Sunday, August 29, 2010

It’s Technological Innovation, Damn It, so Let’s Go Back to the Stone Ages

 
In the widely read e-mail “Mish’s Global Economic Trend Analysis”, Mike is trying to decide: Who's to Blame for Rising Healthcare Costs?


He quotes a Therapist CEO who wrote:


"It’s a joke when patients come in and present their insurance card like that provides them any benefit at all."


This CEO is wrong. Why? The deductable may have been raised to $50, which matches the $50 charge for therapy, meaning the patient pays it all; however, what this therapist misses is:


“What does he charge if you do NOT have an insurance card... $100, $200?”


I have a high deductable insurance policy, and while it’s STILL expensive, I can’t really “self-insure the little expenses” because to obtain the “price schedule” available to insurance companies, I have to have an insurance card. Otherwise, a $50 charge to a person with insurance is a $100 to $200 charge to a person without insurance. In other words, let’s charge more to the person who can’t afford it!



How did we get “so out of whack”?


Mish is looking for “Who's to Blame…” but he doesn’t have Congress or "free market capitalism" on the list.

The “Blame for Rising Healthcare Costs” is most easily explained by comparing it to Social Security because our health care system is in a large part responsible for our Social Security crisis, albeit indirectly.


Life expectancy was around 65 when Social Security was created. Thus Social Security was, in essence, started as a "windows and orphan" fund. Few people actually lived to retirement age so few people collected retirement benefits. Thus it was NOT a retirement system.


Perhaps as an excuse to increase social security taxes over the years, Congress expanded the benefits until it became a "rob Peter to pay Paul" (pyramid) scheme. We’re robbing young workers to pay old ones.


As everyone knows, with the baby boomers reaching retirement age, the "42 16 workers for every 1 retiree" pyramid is “approaching inversion”; we're down to somewhere between 2-3 workers for every 1 retired person.


Why is this a "health care problem"?


If you look at health care, we don't actually have a "health care cost crisis" and we don't have "a bad system relative to other countries".



Too Much of a Good Thing



What we actually have is a "too much of a good thing" health care crisis.


The US produces the bulk of technological innovations in health care, and while it is expensive in the short run, like all technological innovation, it ultimately drives DOWN the cost.


Studies show the cost savings from technological innovations accrue not to the government or business bottom lines because competition arises to match the new innovation, driving down costs.


Who’s the ultimate beneficiary of these cost savings? You and me, the consumer.



The Downside to Too Much of a Good Thing



Regrettably, there is a "bad side effect" to this health care innovation. It creates significantly longer life spans: You can read this link to see Average life span has increased 19 years since 1900 and about 10 years since 1950. Or you can watch a comparable video here to see free market capitalism is the best path to wealth and health!



Simply put, people just use to die... earlier. Now they live significantly longer, consuming BOTH more Social Security AND medicare/medicaid benefits.


So our Social Security problem AND our Health Care problem are one in the same, it’s a “technological innovation” problem. Damn it, let’s go back to the stone ages!



Our Cost, Their Benefit



At this point, we should address the critics who contend that our health care spending is higher than other countries. Yes, it is.


While I have not found a good answer on why life expectancies are roughly the same in the advanced countries, throughout the rest of the world, the governments are "more Keynesian" (ie, socialistic / interventionist) than in the US (that is, until recently).

[ Jan 2014 addendum:
A few months ago I read a good piece that explained the "so-called" differences in life expectancies:

1) America is a nation of risk-takers. There are significantly greater "accidental" deaths (and the author somehow included suicides here) in the US versus other nations. Our life expectancy is skewed down by this factor.

2) Definition of "live birth": In many countries, a "live birth" ONLY occurs if the infant survives 36-48 hrs. So if an infant dies "too quickly", they don't count it as a live birth. To me, this equates to saying "we're only going to count those statistics that make us look good", aka we're ignoring infant deaths that occur too quickly. In the US, medical technology has pushed us to the other extreme, where we attempt to save infants even before they would normally be viable on their own.

The author stated that if you remove these two factors from official statistics, America's longevity is, in fact, the longest (ergo the best).
]

Other countries simply have more control over their economies, and in health care specifically, a lot of it is cost controls (but some of it is availability too).


Regrettably, this means other countries benefit from our technological innovation in health care without paying for it (drugs), or they “don’t pay for it” (medical equipment where they have, say, 1 MRI machine for a given population whereas the US might have 5, and “the cost” to their people is "waiting for access").


