Over the last few years I have been talking about how Federal Reserve officials misdirect investors, businesses and Americans about the economy, the financial markets, and their own intentions. This is somewhat by design, since the Federal Reserve uses artificially means to benefit the financial industry while disrupting the free market. In the midst of what is called a “market economy” in America, the cost of money itself is not allowed to be set by the markets. The Federal Reserve directly controls the cost of money, by manipulation of interest rates, the money supply and inflation, and to a lesser extent, the financial markets. In this latest economic cycle, the Fed has used its control over interest rates, and its words, to control Wall Street and buyers of U.S. Treasury debt, with financial bubbles and misallocated resources being unfortunate byproducts.
The stock market has continued its 4th quarter slide. From its September 20 highs, the U.S. stock market, as measured by the broad Wilshire 5000 index, is now down 20% from those September highs, and officially in a Bear Market. (see graph below). Such a decline hasn't happened since the 2008 market, credit, real estate and financial meltdown. I've been commenting on how over the past couple decades, the performance of the financial markets has become ever more intertwined with overall economic activity. And since economic activity in the U.S. is increasingly financed with debt, and since current debt levels are based on higher stock prices, not lower ones, the pullback in the financial markets are already having an impact on credit growth. That in turn, will affect economic growth. And if the stock market stays down, economic growth in the U.S. will soon turn negative.
Amid the recent pullback in the stock market, the chorus of commentators talking about a bubble in the financial markets has gotten louder. Especially when eyeing the crumbling prices of previously high-flying FAANG stocks, there seems to be increasing signs of a classic bubble breaking down. Yet most investors are staying put in this market, or even doubling down. Even as the market has grown to the richest valuations in decades, the vast majority of investors seem to believe there is more risk in being out of the market than in.
The relationship between risk and return is a fundamental and powerful aspect of investing. Over the long term, low risk (low volatility) investments generally earn low average returns and higher volatility investments have higher average returns. So 3-month Treasury bills usually earn lower returns than 30-year Treasury bonds; less volatile AAA-rated corporate bonds usually earn less than lower-rated “junk” bonds; smaller, more volatile company stocks generally outperform larger ones, and more volatile emerging market stocks generally outperform stocks from more stable developed nations. But while this has been a fundamental principle of investing, the extent of worldwide “quantitative easing” (money-printing) and severely manipulated interest rates to zero or even negative, seems to have upended this powerful link, at least for a time. But if the financial world has ventured into uncharted territory from a risk-return standpoint, the road back to normalcy will be very unwelcome to many, with some equally unwelcome consequences.
Last time I talked a little bit about the recent decline in the U.S. stock market and what it might mean for the economy. For a variety of reasons, performance in the stock market has become increasingly correlated with consumer confidence, which in turn, is highly correlated with consumer spending (see graph below). In August, September and October the Conference Board's Consumer Confidence Index hit successive 18-year highs, coinciding with record highs in the stock market. But with the recent break in the stock market, November's consumer confidence reading will likely be lower, and if the current market decline turns into a rout, consumer confidence will plummet, just as it did with past Bear Markets. Once consumer confidence takes a hit, auto sales, home sales, and retail sales will decline. Especially when combined with rising interest rates, a popping of the equity bubble will have long-lasting consequences for the economy.
It's been a long time now in which commentators have been predicting the end of the Bull Market in America. That Bull is now approaching a decade, and is generally credited as being the 1st or 2nd longest in history, depending how you measure such things. With each market pullback along the way many analysts and commentators have predicted the decline was the beginning of the end of the Bull run. Other commentators have said that no, the decline was just a market pullback, to be quickly resumed by new heights and new highs. And until now it's been those latter soothsayers that have been right. For nearly ten years, the U.S. stock market has defined the naysayers. And for nearly ten years the market has had the Federal Reserve and its near-zero percent interest rate scheme to inflate the market, and the economy, and keep any declines with either contained. But as the Fed has finally relaxed its iron grip on interest rates a bit over the past couple years, the Bull has started to look weary. With the U.S. stock market ever more entwined with its overall economy, if this modest market decline turns into meltdown, the economy will expose its fundamentals as it loses the crutch of its booming stock market to support it.
At the beginning of this year I wrote a series of five articles on the state of healthcare, medical spending, and health outcomes around the world. Through that research I found that a country's wealth and the level of its healthcare spending are both highly correlated with healthcare outcomes such as life expectancy (see graph below). Within that strong correlation, we find that some countries strongly outperform lifespan expectations based on their wealth and healthcare spending, while others underperform. Among the wealthiest, highest-spending nations, the U.S. is far and away the worst in terms of average life expectancy compared to the level of its wealth or healthcare spending. Even worse perhaps, is that while average lifespans around the world continue to increase, those in the U.S. have flattened and even declined. Despite the U.S. continuing to spend record amounts on its medical care, and more than any other country, lately, we are not seeing corresponding improvements in Americans' health compared to other countries.
In June of this year Portland-based Western States Office and Professional Employees Pension fund told thousands of its members that most would see cuts of 30% in their pension checks starting October 1. While this is not particularly new in a long trend of pension cutbacks, what is more significant is that these cutbacks reflects a U.S. Treasury decision in 2014 that for the first time allows multi-employer pension plans to cut back pension benefits to those already retired (but under age 80). While pension plans have been cutting retirement benefits for younger workers and sometimes eliminating pension plans altogether, these new regulations have paved the way for a wholesale slashing of pension benefits that will only spread across the country. In the past, it was younger workers who worried about their pensions being cut. Now retirees can spend their retirement doing the same.
It's been a decade now since the U.S Federal Reserve Bank reacted to the busting of the U.S. real estate bubble by lowering interest rates to nearly zero, and keeping them there for most of the past decade (see graph below). The Fed's experiment has changed the financial condition and economics of the world, and overall, not for the better. One of the fundamental laws of nature, and economics, is reversal to the mean. Those areas that prospered by unnatural actions will reverse when those unnatural actions are removed. If the Fed's objective was to keep firm control on the world's financial and economic system, chaos and unpredictability are the inevitable results if the natural order ever takes the upper hand.
Last time I talked about how the Social Security program has nothing to show for trillions of dollars of past profits, and uses crony accounting to show profits for its program by including mythical interest on non-existent assets. This time we'll see that how the losses for the Social Security, Medicaid and Medicare programs are sharply increasing and spending on these programs is growing faster than the rest of government. Except for the nearly unthinkable scenario in which Social Security and Medicare (and Medicaid) benefits are substantially reduced, these programs will continue to crowd out the rest of the government, including the military. This is already happening as the “non-discretionary” programs of Social Security, Medicare and Medicaid are untouchable to government reductions, leaving just a small and shrinking slice of government spending with which to make spending cuts. Ironically, this will speed the process whereby these social welfare and insurance programs take over and become the U.S. federal government.
David A. Pace, CFA
Note: These comments and articles are for informational purposes only. Nothing in these articles are meant to provide specific investment advice and are not a substitute for professional advice from a qualified adviser. Since every investor's investment and personal circumstances are unique, he or she should always enlist the help of a competent and trustworthy professional in addressing their financial needs.