Excerpts
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I realized early on that the bull market since March 2009 was likely to be plagued by frequent anxiety attacks, because the trauma of 2008 had left investors feeling overly jittery. Their PTSD was understandable, certainly, given the S&P 500’s 56.8% plunge in less than a year and a half, from October 9, 2007 through March 9, 2009. But investors’ fears that a similar calamity might strike their world again at any moment clearly were overblown. So I predicted that panic attacks would be followed by relief rallies once proven to be false alarms, i.e., when nothing bad happened. Indeed, the pattern I had foreseen unfolded as if scripted: recurring panic attacks were followed by relief rallies, carrying the market to new cycle highs and then on to new record highs after March 28, 2013, when the S&P 500 exceeded its previous record high of October 9, 2007.
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During the latest bull market in stocks, there have been lots of vocal bearish prognosticators who warned that the stock market was on a “sugar high” from all the liquidity injected by the central banks into the financial markets. My response to their warnings: “So what’s your point?” Their point was often simply that “this will all end badly.” I retorted, “All the more reason to make lots of money before that happens.” The pessimists countered that the central banks were just “kicking the can down the road.” “That might be better than doing nothing” was my reply. The doomsayers said that it was all heading toward a widely dreaded “endgame” in a repeat of 2008 or worse. I countered with arguments suggesting there might be no end to this game.
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At the start of 2018, after Trump had signed the Tax Cut and Jobs Act at the end of 2017, the stock market continued to climb to new highs. I remained bullish and lifted my odds of a meltup from 55% to 70%. However, I also observed in my January 16 commentary: “We may be experiencing an extremely unusual earnings- led meltup. If so, it is more likely to be sustainable than the run-of-the-mill P/E-led meltup, as long as it doesn’t morph into one.”
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I firmly believe and often say that recessions are the major risk for stock investors. The stock market tends to rise along with earnings as long as the economy is expanding, not contracting. . . . [S]ince World War II, recessionary periods have been infrequent and relatively short. From 1948 through 2016, real GDP rose during 236 quarters and fell during just 39 of them, with one showing no change.
industry analysts. It’s those expectations that I want to quantify and use in the stock market equation as a benchmark for my own forecasts.
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The Bond Vigilantes Model relates the bond yield to the growth rate in nominal GDP, which reflects inflation as well as the real growth of the economy. The divergence between the nominal growth rate and the bond yield may very well be influenced by the inflationary expectations of investors as well as by their expectations for monetary policy.
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The great bond bull market may be over, though I wouldn’t rule out even lower yields in coming years. A bear market is conceivable if inflation makes a comeback, though that’s not the most likely outlook, in my opinion. More likely is that bond yields will meander for a prolonged period.
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The secular forces that have brought bond yields down since the early 1980s remain
intact and in some ways are more powerful than ever. These same forces are keeping a lid on inflation. They are global competition, technological innovation, and aging populations.
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In this Yield Curve Model, inflation matters a great deal to markets because it matters to the central bank. Investors have learned to anticipate how the Fed’s inflationary expectations might drive short-term interest rates, and to determine yields on bonds accordingly. So the measure of inflationary expectations deduced from the yield spread between the Treasury bond and the TIPS might very well reflect not only the expectations of borrowers and lenders but also their assessment of the expectations and the likely response of Fed officials! The data are very supportive of these relationships among inflation, the Fed policy cycle, and the bond yield.
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My favorite of all the economic indicators that I track is the raw industrials spot price index compiled daily by the Commodity Research Bureau (CRB). It is composed of the spot prices of the following 13 commodities. . . . I’ve been relying on it for years as a very sensitive indicator of both global and US economic activity. . . . Over the years, I’ve found that the CRB raw industrials spot price index is highly correlated not only with almost all the major US business- cycle indicators but also with global ones.
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The frackers offer a great example of how unexpected technological innovations tend to solve problems when market forces can work relatively freely. Their story is also a reminder of the ability of entrepreneurs to see inherent opportunities in solving problems. In the midst of widespread pessimism about an economic problem, entrepreneurs find a solution that benefits all consumers. In other words, one of the reasons that high prices lead to low prices is that entrepreneurs figure out how to increase supplies with new technological innovations.