As much as a free trader I am, at times I get so mad that I think we ought to say that the drug companies can NOT sell their products outside the US for cheaper than in the US ("no pay, no play").


I think in time the life expectancy puzzle would be solved... or other countries health care spending would grow to meet ours, but putting controls on something, like medical salaries, is not the solution.




Why Up If Technology Drives Costs Down?

If technological innovation drives health care costs down, why are they going up? Largely, it is due to the increasing life expectancies I've discussed. However, there is also a “more sinister” answer.

Have you ever looked at WHEN the health care cost "explosion" began (if you must call it that)? To a large degree, it started in the 1970s.


Why is this important?


The
Medicare and Medicaid programs were started in the mid-60s. So government "got control" of a significant chuck of health care spending. And health care inflation started shortly thereafter? Hummmm!


Sounds like today. From the time Obamacare was “put on the table” through its becoming law, my high-deductable health insurance premium has doubled. But I have a high deductable policy and my family is healthy; there is NO cost to the insurance company… or is there?


So the government got involved in health care, and health care inflation accelerated. Then the high inflation of 1970s hit. Who was responsible for this? Do you truly need to ask?


President Kennedy advocated a "
War on Poverty", which President Johnson took to heart and announced (“as his”) during a State of The Union address. And both Presidents contributed to a significantly expanded presence in Vietnam.


These "war cost pressures" were significant, but let's not forget about the baby boomers. They were entering prime consumption age.


So there were huge social (ie, government) and demographic cost pressures creating the significant, widespread inflation of the 1970s.


Go to the Root!
The cost pressures of the 1970s were part of a larger cycle which is the main cause of our problems today, so let’s back up.



The post World War 2 economy was dominated by a long cycle and the long term cycle of credit expansion and contraction.


While mortgages existed prior to 1932, prior to 1916, national banks and many state banks were prohibited from making real estate loans. And those that did generally did so only at loan to value ratios of 50% or less “because the loans were illiquid”.


Nonetheless, like recently, 2nd and 3rd mortgages were available – at a high cost – and this was how many homeowners were able to purchase homes prior to the
Great Depression.


And guess what. “Home prices never went down” back then either! Until they did. And that happened when things crashed. Thus…
In 1932, however, President Hoover signed the Federal Home Loan Bank Act. I’ll let Hoover explain why:
"The purpose of the system is to both meet the present emergency and to build up homeownership on more favorable terms than exist today.”


“A considerable part of our unemployment is due to stagnation in residential construction. There has been overbuilding in certain localities in boom years…”


(MRH: so let’s build more!)

“In the long term we need at all times to encourage homeownership…”


Does all this sound familiar?

There actually were numerous governmental financing agencies created in the early 20th century but I highlight the “FHLB” because it sounds… “so today”.


Further back, the Panic of 1907 was the first US banking crisis to affect, in essence, the wealthy. It actually hurt Wall Street and the eastern establishment.


Thus out of this panic was laid the roots to the Federal Reserve Act of 1913. While created for many reasons, prominent among them was that “the people no longer trusted private bankers to shepherd the financial markets.” (I’m smiling!)


What the Federal Reserve Act did, primarily, was attempt to restore peoples faith in the banking system. It was to do this by avoiding the monetary panics that occur at the end of credit expansions (aka manias) as well as prevent or reducing the contraction of credit that inevitably occurred after these panics.


Remember how Greenspan “couldn’t control” the tech bubble, but Bernanke “can” for the housing bubble? Hey, aren’t they both “sort-of” associated with the Federal Reserve?




Why Back Up to the 1930s and before?
But aren’t we talking about health care? Yep! Nope! Both.


On the surface, it’s a complex issue. But in reality, it boils down to something simple. Bear with me and I’ll get there.


So let’s review the present and “recent” past. The government helped “push” a post-WW2 credit cycle expansion (especially a booming home mortgage expansion) that ultimately “collapsed into” the inflation plagued 1970s.


This is also when government made its first big push into health care. And it’s also when health care costs really started rising.


This 1970s inflation period was part of the credit contraction:


It gets harder and harder to qualify for loans when the interest rates keep going up and up and up. At the Savings and Loan I worked at in 1981, we simply quite lending at 15% mortgage rates (that no one could afford anyway) because we could get 20% on short term deposits with the Fed (the Fed Funds peaked in June 1981).


