Why does the market and our economy cycle through up and down phases?
It seems like a simple question - why do we have this boom-and-bust cycle in the stock market and the economy? I mean, in a steady-state system, it should just chug along at a nice pace and everything should remain, well, stable. And until this year, we pretty much had that - a steady if not overwhelming economy with growth under 3%. Many folks said this was horrible, as we should have skyrocketing growth - but then again, whenever the skyrocket goes up, well, it falls back down.
If you studied control theory, what our markets do is less of a mystery to you. And you don't have to get into the higher levels of that science to see how it affects everyday economic transactions. Hysteresis, for example, is something you may be familiar with in your home thermostat. If you set your furnace at 70 degrees (which is way too warm, but let's take that aside), it will kick on only when the house temperature drops to 69 or even 68 degrees, depending on how much hysteresis the system has. The furnace will stay on until it hits about 71 or 72 degrees, and then shut off.
Over time, the house cools down as heat is lost through the walls and windows, not to mention the opening and closing of exterior doors. When the temperature hits 69 or 68, the furnace kicks on again, and the cycle repeats. Why? Why not have it kick on at 70 and shut off at 70 and maintain a "perfect" set temperature? Well the reason is, the furnace would be turning on and off every minute or so, which is not good for the furnace. It would also be annoying to the homeowner as the thing came on and off. So instead, we dial some hysteresis into the system so that it runs more smoothly.
Now, with modern split-system heat pumps, more precise control can be achieved. That's the Japanese for you -solving problems like this. They figured out how to throttle the system using inverter technology so that the system provides the correct amount of heating (or cooling) to match the load in the room, and eventually achieve a steady-state condition. However, even in those systems, there is some overshoot, particularly when you first turn them on, until they settle down to a steady-state condition. And when the load changes (the sun comes up, someone opens a door) it may cycle for a bit before it finds a new equilibrium. So even very finely made machinery will undershoot and overshoot on occasion - just like the cruise control on your car.
With markets, we have the added problem of emotional thinking on the part of investors. And as more and more small investors, who tend to think emotionally, get into the market, it becomes more unstable. These are the sorts of people who bid up the price of stocks without even knowing what they are buying. The Long Island Iced Tea Company changed its name to the Long Blockchain Company and the stock went through the roof. People bought it without even bothering to know what the company made. Yes, they make iced tea drinks still, but claim to have plans to partner with a blockchain company. That was enough to send the stock soaring well nearly 300%. Does this sound like rational investing to you?
So on the way up, the market overshoots, as people become exuberant and think that nothing can possibly go wrong - after all, everyone is making money on paper. And subconsciously, we all get drawn into it, humming "happy days are here again!" and going out and buying that new outfit we had our eye on, but thought maybe was a little to pricey. And we stop noticing how much things cost - buying stuff without looking at prices, or accepting small increases in prices. So business does well, as everyone is spending more money.
More people do things like go out to eat. The restaurant has to hire more people. There is a labor shortage (sound familiar?) so they offer more money to get more help. This raises their costs, so they raise the price of beer by 50 cents a glass. The customers are giddy after seeing their latest 401(k) statement and don't grouse about the price increases. Inflation starts to creep up.
It becomes an upwardly moving spiral, where increased spending leads to increased wages, which leads to increased prices. And it is what we are going through right now, in the second-longest bull market in history - seven months shy of being number one.
So why doesn't this just go on forever? People spend more, people pay more, people get paid more. Everyone is happy and prosperous and the world is a paradise. That's what Republicans argue will happen - but history has shown them to be wrong, time and time again. And a tax cut for corporations may throw gasoline on this economic fire and keep it burning a while longer, but eventually every bull market turns bear.
And the signs are usually there - increased debt loads for companies and consumers. Companies that appear to be doing well, but are actually hollowed out. Some change in world economic patterns (a hike in the price of oil, some natural disaster, a war) that causes economic patterns to shift. Or it could be that people just run out of things to buy, get bored of buying, or just run out of money to spend, or worse yet, money to borrow. Tightening and loosening of credit, as well as government money policies also play a factor.
Whatever the cause - or causes - one day people wake up and realize that they are living in a house of cards. Or maybe just one person realizes it. One person says "Sell!" when everyone else is buying, and others get nervous - what does he know that we don't? And maybe someone else loses their job or needs money and they decide to sell. Or they cut back on spending, and suddenly that restaurant owner has an empty table, and a highly overpaid waitress. And he realizes that even though business was booming, his increased expenses meant he wasn't making more money.
Emotions kick in. People get nervous. People start to look at prices and think about cutting back. As the market starts to decline a bit, people get more nervous. Go out to the restaurant tonight? Um, no, we need to start cutting back on extravagances - have you seen our monthly report from Fidelity? It's scary!
