Why Everything Is Selling Off

A couple of days ago, I was listening to an analyst on CNBC in the US, who was puzzled. How was it, he wondered that both bonds and shares were selling off simultaneously? Usually, he went on, if speculators sell bonds, its to switch into shares, and vice versa. In fact, there is nothing puzzling going on here at all. The reason the analyst was puzzled is the same as that I referred to recently, that even those analysts, and fund managers, who have worked in the industry for the longest periods, have only done so for the last thirty years. For all of that period, interest rates have been in a secular down trend, whilst bonds and shares have been in a secular up trend.

What that means is that if you looked at the price of both bonds and shares over the whole of this period, both rose. The other side of it is that the yields on both bonds and shares fell. The only reason that it appeared to be the case that bonds sell off when shares rise, is that this reflected a reallocation of funds within portfolios, in response to at one time bonds being relatively cheap as against shares, and vice versa. During the whole period, whilst there were these relative differences in prices, both were in absolute terms becoming more and more expensive, as were other asset classes, such as property, and then things such as gold, art and so on. Money found its way into all of these things increasingly not in search of an income – there is no income from owning art, wine, gold, diamonds and so on – but purely in search of speculative capital gains.

Why did this happen? In the 1960's, and particularly the 1970's, the expansion of capital, occurred mostly on the basis of extensive accumulation. That is, firms employed more machines of the same kind, which employed more workers, and processed more material. Increasingly during this Summer and Autumn phase of the long wave cycle, therefore, the existing supplies of labour start to get used up. Wages tend to rise, as a result, and this also means that they satisfy more of their consumption requirements. In fact, that is the case to an extent during this period, that workers even begin to use some of their wages to buy things that were previously luxuries only consumed by the better off.

This has two immediate consequences. Firstly, the rise in wages directly reduces profits. Secondly, the more workers satisfy their consumption requirements for various wage goods, the harder it is for the sellers of those commodities to get them to buy more, or to buy the same amount at higher prices. So, when the producers of those commodities face rising costs, for materials and so on, they cannot pass the cost on, and have to absorb it again out of their profits. Similarly, to reduce their costs, they seek to produce on a larger scale, which they also do in order to try to increase their mass of profit, by capturing a larger share of the market, but when they come to sell this larger quantity of products, they find that they have to reduce the selling prices to do so, because workers have already satisfied much of their consumption needs. So, again they have to forego some of the surplus value that has been produced, by realising less profit, to sell all of their output. These are the conditions that lead to a crisis of overproduction.

Increasingly, therefore, firms start to look for ways of reducing these costs, and in particular to reduce their labour costs. The way to do this is by introducing new types of labour-saving technology. Now when the firm invests, instead of simply buying additional machines, which require additional workers, and additional material to be processed, it does so by replacing its existing machines, with these new machines. The way this happens at first, is that when an old machine wears out, and needs to be replaced, it is replaced with one of these new machines. Better still if two machines wear out, and need to be replaced, and one of the new machines will do the work of two of the older machines, then just one of the new machines is introduced. That means that one worker, can also then be laid off.

During the period of extensive accumulation, the intention was to increase output, but now the intention is not to increase output, but to be able to produce the same output at less cost, with less labour. So, for example, in the early 1980's, a range of new technologies began to be introduced in the printing industry. It undermined the power of the print unions, because now, a large amount of the work could be undertaken by unskilled labour. Computers, were able to take material straight from the hands of journalists, into a form ready for printing. A range of instant print workshops sprang up across the country that used much cheaper, much more effective photocopiers, and so on. At the same time, computers began to be introduced to control lathes, milling machines and so on in engineering workshops.

None of this was particularly aimed at increasing output. It was intended to produce the same output with less labour, i.e. to raise productivity. The consequence of this is that a relative surplus population is created. It was manifest in the rising unemployment of the early 1980's. It also creates the conditions that Marx describes, for the tendency for the rate of profit to fall, because the consequence of this rise in productivity, is that the same value of material is processed, but less labour-power is employed to process it. Because less labour is employed, less surplus value is created, which creates the tendency for the rate of profit to fall.

