightest nuance of monetary policy.

  FIGURE 4.1 Uncle Sam the Borrower

  Source: Office of Management and Budget

  Pillar #3: Consumer Spending

  Every month the government reports on American consumer spending. Wall Street cheers every report showing that we are continuing to spend like 1920s bootleggers and boos any hint of frugality. The assumption is that the more the U.S. consumer spends, the better for the U.S. economy.

  Can a country really become rich by spending more than it earns and by printing money?

  No. Government deficits promote waste. Loose money creates inflation, not wealth. Finally, it is possible for consumers to spend too little (e.g., Japan), but the U.S. personal savings rate is close to zero. If profligacy and printing presses were the way to grow an economy, then many countries that are now bankrupt would be economic superpowers. Similarly, seven years of fat, drunk, and stupid would be a good start to college.

  Bear #2: Financial Hangover

  When I was a graduate student, I played on the Harvard Ultimate Frisbee team. One of our rivals, Williams College, had an excellent team for some years until most of their star players graduated in the same class. The next year, the Harvard team destroyed Williams. In their dazed and defeated state, the Williams players gathered to regroup. One of the optimistic players said, “We can learn and improve,” to which another responded, “But who is left to teach us?” The pessimistic answer: no one.

  The financial hangover argument looks at the purchasers of U.S. products and asks who will buy? The pessimistic answer: no one.

  To make the effects of financial hangover clear, Figure 4.2 classifies the purchasers of U.S. production. The diagram looks at actual purchases. For example, the money that the government collects for Social Security is almost immediately sent back from the government to individuals. Thus, Social Security taxes collected by the government are counted in the U.S. consumer category. Similarly, U.S. consumers’ purchases of foreign goods are not included.

  FIGURE 4.2 Buyers of U.S. Output

  Source: U.S. Department of Commerce Estimates, 2004

  There are four major groups of purchasers of U.S.-made products and services. We’ll look at the financial health of these four groups of buyers and see that most buyers are not in a position to increase purchases: (1) U.S. consumers; (2) U.S. businesses; (3) foreigners; and (4) governments.

  U.S. Consumers

  Consumer spending is driven by both wealth and income, that is, how rich we are and how much we earn.

  Because of financial market declines, the total wealth of U.S. families in 2004 was almost identical to that in 2000.2 Even as wealth has not increased, U.S. consumers have continued to spend. Unfortunately, income growth has also slowed considerably. The average annual growth rate of disposable personal income dropped from 4.0% in the five years ending in 2000 to 2.7% so far in the twenty-first century.3

  So if U.S. consumers are not getting richer, and have less income to spend, is there hope of continued spending? Yes, but it will have to come by decreasing the savings rate. Figure 4.3 shows the savings behavior of U.S. consumers.

  From a historical level of around 10%, the U.S. personal savings rate has declined toward zero. While it is possible for the savings rate to decline even further, I read the chart to indicate a possible rebound in savings. A return to a higher U.S. savings rate is a positive development for the long run, but it means that the U.S. consumer is unlikely to be the engine of economic growth over the next few years.

  FIGURE 4.3 Americans Do Not Save Very Much

  Source: U.S. Commerce Department

  This idea that increased savings hurts the economy is known as the “paradox of thrift.” Saving money is prudent and good for the individual, but the more people save, the less they buy.

  To summarize the state of the U.S. consumer, both wealth and income growth have slowed. For U.S. consumers to continue to support the economy, the savings rate would have to decline even further. If consumers return to their more traditional, higher rates of savings, their rediscovered frugality will place a serious drag on the economy.

  Conclusion: The U.S. consumer is unlikely to be a major source of economic growth.

  U.S. Businesses

  What about investment by U.S. businesses? One of the important factors driving business investment is the amount of idle production capacity. Simply put, companies with idle facilities are not likely to be aggressive purchasers of new equipment. Figure 4.4 shows the percentage of idle capacity for U.S. businesses.

