Should we blame Biden for the recession?

 Many Americans believe the President controls the economy, which is why exit polls after a presidential election have shown, for decades, that the most important issue on the minds of voters in choosing a candidate is the economy. Economic indicators in the election year are the best predictor of the winner. If Gross Domestic Product (GDP) is growing at or above average, the incumbent party usually wins. If not, the challenger wins. President Trump lost his bid for a second term in office largely because of the recession caused by COVID.

U.S. real GDP fell last quarter by 0.9% from the first quarter, which had also declined by 1.6%, causing many pundits in the news business to declare that we are in a recession. Republicans have tagged it the Biden recession, while the President has tried to redefine the term to not take the blame. Both parties see the state of the economy as a factor in determining the outcomes of the congressional elections this November.

Deutsche Bank - the snowflake that could trigger an avalance

Avalanches build up one special snowflake at a time. The last snowflake launches the avalanche. Financial avalanche specialists are wondering if the troubled Deutsche Bank will earn the honor of being that last special snowflake, the Lehman Brothers of the latest recession.

After Brexit, the IMF warned that the bank was the most significant contributor to systemic risks. Experts have expressed fears about its undercapitalized state for several years. Alt-M’s Keven Dowd confirmed that those fears are justified in his post “Is Deutsche Bank Kaputt?” He wrote that the bank claimed a leverage ratio of 3.5 percent in its 2015 annual report:

What’s an investor to do when the market won’t cooperate?

What is an investor who follows the Austrian school of economics supposed to do with a market that has traded in a narrow range for almost two years and refuses to bend to the reality of falling profits and a slow economy? After all, we may already be in a recession, as Peter Schiff thinks, but the market is clueless.

A couple of posts ago I wrote about the fetish with randomness that afflicts mainstream economics and finance. One result of that fetish is the dogma that no one should try to time the market; just pick good stocks and stay with them. The high priests ridicule those of us who make any effort at looking into the future.

Bank for central bankers confirms ABCT

The popular press blames Wall Street shenanigans and banker greed for the most recent recession as the movie The Big Short demonstrates. Politicians digest the economics of the mainstream media and that is the reason Congress passed the Frank-Dodd Act increasing regulation of banks. It was punishment for what politicians perceived as banker sins.

Congress passed the act in spite of the fact that no mainstream economist I know of has blamed Wall Street or banks for the crisis. In the minds of mainstream economists, recessions are random events. The economy naturally spins in equilibrium like a top until an unforeseen “shock” slams into it, makes it wobble and sling thousands of people out of work. I like to call it the “crap happens” theory of business cycles.

A much better explanation of recessions come from the Austrian school of economics in which credit expansion causes misallocations of capital that accumulate during an expansion. The weight of those misallocations eventually crushes the expansion and a recession follows. The most robust explanation of the mechanism is Hayek’s Ricardo Effect [link] in which nominal profits guide the allocation of capital.

Japan’s 4th quarter torpedoes Market Monetarism

Japan’s GDP fell 0.4 percent from the third to fourth quarters, which translates into an annual rate of -1.4 percent as it is commonly reported. The shrinkage dealt another blow to Abenomics, the term the press invented for the Prime Minister Shinzo Abe’s economic plan to boost the Japanese economy through massive money printing. Last month, and before the latest data, the central bank of Japan drove interest rates into negative territory in further hopes of jump starting the economy.

"The latest data show that it is difficult to say that the Abe government has achieved of its goal of a 'virtuous cycle' of rising incomes, wages, and investment," said Tobias Harris, political risk analyst at US-based consultancy Teneo. 

"It's getting clearer that Abenomics is a paper tiger," said Seiya Nakajima, chief economist at Office Niwa, a consultancy, referring to Prime Minister Shinzo Abe's policy mix of monetary easing, spending and reform. 

Year ahead forecast - stormy

Austrian economists are not huge fans of forecasting as are most mainstream economists, especially those who add a decimal point to lure the gullible into thinking the forecast is accurate. But that doesn’t mean Austrians don’t forecast. Hayek wrote in his Nobel Prize acceptance speech that... 

"Without such specific information about the individual elements we shall be confined to what on another occasion I have called mere pattern predictions - predictions of some of the general attributes of the structures that will form themselves, but not containing specific statements about the individual elements of which the structures will be made up."

