The Fix

"Fix it, Fix it!" yells the financial pundit on Saturday Night Live's Weekend Update when commenting on the economy.  Without being presumptuous I believe that all of us echo this sentiment when we reflect on the disjointedness of the economy.  Nothing seems to fit and anxiety is causing a dangerous reluctance among consumers.  So that said, what's the fix?

The fix is actually very simple in theory.  The run up in prices that occurred during the reckless extension of credit from 2001-2006 was not accompanied with equal wage appreciation.  The net result was the extension of credit that the borrower ultimately could not afford.  Prices were thus inflated beyond the means of population, and the only possible effects were a fall in prices to meet wages or an increase in wages to meet the prices.  On the back of massive foreclosures, repossessions and short sales accompanied by wage deflation caused by a foolish reliance on globalization of labor the former occurred.

Now I realize this is quite intuitive, but the solution is bringing prices and wages into equilibrium.  Our choices are 1. allow deflation to continue until the price for goods has fallen to a level where those left with jobs can afford assets in cash or 2. create across the board inflation so that wages increase as well as prices.  If number two is picked, the government must slow inflation once prices reach the desired equilibrium least we be faced with run-away inflation.

Choice 1

Deflation is a monster that destroys everything in its path.  It is the worst thing that can happen to an economy as it counteracts the whole purpose of free market capitalism, wealth creation.  Unchecked, deflation can continue for a decade to  a generation stifling innovation and punishing production (see What's Wrong with Our Economy, this Blog).  In the quickest summation, prices fall and the population still will not purchase.  Businesses fire workers or shutter their operations as they cannot convince consumers to consume.  As businesses close, prices fall further and eventually the production of goods is no longer profitable as the market is littered with unsold inventory.  More unemployment and wage decreases ensue.  Investments, homes and large holdings continue to lose value as the falling wages cannot afford once affordable prices.  This destruction in wealth cools more innovation as banks are not comfortable to lend and people with cash wait for prices to fall further.  Therefore, wage and price reach equilibrium somewhere down the road of massive wealth destruction.  At this point, prices can once again gradually appreciate.

The two problems with allowing this solution is that it can take an extended period of time and civil unrest is very likely.  Under this scenario unemployment will be very high before it corrects, 20-35%.  Markets will not function normally and frustration of the population will create a dangerous scenario.

Choice 2

Since the Great Depression free market capitalism has bee dominated by a school of thought in conjunction with the battle cry of John Maynard Keynes, "in the long run, we are all dead."  The government in using this school of thought has two major tools to set the economy back into equilibrium.  The first is monetary policy.  With the Fed Funds target rate at one quarter percent, clearly interest rates are not having traction against the massive pull back of financial institutions and consumers.  The second tool is fiscal policy.

Fiscal policy comes in two categories 1. direct and 2. indirect spending.  Direct spending is literally the government filling in as the spender of last resort and directly spending money to create the recirculation of money in the economy and reflate prices.  The second category is usually in the form of reduced regulation or reducing taxes, leaving more money in market participants pockets which they can spend and reflate prices.  There is much debate over which of the categories are more effective, but both by definition will stimulate the economy  as there are literally more dollars available in the market.  

As the dollars are spent, the multiplier effect will take place in which one dollar spent will literally be passed from one participant to another up to eight times.  Prices will inflate, and wages should increase with increased profits; that is, so long as corporate policy commits to  American labor (see the Float).

Whether one prefers Choice 1 or Choice 2 the limiting factor is time.  This commentary shall not attempt to differentiate between any of the alternatives suggested as that is a complex argument for another article.  For now I wanted to simply identify the issues we are facing and intelligently explain the possible fixes.  Without bias I will close by stating that it is doubtful the American population has the patience and tolerance to undergo what Choice 1 would take to reach equilibrium.  For now let it suffice that the market disjunction shall be fixed and the how is literally in Americans hands.

The stock market: Is it a trailing or leading indicator

Does the stock market predict things to come, or does it reflect things passed? Believe it or not, the answer is quite intuitive and simple. Stranger than that is that many financial planners, economists business leaders and stock analysts have it wrong. The answer is unavoidably that the stock market trails movement in the real economy.

How can this be? Everyday on the financial news it is taken as a given that the stock market is a predictor of the future of the economy and quite efficient in doing it. Such sources also tell us that the stock market is an efficient mechanism that reflects the true price of an asset or company based on the compilation of large sampling of peoples' opinions. Books such as The Wisdom of Crowds, by James Suroweiki, further state that large sample sizes of random guesses tend to better predict an unknown (such as an asset value or stock price) than an individual. Further, this school of thought has run a number of controlled tests that proved that a large sample size of random guesses is better at predicting an unknown than a small number of better equipped individuals (smarter or more experienced) who are collaborating to formulate a guess.

The fundamental premise is that information provided must be equal to all guessing.

It is a very small jump from this conclusion to state that markets best reflect the true value of an asset or company so long as information is freely available. People from this school of thought are most commonly referred to as Efficient Market Theorists (EMTs). Business programs predominately teach this method of market valuation to MBA students and the majority of players on the scene believe this to be true. So, if assuming EMT is correct, how can the market be a trailing indicator? Wouldn't it be a good predictor of the future?

