# Price Illusion

January 8, 2023

by Stephen Stofka

This week’s letter is about price illusions. The past two weeks I have written about the need to sort through past events to find the lessons. The past is a teacher, not a goal. Those who idealize and revere the past must eventually be swept down the drain of time. During this week’s struggle to elect Kevin McCarthy as House Speaker, the more conservative members of the Republican Party voiced their desire to return the country to the past of more than a hundred years ago when the population of 112,000,000 was a third the current size. Instead of learning from the past, we often use elements of history to tell a story. We discard events that do not fit our narrative. Historical analysis serves political interests. Asset analysis suffers from similar distorting strategies.

Technical analysis studies price movements with little regard for the circumstances that prompted the supply and demand, the buying and selling that underlie those movements. I will pick a few such variants at random. Elliott Wave theory bases its interpretation of price movement on the Fibonacci sequence of numbers. Beginning with 1, 1 this number series is constructed from the sum of the previous two numbers in the series. Thus 1 + 1 = 2, 2+1 = 3, and so on. This simple rule produces a sequence found in plant growth and the development of nautilus shells, for example.

Elliot Wave analysis claims that price movements come in waves. Understanding the current position within a wave can help an investor predict subsequent price action. The system is famously prolific in its prophecy, indicating several interpretations. It is better suited to a post hoc narrative. An investor can believe that if they just got better at interpreting the waves, they could time their buying and selling. As the physicist Richard Feynman said, “The first principle is that you must not fool yourself, and you are the easiest person to fool.”

Another technical system relies on the recognition of price trends, identifying those to follow and those that signal a likely reversal. These are visual and geometric, full of rising wedges, head and shoulders price patterns, double tops and bottoms. Much human behavior is repetitive, tempting an investor to perceive a pattern then extend it into the future. The repetition hides the recursive or evolutionary nature of human thinking. Inertia, Newton’s First Law of Motion, may apply to inanimate objects but not to human behavior. Biological systems have built-in dampeners that counteract a stimulus. Without repeated stimulus, the formation of any possible pattern decays.

Price behaves like a biological organism, not an inanimate object. We can see beautiful symmetries in graphical chart analysis but each pattern formation has a unique history. Price is the visible point of a response to events, needs and expectations. Price is a story of people. George Soros, a highly successful investor, constructs a predictive story, then watches price only as a confirmation or refutation of the story. If Soros thinks his story is not unfolding as he predicted, he exits his position.

In school we encountered various branches of mathematics where we were given formulas and plotted data points or intersections, the solutions to a set of equations. Statistics is the reverse of that process. We are given data sets and try to derive formulas to explain relationships within the data. A data set might be the test scores of students before and after the initiation of a certain curriculum. We may represent the test scores on a graph, but the scores reflect a complex set of individual behavior and circumstances, institutional policies, cultural background and economic resources. A statistical analysis tries to include some of these aspects in its findings. A student population is likely more homogenous than the companies in the SP500 stock index who represent a variety of industries. Just as test scores cannot fully explain the efficacy of a school policy or curriculum, asset prices do not reflect the complexity of a day’s events. In our longing for predictability and our fondness of patterns, we prefer analysis that explains price action as a rational sequence of responses to economic, political and financial events. Much financial reporting is happy to oblige.

//////////////////

Photo by FLY:D on Unsplash

# The Two 10%

August 9, 2020

by Steve Stofka

In the past three months the stock market has been on a tear. The last time we’ve seen such a rise? 1938. People are day trading on the Robinhood platform. Hop aboard the gravy train and party like it’s 1999, near the height of the dot-com bubble.

According to the Federal Reserve, the top half of households in this country own 99% of the stock market. The top 10% own a whopping 87% of the market. So why do many news outlets broadcast updates on the stock market  every hour?

A second group of 10% is unemployed, according to the unemployment report released Friday. House Democrats passed a \$3 trillion bill in May. Republicans and the White House have been worried that too many Americans are going to get fat and lazy if the federal government continues to support the unemployed with extra benefits. They have fought among themselves about a stimulus package, and 15 Republican Senators – half their caucus – don’t want to do anything more for the American people. The Senators who are up for election this year do want to pass something but want to appear frugal at the same time – a difficult task.

The richest 10% are doing fine. This week the NY State’s Attorney General announced a suit to terminate the non-profit status of the NRA and dissolve the organization. Their investigation has been going on for more than a year. In September 2019, House Ways and Means Committee member Brad Schneider revealed several allegations against NRA executives (2019). Whether the IRS had already begun an investigation at that time is unclear.  The NRA has paid exorbitant expenses for their executives, including Wayne LaPierre, the public spokesman and VP of the organization. These include homes, yachts, and private jets for them and their families. The executives billed the “expenses” to the NRA’s ad agency, Ackerman McQueen, who then submitted bills with little detail to the NRA, which paid the ad agency.

