Manias in Markets

 

 

Since 2022, the cost of capital for the U.S. has approximately doubled. The 6/8/24 WSJ notes:

 

·      Owners of billions of dollars of apartment debt set to come due last

·       year extended these loans by a year or so. Many of these properties

·      have fallen in value because they are refinancing 3% mortgages

·      taken out in 2020 or 2021 with rates that are now near 7%.

                      

So if depreciation is true for real estate and bonds, why is it not true for common stocks at this time? Isn’t the stock market rational?  The stock market is in a speculative bubble fueled by AI. But as Edward Tufte wrote, “…statistical graphics, just like statistical calculations, are only as good as what goes into them. An ill-specified or preposterous model or a puny data set cannot be rescued…A silly theory means a silly graphic.” ¹ The profitable application of AI to the entire U.S., economy will require a lot of work over time.

 

 Modern finance derives from economics, now a highly mathematical discipline where the only thing that matters is the “rational” behavior of all participants, which assumes that the market accurately captures all information and is thus always fairly priced. This view, however, does not reflect two other major effects in the short-term, day-to-day market. First, it does not reflect the effect of the Federal Reserve, which substantially sets, by administrative fiat, the appropriate short-term rate for the entire U.S. economy; and second it cannot consider the net effect of the participants’ short-term strategies as they encounter innovations and/or increased earnings in different sectors and assets. Since the stock market can be irrational, Warren Buffet said, “I call investing the greatest business in the world…because you never have to swing.…There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.” ²

 

Irrational complications can culminate, at the extreme, in “Manias, Panics, and Crashes,” which is where we are now. In 1978, the economist Charles P. Kindleberger published what is likely the definitive work on these. Speculation for resale, as opposed investing for keeps, is a feature of all financial markets. “The word ‘mania’ suggests a complete loss of connection with rationality, perhaps mass hysteria. Economic history is replete with canal manias, railroad manias, joint stock price manias – surges in investment in a particular activity. Economic theory assumes that men and women are rational – and hence manias cannot occur. There is a disconnect between the observation that manias occur episodically and the (substantial) rationality assumption....Consider some of the phrases in the literature: insane land speculation...blind passion…financial orgies…epidemic desire to become rich quick…intoxicated investors…people without ears to hear or eyes to see...overconfidence…overtrading.” ³

 

Historians believe in the unique. As an economist, Professor Kindleberger believed in structure. Hyman Minsky was an economist at Washington University in St. Louis and at Bard College and proposed a structure for manias in the financial markets. “Minsky believed that increases in the supply of credit in good economic times and the subsequent decline in the supply led to fragility in financial arrangements and increased the likelihood of a crisis…(he) suggested that the events that lead to a crisis start with a ‘displacement’ or innovation, some exogenous shock to the macroeconomic system. If the shock was sufficiently large and pervasive, the economic outlook and the anticipated profit opportunities would improve in at least one important sector of the economy….A follow-the-leader process develops as firms and households see that the speculators are making a lot of money…More and more firms and households begin to participate in the scramble for high profits…The term bubble means any significant increase in the price of an asset or a security or a commodity that cannot be explained by the (sustainable) ‘fundamentals’…. (But) the specific signal that precipitates the crisis may be the failure of a bank or firm, the revelation of a swindle or defalcation by an investor who sought to escape distress by dishonest means, or a sharp fall in the price of a security…The rush is on…” ⁴

 

A Wall Street stock analyst once confessed, “The stock market is like life; it cannot be predicted.” We have illustrated why this is so. But in the long-run, the stock market has been somewhat predictable. Stocks are long-run assets; and in that time frame the short-term vagaries cancel out; only the growth in earnings (dividends) and their price matter. The general environment, however, is beginning to undergo tectonic changes. How things turn out depends upon the policies enacted; it’s a matter of choice.

 

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How do real financial markets act at extremes? Due to the failure of the world-wide banking system, 1931 was a very bad year for everyone. Keynes, an accomplished stock market value investor, was among other things, an investment advisor to a major British insurance company. On February 18, 1931 he wrote:

 

“(1) There is a great deal of fear psychology just now. Prices bear very little relationship to ultimate values or even to reasonable forecasts of ultimate values. They are determined by indefinite anxieties, chance market conditions, and whether some urgent selling comes on to a market bare of buyers. Just as many people were quite willing in the boom, not only to value shares on the basis of a single year’s earnings, but to assume that increases in earnings would continue geometrically (sound familiar?), so now (in 1931) they are ready to estimate capital values on today’s earnings and to assume that decreases will continue geometrically. (Given the challenges facing the world order and the U.S. financial system, we think we are being fairly optimistic by assuming historical economic results.)

 

(2) In the midst of one of the greatest slumps in history, it would be absurd to say that fears and anxieties are baseless….

 

(3) But I do not draw from this the conclusion that a responsible investing body should every week cast panic glances over its list of securities to find one more victim to fling to the bears….

 

(4) …the situation is quite capable of turning around at any time with extreme suddenness….⁵

 

Markets at extremes can also be mulish, having to be hit on the head to change direction. We have also noted, if long-term cash flows are not too much affected, rates of investment return go up with decreased prices, and vice-versa. In any case, purchased long-term stock rates of return should exceed BAA long-term bond rates of return.

 

From the standpoint of portfolio construction, one might further note that in the short-run, it might be possible to live off the capital appreciation afforded by the stock market until something happens, and then it will be necessary to sell stock at a loss. In the long-run, its secure income that will carry its owner through retirement. Stock market investments in the latter context provide a hedge against inflation and/or a means of capital appreciation if properly priced.  It is, regardless, necessary to sell growth in favor of income near retirement.

 

We will further discuss generative AI, as a business, in Article 3, Research4.

 

 

 

¹ Edward Tufte; “The Visual Display of Quantitative Information”; Graphics Press; Cheshire, Connecticut; 1983; p. 15.

 

² Warren Buffet Quotes; accessed 6/12/24.

 

³ Charles Kindleberger; “Manias, Panics, and Crashes”; Palgrave McMillan; New York, N.Y.; 1978, 2011; p.p. 39,41.

 

⁴ Ibid.; p.p. 27,28,30,32,33.

 

⁵ J.M. Keynes; XII “Economic Articles and Correspondence: Investment and Editorial”; MacMillan Cambridge University Press;  London; 1983; p.p. 17-19.

 

 

 

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