Unfortunately not. The precipitous decline in the stock market in the fall of 2008 was clearly a reflection of the steady decline in the American economy beginning in the middle of 2007. The economy was sputtering in 2007, and financial analysts told the public nothing was wrong, and that if one separated the durables, autos, homes and mortgage business from the remainder of the economy everything was just fine. That was an incredible statement, and a terrible misrepresentation. It is common knowledge that durables, autos, and homes are the first indicator of a recession and as soon as they show declines, the entire economy shall follow. In fact, Alan Greenspan's company, prior to him becoming Federal Reserve Chairman, used to predict business cycles by simply tracking durables and automobile sales. That said, financial analysts, newscasters and government officials insisted that this was a "new" economy and such variables were no longer dispositive. Wrong. Funny how Greenspan, in his eighties nonetheless, predicted the recession within weeks.

The stock market continued on its upward trend throughout 2007 despite all prudent economists understanding a full blown recession would hit before the end of the year. Why was the market not reacting? The answer: denial and data.

1. Data

The first reason why the stock market is unable to predict future movements in the economy is that the prices are set by the purchase and sale of equities by analysts who base their decisions on data now known. The imperative here is that the prices are dependant on the reporting by companies of events that have already happened. Earnings, estimates and strategies released by companies are always released well after they have occurred. In other words, analysts, financial reporters, and traders receive data that has been processed by Board of Directors and executives for days, weeks and months. Therefore, it is an incontrovertible fact that stock prices trail real economic events. This reality is multiplied tenfold when the economy is recessing as companies will use deferrals and reserved profits from past expansions to buffer evidence of a slowdown in their business. The result, analysts and buyers are even further behind the curve of a bear market.

It is important to note that it isn't only business data that is slow to market, government data is painfully slow to market. One great example is jobless claims. First, one must admit that reducing capacity is one of the last cuts a business is to make. In most cases, businesses will begin cutting all areas that don't directly affect their ability to produce. As a result, necessary job cuts often come well too late in the business cycle as businesses must be sure demand won't rebound before diminishing capacity in the work force. The point is that the real economy has shifted and the financial news channels, traders, analysts and economists cannot see the shift. In other words, the government reports, which traders rely on to trade and invariably derive some picture of the future are more analogous to the wake than the boat.

In addition to equity reports and government reports lagging economic realities, commodity reports must be the least reliable of the bunch. A great example is OPEC. Cheating, overproducing and general market manipulation have created an environment where analysts and traders no longer trust forward announcements of OPEC. Analysts don't believe OPEC when they declare they will produce more oil to keep prices tolerable and they don't believe OPEC can restrain from producing at lower prices despite promises to do so to increase prices.

The net result is analysts, financial networks, and traders basing future decisions on inventory reports from the past. Worse yet, these reports are incapable of determining whether reserved supplies increased or decreased due to demand or supply. Regardless, players in this game determine how to bet based changes in the past.

In all fairness, I must state that many efficient market theorists would argue that traders, analysts and economists don't believe they are guessing at a future valuation of a company, but rather using the data to generate a prediction as to the present value of the company in real time. If that is the case, then the stock market is neither a trailing indicator or a leading indicator of the economy, but rather a barometer of the economy in that exact moment. That said, the general tendency of the market to wait for trends to emerge and the complimentary tendency to hesitate before declaring a change of trend leads to a conclusion that the stock market isn't even an efficient indicator of the current market.

2. Denial

The second reason why the stock market and asset prices always lag reality is because of momentum, or as I like to call it denial. Humans are creatures of habit. When things have been trending downward, people cannot imagine what it was like when things were growing. Vice-versa, when things are growing people cannot imagine a reversal as the common tendency is to believe "things are fundamentally different this time(commodity bubble, tech bubble, housing bubble, and soon to be the end of health care bubble)." As a result, analysts, brokers, traders and economists wait for a trend to emerge before declaring it safe to change direction.

That's right! Not only are these market participants basing decisions off of old data, once they see data signaling a change, such data is earmarked as an "aberration" until it duplicates itself. In the clearest sense people literally wait to buy once the real economics have turned more favorable and usually do so six to eight months after the company has realized the change in business.

The funniest part is that once the decision to purchase or sell is made, the real run of expansion or recession is well underway indicating that the reversal of that trend is closer than the market participants realize. As the price moves because of these transactions, it attracts more transactions in the same direction which most closely can be analogized to a stampede. This stampede always overshoots its target as the participants are watching old data and waiting in denial for trends. This creates the wild inefficiencies of markets in the short run, and also illuminates why 95% of the investing public ends up wrong all the time.

While I'm certain it is human nature to buy high and sell low because its the popular thing to do, its comical how we fear to act when the opportunity costs are low (prices are low because the majority are predicting further wealth destruction) and are so brave to act when the opposite is true. When the trend of past data is upward, indicative of a bull market, we as investors love to run directly off a cliff. Reminiscent of the old roadrunner cartoon, standing on nothing but air and filled with a false confidence by the reported data we believe to be a reliable prophecy of the future, there is no where to go but down.

