Notebook, 7 November 2010: My view of markets

At some point in the near future, a “good job” may be defined as whether or not someone asks: “How do you want that cooked?”

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Alan Greenspan, 5 December, 1996, Francis Boyer Lecture at The American Enterprise Institute. Accessed 6 November 2010.

There is certainly enough well documented history by now to reach some substantial conclusions about the worth and efficiency of the free market system. When Fed Chairman Alan Greenspan gave the speech at a black-tie event within the friendly confines of the American Enterprise Institute, the Nikkei index dropped 3.2%, the Hang Seng fell by 2.9%, the Dax dropped 4%, and when trade resumed the next morning, the Dow shed 2.3%[1]. The one man charged and believed to have the best overview of the actual state of the economy had just told the world that stocks weren’t worth the prices they were being traded at, and traders heeded those words for less than 48 hours.

On 4 December, the Dow Jones Industrial Average closed at 6422.94. The day of the speech, which was given after close of market, the Dow closed at 6437.1 and by close of the 6th, 6381.94 (-41). Over the weekend, traders “came to their senses” and drove the market up to 6463.94 and the race was back on.

This sort of thing happens all the time. I cannot tell you how many trading sessions I’ve witnessed going up on bad news and falling on good news. The reason given for this is that news, even before it is released, had already been factored into the share prices, which most likely are viewed as having overshot “rational” levels. Which ever way you look at it, the fact is that whenever you hear business news personalities say the words, “widely expected,” what is actually being stated is that this point is something traders and money managers have hung their hats on, and that this is something considered a sound speculation. It sounds harmless enough. It even sounds rational stated exactly like that, however, it remains a speculative gamble, and speculative gambles are what the stock market it all about.

Which creates a serious problem when ordinary people, professional traders (who are no less likely to fail than retail investors) and even legislators take the DJIA as a proxy for the overall health of the economy[2]. Talk about efficient markets. On Monday, 29 September 2008, the Emergency Economic Stabilization Act of 2008 came to the floor for a vote, and failed 205 to 228:

NEWSCASTER [Rick Santelli]: They didn’t pass it. The did not pass it. And I see that the Dow traders are standing there watching in amazement, and I don’t blame them!

NEWSCASTER: Look at the Dow Jones industrial average!

NEWSCASTER: The market right now is down 521 points.

NARRATOR: Ninety-five Democrats also voted against the measure.

DAVID FABER, CNBC Anchor: The shock of the fact that it wasn’t going to pass on the first go there was amazing to people. “Oh, my God, these guys don’t know what they’re doing. We’re in really deep trouble.”

MARK LANDLER: I thought it was one of those moments where you could not actually see the bottom. I wasn’t sure where the market was going to stop, and I had a very bad feeling that forces had been unleashed that we couldn’t control.

NEWSCASTER: A history-making 777-point nosedive-

NEWSCASTER: -plunged for the single greatest point loss in the Dow average in one day ever.[3]

Then the Senate co-opted a bill previously passed by the House, rewrote it entirely to match almost identically the House bill which failed, and passed that bill on 1 October 2008. The House agreed to the Senate’s bill on 3 October 2008 and it was signed into law by President George W. Bush the same day.[4] The stock market, which had held steady through September 29th through October 3rd, then returned Monday morning on the 6th to drop below 10,000. The DJIA would remain below 10,000 for a year. There is no clearer illustration of financial markets heeding their own marketing rather than reality than this: the markets dropped substantially after the bailout was enacted, when rationally, they should have rebounded.

Assuming you get a “good” job, you’ll more likely than not have to contend with poor lighting when judging whether that burger on your grill is actually cooked to the degree the discerning diner demands. To judge a burger before flipping, it is necessary to observe the edge of the pattie minutely, so good lighting is, in this writer’s opinion, absolutely vital.

And the DJIA may still have been too high. It’s difficult to tell. The fact of the matter is, the concept of “The Market” misleads, as there are different kinds of markets. Old school traders recognize this, economists tend to ignore it. Beneath all this is the knowledge that everything depends on the willingness of businessmen and customers everywhere to agree to do a deal. the trillions of deals that taken together make up the global economy. Which people must, at the lowest level, undertake in order to survive. What we can do is try to judge price by whatever mechanism we can think of, but prices are subject to forces beyond perceived “worth,” something humans are demonstrably incapable of rationally determining[5], and all we’re left with is examining price history—the province of technical traders and economists.

