An Uneasy Prosperity: Kindleberger Meets Buffet thumbnail

An Uneasy Prosperity: Kindleberger Meets Buffet

By Neland Nobel

Estimated Reading Time: 9 minutes

Many commentators suggest the economy and the stock market are both exceptionally healthy and that Donald Trump is quite fortunate to have inherited economic conditions that are so favorable.  A good example of this view from Marketplace.org :

“President-elect Donald Trump is poised to inherit a remarkably healthy economy when he takes office in January. By almost all measures, the U.S. economy is doing exceptionally well. Gross domestic product was up an annual 2.8% last quarter, inflation is just about down to the Federal Reserve’s target rate of 2% and unemployment is low by historic standards. So what does that mean for the incoming president and his administration?”

Is it “remarkably healthy” to have much of the economic recovery financed by deficit spending on a wartime scale, the highest inflation in two generations, government employment leading job creation, most of the jobs going to illegal aliens, and the highest bankruptcy rate in 15 years?  Well, maybe not.

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President Biden recently also praised himself and touted the economy of Bidenomics, taking credit for the natural rebound that occurred after the world economy was virtually shut down because of the idiotic reaction to the man-made COVID pandemic.

Meanwhile, the jobs picture remains very murky, with some numbers showing jobs going up and some down, but the unemployment rate is up, and the number of new job openings is collapsing. Despite the administration’s boasting, real wages have actually fallen 1.3% under Biden.

Our concern is that this popular narrative suggests everything was great under Bidenomics and that if the economy and markets should falter, it will be Trump’s fault.  In this way, Democrats are set up to “Hooverize” the Republicans if there is a downturn like they demonized them in the 1930s and subsequently gained 20 years of political control.

It seems lost on these folks that the chief reason people voted for Trump was precisely because the majority of Americans did not regard the economy as healthy. How can we explain this disconnect?

In addition, we repeat a warning we have uttered before. The connection between the economy and financial markets is loose, but it seems uncanny that they reconnect once again at the peak of major cycles.

To help us understand this predicament, we will turn to Professor Charles Kindleberger, who taught Economics at MIT for 33 years and wrote Manias, Panics, and Crashes in 1978.  

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It is considered a classic by many economic historians.  To this, we will add our own experience as a financial advisor. We lived through the Crash of 1973-74 (50% drop), the Japanese boom and bust of 1988-90 (peaked in 1988 and only recovered in nominal, not inflation-adjusted terms this year), Black Monday, October of 1987 (35% drop in stocks in two days), the Dot-Com bust of 1999-2000 (50% drop),  the Great Financial Crisis of 2007-2009 (57% drop).

According to Kindleberger, each boom and bust cycle, while different in particular, has common elements.  Among them are:

Displacement is a significant economic change, innovation, or regulation that captures the public’s fancy and presents colossal profit opportunities. A good example is the Dot-com bubble of 1999-2000 and the promise of the Internet. Notice that the Internet was real and went on to change the world fundamentally. It was not a fantasy. That did not stop markets from having a cycle.

Credit expansion: Easy access to cheap, low-interest-rate money fuels speculation in asset classes. This encourages the use of financial leverage by corporations and within investment vehicles, which in turn amplifies asset price appreciation. Stock market booms are often associated with new investment vehicles using leverage.

Euphoria and Crowd Behavior:  The masses enter into financial speculation on the belief that prices will rise much higher, that risk is low, and that old rules do not apply because the world is entering a “new era.”

Asset Prices detach from underlying reality: Asset prices appreciate well above historical norms and well above their price range relative to other assets.  This overvaluation is usually ignored because it appears assets can be sold to others, even if the price is excessive.  This is sometimes referred to as “the greater fool theory” in that one can always sell to a greater fool when prices depart drastically from underlying fundamentals or past history.  Price no longer matters; it is only momentum and the chance to sell at even higher prices that are important.

These are all the general characteristics of the environment of a boom that turns into a bubble.

What about when the bubble pops?  What causes that?