Dues to the organization have been declining since Donald Trump was elected president. Gun manufacturers have relied on scare tactics to sell their products and have been big supporters of the NRA. Since the election of Trump, sales have declined. Two years ago, the oldest gun manufacturer, Remington, declared bankruptcy. As NRA revenues fell, the abuses came to light when the organization fell behind on payments to the ad agency. Influential members devoted to the mission of the organization have been appalled at the corruption.

Mr. Trump has signaled his support for the organization. Like all Presidential hopefuls, his financial affairs came under scrutiny. The Trump Foundation was later dissolved because of the same self-dealing practices.

The top 10% are always doing fine because they pay an army of lawyers and accountants to legally dodge the rules. Every week, Mr. Trump’s comments indicate how little he knows about any of the laws of this country because the laws don’t apply to him. He is part of the 10% that owns the stock market. When those markets came under stress a few months ago, the Federal Reserve stepped in with massive infusions of liquidity to preserve the assets of that 10%. They are the fire department for the rich.

Who will come to rescue the homes and families in the unfortunate 10% whose extra UI benefits have ended?

/////////////////////

Notes:

Photo by Fritz Benning on Unsplash

Schneider, B. (2019, October 09). NRA’s Actions “Absolutely” Raise Questions on Tax-Exempt Status Testifies Non-Profit Tax Expert. Retrieved August 08, 2020, from https://schneider.house.gov/media/press-releases/nra-s-actions-absolutely-raise-questions-tax-exempt-status-testifies-non-profit

# President Mayor?

March 1st, 2020

by Steve Stofka

Among the Democratic candidates for President are two mayors. Mike Bloomberg was mayor of New York City for the twelve years following 9-11. Pete Buttigieg just completed an eight year stint as mayor of South Bend, Indiana. Americans have never elected a recent mayor to the presidency (Badger, 2019). Will this year be different?

Mayors are responsible for everything that happens in their city – from policing practices to snow removal. John Lindsay, a former mayor of New York City, almost lost his job because of a snowstorm (Marton, 2019). Too many homeless people in Los Angeles? Mayor Eric Garcetti takes full responsibility (City News Service, 2019). Few residents write to the mayor to say that they are so happy that their streetlights are working. The lack of complaints tells a mayor that he or she is doing a good job. Mayors are a tough bunch with strong shoulders.

Do we take the same responsibility for our savings portfolios? If interest rates are too low, do we keep all the money in a savings account and blame the system? When the market goes down, do we rethink our risk appetite, or do we blame those invisible market forces?

At nearly 11 years, this bull market is the longest running in the past one hundred years. The 400% gain since the March 2009 low beats both the gains of the 1920s and 1990s bull markets. Just a month ago, the investment firm Goldman Sachs estimated that there was still room for more price appreciation this year (Winck, 2020).

This week’s downturn was made sharper by several practical factors. In any abrupt downturn that last a few days or longer, margin calls prompt more selling. What is a margin call? Let’s say I borrow \$50 from my broker to buy a \$100 stock. If the price goes down to \$90, my broker wants me to pony up another \$5. If I don’t have the cash, the broker will sell some of my holdings to raise the cash.

The Coronavirus prompted investors to reassess projected earnings for this year and to assign a greater risk to their stock exposure. A lot of investors bought bonds with the proceeds from their stock sales. Worst time to buy long term bonds? Probably. An ETF of 30-year Treasury bonds (TLT) hit its highest price ever this week.

President Trump regards stock market performance as an important indicator of his success. What will he do if market prices decline another 10%? Will he attack Fed chairman Jerome Powell as he did in 2018? Has Mr. Trump become the most wearisome President in modern history?

Joe Biden took almost half the votes in the S. Carolina primary this week, but Bernie Sanders is still leading the roster of candidates with 54 delegates (Leatherby and Almukhtar, 2020). It’s a long road to the goal of 1991 delegates to secure the nomination. The delegates captured in the first four primaries are dwarfed by the 1344 delegates in play this week on Super Tuesday. 643 of those delegates are in California and Texas. It’s a reminder of the power of a few states in the selection of a President.

What about the mayors in the race? Pete Buttigieg is 3rd in delegate count. Because Mike Bloomberg entered the race late, he set his sights on Super Tuesday and currently has 0 delegates. Elizabeth Warren and Amy Klobuchar have both worked long and hard, have enthusiastic supporters but have earned few delegates. Running for the top office is a hard job.

