2019 has been a persistently positive year with a final move up in Q4. For the year, the Dow ended 22% higher, the S&P gained 29%, and the Nasdaq rose 35%
For further market coverage, see
https://markets.on.nytimes.com/research/markets/overview/overview.asp
Long term investors have been rewarded with a significant upswing for 2019. For those that believe in “Get Invested, Stay Invested”, this feels pretty good. Holding diversified mutual funds long term sounds simple, but it may be more difficult than most people truly understand. Few can ever actually muster the patience and perseverance to effectively execute this philosophy. The process of staying resilient through the economic cycle and for the long run allows portfolios to avoid being caught in cash by swells of optimism, while it also requires us to gut it out during the downswings.
These commentaries often contain descriptions of troubling economic events, questionable government policy, and a myriad of scenarios where investors will be challenged. The purpose in discussing the troubles ahead is to prepare for the many difficulties that await equity portfolios. Significant effort is devoted here to observing the current environment, while at the same time directing focus to the crucial behavioral elements that will have great impact on our future.
Long term investors can feel inordinately smart when we witness the big results of a year like 2019. It is imperative to remember that as prices rise more selling will ultimately arrive. There are currently oceans of cash that have been created by the Federal Reserve and central banks around the world. This money has added to demand for stocks globally, particularly as interest rates have remained low. The market surge of Q4 2019 may have been money managers and other decision makers who were bearish at the beginning of 2018 trying to catch the bullish wave.
Calendar years with high returns can often be followed by corrections that are simply the function of supply and demand. We can be grateful about the rewards of the upswing, while at the same time recognizing that the perseverance of less good times allowed the portfolio to benefit.
Without proper perspective, attitude and expectations, knowledge cannot buffer against poor reactions and fear driven choices that will push us into ideas that will not be optimal for the long run. Behavioral economics is filled with theory and insight into where success and mediocrity are defined: our worldview and the decisions that are driven by it. It is these behaviors that will be the ultimate determinants of our investing outcomes.
Human decision making is drawn through a filter carved from evolution in ways that are frequently opposed to our interests and are endlessly illuminating. George Katona (Nov. 6, 1901, June 18, 1981) was a Hungarian-born American psychologist, and Professor at the University of Michigan, who was one of the first to advocate a connection between economists and psychologists. He is recognized as one of the founding fathers of behavioral economics.
In the 1975 book Psychological Economics, Katona observed a fascinating dynamic: when he interviewed non-academic people and asked them about their perception of economic variables, he had the feeling that they had no clear expectations, yet they eagerly constructed theories to somehow satisfy the researcher.
This is another example of the Dunning Kruger effect. The less sophisticated a person may be, the more ambitious they often become in projecting theories and explanations of the complex and unknowable. This lack of awareness is compounded by the craving for narrative and pattern recognition. The Dunning Kruger effect is the concept of people feeling smarter than they are, while being unaware of how big a given deficit of understanding that may exist. Look no further than the Retirement Systems of Alabama pension manager chief Marc Green for an example of this.
https://www.wsj.com/articles/alabama-pensions-troubled-bet-lobster-rolls-and-star-wars-11577269802
From the WSJ article: “The Retirement Systems of Alabama has sunk upward of $221 million into a 16-location, boutique theater-and-restaurant chain, recently wresting control of the company in bankruptcy court. Alabama pensioners are now the owners and operators of iPic Entertainment Inc., a loss-making chain that helped usher in the era of dine-in theaters, serving moviegoers lobster rolls, steak skewers and cocktails in buttery leather recliners.”
“Lending directly to companies, as Alabama has done with iPic, rather than through a specialty fund saves fees paid to investment managers. But doing so can put pension fund managers in unfamiliar territory, trying to operate businesses beyond their expertise.”
The movie theater investment has been crushed and is now worth very little. Apparently, these pension fund managers had themselves confused with entertainment entrepreneurs. One is left to wonder if these managers thoroughly researched the impact of Netflix, Apple, Amazon and ubiquitous entertainment options streaming in high definition directly to everyone’s cell phone, tablet, and wide screen television.