Loss of confidence: Kindleberger says a triggering event or events usually cause investors to question their actions. This can come from negative news regarding war, interest rate increases, or sudden regulatory changes.

Liquidity problems: A series of events causes previously cheap credit to become restrictive. These may include tightening lending requirements, rising borrowing costs, financial institutions getting in trouble, new financial vehicles blowing up, financial institutions being weakened, or the inability of markets to absorb panic selling.

Market Saturation: An inflection point is reached when most of the maximum available money and number of investors become committed to a market idea. However, the available supply of funds and investors begins to fall off because new buyers have largely disappeared.  Everyone is in; who can get in, and few new buyers are left.

Psychological shift:  To commit money, the mind must first be convinced. But often, in speculative endeavors, attitudes become short-term and emotional, not logical.  Contagion occurs when crowd behavior takes over and rational thinking is no longer operable.  Euphoria and the dreams of riches grip the crowd and can be replaced relatively quickly by panic to cash in profits.

In his study of economic and investment cycles, Kindleberger sees a fairly reliable sequence. The shorthand sequence is displacement, mania, bubble, distress, crash, and panic.

Within this historical template is a high degree of repeatability because human nature appears not to change. While each period’s specifics may differ, people do not learn or remember previous boom and bust cycles.

Fair enough, you might say that history and analysis are fascinating, but is this history relevant to today?  Yes, if you think history tends to repeat.

Several candidates could qualify in terms of displacement, ranging from the disruptive potential of a new Trump Administration,  a social media landscape that has changed the way we get information and communicate, to the rapid changes wrought by artificial intelligence and robotics.

In terms of credit expansion, we can’t think of a time in history when the cost of money was kept at zero for much of a 20-year period. In inflation-adjusted terms, the cost was negative. If the price of beer were zero for much of 20 years, do you think it might change drinking habits?  Zero-cost money has induced many to borrow who might otherwise not have.  This includes individuals, corporations, and governments. Money supply, credit growth, and debt expansion have been very rapid, causing widespread price inflation, particularly asset price inflation. Government stimulus has been on par with significant wars or depressions, yet it has been applied to peacetime.  The current period easily qualifies with the past in terms of credit expansion and may exceed any other period.

In terms of herd behavior, US families now hold a greater percentage of their wealth in stocks than at any other time in history. New financial products abound. Among these are leverage ETFs that allow buyers to magnify price movement. Currently, there are 13 times more leveraged longs than shorts. Deutsche Bank recently conducted a survey of investor expectations for next year and concluded that the retail public has rarely been this bullish.  Yet, corporate insiders remain big sellers. That is worrisome.  And it is not just expectations.  The public is taking action, as seen by recent torrential monthly inflows of money into stocks.  Chart courtesy Markets& Mayhem

New-era thinking is now evident.  Black Rock, a giant and influential investment firm, believes we have entered a new period free from boom and bust cycles: “In its 2025 Global Outlook, Black Rock said it believes the world economy is currently in the process of being entirely “reshaped” by the emergence of five new “mega forces,” including the shift to net zero carbon emissions, geopolitical fragmentation, demographic trends, digitization of finance and AI.  …The fund manager, which controls $11.5 trillion worth of assets, said it now believes this “economic transformation” has seen the global economy break away from “historical trends” that have seen markets go through cycles of boom and bust for centuries. “

What about valuation? Historical metrics show that valuation for most asset classes is very high. The price of residential homes is beyond what most middle-class people can afford. Stocks are selling at PE multiples near the top of the range, as well as price-to-book ratio, price-to-sales, and market cap versus GDP (we are at 209% of GDP, the highest ever recorded). The same is true of the CAPE ratio, which is the cyclically adjusted price-to-earnings multiple. It is currently at about 38, while the median average is just below 16. The US market has never been this expensive on a PE basis relative to global stocks in general. This raises the question: Does AI only apply to US companies?