Will this week bring more downturns in the market? There was a big surge of investors willing to buy late Friday afternoon. It’s a good sign when large investors are willing to take a position before the weekend.

///////////////////////

Notes:

Badger, E. (2019, November 18). Pete Buttigieg Tests 230 Years of History: Why Can’t a Mayor Be President? N.Y. Times. Retrieved from https://www.nytimes.com/2019/11/18/upshot/Buttigieg-2020-race-mayors.html

City News Service. (2019, August 26). Mayor of LA Promises More Help to Solve Homelessness Problem. Retrieved from https://www.nbclosangeles.com/news/local/streets-of-shame/mayor-garcetti-homeless-los-angeles-crisis-response/129407/

Leatherby, L., & Almukhtar, S. (2020, February 3). Democratic Primary Election Results 2020. Retrieved from https://www.nytimes.com/interactive/2020/us/elections/delegate-count-primary-results.html

Photo by Mateus Campos Felipe on Unsplash

Winck, B. (2020, January 23). GOLDMAN SACHS: Lagging fund inflows can drive the stock market even higher | Markets Insider. Retrieved from https://markets.businessinsider.com/news/stocks/stock-market-higher-forecast-inflows-safe-asset-crowding-goldman-sachs-2020-1-1028840905

# Price Points

December 15, 2019

by Steve Stofka

This week I tested Alexa. You know who I mean. She who shall not be named in idle conversation for she will respond. She can do arithmetic, but can she do algebra? I asked her, “What are the factors to the expression x2+2x+1?” She gave me the simple factors x(x+2) + 1. A better answer would have been (x+1)2. Not bad.

We have adapted so quickly to these new technologies. It is normal to talk to a cylinder. Farmers guide their tractors with a cellphone app (Future Farming, 2017). A library of information readily available 24 hours a day. An earthquake on the other side of the planet and we learn of it within the hour.

Despite the accessibility of information and communication, we are bombarded with disinformation. We can’t talk to members of our family or some of our friends because of their political beliefs. Has technology unloosed our own demons from Pandora’s box? In one version of the myth, the demons burst out from Pandora’s box and she was so frightened and alarmed that she closed the lid before the last demon, Hope, could get out. Is hope a curse or a blessing?

We have become accustomed to the entertainment, communication, information and convenience of our phones. They make us powerful. We watched a movie on DVD tonight. I forgot we still had a DVD player. The remote didn’t work. We had to put new batteries in.

On a job site a decade ago, I heard a family arguing. Mom was taking her kids’ phone away because he did something or didn’t do something. A short while later I heard the kid crying. This was a big 12-year-old boy who had received a smart phone as a gift. The phone had become this kid’s heartbeat. He was addicted to a phone.

Have we become a nation of addicts? We are addicted to high energy use even if it does introduce much more carbon dioxide into the atmosphere than the plants, soils and oceans can absorb. Yes, it’s a problem, but …

I forgot my phone last week, turned the car around and came back eight blocks to get it. I was only going to be gone for a few hours. Yes, I know I’m addicted to my phone, but…

Are we addicted to our opinions? God forbid that someone should threaten our political or religious beliefs. Don’t try to change my mind about something. If I want to change my mind, I’ll do it on my own time, thank you. We have so much information at our fingertips that we can’t absorb it all, so we select a few sources and satisfy ourselves that we have a balanced enough perspective.

The stock market has gone up more than 10% in the past one hundred days. Is that the final hurrah before prices dive? Or is the market waking up to a new era of continued low inflation and healthy corporate profits? I’m surrounded by a cacophony of opinion.

In a decade, my calendar app will know what to remind me about. I won’t have to tell it. For that to happen, the app will need access to a lot of personal and financial information about me. “You paid for a subscription to National Geographic magazine last February,” my app will say. “Shall I add a reminder for this coming February?” Sure, why not. I’ve already given away so much information.  I will need an app to guard my information in case someone hacks into the database where my calendar app stores all my information.

Each of us has price points – boundaries of what we’re willing to pay for something. There was a time in my life when I wouldn’t spend more than a \$1000 on a car. Then it was \$2000 for a reliable car. My price points were moving up.

Starbucks has been around for almost 50 years (Starbucks, n.d.). I couldn’t believe it. Sometime in the 1990s I became aware of them. Who would pay \$3 for a \$1 cup of coffee? Lots of people.