My commentary from April 23rd, 2019 stated: “The Narrative Fallacy illuminates our limited ability to look at sequences of facts without creating an explanation for them, or forcing a logical link, an arc of relationship upon them. Explanations that tie facts together often ignore the underlying randomness and alternative paths that were just as likely, but we are oblivious to. Our stories make events more easily remembered and help them make more sense. This heuristic increases our impression of understanding that may be ill informed or utterly mistaken.”
On October 1st, 2019 Robert J. Schiller published Narrative Economics: How Stories Go Viral and Drive Major Economic Events. Shiller is a highly regarded, Nobel prize winning economist who was born In Detroit with a BA from the University of Michigan in 1967. The book is a deep dive into how economic theory has yet to incorporate societal (rather than individual) narratives into economic theory.
“We need to incorporate the contagion of narratives into economic theory. Otherwise, we remain blind to a very real, very palpable, very important mechanism for economic change, as well as a crucial element for economic forecasting. If we do not understand the epidemics of popular narratives, we do not fully understand changes in the economy and in economic behavior.”
Shiller, Robert J.. Narrative Economics (p. xi). Princeton University Press. Kindle Edition.
The spread of belief systems in the public consciousness can have dramatic impact on government policy, academic trends and market outcomes. The book is a fascinating journey into the history of how public consciousness drove thinking in numerous strange and often counterproductive directions.
From Schiller: …the US Senate in Washington, DC, replaced its non-dial phones with dial telephones in 1930, the first year of the Great Depression. Three weeks after their installation, Senator Carter Glass introduced a resolution to have them torn out and replaced with the older phones. Noting that operators’ jobs would be lost, he expressed true moral indignation against the new phones: I ask unanimous consent to take from the table Senate resolution 74 directing the sergeant at arms to have these abominable dial telephones taken out on the Senate side … I object to being transformed into one of the employees of the telephone company without compensation. His resolution passed, and the dial phones were removed. It is hard to imagine that such a resolution would have passed if the nation had not been experiencing high unemployment. This story fed a contagious economic narrative that helped augment the atmosphere of fear associated with the contraction in aggregate demand during the Great Depression.
Shiller, Robert J.. Narrative Economics (p. 191). Princeton University Press. Kindle Edition.
Fear of technology was featured by the Economist in the 12-18-2019 cover story Pessimism v progress https://www.economist.com/leaders/2019/12/18/pessimism-v-progress
From the essay: Too often people focus on the drawbacks of a new technology while taking its benefits for granted. Worries about screen time should be weighed against the much more substantial benefits of ubiquitous communication and the instant access to information and entertainment that smartphones make possible. A further danger is that Luddite efforts to avoid the short-term costs associated with a new technology will end up denying access to its long-term benefits—something Carl Benedikt Frey, an Oxford academic, calls a “technology trap”. Fears that robots will steal people’s jobs may prompt politicians to tax them, for example, to discourage their use. Yet in the long run countries that wish to maintain their standard of living as their workforce ages and shrinks will need more robots, not fewer.
Shiller’s work provides stark insight into historical narratives of gold backed currency, The Depression, innovation’s threat to human employment among many others. These concepts and conflicts of the past illustrate the resilience of market-based capitalism. Knowledge of this historical legacy of fear can be helpful in fortifying our courage in the face of future challenges.
The current threat of mass job loss due to driverless cars, AI and machine learning ignore the avalanche of job creation that new technologies generate. The answer to the threat is, as always, education and training.
It is likely that there will be colossal opportunities in the training of digital workers. American universities and traditional higher education will need to introduce all manner of new approaches, apprenticeship and learning systems. Think of the possibilities and fortunes to be made in development of the workforce that will prosper in the 2020s.
2019 was a year shaped by powerful “Narratives”
Cheap Money
2019 was to be a year in which the US federal reserve proceeded with a long-awaited path of raising rates to a level that was more appropriate with the growing economic and rapidly rising asset prices.
The Fed action was driven by 2018’s four .25% rate increases. This resulted in the worst December market in many years and 2018 ended on a downswing. The market then began a rally that was initiated by the anticipation that rates would unexpectedly be cut. This is exactly what happened with three .25% cuts that began in August 2019. As we have discussed many times, the price on money drives market psychology and demand for yield. This is a cyclical process that is pushed by relative changes rather than nominal rates. The real challenge that the market is facing is that when a downturn arrives there will be little room for cutting to stimulate with rates at such low absolute levels.
