Economic Chicken and Egg Quandary

Posted by   admin on    July 6, 2010

Economic Chicken and Egg Quandary

Which came first, the chicken or the egg?

This question has a reputation for being impossible to answer and, over the ages, the worlds most thoughtful philosophers have considered it a conundrum - a difficult question to answer.

Over the past two months, the performance of the US stock market and that of the economy are somewhat a similar quandary. Economic data reflected that the US economy entered the second quarter of this year with plenty of economic recovery momentum and exited with very little. The only objective data points that occurred were that the stock and bond markets reflected fear making a comeback  bond yields went significantly lower and so did stock prices.

In this context, objective data refers to observing near term historical data and events that are independent from subjective opinions and forecasts. 

When we talk about subjective data, we are referring to the predictive musings (forecasts) of investors, traders and economists. Currently the traders and investors forecasts are reflecting opposing views and economist forecasts are mixed. To understand why, lets review the roles of each:

The Investor. This player generally seeks to know plenty of fundamental information about his or her investment. Traditional financial analysts fit in this category and operate under the belief that sound investing requires thorough fundamental analysis of a security to determine if it is attractive or not. For example, to increase the probability of making a good stock investment, an individual should try to buy that stock at a good price. In order to do that, the investor needs to determine if the current price of the investment is attractive relative to others by studying earnings trends, current and future business environments, interest rates, and many, many other factors. In making the investment, the investor is not concerned with what is going to happen to the price of the stock the next day, because investments are longer term in nature.

The Trader, on the other hand, uses other information in seeking to generate quick short-term profits. This may be puzzling to some, since the traditional concept of stock ownership involves shared ownership in the prospects of a company, group of companies or a country's economy. The trader has little use for the concept of ownership. Rather, he or she is more interested in the short term dynamics of supply and demand and how to quickly turn a profit. A trader is not trying to predict what is going to happen in the next year; his or her goal is turn a profit as soon as possible.

The Economist is a different breed of participant whose work provides valuable input for both traders and investors. Economists study how society distributes resources, such as land, labor, raw materials, and machinery, to produce goods and services. They perform research, collect and analyze data, monitor economic trends, and develop forecasts on a wide variety of issues, including energy costs, inflation, interest rates, exchange rates, business cycles, taxes, and employment levels, among others. Preparing reports, including tables and charts, on research results also is an important part of an economist's job, as is presenting economic and statistical concepts in a clear and meaningful way for those who do not have a background in economics. Some economists also perform economic analysis for Governments and/or the media. Larry Kudlow is an example of an economist working for a media company - CNBC.

As a side note, in todays day and age, it is not unusual for economists to be in the money management business and those who do are more likely to fall into the investor role. As economists are more big picture player than the traditional stock pickers, exchange traded funds (ETFs) offer an opportunity to complement their work quite well. Yet, there are economists who use their work to trade the markets as well.

So, why is the performance of the US stock market and that of the economy similar to the chicken and egg quandary?

The Quandary

The quandary is this: Are stock and bond markets guided by the economy; or is the economy guided by stock and bond prices? Which comes first?

In the long past, I've always believed the economy has guided stock and bond markets. However, due to the cause and deepness of the recent recession and the fragility of the recovery and investor behavior, I'm beginning to think that the economy is being guided by the markets. In the second quarter of this year, it sure looked like the markets had impacted the economic numbers. Again, economic data reflected that the US economy entered the second quarter of this year with plenty of economic recovery momentum and exited with very little!

Human behavior has much to do with how the economy and the stock and bond markets perform. And, in this context, human behavior is almost always driven by the emotions of fear and greed. These emotions are not bad  when indulged in moderation. However, too much greed promotes excessive risk taking  causing asset bubbles and borrowing over ones head, etc.; while, too much fear promotes excessive risk aversion  is a deterrent to prosperity causing personal to economy wide recessions or depressions.

Stock and bond prices go up when there are more buyers than sellers; and stock and bond prices go down when there are more sellers than buyers. Greed creates buyers, fear creates sellers. In todays electronic age and with  24 hour per day  dedicated financial news coverage, the markets sentiment of fear and greed can change quite rapidly. One can observe, by the large swings in the markets that the trend of sentiment can change many times in a single day  sometimes with good reason, and other times as a result of persuasive rumors or speculations.

The economy, however, has historically been less susceptible to directional changes in sentiment swings. Maybe, because an economy improves with consumers confidence  the opposite of fear  and has long been comprised of many more decision makers than investors, traders and economists. As consumers regain confidence, greed provides the stimulus for people to risk pursuing a business opportunity. And successful business opportunity pursuits create new jobs  which then serves to reinforce confidence and add more fodder for the economy to grow. And, these events take a much longer time to play out. Unlike the volatile markets, economic up-trends and down-trends play out over much longer periods of time. In fact, to the average person, the markets should look schizophrenic by comparison.