I call Hayek's concept of forecasting, pattern predictions, or qualitative forecasting vs quantitative. In other words, Austrian economists can tell what will happen next but not exactly when or how much.

That doesn’t mean that Austrian economists don’t ever use numbers in forecasting. Obviously, I have provided a few of those. But I hope readers interpret those forecasts as tendencies and illustrations of theory, not as point-accurate forecasts.

Poking the bear - what happens next to the market?

The S&P is down about 9% for the year and 10% from the highs last year as of this writing. By the time you read this, the index may be even lower. The bear has been hibernating for seven years and may be waking up. If so, he’ll be hungry for your nest egg. 

Technicians will be looking for the lows of last year for support as if nothing has changed. But a lot has changed. Profits for the fourth quarter of last year are expected to fall over 5%, according to data provider FactSet. And even if you leave out the disastrous energy sector, profits are expected to be flat.

China, Brazil, Europe, Japan are in worse shape. US manufacturing has been in a recession for months. Oil, gas and mining are in recessions. We are beginning to see the effects in the consumer sector as retail sales from the Christmas season sunk below those of last year.

This is a good time to look at where we are in the business cycle using insights from pages 105-107 in my book Financial Bull Riding:

Big Short – good movie, bad economics

The outlaw couple Bonnie and Clyde was not only famous for their bank robberies in the 1930s, they were popular. They lost some of their appeal when they began murdering policemen, but people loved the fact that they robbed banks because the people hated banks. They had watched banks foreclose on farm families during the Dust Bowl and depression. Committing the economic sin of fixating on the seen while ignoring the unseen, an error first identified by the great French economist Frederick Bastiat, they blamed the bankers for the farming disasters.

People have loved to hate bankers for centuries, often for good reason. Until the creation of the FDIC, depositors occasionally lost their life savings to bank failures. Now they don’t, but the people see banks constantly bailed out by governments when they make bad decisions and then foreclosing on borrowers who have made decisions that were no worse.

So it was no surprise that the movie The Big Short blamed greedy bankers for the recent Great Recession. I reviewed the book on which the movie was based, Michael Lewis’ The Big Short: Inside the Doomsday Machine, here. As I noted then, Lewis’ economics is terrible, but the book is a great read because at its heart it glorifies the difficulties, hard work and genius of entrepreneurs and the heroes of the film are entrepreneurs.

The real economy will end the expansion, not the Fed

The Fed has done an excellent job of preparing the world for this rate hike so it was already built into market prices. Don’t expect much to happen.

Some economists expect rising interest rates to kill the “recovery” and plunge the US economy into a recession. And of course the standard Austrian business-cycle theory teaches that rises rates will cut short an expansion. But as I have written before, recessions can happen without rising rates because of the Ricardo Effect.

But the idea that tight money is the only cause of recessions, as monetarists claim, is an example of the post hoc fallacy: because recessions happen after several rate increases by central banks, people think the event that happened first caused the one that happened later. It’s similar to attributing the rising of the sun every morning to roosters crowing.

Japan, Europe and mainstream monetary theory are out of gas

When a sailor hits a dead spot where the wind refuses to blow he cays he is “in irons.” Japan’s economy sailed into the irons this past quarter when its GDP declined for the second quarter in a row and officially signaled a recession. GDP fell 0.8% in the third quarter after shrinking 0.7% in the second on an annualized basis. This marks the fourth recession Japan has endured since the global crisis hit in 2008.

Following so soon on the heels of massive stimulus, the recession should strike a death blow to mainstream monetary theory. Abenomics, the economic recovery plan that Prime Minister Shinzo Abe launched in 2012, was the poster child for mainstream monetary theory. Japan would wash away deflation and decline with a torrent of new money.

Debt service burden signals downturn

Investors can never have too many omens of disaster and the Bank for International Settlements has given us a new one to watch for signs of impending recessions - the corporate debt service burden.

Authors Mathias Drehmann and Mikael Juselius first wrote about it in their article "Do debt service costs affect macroeconomic and financial stability?" published in the BIS Quarterly Review September 2012. They summarized their findings this way:

"We find that the DSR prior to economic slumps is related to the size of the subsequent output losses. Moreover, the DSR provides a very accurate early warning signal of impending systemic banking crises at horizons of up to one to two years in advance."