We’re also wide open to value manipulation and value manipulation is what enables the talking heads on CNBC and Bloomberg to successfully build castles in the air. Like the dot-bomb. Like the overheated housing market. Like the electronics boom. Like the “lean and mean” boom of the eighties which brought us business geniuses like “Chainsaw” Al Dunlap, who destroyed every company he ran, but brought shareholders, and himself, handsome returns for awhile. The list goes on, because this has been the aim of traders since the Tulip bubble in the Netherlands to the South Sea Bubble in London. And don’t let professional investment analysts and money managers tell you that they possess superior knowledge and experience, because history amply demonstrates the exact opposite[6]. Heeding the advice of professional investment analysts may well be the worst stock trading technique available. So what’s the rational price of the market? Nobody knows. This is to be determined “by the market,” of course. We can, however, try to judge where the market stands at any given time by viewing the sentiment, as expressed by the price to earnings ratio (courtesy Dr. Robert Schiller):

S&P 500 P/E Ratio, 1970 to present

Note: Many traders and economists credit this rise to an inverse lowering of interest rates, and yes, there are graphs out there to support this, however, I remember my history better than many would have it, and I recall that interest rates are a product of economic conditions, mostly inflation, unrelated to equity price levels. During the late seventies to early eighties, when interest rates peaked (quite sharply) at 13.5% (to counter stagflation), please note the lack of effect on the P/E ratio, which remained relatively flat throughout this period. It would be more accurate to say that the financial markets wanted lower interest rates, and getting what they asked for, felt free to drive prices upward. Which may have been no more than a meme theme traders and advisors felt they could sell. In reality, it took a great deal more to drive equities markets upward.

What the above table shows is that stocks seemingly gained intrinsic value throughout this period (as measured here by price to earnings). We know that rational determination of price is not one of mankind’s intellectual assets, and what we see here is the ability of economic theorists marketers to create a value myth. I chose this period for another reason. Perhaps more significantly, the rise in P/E may also reflect the guaranteed inputs, which began in the same period, of money granted it by the tax subsidization of retirement plans, which allowed for a greater rate of withdrawl of wealth from the markets without adversely affecting prices. So there was something of a perfect storm in reverse: interest rates were going down, money was flowing into the markets with every paycheck (and as prices rose, more money flowed into equities), a lax regulatory environment from 1980 onwards, and labor relegated to the status of any other commodity. A lot of things Wall Street wanted to see.

And yet . . . all this resulted in a spectacle of traders standing helplessly on the floors of exchanges in Chicago and New York as Washington decided that moral hazard trumped business, that moment when it became crystal clear that bankers, hedge fund managers and traders had, in fact, trumped themselves. That moment when the scales had fallen and even those whose daily burden was to somehow extract wealth from the boiling cauldron of economic activity came to realize that their risk hedging techniques and carefully constructed portfolio models where returns are maximized and risk is minimized, meant nothing. In that moment, their castle in the air went “poof!” and turned out to be nothing more than, well, air.

I stopped believing in the stock market in 1999, when the DJIA first hit 10,000 (29 March 1999). They stopped believing it on September 29, 2008. I don’t think they fully believe in it even now.

Presumably Congressional Republicans who felt this way about the TARP:

Rep. PAUL BROUN (R), Georgia: This is essentially Mr. Paulson’s bill to help his friends, and I can’t buy it.
[ . . . ]
Rep. LOUIE GOHMERT (R), Texas: Please! Please don’t betray this nation’s great history![7]

. . . had some kind of point. Certainly, the likes of Jamie Dimon, Lloyd Blankfein, Uri Landesman, Rick Santelli and “Lawrence of Amerika” Kudlow, seem to argue the point today that the government has no place in the markets, and by implication, should not have intervened then either. From a purely market-oriented point of view, the pain would have been intense (and global), the effects long-lasting (as an entire generation of elementary level schoolchildren remained perpetually behind), yet economic activity might have rebounded on its own. At the time, however, even Hank Paulson didn’t want to run that risk. He made the right decision to intervene then, and all the free market jihadists who today rail against TARP and the bailout are disingenuous, to say the very least.

The most frequent sin committed in cooking fries it to add too many raw fries to the oil at once. To avoid heavy, soggy fries fit only for the garbage pail, one must at all costs maintain oil temperature! It is simple physics: larger reservoirs of hot cooking oil will resist cooling longer, and thus permit larger batches.

The human cost of free market purists like Broun and Gohmert was unthinkable to contemplate, even for another free market supporter like Hank Paulson, who took the lead on TARP (it was beyond Bernanke’s authority). It would have been for Ronald Reagan as well, who fully realized that some protectionist measures were necessary to soften the blow to American industries and workers. Would such pragmatic ideas fly today? After one of the dumbest crop of freshman congressmen was elected into office?