Nonetheless, this post-WW2 credit cycle collapsed into the inflation plagued 1970s, and then we began a new period of long term credit expansion, as interest rates declined from their highs of the early 1980s to the lows of a couple of years ago.


This credit cycle expansion has technically ended a couple of times. In reality, it ended with the bursting of the “Technology/Internet bubble” of the late 1990s. But Greenspan, who thought he couldn’t control its growth, decided he could control its collapse. In doing so, Greenspan created “The Great Housing Bubble”. Bernanke had less of a roll in this bubble, but by damned, he (too) was going to control a bubble collapse.


Thus the end of the long credit expansion cycle has been “artificially” extended not once, but twice (by the Fed)… at least in theory… but it’s not really a credit expansion when banks won’t lend because they’re tightening credit standards and people and businesses are too afraid to borrow despite super low interest rates (aka the “Fed “pushing on a string”).

 


So what the heck are you saying?
Health Care.
Social Security.
Technological Innovation.
Inflation.
Housing.
Bubbles.
Remember under “Go to the Root” I talked about a larger cycle, a long cycle, and I inferred it was a long cycle of credit expansion and contraction.


I really did NOT infer, rather I was trying to “fool you”, as Washington and Keynesian economics has done for 100 years.


The LONG cycle I’m talking about is a cycle where people put “trust in their government”, a government to “solve all the problems”.


The Fed was to control, essentially, credit booms and busts. Job well done… NOT.


The FHLB board was to create conditions for a stable housing market and stable employment in the housing industry. Job well done… NOT.


Social Security was to create a program to improve, among other things, poverty, old age, disability and the unemployed. Job well done… MOSTLY not (but the old people sure benefited by the robbing of the young).


Kennedy and Johnson’s war on poverty, which beefed up Social Security AND created Medicare/Medicaid was to improve poverty and the health system. Job well done…. NOT.
BTW: Post WW2, we were NOT "1-1-1" (GulfWars-Korea-Vietnam), we were "1-1-2" because we lost the "War on Poverty".


[ Jan 2014 addendum:
According to a left-leaning organization, the govt official poverty stats do NOT include "WOP" benefits like Social Security, Medicaid, etc., and if these benefits are included, the US poverty rate drops from around 20% into the low teens. Given the unjustifiable ignoring of WOP benefits, it appears the War on Poverty is not quite the failure I understood it to be.

Conservative authors are quick to point out that when enacted, the program(s) promised much more than it delivered, such as eliminating poverty, and it is a failure relative to expectations.

I would thus have to say that we're "1-2-1" post-WW2 because the WOP was a stalemate.

Nonetheless, the real question to me is the cost-benefit of all this spending, especially when you include the fact that the costs keep escalating and there is a huge "off-balance-sheet, unfunded-liability". In other words, the WOP programs has produced some benefits, but the total bill has NOT yet come due.

And more importantly, if the govt did not spend these vast sums on the WOP, in economic theory, this investment would have been available elsewhere in the economy. How much better would the economy be with this investment? This question can't be answered, especially since the govt created much of this investment "out of thin air" - ie, borrowing it through money creation.

In the end, I am a firm believer in free markets, so I believe had the WOP programs been not so expansive, the markets would have provided a better solution, but we can not ever truly know the answer to this.
]

 
What’s the solution?
To solve the health care problem, maybe you should retire with great benefits at 65… but at 70, we kill you.

To solve the housing crisis, maybe we just tear down 20% of all housing and start new.


To solve the Social Security crisis, maybe we open the borders to any immigrants that want to come but will do so legally and pay taxes. This would help "the Social Security pyramid" (by bringing in more suckers!), and even though this would ALSO help our housing crisis, I doubt anyone would want to go this route.


Obviously I jest, but what we need to kill is Keynesian economics. What we need to tear down is government, which does NOT solve problems but rather just makes them worse (maybe the pain is not as acute, BUT it is significantly prolonged and more widespread). What we need to open up is the free markets.


I hope The long cycle of trusting that government can control and improve the economy is coming to an end. I do hope this is the death of Keynesian economics, because he got it wrong.