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My research led me to conclude that the Great Depression was caused by the Smoot–Hawley Tariff Act of June 1930. . . . Donald Trump won the presidential election on November 8, 2016. He did so to an important extent because he promised to bring jobs back to the United States by either renegotiating trade agreements or imposing tariffs if necessary. His policies could pose a threat to global trade. However, the threat level seems more like what it was during the Reagan years than the debacle of the Hoover administration.
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The good news is that robots may not eliminate lots of jobs done by humans, as is widely feared. Instead, they may be filling the gap as shortages of working human stiffs become more prevalent.
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One of the main themes of my book is that economists, especially of the pessimistic persuasion, rarely pay much attention to technological developments. Yet these developments regularly transform the course of human history. Human nature may not change much over time, but technology often does so in ways that profoundly impact human societies and their economies and financial markets.
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To explain the war-and-peace cycle in the CPI, I came up with my Tolstoy Model of inflation. During wartimes, global markets are fragmented. Countries don’t trade with their enemies. They face military obstacles to trading with their allies and friends. Commodity prices tend to soar as the combatants scramble to obtain the raw materials needed for the war effort. A significant portion of the labor force has been drafted and is in the trenches. The upward pressure on labor costs and prices often is met with government-imposed wage and price controls that rarely work. Entrepreneurs, engineers, and scientists are recruited by the government to win the war by designing more effective and lethal weapons.
Peacetimes tend to be deflationary because freer trade in an expanding global marketplace increases competition among producers. Domestic producers no longer are protected by wartime restrictions on both domestic and foreign competitors. There are fewer geographic limits to trade and no serious military impediments. Economists mostly agree that the fewer restrictions on trade and the bigger the market, the lower the prices paid by consumers and the better the quality of the goods and services offered by producers. These beneficial results occur thanks to the powerful forces unleashed by global competition during peacetimes.
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The US economy is less prone to transmit inflationary shocks today and in the future than in the past. The oil price shocks of 1973 and 1979 were rapidly passed through to wages by cost-of-living adjustments in the labor contracts of unionized workers. Today and tomorrow, similar price shocks are much less likely to trigger a broad and sustained upturn in inflation. That’s as long as globalization persists and perhaps even proliferates despite populist resistance.
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To take this a step further: other things being equal, inflation is likely to be structurally lower the less that market forces are messed with. Monopoly, oligopoly, cartelization, price-fixing, collusion, subsidization, protection, and socialism all exist to some extent in every economic system, and all distort the action of market forces.
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Over the years, I’ve come to believe that the profits cycle drives the business cycle. Causality works both ways, of course. However, my simple thesis is that profitable companies expand their payrolls and capacity, while unprofitable companies struggle to stay in business by cutting their costs. They do so by reducing their payrolls and their spending on new equipment and structures to revive their profitability.
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The interactions of the business, profits, and credit cycles discussed above strongly suggest that just as recessions have a tendency to be self-healing, booms are self-destructive. However, focusing on cycles misses important secular trends that can influence the economy—including the demographic, technological, and political trends that this book examines.
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I agree that some of the sinning during booms often can be blamed on the central bankers. I also agree that soaring credit facilitates the booms that turn to busts. Credit is a better measure of these excesses than are money-supply measures, which tend to have a less stable relationship with the economy. Credit measures also can pinpoint the epicenter of the excesses and predict where the damage will be greatest when the speculative bubble bursts. I think that consumers, investors, and business managers tend to behave rationally more often than not but can behave irrationally as well on a regular basis. They tend to be rational during and after recessions. They tend to lose their minds during booms.
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On my firm’s website, we post and update all the FOMC statements, with the record going back to 1997. That allows me to search for key words and phrases when I’m writing about changes in Fed policy or trying to keep track of how long a key word appeared in the statements. We also provide links to all the FOMC minutes over that same period. Often when the minutes are released, I count certain key words to help
assess whether increasing or decreasing frequency of mention suggests that something relevant to policymaking is becoming more important or less so.
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At the time, I argued that if the Fed’s econometric model was calling for a negative official policy rate, then either there was something wrong with the model or the Fed was trying to fix economic problems that could not be fixed with monetary policy. In my opinion, when the federal funds rate was lowered to zero, Fed officials should have said that that was all they could do. While I expected and endorsed QE1, I am not convinced that QE2 and then QE3 were necessary. But there I go again, critiquing monetary policy.
