Guest Post: Three Times Is Enemy Action
Submitted by Daniel Cloud
Three Times is Enemy Action
People seem surprised by the suddenness of the decline in the stock market. It keeps trying to rally, and the rallies keep getting sold. There’s no shortage of worrying circumstances in the real world to explain a fall in prices, and it’s normal for people to disagree about whether they should be going up or down. But the violence of this move has caught many of us by surprise.
I don’t think it should have. I think there are good theoretical reasons, very simple, orthodox economic ones, to expect more of the same, to expect equally dramatic, or even more dramatic moves down, going forward.
Of course, given the fact that I presumably have some sort of bets on the table, anything I say about that belief, like anything any market participant says, should be taken with a very large grain of salt. On the other side, there’s the danger that I’m merely stating the obvious, and wasting the reader’s time. (But then why are so many of us still long?)
Nevertheless, despite the fact that I clearly can’t be trusted, and consequently won’t persuade many people to change their views, and even if there’s nothing startlingly original about what I’m going to say, I think it’s worth laying out what I believe to be the correct explanation of the crash as it’s still happening, so that later on, when we’re tempted to blame various scapegoats – derivatives traders, European politicians, bankers, our neighbors, immigrants, the opposing political party, etc., etc. – we’ll perhaps remember that one of these analyses was predictive of the timing and scale of the event at the time, while the others are invidious reconstructions after the fact.
So let me just tell you why it seems obvious that this market should now continue to move down a lot in a fairly abrupt manner, should finish crashing. As a serendipitous benefit, you’ll also get a rather interesting story about why the economy never really recovered after the crash of ’08.
What market is usually the way world markets are at the moment? If you’ve ever looked carefully at a very long-term chart of the Chinese markets – not Taiwan or Hong Kong, markets on the Mainland, Shanghai or Shenzhen, and a chart going all the way back to the early ‘90’s – you’ll notice that they tend to suddenly move straight up or straight down in what seems like a completely abnormal and un-technical way. The very long-term chart just doesn’t look like any normal chart of any real stock market. Of course, I’m exaggerating a bit – it’s a relative thing – but relative to most stock markets, it has the flavor I’ve described.
That’s because the Chinese government is still practically and ideologically committed to planning the Chinese economy, both in aggregate and in detail. When the market goes up, often it’s not because of some subtle, gradual improvement in the earning power of companies, it’s because everybody knows that it’s the policy of the government that the market should go up now, or because the government is going to renew its commitment to endlessly printing RMB to sterilize its interventions in the foreign exchange market. When the market suddenly and abruptly goes down by fifty or seventy-five percent, it’s because the government has decided it’s too high, or is going to flood the market with IPO’s of failing state enterprises, and everybody knows that. It’s a largely policy-driven market, that’s what they look like.
Of course, this creates uncertainty (that’s why it’s necessary to order the banks to lend) and wouldn’t work as a way of encouraging extensive growth, but when you’re just installing equipment invented by someone else, you can get away with this sort of very aggressive management style for a while, until, as happened in Japan, your economy eventually gets too developed for it to work any more, gets to the point where further growth would only come from encouraging individuals to have their own differing points of view, to be creative.
The Shanghai stock market isn’t one that rewards being in the minority, and being right, the way a real capital market would. It’s a market that rewards marching in lockstep with everyone else, but getting the tip-off just a little sooner, because everyone knows (in a society where the very idea of a level playing field is held to be seditious) that the beautiful people should get the beautiful breaks. Chinese people have had six decades of this sort of treatment, and they’ve gotten pretty good at doing things in unison. (The Cultural Revolution was very good training.) That’s why their market tends to sometimes move up and down in relatively straight lines.
By explicitly targeting our stock market, by adding themselves as a source of net new demand for financial assets with their two quantitative easing programs, the Federal Reserve Bank began the process of making it into that sort of market, they tried to make sheep-like obedience to government directives the new ‘clever’. Trading days increasingly resembled rehearsals of synchronized swimming routines. For the time being, we, too, are a policy-driven market, though the current policy is now, unfortunately, suddenly RISK OFF.
For the last two years, being in the majority, not trying to be too clever, not fighting the Fed, buying every dip, has been what’s paid, but now the Fed has had to back away without accomplishing anything in particular for its money, besides pushing the prices of financial assets into unsustainable positions. In the short term, they really did manage to get market participants all doing what the government told them to do, all buying in unison, all fully long at once. But the market is like a Slinky or a rubber band; stretch it too far, in one direction, and then let go, and it will snap back in the other.