One also notes Gohmert’s assertion that Amerika’s greatness is due not to our freedoms, nor on participatory government, but on the success of big business. A true believer in the Washington Consensus, even if the rest of the world (where governments are daily active in attempting to seize as much of the global industrial base as possible) sneers at it. That’s the reality. Governments will offer tax exemptions and loans; they will suppress union organizations, imprison journalists and bloggers. Just to placate corporations and investors. Migrant labor has spread to Asia, where the world’s very poorest come to work sweatshop hours—and maybe get paid. Freedom of contract is a basic tenet of free market philosophy, however observing contracts, when it comes to actually paying your workers, is optional in much of the world. It’s almost certain that every piece of clothing you and I are wearing right now was made in sweatshops. That’s the reality. It’s also reality that anti-sweatshop legislation, repeatedly entered in both houses of Congress never once made it out of committee. There is no political will to actually enforce the legal obligation to pay workers for the work they actually perform. It’s cheaper to confiscate passports, virtually imprison workers and threaten deportation.

At the other end of the scale, the wealthy and major corporations enjoy a multitude of benefits unavailable to ordinary people. Most notably, they get to avoid taxation by booking transactions in jurisdictions where taxes are not applied—these days, a favorite practice among hedge fund managers (in New York, the Cayman Islands is preferred as it keeps the same business hours as Wall Street, while in London, the Channel Island Jersey is preferred for exactly the same reason) and oil companies. In 2009, the second largest oil company in the world, Exxon/Mobil, managed to be liable for no taxes at all in the United States. General Electric did the same. At the present time, the world’s largest company, Wal-Mart is goading the government of Bangladesh to suppress an ad hoc labor group whose demand is to raise the minimum wage to 35¢ an hour. It took an international effort to get three organizers out of prison. All in the name of free markets, where “market forces” (uhm, maybe “shareholder greed” is more like it) decide prices and wages. Even free market jihadists don’t criticize this kind of governmental market intervention, in fact, they demand this time and time again.

If someone is mandated a low-salt diet, they shouldn’t be buying fries at all, so salt liberally, and yes, technique counts here as well. Fries should be salted immediately as they come out of the fryer! This is so important that it bears repeating: salt the fries before they have drained, and ensure that every fry is salted! This yields a tastier fry which remains crisp. They’ll ask for seconds!

For all the history, all the evidence of business misbehavior, the notion of economic liberties being the most important American “freedom” still holds sway among many only too willing to ignore the evidence of economic bondage that free markets always engender. The theories of economic liberties and freedom of contract (which doesn’t, as I’ve mentioned, apply to organized labor) prevail. Unions in the United States are hamstrung by federal and state laws. A compliant press refuses to challenge this ideology, even as it becomes more apparent to all that opportunity is dying in America. and the old adage,

“The best lack all conviction, while the worst
Are full of passionate intensity.”

Is exactly what we witnessed on Tuesday November 2nd, and again on Wednesday November 3rd, in President Obama’s address. I cannot support this. I will not. Work must be rewarded as well as investment gambling, and relying so much on the uncertainties of markets is a sure recipe for national decline. We see this unfolding even today. Just ask Japan, currently being squeezed between the two behemoths of China and Russia—while American prestige and strength are diminished. Apart from the obvious hazards resulting from this loss of prestige, which was predicted two years ago, it is a betrayal of every working person and every parent in America to continue along the path of free market fundamentalism, and to refuse to even raise the question of the proper place of business in society.

[1] Schiller, Robert J. Irrational Exuberance Second Edition. New York: Broadway Books, 2005.
[2] Excerpt taken from Inside The Meltdown, FRONTLINE, Accessed 6 November, 2010.
[3] “FINAL VOTE RESULTS FOR ROLL CALL 674”, Clerk of the House of Representatives, Accessed 6 November 2010.
[4] Legislative details taken from Accessed 6 November 2010.
[5] Poundstone, William. Priceless: The Myth of Fair Value, New York: Farrar, Straus and Giroux, 2010. Poundstone pulls together numerous studies in which prices (or jury awards, the same dynamic applies) absent other information cannot be guessed correctly, or are subject to manipulation. Like cats, who are ill-equipped to distinguish color, “value” is something humans see very poorly. It seems that we perceive value mostly in relation to other objects whose value we have already assigned places in our values scale. I highly recommend this book, btw.
[6]Malkiel, Burton G. A Random Walk Down Wall Street, Ninth Edition, New York: W.W. Norton & Company, 2007. Anyone with, or considering putting money into stocks should absolutely read this first.
[7] “Inside The Meltdown” transcript, Accessed 7 November 2010.


3 thoughts on “Notebook, 7 November 2010: My view of markets

  1. Measuring the societal costs of economic policy and business decision-making has never, to my knowledge, been undertaken methodically. Simply adding up the prices of goods sold and of goods purchased is about as far as policy makers and academics seem to want to go. Yet it shouldn’t be this way.

    After all, if the worth of human capital can be quantified (and it has begun to be), you’re halfway home.

  2. Pingback: World Spinner

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