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However, my focus from the beginning of my career has been on objective, rather than subjective, analysis. I’m not advocating either ending the Fed or changing it. My job is to understand the Fed and the other central bankers as they are, not as I think they should be, and to predict their actions accordingly. Nevertheless, I do try occasionally to puzzle out whether technological innovation might put the central bankers out of business or radically change their modus operandi. I’m particularly intrigued by the impact of bitcoin and other cryptocurrencies on our monetary system.
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But why has it been so hard to get inflation back up to a measly 2.0% on a sustainable basis following the financial crisis of 2008, especially in Japan and the Eurozone, at least through mid-2017? In the United States, both the headline and the core PCED inflation rates also remained stubbornly below 2.0% post-crisis. The answer is that the central banks have been fighting powerful forces of deflation unleashed by peacetime, global competition, technological innovation, and aging demographics.
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I can understand why there was so much unease about the extreme measures that the major central banks took to avoid another financial crisis. They were indeed extreme, and without precedent. From time to time, I too was shocked by their latest maneuver and accused them of being “central monetary planners.” I objected to their central conceit, namely that monetary policy could solve all our problems. The central bankers
occasionally admitted that they didn’t really believe that but had no choice except to do whatever it took to save the day, since fiscal policymakers seemed incapable of taking appropriate action.
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In my opinion, after the financial crisis of 2008, ultra-easy monetary policies may very well have propped up supply much more than they boosted demand. Credit crunches are nature’s way of cleaning out insolvent borrowers from the economy. Easier credit conditions may exacerbate the zombie problem, resulting in more deflationary pressures.
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My complaint with treating economics and the other “social sciences” as sciences—governed by the immutable laws of physics and nature—is that they aren’t. The social sciences are concerned with human behavior, and human behavior is quite mutable, constantly changing in response to the ever-changing course of human events. The laws of physics have been discovered over time, gradually advancing our understanding of our universe. Similar progress has eluded social scientists trying to understand,
predict, and even change human nature. It’s hard enough to get humans to obey their own laws let alone any universal laws of human behavior. The natural universe is much more stable and predictable than human society.
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Globally, the most significant demographic development has been the collapse in recent years of fertility rates around the world. . . . All around the world, humans are not having enough babies to replace themselves. There are a few significant exceptions, such as India and Africa. Working-age populations are projected to decline along with general populations in coming years in Asia (excluding India), Europe, and Latin America. The United States has a brighter future, though the pace of its population growth is projected to slow significantly in coming years.
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There is increasing buzz about the need for a universal basic income to support people who can’t compete with robots . . . Maybe what we need instead is a fertility income subsidy to encourage married couples to have children.
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Capitalism provides the incentive for entrepreneurs to innovate. The creators of new goods and services at affordable prices get rich by selling their products to consumers who benefit from them. They are the true revolutionaries. Destroyed are the producers who fail to innovate and to provide consumers with the best goods and services at the lowest prices on a regular basis. Entrepreneurial capitalism naturally promotes technological innovation and progress that benefit all of society.
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Schumpeter’s process of creative destruction naturally leads to the “paradox of progress.” On balance, society benefits from creative destruction, as this creates new products, better working conditions, and jobs, thus raising the standard of living. But it also destroys jobs, companies, and industries—often permanently. That’s the theory. In practice, this process doesn’t happen rapidly enough, for an obvious reason: such restructuring is painful. While there are many more winners than losers overall, knowing this doesn’t make it easier on the losers. Politicians intervene to reduce the pain with policies aimed at preserving jobs and protecting industries, thus slowing or even arresting the pace of progress. The results of such political intervention in the markets are likely to be excess capacity, deflation, and economic stagnation.
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Running my own company has been a great learning experience about “entrepreneurial capitalism.” I am using the adjective “entrepreneurial” to describe the brand of capitalism that I heartily endorse, as distinguished from “crony capitalism,” which is just one of many variations of corruption. . . . My experience as the owner of a small business is that entrepreneurs are driven by insecurity, not selfishness. Our number-one worry is that we won’t satisfy our customers, so they will go elsewhere, putting us out of business. That’s why we strive so hard to grow our businesses. Growth confirms that we are doing right by our customers in the competitive market. This requires that we put our customers first, not ourselves.
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