A decade ago, who would pay \$700 for a phone? A decent computer could be bought for that price. Apple rolled out the iPhone 3G for \$199 with AT&T as the exclusive carrier (Wikipedia, n.d.). More than a million people bought one in the first weeks. \$199 was just the down payment on the phone. The two-year contract with AT&T included about \$20 extra per month for the phone according to some estimates. That raised the cost of the phone to \$700.

If the stock market goes down 20%, who buys and who sells? What are the price points? What about 30%? 50%? During the 2008 financial crisis, brokers said they got a lot of calls when the market was down 50%. They cautioned their clients that this was the wrong time to sell. Most of the damage had been done. Their clients couldn’t take it anymore. Sell, sell, please sell. There was a last hurrah of selling and then…the buying began in earnest.

What are our political price points? I asked Alexa. She doesn’t know that. What causes people to say, “I’ve had enough!” and go out in the streets to demonstrate? In the past month the world has witnessed large scale demonstrations in Tehran, Iran, in Hong Kong, in Baghdad, Iraq, in Santiago, Chile, and in Barcelona, Spain. I think 2020 will be an American crisis year and we will see such demonstrations in our country. I hope I’m wrong.

////////////////////

Notes:

Future Farming. (2017, June 21). App turns smartphone into a cheap tractor guidance system. [Web page]. Retrieved from https://www.futurefarming.com/Tools-data/Articles/2017/6/App-turns-smartphone-into-a-cheap-tractor-guidance-system-1597WP/

Photo by Colin Watts at Unsplash.com

# Price Plateaus

October 20, 2019

by Steve Stofka

Occasionally the stock market plateaus for six to nine months. The competing market sentiments – positive and negative – that cause a price plateau usually turn in one direction or another. Rarely does this leveling period last for twelve months or more. When those indecisive conditions don’t resolve for a year, what happens next?

Let’s begin by looking at shorter duration plateaus which occur more frequently. The market gets a bit too exuberant or conflicting economic signals make it more difficult to predict the future. Some investors read the data and reach for risk; others read the same tea leaves and opt for safety.

In 1999, near the peak of the dot-com fever, prices plateaued for seven months before going onto new highs in 2000 . Again, the market paused for much of the year.  It was the end of the huge bull market of the 1990s.

In the beginning of 2004, investor indecision caused a leveling of price action after market sentiment had turned positive in 2003. The dot-com bust, the 2001 recession, the 9-11 tragedy, and the Enron and accounting scandals had combined to cut stock values in half by the spring of 2003. Investor optimism following the tax cut package of 2003 suffered when employment gains in late 2003 turned erratic. Investors were wary. Would this be a double-dip recession like the early 1980s?

A relaxation of financial regulations helped spur more residential investment and the market continued upward. The erratic gains in employment were attributed to seasonal volatility in the construction industry. Many factors contributed to the complex international financial environment that spurred a boom in housing. In 2007, investors began to question market evaluations and prices plateaued for six months.

Two recent price stalls lasting more than twelve months seem to buck the trend of shorter-term plateaus. That there have been two in less than five years is concerning. In mid-2014, oil prices began a steep decline. Lower commodity input prices helped the profits of the broad market but by early 2015, investors grew worried that this decline was a reaction to a broad economic downturn. For 18 months, prices leveled. As voters went to the polls in early November 2016, prices were the same as in February 2015. Some voters chose an inexperienced Donald Trump as an alternative to Clinton 3.0 or Obama 3.0.

Shortly after the passage of tax reform in December 2017, investor optimism hit a peak and it has barely surpassed that high since then. The optimism of this year’s gains has only balanced the pessimism and losses of last year’s final quarter. What will happen after this? I don’t know. Investors need to think like fighters who stay balanced on their feet because they don’t know where the next punch is coming from.

# Portfolio Performance & Presidents

October 6, 2019

by Steve Stofka

The employment report released Friday was a Goldilocks gain of 136,000 jobs for the month of September. Why Goldilocks? Not as weak as some feared following news this week that manufacturing was getting hit hard in the trade war with China (Note #1). Not so strong that it ruled out the possibility of another rate cut from the Fed this year. Just weak enough to speculate on another rate cut by year’s end. After several days of big losses, the market rallied on Friday.

Although manufacturing has been contracting, a report on the rest of the economy was more encouraging, although a bit lackluster (Note #2). Service businesses are continuing to hire but the pace has slowed. New export orders have accelerated but new orders in total slowed significantly from August. Something to like, something not to like.