Jason Geopfert runs an interesting site called Sentiment Trader, which is full of historical relationships. One that got our attention recently was a study of the long-term trend in stock prices. Current levels are about the highest in 90 years. “When we do those calculations…and it’s not a particularly pretty picture, as it suggests the S&P is so far above its long-term trajectory that only the 2000 and 1920s bubbles can compare.”  Thus, it looks like price has departed from underlying fundamentals.

To be sure, expensive markets can continue to appreciate to ever-more extreme levels, but examining all previous historical relationships suggests that risks are rising now, perhaps even faster than prices.

When price no longer matters, we have a problem.

Without getting into the merits of cryptocurrencies, we can only say WOW, but such parabolic rises in the past have ended in very sharp corrections.  However, it may be more of a display of speculative fervor that is dominating rather than a violation of fundamentals.  After all, their price action is so erratic that they cannot qualify as currency even though we use the word currency in naming them.  If they are not currencies, what the heck are they? They have no earnings and pay no dividends. And, unlike commodities, crypto is not used to make anything or feed anyone. Unlike bonds, they pay no interest. Moreover, some firms are now using their balance sheets and the ability to borrow to purchase Bitcoin.  This is a troubling sign.

So, it would seem that much of today qualifies with the template laid down by Kindleberger. That is the bad news. The good news is that we are not seeing a loss of confidence, liquidity problems, or any major breakdown in price trends…yet.

Recently, though, the market reached new highs with declining volume and more shares declining in price than advancing in price. This has persisted for more than a week near all-time highs. That may be a sign that the market’s technical underpinnings are weakening.  Usually, the period from Thanksgiving through Christmas into January is robust for stocks.  If so, the market behavior by the end of January could give us a peek into what should be expected in the coming year.

And while we don’t see any immediate liquidity threat, we point out what we have previously.  Namely, interest rates are defying the Fed and rising, even though they have pivoted to cutting rates.  This behavior is abnormal, and academic interest aside, the rising rates can create a liquidity crisis for the highly indebted.

We will close by noting that many economic data points floated by the press, usually at the government’s behest, have been subject to frequent revision. In almost all cases, they have been downward revisions. 

Most of the Biden era’s economic growth has been stimulated by deficit spending, government employment, or just a natural bounce back from lockdown. Reducing spending and government employment could make today’s soft numbers look much weaker. So much of our “growth” has been in government. The question is: how can one cut back on government without cutting “growth?”

We think the American people voted to cut the size and expense of government. It will be a painful but necessary process. But this historic shift is not occurring in a vacuum. It is happening within the context of an expensive market and overly leveraged economy, which displays most of the Kindleberger criteria for a bubble.

Contrary to public belief, Trump has been handed a struggling economy, not a robust one. Moreover, he has been given increasingly expensive and frothy markets, with extreme investor sentiments accented with “new era” thinking. He also has multiple foreign policy issues to handle, which we have no time to explore right now. Iran, Syria, Turkey, Israel, Ukraine, Russia, and the EU are all challenging in the best of times.  Each has the possibility of adverse outcomes.

One of the hallmarks of mania thinking is the famous quote from Irving Fisher, perhaps the most famous economist of his era.  He said 12 days before the Great Crash in 1929,  “Stock prices have reached what looks like a permanently high plateau.”

This is part of “New Era” thinking. This time, it is different. Sure, the market is overvalued, and all segments of society are too heavy in debt. But today, the conditions that have historically caused markets to cycle up and down have been repealed by new technology and new ways to manage men’s affairs. Therefore, stocks will stay where they are or go even higher because a new dawn is about to break for all of our benefit.

Black Rock’s statement comes very close to saying the same thing, and they have more influence than a single academic economist. As Mark Twain noted, history may not repeat itself, but it sure rhymes. Let’s all hope we have more than 12 days before the markets respond to such hubris.

I don’t know if Warren Buffet is a fan of Kindleberger, but he has been selling equities and accumulating a most impressive hoard of cash.  Why is he doing that?

Maybe you should read a copy of Kindleberger?  Buy the 7th edition, 2017.

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Image credits:  Screenshot Amazon.com Bookcover and chart Financial Times.

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