  FIGURE 4.4 Lots of Excess Capacity in America

  Source: Federal Reserve

  U.S. businesses have about one-quarter of their capacity sitting idle, and this level has increased rapidly since the bursting of the bubble. Companies have enough spare capacity to accommodate years of economic growth without any additional investment.

  The two recessions of the early 1980s and 1990s also had high levels of idle capacity. The personal savings rate diagram (Figure 4.3) shows that those recessions ended when U.S. consumers sharply decreased their
savings rate throughout the 1980s and 1990s. In previous recessions, high levels of idle business capacity were put to use when consumers increased spending.

  Thus, a key to U.S. business spending lies with the U.S. consumer. If consumers increase their spending, business investment will follow. If the U.S. consumer cannot be an engine of growth, then businesses are unlikely to increase their investment spending.

  Conclusion: U.S. businesses may follow, but they are unlikely to lead economy recovery.

  Foreigners

  In the midst of the 1990s’ stock market bubble, one of the common justifications for ridiculous stock prices was the entry of China into the world economic system. Cisco’s high stock price, it was widely said, made sense because Cisco would sell a lot of product to China. More broadly, the hope was that U.S. companies could export products to many foreign markets and thus not depend on the U.S. consumer.

  While this export-based argument was wrong with regard to stock prices (Cisco shares have lost 75% of their value), a significant and growing proportion of U.S. output is indeed sold to foreign consumers. With U.S. consumers possibly looking to save, and U.S. factories sitting idle, perhaps the foreign consumer will provide growth.

  Unfortunately, important foreign economies are not in great shape. Japan and Germany—the world’s second- and third-largest economies—continue to struggle to recover from economic slumps. The German economy is barely growing at all, and the German unemployment rate is near 10%.4

  The Japanese economy is not in much better shape. Since the late 1980s, the Japanese stock market average has declined from 40,000 to just over 11,000 (July 2004). This decline far exceeds both the length and depth of the U.S. stock market troubles. The Japanese stock market decline provides a measure of Japanese economic weakness. It also reduces the wealth of Japanese people and puts further downward pressure on the global economy.

  Even the effect of Chinese economic liberalization has been negative for U.S. producers. Chinese workers make products more cheaply than U.S. workers. The export of those Chinese products has negative effects on the U.S. economy.

  Conclusion: Exports are a potential source for economic growth, but given their relatively small role in the U.S. economy, the effect may not be significant.

  Governments

  The final significant piece of economic consumption is local, state, and federal governments. With overburdened U.S. consumers, idle factories, and less-than-robust foreign economies, can government spending fuel the economy?

  Most of the discussion about government spending revolves around U.S. federal spending. It is important to note that state and local government spending is almost as important as that of the federal government.

  In his campaign for California governor, Arnold Schwarzenegger famously remarked, “The public doesn’t care about figures.”5 That may be an accurate assessment of voter sentiment, but governors themselves must care about numbers. Most state and local governments are legally required to run balanced budgets, so when times are tough, their spending must be reduced.

  All around the country, state and local governments are cutting services and raising taxes. In order to close its budget gap, New York City raised property taxes. California Governor Gray Davis earned the hatred of many by tripling the tax on car registration. A similar story is unfolding across the country. The conclusion is that state and local governments will be a drag on economic recovery, not a stimulant.

  What about the federal government? As we discussed earlier in the chapter, the federal government has been the major supporter of economic growth by heavy deficit spending. Can the federal government increase the deficit even more and provide more economic growth? Yes. A $500 billion deficit is large by any measure. When compared to the size of the economy, however, the current deficit is much smaller than historical extremes.6 Thus, if needed, the federal government can increase purchases.

  There are, however, risks to increased federal deficits. The most obvious is the possibility of rising interest rates. If large, additional government borrowing forces up interest rates, the increase in mortgage rates will depress the housing sector. The U.S. market for homes has remained strong because it has been fueled by low mortgage rates. The housing market will be hurt if mortgage rates rise in response to additional federal spending.