Billions of dollars around the world are traded as soon as the employment report is released each month. During Mr. Obama’s tenure private citizen Donald Trump accused Obama of fudging the employment numbers. Larry Kudlow, now Mr. Trump’s economic advisor, took him to task for that. Mr. Kudlow worked in the Reagan administration and knew well how sacrosanct the employment numbers were. The BLS is an independent agency working in the Department of Labor and its 2400 employees try to collect and publish the most accurate data it can accomplish. The agency’s Commissioner is the only political appointee in the BLS and once confirmed by the Senate, serves four years, the same as the head of the Federal Reserve (Note #3). According to Mr. Kudlow, the White House gets the number the night before only to prepare a press release when the report is released.

Mr. Trump’s reckless behavior helped him take out 16 other Republican presidential candidates in the 2016 election. He acts quickly and aggressively. That lack of caution has led to several bankruptcies, and because of that, no bank in the world will loan him money (Note #4). What if, on an impulse, Mr. Trump tweeted out the employment number shortly before its official release time? Some traders pay a lot of money so that the news will hit their trading desk a split second faster than a conventional news release. It’s that important. An early leak of the employment numbers would cost a lot of influential people big money around the world and would prompt a national if not a global crisis. Forget about the phone calls to foreign leaders to discredit Joe Biden. That would be an act of treason for sure – against the global financial community. Can’t happen? Won’t happen?

Mr. Trump knows no rules. His father protected him when his rash behavior got him into trouble as a child. The elder Trump sheltered Donald from his own mistakes in the real estate industry and his foolish foray into the Atlantic City gambling business. Now that Mr. Trump’s father is no longer there, he depends on others to protect him. He has enlisted a long line of people in that effort. They have come in the revolving door to the White House and left. The list is longer than I imagined (Note #5). John Bolton, the third National Security Advisor under Mr. Trump’s tenure, was the last high-profile team member to leave.

Mr. Trump has said that Americans would get tired of winning so much while he was President. To use a baseball analogy, when he takes the mound, the team doesn’t win very often. People who lose a lot either give up or blame everyone and everything else for their losses. They need to have an ideal environment or get lucky to win. Mr. Trump berates the independent Fed because he wants them to protect him. He needs every crutch he can get. He couldn’t succeed in a war or in the financial crisis because he is not disciplined or organized.

What does this mean for the average investor? Take a cautious approach and keep a balanced portfolio. Betting that Mr. Trump will pitch a good game is a poor bet.

Or is it? At an event on Friday, he claimed that the stock market has gone up 50% since he was elected. Not quite but it is up 42% since the day after he was elected (Note #6). It’s been about 35 months. That’s pretty good. A 60-40 stock-bond portfolio has gone up 30% in that time. Under Obama’s tenure the market only went up 27%. A balanced portfolio went up almost 40% and he had to deal with the worst recession since the Great Depression. The budget battles with Republicans put a big dampener on investor enthusiasm during Obama’s first term.

35 months after the Supreme Court awarded the presidency to George Bush, the market was down 25% but a balanced portfolio was up 21%. Even Mr. Clinton could not best Mr. Trump, although he comes close. 35 months after the 1992 election the market was up 38%. A balanced portfolio was up 40%. The winner? A balanced portfolio.

What might an investor expect? At today’s low interest rates and inflation, a break-even return might be 5% a year, for a total gain of 22% in four years. Will Mr. Trump’s first four years be one of his few wins? Check back in a year. It’s bound to be a tumultuous year.

/////////////////////////////

Notes:

1. Institute for Supply Management (ISM). (2019, October 3). September 2019 Manufacturing ISM Report on Business. [Web page]. Retrieved from https://www.instituteforsupplymanagement.org/ISMReport/MfgROB.cfm
2. Institute for Supply Management (ISM). (2019, October 3). September 2019 Non-Manufacturing ISM Report on Business. [Web page]. Retrieved from https://www.instituteforsupplymanagement.org/ISMReport/NonMfgROB.cfm?navItemNumber=28857&SSO=1
3. Bureau of Labor Statistics. (n.d.). About the U.S. Bureau of Labor Statistics. [Web page]. Retrieved from https://www.bls.gov/bls/infohome.htm
6. Prices are SPY, the leading ETF that tracks the SP500. Clinton: 42 to 58 (approximately) – up 38%. Bush: 138 to 103 – down 25%. Obama: 91 to 116 – up 27%. Trump: 208 to 295 – up 42%. Balanced portfolio returns from Portfolio Visualizer calculated using a mix of 60% U.S. stock market, and 40% of an evenly balanced mix of intermediate term government and corporate bonds. Dividends were reinvested and the portfolio re-balanced annually.