So, just as the upward spiral of the bull market feeds upon itself, the downward spiral of a bear market feeds upon itself - and again, in control theory, we would call this a feedback loop. The difference, as I see it (from being through this cycle several times in my life) is that the bull market is generally a steady increase over time - not very dramatic, except at the end - while the bear market can be easily identified by a sudden crash or drop in prices - in a matter of months, weeks, days, or even hours or minutes.
Catastrophe theory as applied to sports performance.
And again, there is a mathematical model for this in catastrophe theory. Things build up over time and increased stimulation eventually leads to a collapse. Sort of sounds like an orgasm, and maybe that is an appropriate analogy. Things build up, and build up, and finally - blammo! Cigarette?
The funny thing is, we saw this happen not that long ago. In fact, I started this blog in response to the last blow-up, in 2008, when everything went to hell in a hand-basket, pretty damn quickly, and everyone wondered, what happened?
What happened was a pretty predictable pattern - the same one I described above. Exuberance and good times and a lot of fun - and people not thinking about how much things cost or how much they were borrowing. People paying $750,000 for a house that two years earlier sold for $400,000 and two years before that sat unsold at $200,000 - and no one asking why some slum shack was suddenly so valuable, only how do I get in on this deal before it costs $1.5 Million?
Again, a pattern you may see today - in Real Estate, in cryptocurrency, and yes, even in stocks. The economy is doing well, so everyone decides now is the time to invest. After all, now we have money to invest - right? You see how this bootstraps itself. In a recent article in Bloomberg, is this distressing note:
Mom-and-pop investors are pouring money into retirement accounts as the economy picks up speed. Consumer confidence, which measures Americans’ optimism about their own and the economy’s well-being, is at a generation high.
When the grocery clerks are trading stock tips, it is time to get out of the market. This is not to say the market will crash tomorrow - or the next day - but that eventually, overheated and overvalued stocks will be corrected. And when that happens, the market will overshoot in the other direction.
Stung by declining asset values, Mr. & Mrs. Middle-America will put off buying that new car, or new refrigerator, or new dress, or even that restaurant meal. That in turn means less revenue and lower profits for a host of companies - who in turn will lay off employees (the last ones hired, before the bust!) who in turn will panic and cut back on spending as well.
And then the quarterly reports come out and Mr. & Mrs. Middle-America realize their stock portfolio has taken a hit and they start thinking about cutting back more. Or maybe the Mr. loses his job, too. It starts this death spiral.
The good news is twofold, maybe three. First, these things happen pretty quickly and rebound just as fast. There is a lot of blood and anguish as people lose jobs, houses, cars, and savings. But things start to rebound, almost right away. Companies go under, and other companies snap up their assets at bankruptcy sale and now have a much lower cost overhead - and can offer products and services at far lower prices - which the stressed consumers can now afford. Second, historically, these things have always recovered over time. Indeed, it sort of has to be that way - unless our species went extinct. Some sort of economy eventually takes hold and things move on - how long this takes often depends on a number of factors, one big one being government intervention or lack thereof, either of which can shorten or lengthen a recession.
The third thing is, it can be an opportunity to invest for the person who is astute. If you sold out at the peak or bought in at the valley, you will do well. The majority of the plebes - the get-rich-quick idiots - are buying in right now and will sell when it all blows up. Buy high, sell low - the dumbest way to invest!
But timing the market is hard to do. I sold out of real estate in about 2005 - about two years too early. But that was far better than my friends who sold out (or were foreclosed upon) two years too late.
The best that I can do is to not buy in when the market is overheated, which is why I am sitting on a lot of cash right now. I don't see any "opportunities" in a market where everything is at record-high prices. Will it go up that much further? Perhaps, right before it crashes down. And like a rubber-band, the further this is stretched, the further it will hurt when it snaps back.
The other thing that is important to do, I think, is to not let the exuberance get to you. It is all-too-easy to let your personal expenses creep up over time as an economy improves, as you start thinking (wrongly) that "hey, things are going great! I don't need to cut back on spending! Let's go to the club! Let's go to the restaurant! Let's order a pizza for delivery! Let's get cable TV and a new smartphone! Let's SPEND more - let's ENJOY our money!" And these are all things I heard before the last blowup and things I am hearing today - particularly the part about "enjoying" money. But squandering cash never is enjoyable, at least in my book. My greatest enjoyments in life are often things I bought cheap or better yet, got for free. It makes the satisfaction that much sweeter.
What got me thinking about this was a restaurant bill. We took a friend out to lunch and with tip the bill was over $80, which seemed kind of excessive to me. That's enough to buy sacks of groceries, and quite frankly, the food and service weren't that great. And yet, it is tempting, after seeing your net worth jump up $40,000 in a week during the "Trump Bubble" to think, "hey, I can afford this!"
And all I thought to myself, was, "Gee, I am picking up all the bad habits I used to have, once again!"