Now some people are trying to sell, still in an atmosphere of only-slightly-perturbed calm, while very few people are still buying, since the Fed’s monetary signal to do so has been switched off, and rallies keep getting sold. It’s possible to identify technical support at various levels, but I’m not sure it matters, it seems to me that there will still be people who have to sell but nobody who has to buy, even at those levels, because people have been conditioned to buy when the Fed is buying, and won’t know they ought to act without that coordinating signal. Policy-driven markets tend to go up and down in straight lines when policy changes, hence I expect a surprisingly savage sell off in this one.
All of this could have been predicted by anyone who bothered to read Charles Kindleberger’s Manias, Panics, and Crashes. If you don’t own it, I suggest you buy a copy. His argument seems complicated, but it boils down to something very simple. Kindleberger argues that bubbles, in the modern world, are often caused by cross-border capital flows, and shows that we can explain much of the history of the last several decades with a very simple model.
If we just assume that every dollar that is brought into a country by foreigners to buy some financial asset, say a bond, from a local, is used by that local to buy another financial asset, say a stock, instead of used to fund consumption (and why should the mere presence of a foreigner change the local’s propensity to save?) then we can easily explain events like the Japan bubble of the late 1980’s, or the American bull market of the three decades prior to 2000, and the series of bubbles since then, as the result of events like yen purchasing after its un-pegging, and the huge net flows of Asian savings into dollar-denominated US asset markets over the relevant period. Asian institutions may have mostly bought bonds, in the US, but the portfolio preferences of American investors weren’t changed by that, or got skewed towards risky assets by the resulting bull market, so even though it was the bond market the inflows were coming into, and we did get a bull market in bonds, it was much riskier assets that went up most in price.
Asia just eventually got too big, without much of a decline in savings rates, for this game to go on forever – by the end, they needed to lend us far more money than we had any actual use for, so we could buy far more gadgets than we had time to learn how to operate, and fight endless wars without any real political objectives. The whole thing fell apart by being reduced to an absurdity, to a system that would have required every American, even the ones working for minimum wage, to buy a mansion full of robots. That couldn’t happen, so the system broke.
All that should be fairly obvious by now. But if Kindleberger’s is the correct analysis of the effects of natural sources of exogenous demand for financial assets, which come on stream gradually and ebb away gradually, what should be the consequence of an artificial source of exogenous demand for financial assets, which switches on like a light, and then switches off abruptly a year or two later?
Well, presumably anyone the Fed bought a bond from, in the course of QE’s 1 and 2, immediately took the money and bought stock, encouraged by the fact that the Fed was publicly putting its credibility behind the notion that stock markets should only go up and can be planned, successfully, in a manner that causes them to only go up, a theory I first heard from a Japanese speculator in the late 1980’s.
So you should get a big bubble in the stock market, just as you would if the source of exogenous demand for financial assets had been capital inflows. This also explains the rather pointless bubble in gold and other commodities. If the Fed really does succeed in manipulating expectations, everyone should become convinced that by getting long anything liquid they’re doing the only safe thing, that people who still see risk are idiots and troublemakers. They’ll all get two hundred percent leverage, and financial institutions will all gear themselves up sixty times again. The VIX will fall to 16. Banks and private savers will arrange their speculations in liquid assets on the assumption than the economy is very much better than their own internal data makes it seem to be, because how could the Fed and all those smart people in the market all be wrong? (Does any of this sound familiar?)
At the same time, nobody will want to invest any money in any real productive activity, or to own anything they can’t sell in a day or two, because the question of the Fed’s exit strategy, and the Federal Government’s exit strategy from a very stimulatory level of deficit spending, will always force them to stay liquid, the more so the more it looks like the economy might recover. (Because they know, from their past experience with this Fed, that any such exit will inevitably be accompanied by a severe financial crisis or market panic which will destroy anyone who isn’t perfectly liquid, that if they get stuck in some productive investment they can’t immediately sell, if they don’t find a chair when the music stops, they may well, if recent history is any guide, end up in jail, or branded a public enemy.) And when the music finally stops, when the pied piper finally throws up his hands and says ‘to heck with those ingrates in Hamelin town’, there will be nobody who’s not fully invested, or who’s short, left to buy from them, nor any investment going on in the real economy, and the bubble will pop quickly and loudly.
The thing that ought to be stressed, about this explanation of the pattern of events we now see unfolding, is its orthodoxy as economics. These are exactly the reasons that have always, in the past, dissuaded the Fed, or any other well-run central bank besides Japan’s (they somehow don’t seem to mind the fact that it has never worked and theoretically shouldn’t work) from ever pursuing any such policy of directly targeting asset markets over long periods of time (other than the market for government bonds, which central banks must manage) and that will dissuade any other well-run central bank from ever emulating the Fed’s current policy in the future.