Keynes main “economic opponent” was Friedrick Hayek, known for his belief in the free-market capitalism. Prior to the 20th century, the government intervened hardly at all. We had numerous depressions, which tended to last about 12-18 months as the excesses from whatever bubble-bursting caused the depression in the first place. But cleansed the system was.
( Murray Rothbard's "America's Great Depression" is a MUST READ for more information... one-quarter of the book is simply footnotes of Rothbard's sources).


Do you realize that, while we had depressions prior to the 20th century, we NEVER had one recession, not a single one?


The reason is, after the government activism that was born from the Panic of 1907 and matured in the Great Depression, well, it succeeded in doing one thing. Depressions did become shallower, so the politicians and Keynesians coined the phrase “recession” because it “sounded softer”.


What was the cost of “a recession” rather than “a depression.” As I said, the pre-20th century depressions lasted, on average, 12-18 months because the excesses were cleaned up quickly.


On the other hand, the Great Depression lasted, what, 15 years or so and it took a world war to create a recovery (it was actually a Depression that became a Great Recession, but that phrase wasn’t coined yet).


The “inflation recession” of the 1970s (or stagflation) took only a decade or so to recover.


And our current “roller-coaster recession”, well I count its start at the year 2000. With all the governmental intervention going on, I’ll be thankful if it’s shorter than “interventionalistic” Japan’s “two lost decades”.


Hopefully we’ll see this Great Recessions demise soon as the Tea Party wakes up the rest of America to the realities of out of control government and out of control spending.


Creative Destruction

 
One final thought. The problem with Keysians and the people that believe in big government is they just don’t understand Joseph Schumpeter, whom I consider the greatest disciple of Hayek.


Schumpeter studied business cycles, and quite opposite to Keynes, he concluded that the boom/bust cycles the Keynesians wanted to eliminate (or at least moderate) were actually good for the economy in the long run.


Simply put, you can’t have creation without destruction. But out of destruction, new technological innovations (creations) arise.


Keynes (and Obama) would have supported the horse and carriage industry, given unemployment benefits to those put out of work by the invention of the automobile, and paid for it by taxing the productive growing industries to support the unproductive dying industries.


I pray to God when my time comes, I won’t experience a lingering death; I pray that I won’t have some Obama/Keynesian Doctor that insists on keeping me on life support. God please, when I die, let it be a quick heart attack, the sooner to be reborn.


So the root of most if not all of our problems (ie, problems of Capitalism) are precisely as Schumpeter foresaw. The root is that Capitalism has been enourmously successful. But also as Scumpeter foresaw, the success of the creative side of Capitalism has breed a system dominated by bureaucrats and intelligensia (of which lawyers are perhaps the foremost group), a system that as such becomes so corrupt as to drive a capitalistic society into socialism (ie, destruction!).

Obama is the perfect figurehead, nes pa?


ps:
You may wonder why we're not "all Schumpeterians" rather than Keynesians, but Schumpeter agreed with Marx: Capitalism would fail. Schumpeter, however, didn't think Capitalism was a flawed system like Marx (and thus doomed to failure); rather, he thought it would fail through it's own success. Back then, people we're looking for answers and they certainly weren't looking for answers from someone who agreed with Marx. Besides, Schumpeter always thought asking the right questions was more important than having the right answers. Again, back then people were looking for answers... and Keynes had answers...

even if they've ultimately been proven wrong.





addendum 6/17/11: this started as a comment on health care, and I'm glad to learn there are increasing amounts of data that confirm my belief. See how "Unfree" the Medical Marketplace is.

Tuesday, February 16, 2010

Efficient market theory "CORPSE"

I discovered The Business Insider from Carpe Diem, my favorite economic website ("hat tip" to CNBC's Larry Kudlow, who mentioned "CD" as his favorite). Anyway, Carpe Diem recently posted a list of the top 20 business blogs, pointing out he was #15. The "BI" was #2 for January 2010 and I have since subscribed. It has a lot of short articles and/or graphics derived from a variety of sources.

Regrettably, it led me to "a goat" (My "What's Your Decade, Man?" was "goat generated" but I hope to be shorter here).

"Efficient market corpse" is a link the article "that got my goat", but I would not bother reading it. If you do, be sure to read my reply...

====================================
in case link doesn't work:
http://www.niemanwatchdog.org/index.cfm?fuseaction=background.view&backgroundid=00431
====================================

Economics lesson from a lawyer?


