Last Friday, I started to write about the stock market cycle, prompted by a phone call from my younger son. This is the second installment.
the old model
In a closed economy, unaffected by imports and exports and untroubled by external shocks, the cyclical rhythms of GDP growth–and therefore of the stock market–are controlled by the government. In the US this has meant, theoretically at least, applying stimulus when GDP begins to falter and taking it away when the economy begins to expand at an unsustainably high rate. The peak-to-peak or trough-to trough cycle that this action produces has averaged about four years during the post-WW II period–broken out into 2 1/2 years of up and 1 1/2 years of down.
Not over the past two decades, though.
the world has changed
After almost a half-century of globalization–of governments forging ever stronger economic links with one another–the rest of the world is much more important than previously to almost any nation’s domestic stock market.
In the case of the US, the available data suggest that only about half of the profits of S&P companies now come from the domestic economy. The rest derive in roughly equal amounts from Europe and from the Pacific + other emerging areas.
Surprisingly, this increased economic openness hasn’t been an important disrupter of the US stock market cycle so far. The culprit has been government policy instead.
policy mistakes in the US
In hindsight, Alan Greenspan made a series of monetary blunders in the 1990s and early 2000s that extended economic cycles but created in both cases stock market/economic bubbles that ultimately collapsed of their own weight. The damage these collapsing bubbles created was severe.
1997-1999: the internet bubble
In 1997, a banking crisis in heavily indebted Thailand began to spread to other smaller Asian economies. Mr. Greenspan chose to open the domestic money taps to offset possible negative economic effects on the US, at a time when domestic considerations alone would have had him either neutral or tightening. Two years later, he expanded the money supply further. He feared the possible economic disaster that might occur if all the world’s electronic devices stopped working on January 1, 2000–as prophets of doom like Ed Yardeni were predicting (horse-drawn plows were in short supply, for example, as survivalists planned for a post-Y2K apocalypse).
These actions, however, also allowed the Internet Bubble to form. That was a heady concoction of hype and fraud concocted by investment banks and the loony predictions of internet “analysts” like Henry Blodget (subsequently barred from the securities business) and Mary Meeker. The bubble collapsed when earnings reports showed the so-called TMT business had begun to contract in early 2000, not expand.
2003-2007: the housing bubble
This was a much more devastating episode and a much more complex one.
–The Fed supplied the easy money.
–Mr. Greenspan failed to supervise the mortgage industry the way he was supposed to. “Liars loans” proliferated.
–Congress, which had barred commercial banks from the securities business for their role in causing the Great Depression, let them back into the fray during the late Clinton years–just in time to work their “magic” again.
–Bank and securities regulators failed to stop the spread of complex, badly understood–but nonetheless toxic–derivative securities spawned by commercial and investment banks.
The resulting house of cards began to implode as large numbers of borrowers were unable to make their mortgage payments.
flying by the seat of our pants
That’s where we are now, I think.
The old four-year economic cycle idea hasn’t worked recently. I don’t see much to generalize from in the two most recent cycles that would provide a framework to replace it. Both downturns were caused by systematic shocks. But both emanated from the US. Both had excessively easy money policy at their root. The Great Recession added in regulatory and Congressional incompetence.
The only practical tool I can see is the general principle that government policy is accommodative while the greater worry is economic weakness. It turns contractionary (and upward stock market movement ends) when the greater fear is inflation.
Despite my periodic worries about the apparently high current level of the S&P, I think we’re still in accommodative mode, not contractionary.
One other comment: given that interest rates are zero and that Washington is dysfunctional, the US is especially vulnerable at present to external shocks–though I see none on the horizon and have no strong ideas of when/where one might arise.