Omens of the fall

In the ancient world outside of Israel pagan priests discerned the will of the gods through omens in the sky and on earth.  Israelis didn’t need omens because they had revelation straight from God in the Torah. Omens came from the movement of planets and from the structure of kidneys in goats sacrificed to idols. Pagan gods would never have considered humiliating themselves by speaking directly to insignificant humans. The more omens a priest collected the more certain he could be of the will of the gods.

Investors today don’t have a revelation about the future. We have the Austrian business-cycle theory that tells us to expect a crash after years of artificially stimulating the economy with near-zero short term interest rates and massive buying of junk bonds by the Fed. But we can’t know the exact date, or even the quarter, when the crash will come. So like ancient pagans we have to rely on omens that suggest we are near the end of the expansion. These omens are what mainstream economists consider good news about the economy. Here are some gleaned from the kidneys of the Wall Street Journal.

Revenue increases 

The Journal reported on Monday, August 4, on the front page that Fortune 500 companies began to see rising revenues for the first time since 2012. The author wrote,

“For much of the past two years, lackluster sales forced companies to boost earnings by cutting costs, squeezing suppliers and buying back stock. But second-quarter results for companies in the S&P 500 index show signs of a return to basic revenue growth.”

Revenues increases 4.5% over the same quarter last year for the nation’s largest companies and has been broad based with the largest increase going toward healthcare, which saw 12% growth.

How can we interpret this omen? The ABCT states that with a fixed stock of money, low interest rates caused by increased savings will reduce revenues for consumer goods manufacturers and increase them for capital goods producers. But an increasing money stock due to Fed policy will cause revenue for both sectors to increase at the same time and produce a broad based increase in revenue, as the Journal article reported.

At some point this will cause the Ricardo Effect to kick in because the supply of capital goods to support growth is limited. Recession happen, partly, when the economy runs into the Wall of China that is limited capital goods. Higher profits in consumer goods industries will motivate businessmen to switch investment from capital equipment to consumer goods and the end will follow rapidly.

Increased lending

The Journal reported on Thursday, July 31, on C8 that bank lending to businesses increased last quarter over six months ago by 3.9%, the highest rate since 2007. Businesses are either expanding or buying back stock to boost prices. If they’re expanding, they will hire new workers who will chase a limited supply of consumer goods. That will boost profits for consumer goods companies and speed up the onset of the Ricardo Effect.

Also, most businessmen, like most investors, use mental linear forecasting to predict the future. In other words, they assume the current trend will continue indefinitely. But they wait for years to determine if the trend is real, which means they wait until the trend is almost over before deciding it is real. When investors do that they wait to jump into the market until the bull is almost exhausted. This expansion is already old by historical standards so the fact that businessmen are confident enough to borrow and invest is a good omen that the end of the expansion is near.

Investment in oil

Between 2006 and 2012, oil companies invested $1 trillion in capital expenditures on oil production in the US while earning only $670 billion in operating revenues, according to the Tuesday, August 5, Journal on page C8. They made up the deficit with massive borrowing. Debt per barrel of oil rose from $29 to more than $39.

This omen is similar to the one above but emphasizes that investment in the capital goods sector has reached dangerous levels. The Ricardo Effect will kick in when profits fall in capital goods relative to consumer goods and investors reallocate their money to consumer goods companies. That will happen in the oil patch when falling oil prices combined with rising costs of labor, rental of rigs, and other inputs rise enough to dissipate profits.

 Venture Capital

Venture capitalists invested $5 billion in startups the first half of this year according to the Tuesday, August 5 edition of the Journal on page B5. That’s 45% higher than last year and they haven’t invested as much since the dot.com bubble of the late 1990’s.

“For the first time in a number of years I think companies are reorienting their focus from how do I reduce costs to how do I grow my business,” said Mark Zanid, chief economist for Moody’s Analytics, adding, “It feels like there’s been this shift in attitude with regard to risk-taking among a lot of business people and a lot of industries.”

Greater tolerance for risk and increased capital investment while consumer spending ramps up, are all signs of the top of the expansion and therefore the top of the stock market as well.

Keep in mind that omens of impending disaster are necessarily signs of a robust economy. When the signs in the economy turn bad, it’s too late for investors; the recession is already upon us and the market has already crashed. So the better the signs of the economy are the closer the end. That shouldn’t make investors perma bears, always seeing disaster behind every omen, as many Austrian economists have become. After the recession hits, investors should be able to enjoy several years of great income with peace, knowing that the next collapse won’t happen for a while.

The trick is to know when to be contrarian and when to enjoy membership in the majority. Be contrarian only when turning points are near, but keep it to yourself at parties or you’ll be 1) the nut when the economy is still good or 2) hated by the envious who lost fortunes in the latest market crash. Go with the crowd the rest of the time.