Massive deficit spending
2019 witnessed increasingly positive economic data coupled with massive Federal deficit spending. This dynamic is a consequence of the populism that has drowned out conservative voices on the dangers of fiscal recklessness. This is likely to be a big issue that will compound the next downturn.
Fiscal conservatives have gone quiet. Deficit hawks would have stark concerns about the profligate spending that has occurred since 2016, but these voices have been quelled by the hibernation of those that would speak out on profligate spending. There is little focus on the future fiscal consequences in this political environment. The election cycle and the twin propellants of cheap money and federal spending are perceived as keys to the presidential election.
Today’s conservative establishment has shredded its Contract with America (1994). The contracts number one item: The Fiscal Responsibility Act which states “a balanced budget tax limitation amendment and legislative line item veto to restore fiscal responsibility to an out-of-control congress requiring them to live under the same budget constraints as families and businesses.” This contract is null and void.
Newt Gingrich, the contract’s leading proponent is still active as a pundit, spreading all sorts of talking points about the evils of the opposition. He is not advocating for his prized contract and notions of spending discipline. Mark it down to another empty political gimmick of the past.
The consequences of rising Federal debt in the United States is a looming cloud on the future. People have been warning about this issue and issuing dire forecasts that have never seemed to pan out. The US system is messy and out of control, while at the same time it is perceived as the world’s safe haven. American government bonds are considered iron clad and form the basis of the global monetary system. Alternatives like the EU, China or Japan all have drastically lower levels of perceived trust.
Trade War “Phase One”
On November 19, 1969 The cover of the NYT proclaimed “2 ASTONAUTS LAND ON MOON, RIGHT DOWN ON THE TARGET”.
Next to this was a story on trade policy, “President Urges Aid To Industries Hurt By Imports, Offers Legislation and Says he Favors Continuation of Policy of Freer Trade”
https://timesmachine.nytimes.com/timesmachine/1969/11/19/issue.html
Free trade has been the foundation of US policy for a very long time. The push for open markets has had a significant impact on many industries, workers and export markets. The troubles of past protectionist eras had seemingly served as a guidepost and warning that protectionism would yield painful outcomes. The current populist trends have turned against these longstanding beliefs.
The trade war began as a presidential decree against perceived injustice fostered on the US economy by the Chinese economic juggernaut. The Middle Kingdom was accused of a wide range of transgressions. These alleged exploits of the global trading system allowed China to cheat its way to global prosperity.
These commentaries have been immensely skeptical of the notion that US workers, manufacturing, agriculture and all manner of economic interests could benefit from aggressive tariff strategies.
The data of these policies is beginning to be revealed. Federal reserve economists Flaaen and Pierce published a paper on 12-23-19 that states: “We find that U.S. manufacturing industries more exposed to tariff increases experience relative reductions in employment as a positive effect from import protection is offset by larger negative effects from rising input costs and retaliatory tariffs. Higher tariffs are also associated with relative increases in producer prices via
rising input costs.”
https://www.federalreserve.gov/econres/feds/files/2019086pap.pdf?mod=article_inline
The evidence will likely continue to show that any benefits of protectionism are outweighed by uncertainties and costs created by the effort to regulate global trade. The federal government is effectively picking winners and losers. The market and competition are the only effective arbiters of who should succeed. The desire to see domestic industry grow cannot supplant the economic realities of capitalism.
The market has been whipsawed by presidential threats and oscillation between references to productive negotiations and frightening tariff announcements. The idea that these problems could be “negotiated” was fragile to begin with. The difficulties may have led to the notion of segmenting the more difficult problems into future “Phases” and being able to pull back the threats prior to the election year 2020. Disrupting the global economy carried significant political risk as a 2020 recession could result, thus impairing re-election of the president.
These political pressures also drove a quiet agriculture “bailout” that was larger than the lending to the automotive sector during the 2008 financial crisis.