This tendency for the rate of profit to fall, during this period, of rising productivity, is different to the squeeze on profits that arose in the previous period, whose cause was essentially a failure of productivity to rise fast enough. But, now the creation of a relative surplus population, puts downward pressure on wages, causing the rate of surplus value to rise. At the same time, the rise in productivity causes the value of fixed capital to fall progressively, as the new machines become increasingly cheaper.

Interest rates during this period, which runs from around 1982-87, are low, because the demand for capital is low. Firms do not seek to expand, but to reduce their costs. They are able to replace their worn out fixed capital with new technologies, that are both cheaper and more effective, and in the process they are able to lay off workers, as well as to replace skilled labour with unskilled labour. Interest rates fall, therefore, not because the supply of capital increases, but, because the demand for capital falls, relative to the supply.

In the period after 1987, this begins to change. In this period, the rate of profit rises, because capital has shaken out a lot of labour. Wages have fallen, causing the rate of surplus value to rise. The value of fixed capital continues to fall, and low levels of growth cause the prices of materials to fall. Surplus value rises, whilst the capital advanced as constant and variable capital declines relatively, so that the rate of profit rises. The consequence is that interest rates now fall because the supply of capital from this higher rate of profit, rises, relative to the demand for capital.

Finally, in the period after 1999, until around 2012, although growth increases faster – as can be seen with China, and other economies – this same growth, with continued rises in the rate of profit, causes the supply of capital to continue to exceed the demand, so that interest rates continue to fall.

So, anyone who has only been employed in the financial services industry since around 1982, has only known these conditions, whereby the supply of capital exceeds the demand for capital, so that interest rates are continually pushed lower, which finds its reflection in continually rising prices for shares and bonds, as the prices of these assets, as with land, are inversely related to the rate of interest. So, if bond yields appeared to be high, compared to dividend yields, this meant that bonds were cheap relative to shares, so speculators would, indeed tend to sell shares, causing their prices to all, and buy bonds, causing their price to rise, and vice versa. The same thing applied to property. If rents appeared to be high, speculators would sell shares or bonds, and buy property, causing the prices of the former to fall, and the price of the latter to rise. But, all this occurred within the context of a continual ratcheting higher of the prices of all these assets.

What is true in one direction, is, however, equally true in the other. If interest rates declined in a secular trend for thirty years, causing bonds, shares and property to rise in price, then rising interest rates for thirty years will similarly cause the prices of bonds, shares and property to fall for the next thirty years. There may be times when bonds will be relatively cheaper than shares, causing shares to sell off more, and bond prices to rise, and vice versa, but it will be in the context of the price of both falling. In the same way that a search for assets that might increase in price led to speculation in things like art, wine, gold, or diamonds in a period where all these assets are selling off, there may instead be a tendency to sell them all together, and instead to keep money in cash.

Bill Gross has made such a suggestion recently.

If we look around, its easy to see that the prices of all these things are too high, indeed that they are in a bubble. Of course, all of those with an interest in perpetuating the idea that these assets can keep going up for ever have an interest in claiming that the prices are not out of the ordinary, but simply looking at the extent to which they have risen over the last thirty-five years, compared to the growth of the real economy, shows that whether it is the price of land, bonds or shares the only rational description is that they are in a bubble. The Dow Jones Index has risen by 1700% since 1980, which is about seven times the growth of the economy, for example. The only reason that the valuations are claimed not to be excessive, is because of increasingly elaborate forms of financial engineering, the most obvious being the use of the company's profits to buy back stock, so that earnings per share rises, simply because a given amount of earnings, is divided over a smaller number of shares!

If valuations are conducted on the basis of other methods, such as Tobin's Q, or Schiller's cyclically adjusted price earnings ratio, then we find that shares are at levels only previously seen ahead of major market crashes.