First, this is a "failure of economics" piece written by a lawyer? I guess I shouldn't be so harsh, for if there ever was a failure of economics, it certainly has happened in the American legal system.


The author believes "A very strong case can be made that the Great Recession resulted from a blind faith in an economic theory that was simply wrong." Boy did he get that right... but wrong.


He thinks the 'Reagan belief' in the "Efficient Market Theory" caused the "Great Recession". He's about 60 years off. It's the failure of Keynesian economics that was the cause, as the comments around 9+am (2/12) rightly point out.


This site's "mission statement" says it's mission is to essentially ensure "the right questions are asked".
(Niemanwatchdog.com)


In point #4, the author says the system isn't "fair", but what is? The right question here isn't what is fair but, rather, WHO is to determine what is fair?...

"The urge to save humanity is almost always a false front for the urge to rule."
~H. L. Mencken


The author states "economic collapse was an intellectual failure." He's obviously never heard of Schumpeter's "Creative Destruction", a necessary ("if evil") aspect of a dynamic capitalistic system.


As for economic history and education, Schumpeter did get it right... Capitalism IS doomed, but NOT due to its failures. Rather, the success of capitalism breeds bureacrats (in government and via big business). These bureacrats are the failure of capitalism!


The author closes saying "No wonder we have a tea bag movement", but he (and essentially all lawyers?) are part of that bureacratic class.


My belief is that the Tea Party is actually a rejection of the bureacratic class... Let's hope!


And finally, in the spirit of the mission of this website, here is the right question: "Who do you trust to solve our problems?"


( The government?... LOL )







for more on Schumpeter, here's an abstract on his "seminal" book...
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1496200

Sunday, February 14, 2010

Have I found the Holy Grail?

I'm a fairly hard core follower of the Austrian School of Economics, as in I'm a "Schumpeterian". I just don't believe government works, at least not very well, and not nearly as well as the private sector. At the same time, however, as I've stated in "What's Your Decade, Man?", I fear further asset price collapsing and a corresponding decline in the stock market to single digit PE levels.

I've recently run across two authors/articles that both support my fear... we're in a deflatioanry credit cycle contraction. Yet as similar as their positions appear in terms of what went wrong, they appear to take diametrically opposed approaches to solving the problem:

Richard Koo advocates the government take a very active role to prevent a long, drawn-out depression

The Holy Grail of Macro Economics

whereas

Murray N. Rothbard believes the government needs to let the system collapse so that the free market can begin to repair itself

How the Business Cycle Happens
( "the" book of his is online for free - America's Great Depression )


I'm ordering both books from Amazon and doing further research. I'll report back here when - and if - I reach a conclusion.

Friday, February 5, 2010

The Brilliance of That Hayek vs. Keynes Rap

I'm admitting my "economic nerdiness" by saying that I found this hilarious...

video debate... Hayek vs Keynes


(orig. source... Ludwig von Mises Insitute )

"It is demand", CEO of Cullen Frost bank

Dick Evans, CEO of Cullen-Frost (CFR, $3b mktcap "bread and butter"Tx bank) was on CNBC this morning. As he and Joe K. described CFR, it was a very interesting conversation and somewhat opposed to "blogosphere" chats...

First, CFR refused TARP when they calculated an 11% cost vs the government's 5% cost.

Dick: "On Main Street... our calls are up 75%, our business relationships are up 63%... but our loans are down. The business person is scared to death. Until we get confidence... it not about banks not loaning money... I'd love to make more loans, I need to make more loands and I'm trying to do it. The problem is the business person is scared."

... the real question is that we all want to grow the business, we want to grow, they want to grow, and you've got to have confidence.

Joe K: "... it's been very difficult. So, would you say it's 50% what we've been through and 50% what we might go through...?"

Dick: "I think we're through a lot of it."

Joe: "So now it's about what they might do to us; the government?"

Dick: "Exactly."

( MRH... sounds like the 30's and knowing the gvt, sounds like the 30s! )

...
DICK: CFR "is a relationship bank"... "they just take care of customers".. "bread and butter, make loans and take in deposits."...

Joe: "It's just demand in terms of loans not going out?..."

Dick: "It is demand."

Thursday, February 4, 2010

The "market's telling me the Bear is resuming"

I tried to post the comment below under "What's Your Decade, Man?" but it appeared under my 1st post. Today, 2/4/10, I don't think there's any doubt we've topped and the cyclical bull market is over. Just beware the up days, which can be scary too (2/2 & 2/3 were both 1% up days but, ironically, were indicative that the bear is alive and is mauling "us" down AND UP!)...