You see, in economics, they have this idea that prices depend on supply and demand. You economists, all you PhD’s out there, you wise wizards and technocrats at the Fed who keep us safe from unscientific approaches to the management of the economy, may have heard of these things before, though of course they’re mysteries to the rest of us. The Fed, in doing two, successive, large scale ‘quantitative easing’ programs which basically just amounted to buying lots of bonds, temporarily increased the demand for financial assets. Market participants’ portfolio allocation preferences didn’t change, or became less conservative, so even though they were buying bonds, it was risk assets, equities and commodities, that went up in price. (This is not rocket science.)
Eventually, though, the buying would have to stop, when the program ended. That would remove a source of demand for financial assets; one market participants had grown accustomed to and reliant on. With less demand, the prices of financial assets would then fall, in the typical pattern, with equity market weakness and bond market strength. Since the monetary stimulus, by then, would have been huge, its sudden removal would create a huge hole under the market, into which it would ponderously collapse.
Of course, since the stimulus was all fakery, and was the very least the participants in the rave expected from their DJ, while its removal shows us harsh reality, and comes as an unwelcome surprise, every single time you do this, the cost of the exit will be greater than the benefit of the free lunch you thought you were getting during the bubble period. (The Fed has now had two good opportunities to re-learn this – one in 2000, and one in 2008 – but seems to have learned nothing at all, seems even more committed to blowing up bubbles with printed money, though maybe the third time, which we’re presently living through, will be the charm.)
The asset market will go down by more than the amount you pushed it up each time, as everyone tries to exit at once. The decline in GDP from the crisis will be greater than the boost to GDP from the stimulus that caused the crisis to occur. The basic idea of economics is that there’s no such thing as a ‘money machine’, that you can’t get something for nothing, and the practical wisdom of any competent economist tells him that an attempt to try will always leave you worse off.
(I shouldn’t have to say any of this, all professional economists outside the United States know it, but somehow ours have lost their willingness to contemplate the possibility of perverse policy outcomes, though those are what real economics is all about.)
This all seems blindingly obvious, and many other people have said more or less the same thing. The hardest thing to explain is how people could be fooled by the initial temporary increase in demand for financial assets, but the portfolio allocation effect seems adequate to explain that, and we have plenty of evidence that they were, the S&P 500 did double over the course of two years in the face of weak economic performance, a bad housing market and rapidly snowballing public debt.
How much should prices fall now that the artificial demand for financial assets has been removed? With expectations disappointed, it would be reasonable to expect overshooting on the downside. All of market participants’ ‘ill-gotten’ gains, ill-gotten not in a moral but a practical sense, precarious gains, resulting from just doing what the government told us to do instead of thinking for ourselves, should probably be wiped out before much of anyone has a chance to sell, and there should be some further penalty on top of that, because when the music stops there should be a disorderly scramble for chairs. (Given the number of people trying to delta-hedge, I would expect there might be gaps lower, once we really get going.)
Most people, now, are still thinking that the worst thing that can happen to them is a decline, in the S&P 500, to 1020, the lows last year before QE2 was announced. But people always have modest expectations of the extent of a decline when it starts (otherwise they’d already have sold) and this analysis ignores the fact that there was another, more or less identical quantitative easing program before QE2. (Quite how people could forget that, given QE2’s name, still strikes me as mysterious, but never mind.)
Really, perhaps after some hideously destructive rally off of this forlorn hope of support, shouldn’t we give back the ill-gotten gains from the first program as well? (I know we’re used to having them by now, but the market doesn’t care about that.) That would take us below 800. Actually, if we’re going to overshoot where we should be, we should overshoot the 2008 low, which itself was an overshooting of the 2000 low. After all, now we’ve made a lower high, this whole move up from 666 to above 1300 is just a two year long rally in a secular bear market, and in bear markets, successive lows tend to be lower as well.
(The Fed keeps doing this to us, blowing up bubbles and then backing away. Once could be happenstance, twice might be bad luck, but three times is enemy action, so it seems likely that people will recognize what’s being done to them and act to protect themselves more quickly this time, leading to a more severe, or at least more sudden market event.)
That would indicate an ultimate low somewhere below 650 on the S&P, perhaps 600? Anything that takes us below 800 will amount to an effectively complete claw-back of all the policy-driven gains, but it really seems possible that we could make a new low. This is a crazy-seeming prediction, but it’s where reason seems to lead, and even if it’s wrong, developing this sort of contrarian case is a good exercise. Think of it as a puzzle; please, knock yourself out, find a way to make me wrong, I’d love to be wrong.
Well, that, anyway, was my general theory, a few months ago, we’ll see if I was right, so to test it, I bought enough puts on the S&P 500 to hedge my own illiquid investments in real productive activity. I thought a crash was likely to occur, but I had no theory about the detailed mechanism of the panic, which makes me seem rather stupid, to myself, in retrospect.