22 years ago the Economist Magazine wrote in the 10-23-1997 edition;
It is not a battle between left and right—the debate about China cuts across party lines—but between, you might say, cautious “experts” and excited “activists”
https://www.economist.com/special/1997/10/23/friend-or-foe
The current US political leadership has little interest in China “experts”. See
https://time.com/5375727/peter-navarro/
The populist slogans spreading ideas with little basis in fundamental economics has the upper hand in current thinking regarding trade policy. This simplistic notion that we can have a new agreement to fix the “problem”. After the 2020 election, the next wave of threats may be unleashed, regardless of which party wins the presidency. The genie of protectionism is out of the bottle and until the consequences of trade barriers become more apparent, the US / China relationship is likely to remain contentious and troubling to global markets.
Trade threats and using US markets as a weapon is a strategy that will have unpredictable costs with benefits that will be uneven at best. Trade protectionism is an old idea that has a terrible history of failure. The best case is that this issue becomes much more muted and is approached in a less aggressive manner with finesse, diplomacy and sound economic principals taking the lead.
Escalating Political polarization
US politics have always been filled with contentious struggles for power. The two-party system has devolved into a distinct period of vitriol. Conservative Democrats and progressive Republicans were a fixture of the American political landscape for generations. A messy continuum of views and beliefs sometimes allowed for negotiations that often ended up with centrist policy and compromise.
The current environment has little room for the best aspects of a two-party system. The concept of a disruptor has been personified by someone who has never held public office. The current state of teams at battle with clearly identifiable jerseys seems too prohibit much imagination of centrist compromise.
We are witness to another era of impeachment. The political environment still seems permeated with the combat between the GOP and the house of Clinton. Open disdain for the other party members does not enhance the current opportunities for policy refinements. Yet, there is a notion that “gridlock is good”. There may be a hidden upside for investors, big legislative initiatives are less likely thus the uncertainty that can be created by active government legislation is muted.
The election year of 2020 is likely to exacerbate this combative stretch. There are signs that voters are reaching high levels of fatigue when it comes to national political drama. Reality TV presidencies are unlikely to become a trend and the cycle of “change” and throw the bums out is likely to be repeated.
Impeachment
Bill Clinton’s impeachment and trial in 1999 barely registered a blip in the bull market and long economic expansion of that decade. The Watergate hearings came against the backdrop of the brutal 1973-74 bear market during a steep recession and high inflation amid the oil-price shock and gasoline lines that, along with the Vietnam War, remind investors of a brutal period in American economic history.
The current federal picture in the US has a first time public servant who has never been at the levers of power before. There is no use in anticipating the next comment, conflict or surprise that will be presented to investors. There seems to be a certain glee amongst the President’s supporters in the notion that “he is not a politician”. It may be a big factor going forward in 2020 as we bear witness to strategies seemly drawn from a Roy Cohn playbook, rather than any conventional vision or ideological stance.
https://www.latimes.com/archives/la-xpm-1988-03-18-vw-1638-story.html
The democrats have been sloshing through a messy primary process along with the seemingly pointless effort of impeachment by congress / acquittal by senate. US progressive movements have become mired in seemingly fringe issues like bathroom rights, while producing an endless stream of fanciful new government expansion ideas like Medicare for all. These broad visions are another thread of populism and they are unlikely to lead to optimal policies.
The markets seem to be marching to the drums of a convergence of low inflation, unemployment and cheap money. The signal may be that our system is resilient, and that the political environment is not the threat to investors that it seems to be. How long this “Goldilocks” economy can continue is anyone’s guess.
There are many challenges that will be revealed as we enter the twenties. There is much reason for optimism in the face of perpetual challenge. We are living in an age of powerful technological advances. The escalating power of computers and digital applied sciences are quietly creating growth, new wealth, and the jobs of the future.
The Economist noted that it may soon be possible utilize transparent solar cells to glaze office blocks and create solar powered buildings. The potential for clean urban energy is immense.
Our future is likely to be one of higher standards, greater energy efficiency, and innovation that we could not even imagine. In the face of all these challenges, investors will continue to be rewarded by the push for better medicines, purer foods, and all manner of what will make ever higher standards of living in the US and globally. Facing the present challenges with resilience and reveling in optimism towards a future filled with breakthroughs in economic growth this has always been the case. This is the essence of why we invest.