# Reaching Consensus

September 22, 2019

by Steve Stofka

In the early 1980s, scientists at NASA raised the alarm that much of the protective ozone layer over Antarctica was missing. Newspapers and TV carried images of the “ozone hole” (Note #1). In 1987, countries around the world enacted the Montreal Protocol and banned the use of aerosols and chlorofluorocarbons (CFCs). There were some arguments and a few AM radio talk show hosts called the ozone hole a scientific hoax. However, most of the world reached consensus. There will always be crackpots who ride backwards on their horse and claim that everyone is lying about what lies ahead.

Compare those days of yesteryear with today. We have a wide array of media and information outlets. People who can’t make change are self-proclaimed experts on climate change. The Decider-in-Chief can’t reach consensus with himself for more than a day. A slight breeze changes his opinion. Intentionally or not, he has become the Anarchist-in-Chief.

The younger generation is quite upset because they will have to live with the consequences of climate change. The fat cats who make their money proclaiming climate change is a hoax will be dead. Next week there’s a climate summit at U.N. headquarters in NYC. A lot of young people demonstrated in cities around the world this past Friday to let the world know that they are concerned. That’s consensus.

What happened to us in the past thirty years? It’s tougher for us to reach consensus about guns, immigration, climate change, women’s rights, and health care to name a few. Let’s turn to a group of people whose job it is to craft a consensus. In a recent Town Hall Supreme Court Justice Neil Gorsuch pointed out that the nine justices reach unanimous consensus on 40% of the 70 cases that they decide each year. Only the most contentious cases make it to the Supreme Court. 40% unanimity means they agree on many principles. 25-33% of their cases result in a 5-4 decision. Those are the ones that get all the attention. The nine justices who currently sit on the Court were appointed by five different Presidents over the past 25 years. Despite the changing composition of the Court over the past seventy years, those percentages of unanimous decisions and split decisions have remained the same.

Let’s turn to another issue concerning consensus – money. Specifically, digital money like Bitcoin. Some very smart people believe in the future of Bitcoin and the distributed ledger concept that underlies digital money. In this podcast, a fellow with the moniker of Plan B discusses some of the econometrics and mathematics behind Bitcoin (Note #3). However, I think that pricing Bitcoin like a commodity is a mistake.

I take my cue from Adam Smith, the father of economics, who lived during a time and in a country with commodity-based money like gold and silver. Unlike today, paper money was redeemable in precious metal. However, Smith did not regard gold or silver as money. To Smith, the distinguishing feature of money is that it could be used for nothing else but trade between people. Money’s value depends exclusively on consensus, either by voluntary agreement or by the force of government. Using this reasoning, Bitcoin and other digital currencies are money. They have no other use. We can’t make jewelry with Bitcoin, or fill teeth, or plate dishes as we can with gold and silver. The additional uses for gold and silver give it an anchoring value. Bitcoin has an anchoring value of zero.

When people lose confidence in money, they lose consensus over its value. Previous episodes of a loss of confidence in a country’s money include Zimbabwe in the last decade, Yugoslavia in the 1990s, and the sight of people pushing wheelbarrows of money in Germany during the late 1920s.

Like gold, Bitcoin must be mined, a process that takes a lot of electricity and supercomputers but does not give it any value. Ownership in a stock gives the owner a claim on the assets of a company and some legal recourse. Ownership of a digital currency bestows no such rights.

In an age when we cannot reach consensus on ideas like protecting our children at school or the rights a woman has to her own body, we seek consensus with others on more material things like Bitcoin. We seek out information outlets which can provide us with facts shaped to our perspective. When facts don’t fit our model of the way things should be, we bend the facts the way water bends light.

John Bogle, the founder of Vanguard, died recently. He was an advocate of investing in the consensus of value about stocks and bonds. Now we call it index investing. That’s all an index is – a consensus of millions of buyers and sellers about the value of a financial instrument. There are several million owners of Bitcoin – a small consensus. There are several thousand million owners of SP500 stocks. That is a very large consensus, and like a large ship, turns slowly in its course. A small ship, on the other hand, can zip and zig and zag. That’s all well if you need to zig and zag. Many casual investors don’t like too much of that, though. They prefer a steadier ship.

I do hope we can move toward a consensus about the bigger issues, but I honestly don’t know how we get there. In 2008, former President Obama called out “Si, se puede!” but quickly lost his super-consensus in Congress. “No, you can’t!” called out the new majority of House Republicans in 2010. We’ve gotten more divisive since then. Journalist Bill Bishop’s 2008 book “The Big Sort” explained what we were doing to ourselves (Note #4). Maybe he has an answer.

In the next year we are going to spend billions of dollars gloving up, getting on our end of the electoral rope and pulling hard. Our first President, George Washington, was reluctant to serve a second term. Hadn’t he given enough already? In our times, each President looks to a second term as a validation of his leadership during his first term. There’s that word again – consensus.

