Friday, 21 November 2014

Financial Goldfish

Goldfish are reputed to have such short memories that each time they swim around the goldfish bowl they think to themselves, “Oh look a castle!” Its always puzzled me, however, how anyone knows what if anything is going through a goldfish's mind.

Humans are not supposed to have the kind of memory attributed to elephants, but they are supposed to have longer memories than that of a goldfish. In fact, its memory that accounts for a number of aspects of human behaviour. In Yoga, for example, adepts are encouraged to learn the difference between being hungry, and wanting to eat simply because they have the pleasant memory of food in their mind. Generals are often thought to be guilty of fighting the last battle. That is the memory of what happened previously, especially if you consider you made mistakes, imposes a powerful influence on determining how you will respond in current conditions, even if those conditions have changed.

This is supposed to also have a powerful affect on the way people behave in financial markets. If there has been a big financial crash, such as happened in 1929, 1962, 1974, 1987, 2000 and 2008, for example, this makes many investors fearful of risking their money again, for fear of losing it all. During such times, it is only the professional speculators, those who have a “contrarian” approach, such as espoused by people like Sir John Templeton, or Warren Buffet, “to be fearful when others are greedy, and greedy when others are fearful”, who use the opportunity of low prices to jump in, and buy up stocks ready for them to rise. In fact, not even that dogma is guaranteed either.

After the 1929 Wall Street Crash, the prices of many assets from shares to property could be bought at prices as little as 10% their previous figure. If you bought at those prices you would, as Templeton did, make money over the following period. But, in 1962 although if you bought at the bottom of the market, you would have made money in the following period, it would not have been stellar, and you would have been likely to lose it all again in the crash of 1974. Similarly, if you bought at the low point of 1974, your performance over the following period would not have been great either. On the other hand, if you began to buy in 1982, as the secular bull market began, you would have seen your investments rise steadily. Even though, the 1987 Stock Market Crash had the biggest single fall on a single day ever – 25% - in the following year, the falls were more than recovered. Had you bought at the bottom of the 1987 crash, you would have made a lot of money.

The reason share prices rose during that period was two fold. Firstly, the 1980's and 90's represented the Autumn and Winter phases of the long wave cycle. The Autumn phase is characterised by crises such as those that arose in the 1970's and early 1980's, characterised in Britain by the Miners Strikes, and other widespread industrial and political struggles. That Autumn phase ran from around 1974-87. By the mid 1980's, workers had largely been defeated. Falling wages increased the rate of profit, whereas in the previous period rising wages had squeezed profits. The period of slow economic activity that characterises the Autumn and Winter phase, led to the prices of many primary products falling. That acts to raise the rate of industrial profit. By the late 1980's, therefore, the global rate of profit was rising, and as new technologies based on the microchip, rapidly raised productivity and the rate of turnover of capital, this increased the rate of profit even further. That provided a basis for rising share prices.

But, that basis was nowhere near enough to justify the actual rises in share prices that occurred. The Dow Jones Index rose by 1300% between 1980 and 2000, a rise seven times greater than the growth of the US economy during that period. The additional ballooning of these markets was due to the fact that huge amounts of additional currency was thrown into circulation. The same thing caused property prices to rise massively during the 1980's. In Britain, property prices quadrupled between the late 1970's, and late 1980's. Property prices doubled between 1988-90, before dropping by 40% in the crash of 1990.

The combined effect of the stock market crashes of 2000 and 2008 does seem to have had an effect on ordinary investors. So called retail investors have largely stayed out of the market since 2008 – thereby missing out on the doubling and trebling referred to earlier. The fear they have of losing money seems to be one reason they have kept their money in cash deposits despite the fact they get no meaningful interest on their savings, or in the supposedly safe bonds.

Yet, the collapse of Northern Rock, along with the collapse of other banks across Europe in the last few years, the fact that people lost their deposits in banks in Cyprus and so on, should warn people that not even bank deposits are safe. Still less, at current prices, is money put into bonds, or bond funds provided by insurance companies and mutual funds, safe. Bonds are clearly in a bubble, as is set out in this Money Morning article, yet when it comes to examining the past in that regard people seem to be ignoring the lesson of recent history. 