It should have been obvious that a lot of the money we were printing was actually ending up in Europe, that that was what was being endlessly shoveled into peripheral bond markets by the European banks, it should have been obvious that as soon as QE2 ended there would be a huge hole in the funding system for these quasi-parastatal monstrosities. Naturally that would lead to selling in peripheral bond markets, and naturally that would provoke a run on the same banks by depositors with an accurate conception of how much political interference there’d been with sound balance-sheet management, how much pressure there’d already been and would continue to be, on the banks, to bail out Greek and Italian politicians with the money of German and French depositors. And naturally this run would go all the way, since the sovereigns involved could hardly guarantee bank deposits if they were effectively bankrupt themselves. So of course, what we were always going to end up with, once QE2 stopped, was a classic 1930’s style run on the European banking system, which policy-makers would react to by basically dropping out of sight because they knew the only plans worth articulating, now, were recovery plans for after the crash, that it was pointless to try to prevent it.
I suppose if it really happens, the event I’m describing will leave Europe’s banking system in collapse and the American and Asian ones, aside from a few very weak large institutions, largely intact. Europe’s present regulatory and political institutions are the result of political compromises rather than the test of time, and simply aren’t set up in a way that would permit a successful response to this sort of crisis. They’re the weakest link, because their political system is the most utopian, the most unsustainable, the most fragile, so the destruction of the QE money, and the last decade’s worth of excess Asian savings, is most easily accomplished there.
Because of course, that’s what this sort of event is largely about; a bunch of money corresponding to no existing goods and services has been created out of thin air, and if it can’t be burned off through inflation, hard to do with productivity going up so quickly and so many people joining the global work-force, it has to evaporate in a crash. Someone, somewhere, has to lose that amount of money, has to find out that they can’t actually get it and spend it when they need it, and that describes a stock market crash or a run on a banking system. And there’s always collateral damage, more than the excess, purely imaginary wealth is always lost.
We may have to recapitalize some of the American banks again – from tax receipts, this time, doing it with money borrowed from the banks themselves was never really going to work – but the event should at least scare us back onto the path of fiscal rectitude, and after all, the adjustments we really need to make still aren’t horribly harsh ones. People like me have to pay a little more tax, people who are still fairly young have to get used to the idea of retiring a little later, etc. These aren’t things that will tear our society apart, it’s just that some parts of the existing political class will have to be replaced through elections.
What’s unfortunate is simply that the event is likely to be more damaging, to the world at large, than it would have been without QE2, and the event that would have occurred last summer if we’d had no QE2 would have been worse than what would have happened if we’d had no QE1, and what would have happened if we’d had no QE1 would have been worse than if there’d been no monetary stimulus after 9/11, and what would have happened if there’d been no monetary stimulus after 9/11 would have been worse than what would have happened if LTCM had not been rescued. That was our last real chance to avoid some kind of disaster, small or large. We’ve been in trouble for a long time, now.
The very technical competence of the central bank, its ability to manage markets, is endangering the world economy, and is now apparently threatening to destroy Europe’s banking system. It would be the worst thing in the world for the Fed to launch another iteration of this failed approach, in yet another attempt to avert the inevitable disaster brought on by its last targeting of asset markets.
Of course the Fed needs to act as lender of last resort in a crisis, they’re really good at doing that, but then they never stop acting as lender of last resort, they seem to make no conceptual distinction between the lender of the last resort role and really over-the-top kinds of Keynesian stimulus, and direct, explicit targeting of the stock market (a truly bizarre and self-contradictory policy in the context of the normal, sober behavior of the Federal Reserve Bank of the United States) or else they’re just no good at leaving the limelight. Instead of backing away from the economy after the crisis and letting it equilibrate, they endlessly tease and torture it with their capricious antics, thinking they’ve saved the world by creating this or that new bubble, and then being comically surprised when they stop blowing air in and the air all comes back out.
We don’t really need this huge distorting signal; it’s causing a gigantic flutter in the world economy that’s getting faster and more violent with each cycle. Central banks should probably never target the stock market for any protracted period of time – that’s central planning, not the management of a sound currency, or even protection of the long-term growth trend. After all our protection of full employment by managing markets, over the last fifteen years, how’s employment doing?
And yet that’s what the Fed’s quite likely to try to do, again, not because they really think it will work, it will be clear to them, by then, that QE2 ended up doing enormous damage, but because the political impulse to be seen to seem to be doing something will win out, in the absence of any better option. There isn’t any way to stop that spasmodic action, the only good that can be gotten out of it is to use it to reinforce the lesson, for people outside the Fed, that central banks should never do what they may end up doing yet again, because it only makes things worse in the end. That’s why nobody should be surprised by the violence of this crash; it makes perfect sense that they’ll be worse each time.
- Daniel Cloud