1/22/10 ... still "listening to the mkt"; think it's now telling me the cyclical bull mkt rally is over; secular bear may be resuming (best case = sideways)

Saturday, November 28, 2009

What's Your Decade, Man?

Seeking Alpha is a wonderful website. You can get a lot of great info there... but you can also get crap.

A while back a Seeking Alpha author advocated long-term trending of the S&P500, and "it got my goat"...

Long-term trending doesn’t make sense to me, not when there are undeniable cycles in the market, known as SECULAR Bull and Bear markets.
I’ll trend in a SECULAR Bull Market; buy and hold works.

But in a SECULAR Bear Market, the market moves down, often quickly.
Who wants to buy or hold when the markets are falling? Not me.

As you can see from the long-term Dow chart below, there are
distinct periods in the market which we call secular bull and
bear markets.

click to enlarge (any chart or table)




In a secular bull, even the proverbial monkey can make a lot of money using a Wall Street Journal dart board (“buy and hold”). The secular bull of the “20s” went up 5x. The “50s” were up 10x. And the “80s”, the wonderful 80s, up 14x.
These gains were achieved with relatively low volatility and few corrections over 20%, with the notable exception of the 1987 crash.


Bear market mauling!


The secular bull markets of the last 90 years were “ruler” markets, “straight” up with limited volatility.

The secular Bear markets, however, aren’t even decent enough to be “rulers down”. Instead, in a secular Bear, the market mauls you, down AND UP. Down and UP. Again and again.
In the "BEARS" table below, note the number and magnitude of the down and up cycles. Four to five "down" moves, averaging 41%, followed by "fibonacci" bounces.




Charts and data first draft Sep 2009, revised 10/19/09

We'll look at the 30s Bear market and the infamous market crash of ’29, but first a note on the math: If you start at 100 and fall “50%”, you’re at 50. If you then bounce “50%”, you’re at 75. This still leaves you down 25%.

So beware, large percentage declines require significantly larger percentage gains to breakeven. The first 50% decline requires a 100% gain to get back to breakeven!

So in the “30s”, the first decline was 49%. Then it bounced 52%. Then it crashed 86%! From that low, it bounced back 101%. Do you see my point?

Just in case, let’s look a little closer.

I found the first three moves in the “30s” secular Bear to be down 49%, up 52%, and then down 86%; however, I was using a monthly chart.

Since April 1930 to July 1932 looks “ruler down”, I simply show the market as declining 86% over 27 months. But Doug Short dissects the Bear markets in greater detail using daily prices. Doug agrees with my first two measurements, but in the next move, down 86%, he found even greater volatility, much more then even I imagined.

Using Doug's daily basis, my 86% breaks down into a series of 9 moves of greater than 20%, averaging 45% down followed by a 32% bounce. If we accept the conventional wisdom, this means that my one move “down 86%” is actually 9 moves of “bull and bear market” magnitude.

That is, in 27 months, there were 9 moves of such a large magnitude as to be labeled separate bull and bear markets.

A new bull or bear every 3 months! Now that is what I call a deadly mauling.



Does nominal GDP growth matter?



In the article that prompted this blog, the author justifies his trend line projection by citing 6.9% nominal GDP growth.

Quick, what's the nominal GDP during a bull market?
How about in a bear market?

How wonderful it is that the article used 6.9%, precisely the number Ed Easterling of CrestmontResearch.com uses in his book Unexpected Returns.

In BEAR markets, nominal GDP growth is 6.9%.In BULL markets, nominal GDP averages just 6.3%.

That's right, nominal GDP is stronger in bear markets.
 Why?

Bear markets are often accompanied by high inflation, which boosts "nominal" GDP, but the inflation is destructive to the market's PE multiple.

Thus nominal GDP growth can be misleading. It is impacted by the level of inflation or deflation.

So what does matter?


"It's the credit, stupid!"


Secular bull and bear markets appear to be driven by long-term expansions and contractions in the amount of credit.

Nikolai Kondratyev (aka Kondratieff) was the first to publicize the view of uncontrollable economic cycles in his book, The Major Economic Cycles (1925), although others had written of similar cycles, notably French economist Clement Juglar and British businessman and statician Joseph Kitchin.