Don’t drink the Schwab Kool-Aid

The Schwab Center for Financial Research recently published an article intended to tranquilize investor nerves after the latest volatility and keep them shoveling funds into the stock market. “Schwab’s Perspective on Recent Market Volatility” begins with “Global markets may have swung wildly in recent days, but we think the recent selloff in stocks and commodities is not a sign of imminent global recession.”

I’m picking on Schwab because they are big and can take it, but they have said nothing that almost all mainstream financial service firms aren’t saying. Also, Schwab put their piece in nice bullet points that are easy to address. I’ll take them on one at a time:

1. The basics of investing have not changed.

They should change because the received wisdom is to always buy, never sell and just swallow the bitter pill of a major market decline. Instead, investors should try to time the market by getting out of stocks before a recession hits.

Stock market forecasts better economists

After the stock market stumbling through the past two weeks, you will hear top mainstream economists repeat the old joke that the market has predicted ten of the last eight recessions. The point of the joke is to belittle the idea that the market can predict recessions and to convince investors to remain fully invested. Austan Goolsbee echoed the joke on National Public Radio recently then insisted the economy was fine and he saw no recession in the near future. When asked if now was a good time to panic, he said it’s never a good time to panic and people should just ignore what the market does.

It is true that the market has predicted more recessions than actually happened, but if anyone will examine the data they will find that growth slowed dramatically after major declines in the market even though the fall wasn’t deep enough for the National Bureau of Economic Research to declare an official recession. But even with its false positives, the market has done a better job of predicting recessions than have any mainstream economists.

Mainstream economists predict the past

Mark Twain once said,"Prophesy is a good line of business, but it is full of risks," and "It is difficult to make predictions, especially about the future." In the Bureau of Economic Analysis’ (BEA) recent statement that the GDP of the US grew by 2.3% in the second quarter of this year, it isn’t predicting the future, but the past. And Twain was right, even that is hard.

Initial GDP growth numbers are not actual data; they are the output of statistical models. That’s why the BEA has to revise them in a month and again years later. Most people pay attention to the first estimate, but the real interesting information comes from the direction of the miss. Most math models will miss on the high side as the economy heads into a recession and the gnomes will revise the numbers downward. In an expansion, they will miss on the low side and be revised upward.

Mainstream economists have learning disorder

After the onset of the Great Depression, many economists radically changed their views and adopted Keynes’ “revolution,” which was not a revolution but merely a resurrection of mercantile economics. Mainstream economists don’t understand that because they don’t take economic history in school. Keynesian economics dominated until the stagflation of the 1970’s.

Responding to their mistakes of the 70s, mainstream abandoned paleo-Keynesian economics and the profession split into the New Keynesian, monetarist and neo-classical schools of macroeconomics, though hard-to-kill paleo-Keynesian econ lives on in the writings of Nobel Laureate Paul Krugman. The three new schools rejected Keynes’ idea of having the state micromanage the economy through fiscal policy because they recognized it suffered from the three lags, cogitation, formulation and implementation. In other words, the state always shows up late to the economic “accident” because it’s slow to recognize the problem, slower to formulate policy and tardy in implementing the policy. As a result, fiscal policy tended to make things worse.

Why the Fed won't raise rates

The VIX (volatility index) is in a coma, so most investors are dozing while danger signs about the current stock market pop up. The idea that the Fed causes recessions by raising interest rates has relaxed many investors. Some writers have assured nervous investors that it won’t be until the Fed’s third rate increase that the market will respond.

In this previous post, I used Hayek’s Ricardo Effect to explain that recessions can happen without rising interest rates. Now, Hoisington Investment management adds support for Hayek from a different perspective. In the Quarterly Review and Outlook for the first quarter of this year, Hoisington wrote about the financial histories of nations with over-indebted economies. That history goes back two thousand years, but the US has suffered through four such seizures in the 1830-40s, 1860-70s, 1920-30s and the past two decades. The report offers six characteristics of excessive debt:

Housing bubble reincarnated as oil

We took my six-month old grandson to the park this weekend and put him into a baby swing for the first time. He couldn't decide if it was fun or not and took turns crying for a while then laughing for a while. I think of that when I read about the oil bubble.

The Fed has reincarnated the real estate bubble of the early 2000s in the current tsunami of oil. To see how, we need summon the help of the Austrian Business-Cycle Theory (ABCT). The ABCT says that Fed induced interest rates below  the rate that the market would naturally set causes excess borrowing and investment in capital goods industries, not a general over investment, but bad investments in particular industries. The market reveals those excess investments through falling prices that cut into profits, reduce employment and spark a recession in the economy.

