Current market behavior is concerning. Bonds and stocks remain volatile and near record levels. Markets ignore the continuing stagnation in the pretend economy, buoyed apparently by government liquidity injections.
To justify investing today in these markets, one must anticipate one or both of the following:
- Economic growth is about to surge.
- Market values can continue to rise from here, potentially further widening the already large gap between valuations and fundamental economics.
No reading of the economic tea leaves suggests a surge in economic growth is coming. Indeed, a critical analysis of the data makes one question whether there has been a recovery at all. Certainly any recovery has to be labeled as abnormal.
If economic conditions look like they will continue to be sub-par, then an investor has to believe that it is realistic to expect market valuations to continue to ignore economic conditions. That assumption worked last year when markets rose about 30%. Is it reasonable to expect the divergence to continue for another year?
No divergence can continue forever but that doesn’t mean it can’t persist for a while.
Recession, Not Recovery
The recession ended (according to the National Bureau of Economic Research) in June 2009. Rapid economic expansion normally occurs during the first three or four quarters after a recession ends. The typical recovery period is characterized by three to four quarters of unsustainably high growth rates. That take-off growth never occurred when this recession was declared over. Nevertheless, government went into full propaganda mode and the pretend economy began.
At no time in my recollection has the word “recovering” been used to describe an economy five years after a recession was declared over. Perhaps the term was borrowed from “recovering” alcoholic which I understand is a forever state. Either the government is lying about a recovery or something has radically changed in terms of the economy. Both are likely.
The current “recovery” does not conform to other recoveries. After five years, history suggests we may be close to the next recession, not still “recovering” from the previous one. However, history is not economics. It may repeat or rhyme, but it doesn’t rule.
Causal behavioral relationships determine economic decisions and outcomes — ALWAYS! These relationships, to the extent they remain stable, may appear to produce repetitive time cycles, but that is a secondary effect rather than a causal one.
Behavioral relationships are dependent on perceived incentives and disincentives. If the underlying incentives/disincentives are altered, decisions and outcomes will change. That will alter any macro measurements like those captured in growth rates, employment statistics, etc.
Incentives at the micro-economic level have been altered dramatically. Labor participation rates reflect the disincentives associated with ObamaCare and other regulatory nonsense. Anticipated tax increases to pay interest and government debt dampen people’s expectations regarding the future. Capital expenditures are slowed or canceled in order to get a clearer picture of what is coming and when. When aggregated, the macro-stats appear different.
GDP can be manipulated in terms of definitions and data. Government spending is counted as economic activity. Some of it may be, but most of it is not. Increasing government spending is a way to mask a declining standard of living, which has corrosively been occurring for arguably decades.
There has been no real economic recovery. What has occurred is a pretend recovery. The pretend is not limited to this recent cycle. It has been going on for many years. In a sense, what we now have and have had for the last decade or more is a pretend economy. Government interventions have been the driving force in this pretend economy.
Government has no incentive to not have a real recovery. It would prefer one, but that is no longer possible as a result of an accumulation of distortions that have built up over decades. A pretend economy is the next best thing. Interventions cover up reality (for awhile) but they also add to the economic distortions and damage.
Every intervention is an attempt to create a situation that free markets and men do not want. Every intervention distorts market signals. Decisions made by economic actors based on wrong information must be erroneous, no matter how carefully executed.
Prices are the language of the marketplace and society itself. Prices provide signals to economic actors and non-actors. They provide information regarding career choices, when to purchase less or more of something and many other personal decisions often not considered economic. A properly functioning price system is the foundation for peaceful social interaction and cooperation in any society based on a economic freedom and the division of labor. The price system may be the most important element in society. It makes coexistence, cooperation and peace possible. Damaging it has ramifications well beyond the economic sphere.
When prices are distorted, incorrect decisions are made. These incorrect decisions can be hidden for a while by perpetuating the distortions but not forever. When prices eventually adjust to what they otherwise would have been, prior decisions are shown to have been wrong and unsustainable. This corrective process is referred to as a recession or a depression.
Government always wants to prevent recessions even though it is their policies which produce the distortions. Attempts to do so have been on-going as government policy since the 1960s. It was then when it became fashionable to believe that an economy could be centrally managed. To the extent that government succeeds in its efforts, it merely makes the next problem bigger because distortions are cumulative.
The US economy now contains a half-century of distortions that are now, or soon will be, too much to contain. It is not accidental that the two biggest interventions since World War II were for the last two recessions, both of which occurred in the first decade of this new century. The cumulative effect of covering over distortions lead to the inevitable point at which the system breaks apart. Ludwig von Mises observed:
There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.
What To Expect?
Valuations and economic conditions are inconsistent. They can remain in disequilibrium for a period of time but not forever. One of the two (or both) is going to change to reflect the other.
The economy and the nature of politics are such that policy regarding economic downturns will not be willingly changed. I agree fully with Doug Casey‘s assessment:
I don’t see a real recovery until they stop debasing the currency, radically cut government spending and taxation and eliminate most regulation. In other words, cease doing the things that caused this depression. And that’s not going to happen until there’s a collapse of the current order.
It is suicidal for either political party or any individual running for office to advocate policy changes that necessarily will produce a depression. Mr. Casey’s comment as to how the change will take place is both ominous and obvious: “That’s not going to happen until there’s a collapse of the current order.”
The economy will continue to be pummeled with interventions and distortions for as long as it can sustain the blows. Will the cover-up be able to be extended one more time? I doubt it, but it is easy to underestimate the survival instincts of institutions, especially powerful ones.
Attempts if they do in fact succeed will only serve to weaken the economy further.
Markets will correct before an economic collapse is apparent. This correction may or may not take place in advance of an economic debacle. Even if the economic debacle triggers the market collapse, it will appear that the markets corrected first. Markets react faster than changes in economic momentum and the lag in reported economic statistics.
When the market corrects it is unlikely to be to some fair value commensurate with economic fundamentals. Markets notoriously overshoot, especially on the downside. In the first decade of this century, markets twice dropped from highs to lows by more than 50%. The next correction may exceed this number.
It is impossible to time either a market or economic collapse. A market collapse is possible without an economic collapse, but not vice versa. Once the market begins its decline, it may be orderly (over several months) or nearly instantaneously (think the 23% decline in 1987). Even with “circuit breakers” on markets, a massive drop likely takes only a few days. The fact that it occurs over three days does not mean you or the many others who want to get out on day one or two will be successful in doing so.
Playing these markets in any conventional manner is akin to writing insurance policies for suicide bombers.
They are, in my opinion, ridiculously detached from economic reality. “Bubble” is not too strong a word and a reasonable description. The term “bubble” never appears before an adjustment, whether it be stocks, bonds, housing, student loans or whatever. It is always an after-the-fact description, used matter-of-factly, suggesting everyone could see it. No one wants to be labeled a fool when the bubble bursts.