  Conclusion: The U.S. government has the potential to increase deficit spending and provide a boost to the economy. However, additional deficit spending may cause an increase in mortgage rates and damage the housing market.

  The United States is struggling with a financial hangover. The effects of the 1990s’ excesses will reduce economic growth.

  Bull #1: Economic Eyeglasses for the Short-Sighted

  The first optimistic defense of the economy simply looks at the longer trend instead of the recent past. If we cast our eyes back to the immediate post-bubble past, the picture painted above is quite grim. We are told that things are often darkest before the dawn. It is easy to repeat such phrases, but harder to feel optimistic during tough times. This lesson was demonstrated by one of General George Custer’s men at the Battle of the Little Big Horn.

  There is a story that has been passed around about the battle. As is well known, General Custer’s men were wiped out and none of his troops survived. According to this story—which would have come from Sioux warriors—one of the cavalrymen had an opportunity to escape. He was riding away and had enough of a lead over his pursuers that his odds were good. At precisely the moment when he looked likely to escape, however, he pulled out his pistol and committed suicide.

  The U.S. economy has taken some severe blows in recent years. Yet we may be on the cusp of recovery and ought not despair at what might be our darkest hour. If we take even a slightly longer-term perspective, most economic statistics look quite good. The U.S. stock market as measured by the S&P 500 index is down about one-third from its all-time high (as of July 2004). It has, however, gained almost 1,000% since the stock market bottom in the early 1980s.

  A similar pattern emerges across almost all the seemingly dire economic landscape. Interest rates have risen from their lows (including one amazing 50% rise in little over a month), yet rates remain near 50-year lows. Inflation has become so low that the Federal Reserve has spent considerable effort wondering how to stop prices from falling.

  Rising unemployment is perhaps the worst aspect of current economic troubles. The unemployment rate has risen by almost 50% and literally millions of people have lost their jobs. Even in this area, the longer-term news is good. As recently as 10 years ago, the current unemployment rate of about 6% would have been considered good news.7

  What about the enormous federal government deficit? Surely the rapid swing from large government surplus to gaping deficit cannot be overlooked. Surprisingly, even in this area, the longer-term perspective is very positive. If we measure the amount of U.S. government debt as a percentage of the total economy, the debt is significantly smaller than it was in 1993. Measured this way, the current federal debt is only about one-half as big now as it was at the end of WWII.8

  Conclusion: While the last few years have been painful, there is no proof that the longer-term economic miracle has ended.

  Bull #2: Vince Lombardi Meets the Computer

  “Winning isn’t everything, it is the only thing.”

  This quote is misattributed to legendary Green Bay Packers’ Coach Vince Lombardi, who actually said, “Winning is not everything—but making effort to win is.” It is an odd quirk of history that Lombardi is most remembered for something he didn’t say. What he did say on a variety of topics is great, and much of it is relevant to investing. Among my favorites is, “Winning is a habit. Unfortunately, so is losing.”

  When it comes to economic growth, productivity isn’t everything, it is the only thing. Even though Coach Lombardi probably never said this either, it is a mathematical fact.

  There are two roads to wealth: One is to work harder, and the second is to work smarter.
Obviously, working smarter is the preferred route; productivity measures the economy’s ability to work smart. Thus, productivity becomes the key to long-term economic growth.

  Optimists can make a good argument based on U.S. productivity as shown in Figure 4.5.

  FIGURE 4.5 U.S. Productivity Growth Is Very Rapid

  Source: U.S. Bureau of Labor Statistics (nonfarm business output per hour)

  This young decade has had higher U.S. productivity growth than any other in the post-WWII era.

  Is productivity really higher now than in the past and can the good news continue? It seems possible. Some economic historians make an analogy between the Industrial Revolution and the information technology revolution. It took many decades to learn how to harness machines effectively. Thus, the benefits from the Industrial Revolution were not immediately visible.