There is much controversy surrounding these cycles, perhaps in part because they are more subjective than the mathematically definable ideas of John Maynard Keynes, the economist of the day.

Keynes believed you could control the economy whereas Kondratyev did not.

In the Great Depression, people weren’t looking for explanations, they were looking for solutions, so they bought the Keynesian solution, much to the chagrin of us Kondratyev / Schumpeterians !).

Many theories were offered up to help explain the problems of the day (presumably so that solutions could be found):

Juglar looked at the fixed investment cycle, aka “the business cycle” (7-11 years),
whereas Kitchin focused on “the inventory cycle” (3-5 years).
Simon Kuznets focused on "the infrastructure investment cycle" (15-25 years).

Certainly all these cycles exist to some degree, but when they start, when they end, and even how to measure them is debated. Moreover, they overlap.

Aggregating all these cycle theories into a “unified theory of economic cycle” is something I doubt we’ll ever see, but all these cycles are strongly influenced by credit expansion and contraction.

As Milton Friedman said, "Inflation is always and everywhere a monetary phenomenon." Too much money chasing too few goods. When credit expands, asset values increase (aka “inflate”).

In the worst case scenario, these credit expansions "bubble". Think 1990s tech stocks, oil at $150 a barrel, or housing (“which never declines in price"). If these expansions bubble too much, they burst, and we have a Minsky moment.

Greenspan seemed to be a “Kondratieff” because in the late 1990s he said he couldn’t control the Internet-driven stock market bubble. Conversely, he seemed a "Keynesian" when he kept interest rates low after the Tech bubble burst, attempting to ease the pain.

In the end, however, Greenspan “the Kondratyev” wins because the interest rates that were “too low for too long” created an even bigger bubble in housing.

Both the Tech and Housing bubbles created very bullish markets (as do all bubbles), but when they burst, the create Bear markets.


Secular Bull and Bear Market Profiles


As Bear markets age, they can age “gracefully” like in the 70s, slowly evolving into inflation.
Or they can age “rapidly,” like the 30s, with a quick market drop, spiraling down into deflation.

As shown in the Crestmont Research’s Secular Bull and Bear Markets Profile, from 1901 to 1920 (the “10s”), the stock market experienced a secular Bear market. This bear started with low inflation and a PE in the low 20s (like now). In those 20 years, the market returned a total of 2% as the PE declined from 23x to just 5x. And even worse, the last 4 years of that bear market was accompanied by double digit inflation, eroding the purchasing power of the remaining stock market assets.

Crestmont's profile also shows a secular Bear market from 1966-1981. The market declined 10% as the PE ratio shrank from the low 20x to just 9x. And the inflation rate increased from 3% to just into the double digits.

Of note, however, is the ’29 Bear. It also began with a PE multiple in the 20s, which dropped to 8x in 4 short years. However, it ended NOT with inflation, but with DEFLATION, as price declines reached double digits.


Conversely, the secular Bull markets of the 1920s, 1933-36(?), the “50s” and the “80s” all started with low PE multiples and ended, generally, when the PE multiple reached 20x or more (40x in 1999).


You should visit the main Crestmont Research's website. Better yet, buy Ed's book for a full understanding of the “PE cycles” that accompany credit cycles.


Historically, however, it’s fairly simple: At the end of Bull markets, PE multiples are high (in the 20s are common) and they begin a dramatic decline. Conversely, at the end of Bear markets, PEs have declined to single digits, typically driven there by the instability of deflation or high inflation.

 

Inflation or Deflation?



The debate seems to be whether we're heading into serious inflation (argues the gold bugs),
or deflation (argues the other gold bugs).

So which side of this debate are you on, inflation or deflation?

Me? I say "Does it matter?"

We all know the stock market dislikes instability.

As shown in Easterling’s book Unexpected Returns, as we move from economic stability to inflation or deflation, PE multiples contract. This is called the “Y Curve Effect” and I have a representation below, although you can find Crestmont’s Y-curve here.







With 1-2% inflation, the PE multiple can range from low to very high, but high multiples only occur when inflation is low.

Let me repeat this. You only have high PE ratios when inflation is LOW (and stable).

If you start with a high multiple, like now, but then experience high inflation or deflation, the market multiple becomes depressed.