Over the short term, it looks like the economy is being guided by the markets; and over the long term, the markets have more often been guided by the economy. Yet their relationship seems to have become more intertwined.

Now more than ever before, a larger number of people have money at work in the markets through retirement plans. And, as a result, they base more of their economic decisions upon whether the markets are up or down. Couple this with the rapidity with which financial information is currently being disseminated and society has a heightened awareness to be fearful or confident about their futures.

What Might we Expect Going Forward?

At present, investors have been bullish  looking for the economy to continue to improve and for the markets to continue going up; traders have been bearish  looking for the economy to deteriorate and for the markets to go down; and economists are mixed. Of the economists that are mixed: Those that have been guided by the recent data trends of the economic recovery are bullish; and those that are fixated on government over-spending and the threat of higher taxes are bearish.

In furthering this attempt to sort it all out, lets recap the roles of the investors, traders and economists. Investors look for reasons why others should become greedy or fearful about a particular investment(s); they make their calls and wait for the rest of society to notice and act on the same opportunity or pitfall. Traders are guided by immediate patterns of fear or greed in the markets; they make their calls on very current market trends and seek to ride the wave of the perceived emotional momentum. Economists study the fear and greed of groups of societies (communities, industry sectors, countries, etc.); they base their calls on historical and current trends and may inject how future events may change the course of fear and greed in a societal unit.

Here are some reasons for my bullish view based upon the above:

  • Investors see ample positive signs in the economy and relatively attractive value in the stock market. They are players who are more vested in the outcome of their viewpoint(s) as their view is longer-term;
  • The bullish Economists are those who seem to be relying more on the current data and less on forecasting the effect of future events on fear and greed. Nobody has a crystal ball and predicting behavior is no easy task. Any number of factors can influence the direction of behavior for the masses.
  • The bearish Traders are following trends and trend patterns that predispose them to believing that the trend is down. Yet the markets are more fickle than the economy. And every Trader is aware of the old saying: the trend is your friend, until it isn't.
  • The bearish Economists believe that many of the worlds developed nations  including the US  are spending well beyond their means and will be soon raising taxes in an effort to make up the difference. They believe that sovereign debt investors will revolt causing interest rates to rise significantly and threaten the global economy; and, that probable tax increases will take more out of consumers pockets and cause the effect of reversing this fragile recovery. There is also a concern about too much government regulation in-process and coming out of Washington, DC that is idling business planning and spending from benefiting the recovery.

Don't get me wrong, the threats concerning the bearish Economists portend potentially bad consequences for the economy. However, I also believe that there are plenty of reasons those dangers can be averted.

First, government over-spending was needed to reverse the trend of the economy towards recovery. Yet, now it is important that the spending needs to taper down significantly. Maybe increasing taxes will be necessary in the future, but not until the recovery gains more momentum and is less fragile. Cutting spending and raising taxes at the same time could well be more than the recovery can bear.

Next, I agree that too much regulatory reform is taking place in Washington. Businesses will stay on the sidelines and only make modest investment decisions until they understand the rules of the game. This will keep unemployment high for longer than necessary as a result. I'm of the belief that the financial reform bill working its way through the system will do more harm than good and is less necessary than believed. If existing laws were better enforced for most of the last decade and Washington were more fiscally prudent, I believe we wouldn't have faced too big to fail and could have experienced a much milder or no deep recession.

Lastly, I believe that voters are preparing to make changes in our elected officials coming up for re-election in November and will be voting more fiscally minded candidates in office. Look for the tea party groups and their favored candidates to gather momentum as we near November. Voters do not want to remain in fear and more are fiscally minded than Washington gives credit for; they want to regain normalcy and rebuild their lives after the Great Recession we just experienced. Voters understand that we need to cut spending and nobody wants to pay more in taxes if it can be avoided. Political grid-lock in Washington isn't a bad alternative and I think it might be the most likely outcome. Nevertheless, I don't begrudge the bearish Economists efforts. Maybe their discourse can be viewed as providing the political jaw-boning that is needed to effect the needed change in Washington's politics.

We continue to remain substantially invested as we believe in the adage that profits are the mothers milk for a rising stock market. And, I identify my approach to investing as comparable to the Investor / bullish Economist types discussed above.

In the midst of the downturn, US corporations cut expenses so significantly, that good profits can be reasonably expected even if the economy only grows modestly at present. Yet, modest growth will slow the ability to make significant progress in putting more people back to work. I believe that investors should not be disappointed with slow but steady growth  it is much better than fast and hard market ups and downs. However, until more fear abates, I'm afraid that the markets will be choppy  experiencing wide swings  until the recovery becomes more entrenched, less fragile and less influenced by persuasive pessimistic rumors or speculations.

Following my bullish view has not come without taking some lumps, our portfolio clients ended the month of May down 15.40% and June down 8.62% - we missed putting out our letter last month. Here are some comparative numbers for you to review:

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