What is wrong with our economy?

As the 2009 year begins, this site shall provide timely guidance on how to make the economy of the United States viable and eventually vibrant in the long run. Today it is important for a short discussion on the proper diagnosis of what is wrong with our economy so that the proper cure can be developed.

The problem is very simply, deflation. While this word conjures terrible imagery and tends to carry a bundle of consequences that create fear and panic, one should not fear this diagnosis as it is accurate and can be remedied. Law makers, analysts and business leaders will never admit when an economy encounters deflation because it signals the complete failure of a market or economy. Deflation renders the actual market incapable of righting itself through mechanisms such as supply and demand, and necessitates intervention, whether by government, nature or large private players to reset the devastation.

For those not familiar with deflation I shall provide an example. This morning on the AOL homepage an article was titled "Don't buy a Camera Yet." The article went on to state that consumers should put off purchasing cameras, televisions, computers and other large electronic items as prices are sure to fall further. This behavior, while prudent perhaps, is deflationary as it incites hoarding by the population. It sends the message to hold your money as it shall be able to buy you more goods for the same amount later. Once the citizens decide that the "holding cost" of money is less than the fall in the costs of goods and services the death spiral begins. People stop spending and prices go lower. The problem is simply that as the price falls, people still don't buy so the price falls further.

This translates into an economic level where price falls and quantity falls as well. There is no supply and demand correction because price and quantity are no longer inversely related. In other words, price falls and the market does not react. Once the price falls below the cost to produce an item the seller no longer has an incentive to produce that good or service and the company shuts down leaving the market short of that good or service. At this point, the money hoarded by the citizens cannot buy that good as it is no longer produced. Deflation incentivize us as market participants to do nothing and produce nothing so as to prevent losing money.

Another great example of the deflationary environment we currently are experiencing is watching citizens fill their gas tanks half way, because they know they can fill the other half for less later in the week. This behavior, while prudent, shall lead to gas stations to slow or cease ordering gasoline to avoid taking losses. Sellers of gasoline can buy their inventory for less the very next day, and are punished for holding inventory. This leaves the citizen with shortages or without the product altogether at any price as the incentive is to not produce for the seller.

While terrifying, there are fixes. Generally speaking one can see that an economy must place a firm bottom under prices so that sellers can feel confident in producing a good or service. From that point a controlled increase in that price is necessary for a market to function on its own, inflation. Once citizens understand that an item shall not be reduced further in price, and rather, that same item will cost them more money in the future, they will begin to purchase. This translates into a conscious decision by the citizen to use an amount of their money while it still is able to purchase the good or service as it will take a greater amount of money to purchase the same amount in the future. The price increases allow the seller to make a profit and the seller is able to spend in return on innovation, labor and capacity thus creating greater production.

How does a market get fixed? Two ways. The first is that people magically gain confidence and start spending, which generally substantiates prices and creates price appreciation. This whimsical solution is very inexpensive, but not reliable as there is no guarantee it will occur before the entire production of a market is destroyed. Perhaps if the media created a positive environment people would psychologically react and mirror that environment. Studies have proven that people tend to act out the prognosis and tone of the "general consensus" of a population. As the media is the artery that provides the population with its "general consensus," whether agreeable to us or not, its message under this solution is key to the confidence of citizens. In fact, in our current situation it is amazing to note that the substantial fear amongst the population at large is centered around a threat that impacts very few of the total citizens (less than 8% unemployment, less than 2% of homes in foreclosure, FDIC limits of $2ook per account). Moreover, as the media has become increasingly more negative, the overall health of society has diminished and suicides have increased in step with the message.

That said, it is common knowledge that fear sells. Demanding the media change its message to fix the deflationary environment would be challenged by every media source as a violation of the First Amendment. Therefore, short of the media providing this market intervention against its self interest to save the greater good, another solution must be sought.

The second solution is to increase the Money Supply. Government spending, loaning and stimulus shall make the money that citizens are holding less valuable and eventually promote spending which will provide a price floor and an increase in prices in future years. It is not clear how the general citizen comes to understand that the holding cost of their money becomes expensive, but generally as a population sees citizens enriching themselves with goods and services as a result of more money circulating in the market, an increase in the general standard of living occurs in the short run.

The largest challenge to this solution is that it requires diligent monitoring by the Government so as to not create an over supply of money in the long run creating a jolt in prices once they have bottomed instead of a controlled price appreciation as desired. That said, this form of intervention shall certainly increase prices and solve the deflationary situation.

The second solution has been undertaken by the United States and the approximately four trillion dollars of stimulus provided between the TARP, Federal Reserve lending, Guarantees of Fannie and Freddie and a stimulus plan by the next administration to create three million new jobs will reverse the death spiral of deflation. The management of these programs will be crucial in the upside of the price appreciation to follow.

That said, isn't it interesting that both solutions provided here as well as any solution the reader may create will all entail people to act against their financial self interest and act in the greater good of the society or market as a whole. Perhaps the give and take relationship between self interest and common good are more relevant in a capitalist, or free market based economy, than society currently recognizes.