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    December 2012
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    A bipolar economy and it’s impact on financial markets.

    mspooner

    The economy and financial markets seem to be on a rollercoaster ride, with no end in sight.  And for investors it sure feels like these bipolar symptoms – wild ups and downs – are becoming even more exaggerated as time goes on.

    There’s medicine for bipolar disorder, and there should be government policy that mitigates the volatility.  Unfortunately we voluntarily went off those policy meds, and in an effort to try to prolong the happy mood we now risk going off the rails.

    Yesterday the Fed announced yet another round (QE4) of accomodative easing to replace Operation Twist:

    “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

    When Alan Greenspan was chairman of the FED, he deliberately put his foot on the gas (money supply) a touch whenever it looked like the economy was about to fall into a dark period.  He’d then take his foot off the throttle when there was evidence that things were improving.  Despite the excesses that were building in housing and the financial markets which eventually led to the crisis, it worked out pretty good.

    The financial crisis presented a whole different world of really bad possibilities.  Fed Chairman Bernanke and the rest of the global financial community realized that if the depression (both meanings of the word seem to apply here) was allowed to get worse economic suicide was a real risk. Governments have since been injecting the economy with more and more gas (stimulus) to try to get it back on its feet.  But when is enough just enough? Can you imagine TV’s Homeland character Carrie Mathison unmedicated and on a strict diet of chocolate, coffee and Red Bull?

    Back in the mid-19th Century the Ottoman Empire was falling apart.  Greece, Serbia and Bulgaria were becoming independent and tax revenues from an obsolete feudal administration rapidly running dry.  France, Britain and Austria wanted to keep the Empire afloat to serve as a roadblock to Russian aggression in the Balkans.  By constantly throwing money (lending) at the Sultan (borrowing), who spent it lavishly and foolishly, European generosity actually accelerated the financial demise of the Empire not to mention collapse of banks all over Europe.

    The fundamental divide between staunch Republicans and Democrats in the U.S. hinges on these same issues.  The Republicans believe if the stimulus (akin lending money to the financial sector with borrowed future tax dollars) doesn’t stop the economy will inevitably blow up (bankruptcy) whereas the Democrats want to keep adding fuel hoping for a more lasting high.

    What these unbridled efforts to create prosperity have actually ignited is far more volatility than investors can stomach.

    Once upon a time, the stock market was simply the culmination of multiple investment decisions – whether to buy, hold or sell individual stocks.  In recent decades the introduction of securities that mirror the indexes brought a new layer of volatility to the party.  Now an entire community of institutional and individual investors bet on the direction of the overall markets, using leverage no less.  This simply adds fuel to the fire.

    The bottom line is that every little development in the economy, reflected in those frequently published updates, has a pronounced impact on the whole stock market.  This is not hard to see when graphically presented.  Notice in the accompanying chart how the S&P 500 Index responds to unexpected shorter-term changes in economic news.  These moves seem far out of proportion to the underlying trend which has been a relatively slow and steady improvement in corporate earnings and a fairly steady economic recovery.

    What does this mean to the investor?  In general it means he/she is scared out of his/her wits.  A smart lady I was chatting with today was dumbstruck by an advertisement she read.  Her bank was promoting a new so-called high interest savings accountThe interest rate offered was 1.2%.  We laughed out loud.  It reflects the general aversion to the same volatility we’ve had to suffer of late.  People would rather earn next to nothing than shoot for an uncertain but better rate of return in riskier assets.

    At times like this – and there have been many financial crises over the past hundred years just like that crisis in the 1870’s that crushed the Ottoman Empire – it is usually wise to expect what is totally unexpected.  We humans have a tendency to expect the current situation to simply continue.  But because investors will demand an extremely high average rate of return from stock markets to compensate for the risk, the economist in me suggests that stocks must therefore be priced to deliver that generous return over the next several years.  The optimist in me believes the mass aversion to volatility will cause the gambling community (as opposed to the investing community) to run out of clients and funding.  Governments will begin a painful but necessary rehabilitation.  A reduction in the magnitude of these bipolar swings will restore some semblance of economic health and investors willing to bet on stock markets today will be handsomely rewarded.  After all, if it weren’t for rose-colored glasses we’d all be getting lumps of coal for Christmas rather than iPads.

    Malvin Spooner.

     

     

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