Those of us who have been around a while recall, seldom fondly, the 500 point decline in the Dow Jones Industrial Averages on Monday, October 19, 1987. On that day, the Dow Jones Industrial Averages declined on volumes that the exchanges could not accommodate. The decline was from a far lower level than that exhibited last Friday, when the Dow declined 666 points. In 1987, the percentage decline was over 22 percent. Last Friday, the decline came to 2.5 percent. While the numeric decline was similar, the percentage decline was not. The Dow declined almost 5 percent on Monday, wiping out gains for the year, to recover 2.3 percent on Tuesday.
Perhaps less well remembered from 1987 was the fact that the stock market indexes recovered their pre-crash levels by 1989. From there, they more than tripled through the 1990’s, until the dot-com bust in 1999-2000. The cycle has repeated itself at least twice since, with declines followed by higher advances. Contrary to popular belief, not every market decline signals an economic contraction.
To be sure, not every investment recovered from each pull-back. Some did better. Some did worse. The investment question is: when is the right time to sell, and when to hang on?
This is a difficult question for so-called packaged investment products, such as index funds and exchange traded notes (which can be a bet against market volatility). It is hard, when you do not know exactly what you own, to have faith in its future. In the case of “VIX”, investments against market volatility, the investment was really a speculation on how much the market would fluctuate. After posting annual returns in excess of 40 percent from 2010 to last week, the inverse VIX investments saw 95 percent of their value wiped out the past three trading days, and two of the larger investment vehicles liquidated. Total losses to investors are expected to approach $3 billion.
Aside from the price decline of the inverse VIX ETN, the other big losers this year have been the crypto investments, best known by one of their earliest and largest example, the bitcoin.
Bitcoins were created on the internet as a way to transfer wealth out of a country where exchange controls or the attitude of the government makes it difficult to do so. By buying bitcoins, say, in China and selling them in the US, wealth could be spirited out of one country into another without creating a currency paper trail. Such evasion of government oversight is attractive to criminal elements as well.
A currency is supposed to be a stable store of value, usually backed by a sovereign country. Bitcoins have no government backing. There were fears that the creators of cryptocurrencies could flood the market with new coins, devaluing existing currency in the process. Cryptocurrencies, like bitcoin, pledged to create a finite number of coins to preserve their value.
Once bitcoins were finite in their number, speculators began to bid up the value of the coins themselves. Since any gain in bitcoin trading would not be reported to any government, it became a libertarians’ ideal investment. So popular were the bitcoin investments, the coins appreciated over 14-fold in value in 2017. At one point, there were over 4,000 different versions of cryptocurrencies being created.
Like bets against risk, bets on bitcoins had a reckoning. At one point, young people were buying bitcoins with their credit cards. As different governments cracked down on bitcoin ownership and banks refused to process bitcoin purchases, the coins fell some 70 percent in value as of this writing. There have been several reports of cyber thieves stealing the coins from the accounts of individuals, since the coins have to be kept with the issuer online and are thus susceptible to hacking.
Betting against volatility, like betting against a currency without a government, has not been a good bet. Young investors are often flummoxed by the stock market. They considered bitcoins a safer bet because they “understood” them. They instead learned a valuable, if not expensive, lesson in investor crowd psychology. Knowing the history of the Dutch tulip mania or the South Sea Company bubble could have saved a lot of people a lot of money. But then, history can be a dull subject, and when investors get infected with what Warren Buffet calls FOMO (Fear Of Missing Out), there is little to do but let nature run its course.
While nothing has changed about the economy, what the investing public focuses on has changed greatly.
With 2.6 percent growth in the fourth quarter of last year, and indications of full employment being reached, the prospects for inflation and higher interest rates garners more attention than even a month ago. Since no one can credibly at this point make the case for the economy softening, it seems that we will be dealing more with an economy that has too few inputs rather than not enough demand.
This past year the trade deficit between the US and other countries widened 12 percent to $566 billion. For an administration that promised to narrow this gap, this news is a bit of a setback.
While most people know the administration has passed a tax cut, there is confusion as to whom it impacts. Corporations also seem to be adjusting to lower tax rates on one hand, and higher wage pressures on the other.
One confusing part of the new tax code permits corporations to remit earnings from foreign subsidiaries tax free. This makes it more difficult to justify bringing those operations and jobs back to the US.
The reality of higher interest rates has finally hit home. To the extent the decline of the past two days has any rational basis, higher interest rates and higher inflation were the explanations most often given. Just this quarter alone, the Treasury plans to raise over $441 billion in new funds beyond what is needed for redemptions.
As explained in the last issue, money will become both tighter and more expensive. While this is a reversion to historic standards, a market that floated on easy money and no inflation will have some adjusting to do. Expect four increases in interest rates in 2018.
A weaker dollar, in the face of government interest rates higher than many other countries, is not a good sign. China announced today the free floating of its currency, which immediately appreciated against the US dollar.
This will immediately make Chinese exports to the US more expensive. It will also destroy the argument made by the administration that China is a currency manipulator who holds down the value of its currency to gain export revenues. If its currency is appreciating against the dollar, it will be the US that will, in theory, gain exports against China, rather than vice-versa.
The administration’s response is to plan to stage a Communist May Day style military parade in Washington. Such a show of force will presumably put our foes on notice as to the military prowess of the United States. Whether it implies that the US is becoming more like a military junta, or that such juntas are becoming more like the United States, will be debated by supporters and critics of the event.
The Stock Market
After a moon shot start to 2018, the market has fallen to earth with a thud. Action today has helped to restore a gain for the year, but no doubt other tests will come.
Missing in most accounts of the market is its actual purpose: to buy and sell pro-rata parts of businesses. No one has to buy the entire market. Almost no one is forced to sell in panics. Portfolios that outperform over time know this.
Warren M, Barnett, CFA
February 7, 2018