As the article describes, Apple have just issued a Eurobond for €2.8 bn, which it is borrowing at interest rates as low as 1.08%. Its not that Apple needs the money. It already sits on a huge pile of cash. Although, Apple's profit margin has fallen from over 40% a few years ago to around 35% today, that is still a significant profit margin. As I've set out elsewhere, a firm's profit margin is always less than its annual rate of profit, because its annual rate of profit is increased by the number of times its advanced capital turns over during the year, whilst the profit margin is based on a single turnover of the laid out capital.

Apple wants the money simply because it can borrow it at this low level, and can then use it, not for productive investment, but to buy back its own shares, and thereby boost the stock price, and flatter its future earnings per share figures. But, it does illustrate a point, if companies like Apple, and there are many more doing the same thing, are taking advantage to borrow at these low rates of interest, why is not the capitalist state doing the same thing?

In fact, it comes down to the point made earlier about memory, and fighting the last war. In the 1930's, economists believed that budgets had to be balanced. The experience of the Depression, led, after WWII to the adoption of Keynesian economic policies. They seemed to work. Each time a recession started, the economy received a dose of fiscal stimulus, and the recession was cut short, and the boom continued. But, in the 1970's, the Keynesian medicine stopped being so effective, and side effects in the shape of inflation appeared. The memory of the last battle led economists and governments to keep using the same policy long after it had stopped being effective. Only by the late 1970's, did they begin to look for a different strategy.

Having found it in an application of Hayeckian austerity, followed by Chicago School Monetary stimulus, they have continued to use that strategy ever since, which is why today, we see Osborne and company proposing policies of austerity that crater aggregate demand in the economy, combined with throwing more and more liquidity into the system, encouraging individuals to take on more personal debt, in an attempt to replace the aggregate demand they have taken out of it via fiscal policy. They are bound by the memory of the last battle of the failure of Keynesian stimulus in the 1970's, and without any kind of real understanding of the way capitalist economies actually work, that Marxist theory provides, they can only pull out the old play book from which to draw their current strategy.

In fact, the current conditions are not those that led to the failure of Keynesian solutions in the 1970's, but the conditions that led to their success in the 1950's and 60's! Britain had a debt to GDP ratio of 250% after WWII, compared with around 70% today, yet it engaged in large scale government spending to nationalise and recapitalise staple industries, to invest in infrastructure, and to develop the Welfare State.  Despite all that spending, the deficit and debt fell, because the economy grew, people were put to work and tax revenues rose sharply.  That is why those policies when they were adopted in 2009 worked. Its why everywhere they have continued to be applied, including in the US, they continued to work, and why everywhere they were dropped, such as in the UK and Europe, after 2010, the economies have sunk back into recession, despite the huge amounts of monetary stimulus, and the creation of the financial bubbles, which caused the financial crisis of 2008, and which are about to create an even bigger financial crisis.

But, what is even more surprising is that although many ordinary people have been frightened away from buying shares – and quite rightly because when the financial crash comes those share prices will collapse too – they do not seem to have had the same response to property. In the US and UK, there seems to be some kind of intractable mindset that sees property as somehow immune to all the laws of economics and even mathematics. When I was looking at property to buy in Spain a couple of years ago, I looked at a house being sold by some British people, who repeated the mantra to me that “prices will recover again”. I remember thinking to myself at the time, “Not in my lifetime they won't”. Sure enough, in the time since then, prices have fallen even further, and Idealista, the big Spanish real estate agency, continues to forecast prices falling by another 15%, with only about 12% of the properties put up for disposal by the Spanish banks last year, having been sold.  The particular house has been reduced in price, and still hasn't been sold.

A recent New York Times article by Bethany McClean illustrated the point that already people were beginning to use higher property prices once more to borrow increasing amounts of money to bolster their lifestyle.

To watch the video.

 In the last couple of years, in the US, we have seen student debt go over $1 trillion now exceeding the amount of credit card debt. We have also seen the same kind of practices that led to the 2008 crisis being repeated. This time we have had people being offered sub-prime car loans, that are then packaged up into derivatives.

All in all, it seems that many people are doomed to repeat the mistakes of 2008, and other financial and property crashes. They seem to be destined, like the goldfish to witness, as though for the first time, that property prices can go down very sharply, along with the prices of other such assets.

1 comment:

David Timoney said...

What's always baffled me is how goldfish recognise a particular lump of matter as a "castle".