Its also easy to see why interest rates must rise, and are rising. For one thing, as I've pointed out before, the major advantages gained in productivity from the introduction of all the new technologies developed in the 1970's and 80's, has largely occurred. Its why we saw the growth in productivity slowing. Increasingly, as in the 1960's, we are moving into a period of extensive rather than intensive accumulation, and that has implications for rising wages, which again we are seeing in economies across the globe. This shift of revenues towards wages, also has implications for consumption and aggregate demand, and the need for companies to meet it, by capital expansion, even as their rate of profit is squeezed.

It can also be seen in the extent to which companies like Apple, which have been at the forefront of introducing new products, appear to be struggling to come up with really new products, and so face an increased pressure on their profit margins, for existing products.

But, as I have pointed out elsewhere, the normal fall in primary product prices that occurs at this stage of the long wave cycle, also has implications for the financial markets. For the last fifteen years, there has been surplus profits made in a number of these areas of production, from oil to copper and so on. But, the massive increase in investment, which that encouraged, has now meant that in all these areas, not only has the value of these commodities fallen, as a result of new lower cost production, but, there is now an overproduction of these products, causing a glut, which has pushed the prices down even below the price of production.

At the start of the year, I said that I thought that oil prices may spike down to $25 a barrel before they could begin to stabilise. That still seems about right. It is not lack of demand, or under consumption that is responsible for the fall in the oil price. In fact, oil demand continued to rise over the last couple of years, and has risen faster on the back of lower prices. The low price is the result of the hugely increased production, and even at $45 a barrel, new production continues to be brought on stream. It will only be at around $25 a barrel that the required number of marginal producers will be forced to shut down, to reduce supply, so as to balance demand. That means a lot of debt will go bad. In fact, that is likely to show up in the next few weeks, in respect of a number of junk bonds in the energy sector.

Oil producing countries, for a long time, were able to pump huge amounts of money-capital into global capital markets, which pushed down interest rates. But, the same was true of copper producers and so on. Now that has reversed. Not only are these producing countries not providing money-capital, but they are increasingly demanding it, to cover their own budgets. The supply of money-capital across the globe is being reduced, whilst the demand for money-capital is rising, causing interest rates to rise.

Similarly, China, which made huge profits, as its economy grew, fed large amounts of money-capital into global capital markets, large amounts of it going to buy US and UK bonds, shares, property and so on. But, far more important than any slow down in the Chinese economy, is the bubble in its own financial markets, and their subsequent crash. As China itself faces a squeeze on its rate of profit, along with the need for large scale investment to shift the balance of its economy, towards the development of the domestic market, for example, the need to establish a welfare state, it is likely to need to bring back large amounts of that money, for this domestic investment. With China selling US and UK bonds, shares and property, that will act to reduce the prices of all those assets, and put upward pressure on interest rates.

I wrote recently about the prediction by Martin Armstrong that UK property prices were set to fall for the next 18 years. As I said there, I expect, that this will not be a smooth decline, because whilst bubbles take a long time to inflate, they only ever burst. In 1990, the bubble burst suddenly causing a 40% drop within a matter of months, with prices then remaining flat for another six years, before the new bigger bubble was inflated. I expect the UK property bubble to burst with something around a 60-80% fall over a matter of months, with prices then rising and falling, but with an overall decline over the next thirty years.

If we look at gold, it had its day in the sun between 2000 and the end of 2011, increasing eight-fold in price. That mirrors its rise up to 1960. The increase between 1970 to 1980, reflected the rise in inflation during that period. Today, we have no significant consumer price inflation, instead we have hyper asset price inflation. Gold is trading at its price of production, and so I see no real basis for it to rise significantly in price under current conditions, as interest rates rise. Instead, as Bill Gross says, the best bet is cash, whose relative value will rise sharply as the price of property, bonds and shares crash.