Eventually consumers become depressed. It can cascade, or move in waves, but the net result is the same: the PE declines and becomes clustered in the low single digits range.

And the market returns near nothing for a very long period of time.


If you asked me, "What do you think, are we headed to inflation or deflation?" my answer would be "Yes".



A very smart ex-Merrill Lynch broker friend of mine thinks we'll see inflation by the end of 2010. I'm more afraid that we'll continue to see asset deflation and only later inflation, but I hope my friend is right.


From the Secular Bull & Bear Markets Profile, it appears that high inflation comes near the end of “friendly” Bear markets; that is, the secular Bear market is “friendly” because it is truly ending (the “10s” and the “70s”).


If we continue to see asset deflation like I’m worried about, you may get a heck of a cyclical bull bounce (early 30s… and now?), taking the PE back to 20x, but the secular Bear market will resume.

While I'll leave it to others to determine what the current S&P earnings will be, if we assume EPS of $50, the current S&P PE is back at or above 20x.




What’s Your Decade, Man?


(aka, What's your STARTING PE MULTIPLE?)




The educational starting point of the investment profession appears to begin with Ibbotson & Sinquefield's Stocks, Bonds, Bills and Inflation studies. These studies measured asset returns from 1926-1974 and the concluded that stocks outperform “in the long term”.


I believe the extreme extent of the secular Bull market of the 80s was because the Baby Boomers understand what many conclude from this study - buy stocks for the long term.
Regrettably, the Boomers didn’t understand the “bigger” picture, and the bigger picture is that this study covered almost 50 years (and has been continually updated).

As Easterling and others point out, most people don't have 50 years to invest to achieve the "average" return (which is the Ibbotson & Sinquefield average). Rather, most people accumulate wealth in their 40s and begin using it in their 60s, so they have, at most, a 20 year investment horizon.

Boomers born after WW2 reached 40 around 1990, and the wealth they began to accumulate went into the market. However, they only had a decade before the market’s PE multiple reached AND SIGNIFICANTLY exceeded 20x.

The Boomers failed to realize the return they receive is mostly determined by the starting PE, so they continued putting money in the market when the PE was in excess of 20x (like now).
Ed Easterling's work implies there is not a lot of upside left at 20x, at least not over a 20 year period.




So what’s your time horizon, or “What’s your decade, Man?”

What should you do here?



Buy or Sell?



While I know we're in a secular bear market, I also realize that we're in one of those "up" cyclical bulls that so frequently occur in secular bear markets.

Look at the “BEARS table” again:





In the 3rd “up” column, I shutter to think we're currently up “ONLY” 54% thus far. The third bounce in the 70s reached 80%. Please DON’T look at the third "up" column in the 30s… I don't want to go there!


In the end, I still believe we’re in a secular Bear market. The PE multiple is still around 20x.

As such, I’m not going rely on "the long-term trend" because, as wrong as he was, Keynes was spectacularly right when he said “In the long run, we’re all dead.”

Rather, I expect continued volatility, down AND up.

And while this type of market is scary, it can be very profitable to trade stocks or options.

So I'll follow the wisdom of one of the greatest traders ever, Jesse Livermore (Reminiscences of a Stock Operator), who preached these principles:


1) Are we in a bull market or a bear?

(aka "let the market tell you")

2) What's the path of least resistance at the time of trade?

(aka, "stocks are never too high to buy or too low to sell")

3) Cut your losses and increase your winners.

(aka, "stocks are never too high to buy or too low to sell")



We're in a secular bear market, but if I trade today (10/27/09), the path of least resistance is up (cyclical bull within secular bear). I do think stocks are overvalued, but "stocks are never too high to buy". Until the "markets tell me", we're headed higher.


If you're afraid to buy now, follow another principle of Livermore - scale in and wait for your profit to tell you that you were right. If your loss becomes too high (many say 10-15%), cut your losses and be ready to become bearish. If the market moves up and you’re at a profit, Livermore would say your first instinct was right, so buy more.

Finally, what's the best advice I could give you?

This is a secular bear market, so tread lightly and trade smaller. The main goal right now is to maintain or accumulate enough assets to ride the coming bull market.


If I was a trend trader, like the guy in the "SA" article that “got my goat”, I'd look at the past 3 secular Bull markets and see increases 5x, 10x and 14x, respectively...
If this "trend" continues, the next bull market should be up 20x!