A game of chicken

Much start-stop strangeness is happening in the stock markets.  Ostensibly this is due to companies reporting earnings that either exceed or are in line with expectations; yet whose revenues fail to excite.  This is the very same issue I wrote about over a year ago as the U.S. economy started to recover.  See my post on “operating leverage” for the full story.

Companies can frequently find ways of cutting costs in order to milk out extra profit.  But the grand daddy/mommy number is revenues (i.e. sales).  Sales are driven by actual customers making actual purchases.  As we all know the U.S. consumer is depressed and grumpy.  That means that you and I have anxieties and worries and we are not spending much on non-essential items.  Hence, revenues are disappointing investors.  Consequently, stock market investors are more in a selling than buying mood.  Because consumers look to the stock markets as an indicator of economic health, a declining market makes them even more anxious, depressed and grumpy.  That, in turn, makes it hard for companies to have confidence that it is time to hire more workers.  That, in turn, makes consumers more anxious, more depressed and more grumpy.  See where this is headed?

We are currently in a big ole game of chicken.  Who will blink first in the “I am confident enough to spend” game?  Will consumers get over their fears of job loss and economic ruin and actually start spending money regardless of stock market performance?  Or will businesses hire employees despite the fact that they can’t justify additional workers because of a lack of additional revenues?  Can you see the central axis around which this entire episode is revolving?

FEAR.

Or rather, not real fear, but anxiety.  The problem with anxiety is that it leads to such a clenching of the spending sphincter that real problems can eventually unfold.  That would then lead to circumstances where real fear was warranted.

So what can we do as investors?

For starters (and unfortunately, I have been saying this for awhile), many great companies are selling very cheaply right now.  If you are waiting for conviction that the stock markets are really stable and are not going to drop further from here, I understand.  After all, I would like to have back my approximately 7% in losses suffered since my “buy” call at the beginning of May.  However, if you broaden your horizons beyond the next 6 months and look back 40 years and look forward 10, you will see that great U.S. businesses (including monopolists like Google) are selling very inexpensively relative to historical valuation levels.  Not only, but they are selling cheaply relative to their future prospects.  Are consumers not using Google because they are worried about…..EVERYTHING?  No.  Are consumers going to stop buying toilet paper?  I hope not.

One of my favorite investment models comes from a gentleman named Edgar Peters who once described how market crashes happen.  Let me share that with you.

Stock markets typically have investors who are short-term and long-term focused.  Generally, short-term investors are much more sensitive to gyrations in news.  That is, they will sell based on minor news stories of little true effect.  When the short-term investors sell because of the news they need to find a buyer.  That is, someone willing to provide them with cash for their shares.  Typically the provider of liquidity is the long-term investor.  But what happens when the long-term investor is also deeply affected by the news and is unwilling to provide liquidity?  A big, big market decline.  In other words, market crashes happen when long-term investors become short-term investors.  So what does this all mean?

It means that right now many long-term investors are considering becoming short-term investors.  This is why, in my opinion, the stock market has been so volatile (up and down) for the last several months.  What can you do?  Be a long-term investor.  Liquidity rules in big declines.  When you execute your buy orders, do so on big market decline days and bid for your shares below the current market price if allowed by your broker.  And most importantly, take confidence in that you are buying an interest in an actual business and not in a piece of paper.  That actual business makes actual products and is run by actual people.  That means that you have purchased something real and something that is interested in survival and success no matter what is happening economically.

Separately (I know this is a long post), let me discuss possible policy remedies on the part of politicians…

1.  Keynesian economic theory has been criticized exiting the recession.  Mostly because the recovery has not been kick ass despite massive government spending.  However, the real heart of Keynesian economic theory is not government spending.  It is that the government is assumed to be a more permanent, less volatile, institution than businesses.  That is, government stands outside the realm of the economy.  Consequently, government is one of the institutions (another is the military) that can step in from outside of the economy to influence the economy.  So we should be looking for some political assistance to break up the silly “game of chicken” taking place between consumers and businesses right now.

2.  It’s about the consumer, stupid!  The U.S. government ought to be passing legislation to the benefit of the U.S. consumer.  To some extent this has been done.  There have been: first time home buyer tax credits; cash for clunkers; extensions of unemployment benefits; jobs programs from the U.S. government, etc.  However, none of these has led to the unemployment rate being dented.  And without jobs, the consumer will remain anxious, depressed and grumpy and the economy will remain mired.  So what can the Feds do?

One suggestion is to waive Social Security and payroll taxes for businesses for 18 months.  While potentially very expensive, it will definitely lead to more hiring.  With money in her/his pocket, the consumer’s confidence will increase and their spending is likely to increase, too.

Another suggestion is to enlarge the Federal government’s programs spending.  Countless roads and bridges around the country have been improved by U.S. government jobs programs over the last two years.  Here’s an idea: hire the unemployed to go to the Gulf of Mexico and help clean up the despicable BP oil spill.

Another suggestion: insist that the long-term unemployed go back to a trade or technical or university school to learn additional job skills.  The Feds could agree to pick up half of the cost of the tuition as long as it was job skills related.  Or a tax break could be provided to folks.  The point though is that something like this has to be mandatory.

3.  It’s also about the investor, stupid!  To turn investors more into long-term investors eliminate the long-term capital gains tax for 3 years.  That is, if you hold onto your equity investment longer than a year, then any gain is free.  Additionally, though much more dramatic, you could raise the capital gains tax on the short-term investor, say up to 40-50%.  People would be outraged.  But then again, before they deployed their capital they would be very careful about what they bought and once they did buy they would hold on for awhile.  This would dramatically reduce financial market volatility for several years, though it might induce a stomach-churning sell off in the first several days after the law had passed.

The game of chicken is going to be corrected one way or another.  One method is just to let market forces play themselves out – the reactive method.  The other method is to do something about it – the proactive method.

Jason