Entrepreneurs in the Big Short

Michael Lewis is the bestselling author of many books, but the first one I have read is The Big Short: Inside the Doomsday Machine, which is about the financial crisis of 2008. Lewis’ economics is terrible, but I still recommend the book.

First the terrible part: Lewis doesn't understand good economics, by which I mean Austrian. From the book I would guess he doesn't know much mainstream economics either. If readers really want to understand the mechanics of how the crises unfolded I would recommend Slapped by the Invisible Hand by Gary Gorton. In a nutshell, it was an old fashioned bank run in which depositors got scared that their deposits were in danger and pulled their money out of the bank. Only in this case the depositors were money market mutual funds, pension funds and insurance companies and the banks were the large investment banks like Lehman and Bear Stearns. But what even the Slapped authorGorton doesn't tell readers is that the run began because of the collapse in the price of housing. It wasn't lightening out of a blue sky.

Ghost of Ricardo Haunts Europe and Japan

The ghost of David Ricardo must be sending chills up the spines of the economists of Europe and Japan. They may not understand what causes those chills because of the poverty of their education. The US may soon experience a similar visit. Here is how the Wall Street Journal put it in email newsletter:

Can the U.S. go it alone? All of a sudden, economic data from around the world is looking decidedly worrisome. China on Thursday showed stark, sudden slowdown in lending and home buying in July, while Europe’s second-quarter results confirmed everyone’s worst fears, with Germany registering a contraction for the quarter and the euro zone as a whole failing to grow. This comes after a very big slowdown in the same quarter for Japan, the world’s second-biggest economy.

Dow 17000!

The Dow Jones Industrial Average crossed the 17,000 mark for the first time this year. What does it mean?

The market is somewhere in the Excitement stage of the Overstone cycle of trade.  Overstone described business cycles in the mid-19^th century. Starting at the six o’clock position in the graphic, the cycle begins with Stagnation, the depths of the depression with high unemployment. Stage two is Improvement, followed by Confidence, then Prosperity, Excitement, and last, Convulsion.

If you enlarge the graphic you’ll notice Overstone’s sense of humor. In the Excitement phase, crowds fight to get into the building with the sign “South Pole Warming Company” while a machine lifted by four hot air balloons flies over the building. In the Convulsion stage the Royal Bubble Bank explodes and sends people flying.

George Soros describes the Excitement stage as one in which the stock market becomes disconnected from the real economy, but Soros is thinking like a mainstream economist and assumes that the market has an intrinsic value somewhere close to the net present value. In reality, investors are merely adjusting their risk tolerance for the prevailing interest rates and opportunity costs. With ridiculously low interest rates, investors are showing greater tolerance for risk and a thirst for yield. One of the main drivers of stock prices is the changing discount rate of investors. 

What that means is that PE ratios may continue to rise and there is no way of knowing how far. But investors will have to come back to ground when profits start to fail. We are entering the profit reporting season for the third quarter and it may give us market direction.

At this stage in the cycle investors need patience most of all, but that's what they lack according to this quote from the Wall Street Journal newsletter Wealth Adviser: 

The market’s rarest commodity: patience. Benjamin Roth’s diary of the Great Depression is highly relevant today, as is his notion of why the wealthy investors’ club is an exclusive one. In a Motley Fool column, Morgan Housel cites some excerpts, including this one: “Most people do not have the patience to wait for the bad break. The average speculator is tied up in the market to the hilt when the break comes and has no liquid cash for the bargains that prevail.”

So when the market crashes as it did in 2000 or 2008, their wealth gets caught in the whirlpool and gets flushed.

Not only do investors need patience, but we need to be willing to be wrong as Spitznagel wrote in The Dao of Investing. Investors who followed his MS Index might have exited the market last year and missed the latest run ups to record highs. Friends and family would be mocking them and they might suffer from regret. But if they stick with the index they will earn more in dollars over time by avoiding the major collapse that is coming, even if it is another year away. As Spitznagel wrote, it's counterintuitive, like many of the teachings of the Dao.

Many advisers can find good value stocks when the market is high, but keep in mind what Benjamin Graham wrote about buying unloved stocks when the market is high. Investors won't love those stocks more when the market collapses. They will drop with the crowd.