////////////////////////////

Notes:

1. Images, video of the ozone hole in 1979 and 2018 from NASA.
2. We the People podcast from the National Constitution Center
3. Discussion of bitcoin on this podcast
4. The Big Sort by Bill Bishop

# Strong Reactions

December 30, 2018

by Steve Stofka

Happy New Year!

Dramatic trading days signal a down market. In the week prior, the SP500 index lost over 7%. On Monday, Christmas Eve, the stock market fell to a level that would traditionally signal the beginning of a bear market, which is 20% below a recent high closing price. After a huge rally on Wednesday and a lot of volatile trading this week, the index gained 3%.

A disruptive stock market underscores the importance of asset allocation. The SP500 has lost 10% in December. A conservatively balanced fund like Vanguard’s Wellesley Income (VWINX) lost 1.8%. The fund is actively managed and has 40% stocks, 60% bonds/cash. A fund of index funds, VTHRX, lost 7.8%. It has a more aggressive mix of 65% stocks and 35% bonds/cash.

As I noted a few weeks ago (Hat Trick), there have been repeated signs of a struggle between hope and fear, between competing estimates of future earnings. 7% weekly price falls occur at crises or turning points. In the past sixty years, there have been only fifteen such weeks. Let’s take a look at the most recent.

In August 2011, then President Obama walked away from an informal budget deal with House Speaker John Boehner. The market lost almost 20% but fell short from hitting that mark. Once a budget deal was negotiated, the market recovered but it took five months to make up the losses.

Three years earlier, in October 2008, the market lost more than 7% in a week when negotiations for a bank bailout fell apart. This was a month after the bankruptcy of investment firm Lehman Brothers ignited the financial crisis. The market would take 39 months to recover that October price level. On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act (Note #1). Senate Democrats made many concessions to win a few Republican votes for the bill to gain passage. Once it became clear that the stimulus funds would be trickled into the economy over several years, the market tanked, losing 11% during the month of February. In a final week of capitulation, the market lost 7% in the first week of March. This was the turning point.

A 10% weekly price drop in April 2000 heralded the end of the dot-com boom. The market would not recover for 83 months, almost seven years. An even worse fall came after the market opened following the 9-11 attack. The indictment of the international accounting firm Arthur Anderson sparked doubts about the financial statements of other companies and helped fuel an 8% drop in July 2002.

With six weeks of 7% price drops, the 2000s was the most tumultuous decade since the Great Depression. Strong reactions in the market deserve our attention and caution.

//////////////////////
Notes:
1. The American Recovery and Reinvestment Act

# Engine Flow

July 29, 2018

by Steve Stofka

“Banking was conceived in inequity and born in sin” – Josiah Stamp

In the past two weeks, I’ve looked at the inputs and drains to the economic engine. This week I’ll look at the flow between bank credit, the largest input, and loan payments, the largest drain. Because bankers want to make a profit on the money they pump into the economy, they do a better job of managing the economy than government officials.  Banks manage access to the credit system better than governments and achieve less economic inequality. Whenever governments wrest control of credit creation away from the banks to promote greater equality, the country’s economy suffers.

Let’s begin with the first point; banks must protect their loan portfolios. To do that, they monitor the health of the economy. The Conference Board uses ten data series to construct its index of leading economic indicators to estimate the probability of recession. ECRI uses 50 data series to chart its weekly leading index. These indicators are sensitive and may give a false signal, indicating a coming recession which doesn’t occur. Watching these data series are the banks who form an emergent Artificial Intelligence machine that varies the amount of credit they input into the economic engine.

Let’s piggy back on the efforts and watchfulness of the banks. We can look for a change in the ratio of household credit, an input to the engine, to the unemployment rate, or the ability to drain the input. One quarter’s decline of 2% or greater in this ratio, or two quarters of a smaller decline has been a reliable indicator that a recession is approaching. Below is a graph of the Household Debt-Unemployment ratio during the past thirty years but this signal has been reliable since World War 2.

Bank behavior has accurately predicted the start of every recession since WW2. Is this the holy grail for mid to long-term trading decisions? Not quite. The Federal Reserve does not release the total amount of household debt for each quarter until the end of the following quarter (see #1 at end). However, every month, the BLS releases the unemployment rate, the divisor in the Debt-Unemployment ratio. If the rate is lower than a year ago, no worries. If the year-over-year change in the rate is higher in two consecutive months, worry.

Here’s the same chart with the stock market’s reaction when the year-over-year change has been above zero for two months in a row. Insiders and market movers have lightened their exposure to equities.

Loans add money to the engine. Loan payments drain money from the engine. As unemployment rises, people reduce their loan payments. In managing their risk, the banks react to signs of economic weakness by reducing the amount of credit they issue. Because they are more responsive to evolving conditions than central banks and elected officials, banks manage the economy better than the government.

Access to credit is the key to understanding the disparity in fortunes among Americans. Let’s look at the flow of credit creation in a system where a bank can loan out ten times its deposits. Let’s say I borrow \$10,000 from Bank A for a bath remodel. The contractor might have a gross profit of \$2500 which he deposits in Bank B, who leverages that into a \$25,000 loan to another customer, who remodels her basement. Her contractor’s gross profit of \$5000 is deposited in Bank C, which leverages that into a \$50,000 loan to another customer for a complete kitchen remodel. Only those people with good credit – the haves – can access this money machine. The machine is closed to the have-nots.

Governments have attempted to fix this inequality. The government borrows from the banks, acting as a substitute for the people who cannot borrow. The government then inputs the money into the economy, but this does not make the engine run because there is not enough being drained out in loan payments and taxes. The engine runs on flow – inputs and drains. One without the other damages the engine and makes the country vulnerable to a triggering event which causes collapse and the economic engine blows up. Yugoslavia (1994), Argentina (2000), Zimbabwe (2008) and Venezuela (2017) are the most recent examples.

Quoting an unnamed source, Winston Churchill said, “Democracy is the worst form of Government except for all those other forms that have been tried from time to time.”  Private bank management of credit creation is a terrible system, but far better than the other systems that have been tried.

///////////////////

Notes:
1. With a month delay, the Fed releases a monthly estimate of household debt that excludes mortgages and HELOCs.

Ten years after the recession, the amount of household debt per employee is still above trend. A ratio of debt to disposable income is below trend.

According to the credit reporting agency Experian “Transactors” are 29% of card holders and pay off their balance each month. 43% carry a balance. The rest are dormant accounts. Experian ranks states by the average credit rating of its residents.

Fannie Mae reports that, as of the end of 2017, 37% of the mortgages modified during the housing crisis had defaulted again.

Bank of America clients with High Net Worth reported that their allocations were 55% stocks, 21% bonds, 15% cash, 10% other.

In May, consumer credit increased at a seasonally adjusted annual rate of 7-1/2 percent. Revolving credit increased at an annual rate of 11-1/2 percent, while nonrevolving credit increased at an annual rate of 6-1/4 percent (Federal Reserve)

# Smackdown

February 4, 2018

by Steve Stofka

We tell ourselves stories. Here’s one. The stock market fell over 2% on Friday so I sold everything. Here’s another story. After the stock market fell 2+% on Friday, the SP500 is up only 21% since 2/2/2017. Wait a second. 21%! What was the yearly gain just a few days earlier? 24%! Yikes! How did the market go up that much? Magic beans.

Here’s another story. Did you know that there has been a rout in the bond market? Yep, that’s how one pundit described it. A rout. Let’s look at a broad bond composite like the Vanguard ETF BND, which is down 4% since early September, five months ago.  The stock market can go down that much in a few days. Bonds stabilize a portfolio.

Two stories. Story #1. The Recession in 2008-2009 produced a gap between actual GDP and potential GDP that persists to this day. To try to close that gap, the Federal Reserve had to keep interest rates near zero for almost eight years and is only gradually raising interest rates in small increments.

Story #2. The Great Recession was an overcorrection in a return to normal. The GDP gap was closed by 2014. Here’s a chart to tell that story. It’s GDP since 1981. I have marked the linear trends. The first one is from 1981 through 1994. The second trend is an uptick in growth from 1995 to the present.

What do these competing narratives mean? For two years the economy has been growing at trend. Should the Federal Reserve have started withdrawing stimulus sometime in 2015, instead of waiting till 2017? Perhaps chair Janet Yellen and other members were worried that the economy might not sustain the growth trend. A do-nothing incompetent Congress could not agree on fiscal policy to stimulate the economy.  The extraordinary monetary tools of the Federal Reserve were the only resort for a limping economy during the post-Recession period.

Ms. Yellen’s last day as Fed chair was Friday. She served four years as vice-Chair, then four years as chair. During her tenure, she was the most powerful woman in the history of this country. She was even-tempered in a politically contentious environment. She kept her cool when  testifying before the Senate Finance Committee.  A tip of the hat to Ms. Yellen.

////////////////

Performance

Vanguard recently released a comparison of their funds to the performance of all funds.

///////////////