The Nature of Market Booms and Busts

In a recent article on SeekingAlpha.com titled “The Bigger The Boom, The Bigger The Bust” by William Koldus, it was suggested that:

• “…we have already forgotten the lessons that should have been learned in 2008.”
• “Monetary policy makers have set the course for the next ‘Minsky Moment.’"
• “A good dose of volatility in both the stock and bond markets would be good for all financial market participants.”

In our review of Koldus’ work, we’ll attempt to demonstrate that analysis on stock market history should not begin with evidence that is narrowly defined. Our introduction of secular trends in the market might help put current market moves into perspective.  We’ll also show that the Federal Reserve might not be as powerful as some might think.  Finally, we hope to demonstrate that a moving market, either up or down, is good regardless of the extent and timing.

“Forgotten Lessons”

What are the forgotten lessons that should have been learned in 2008? According to Koldus, the forgotten lessons are that there are no new era[s] of smooth sailing for risk takers and that any perception of easy going was neither manageable nor permanent.  How had we arrived at this false nirvana in the stock market and economy? According to Koldus, markets were somehow assured by money manager’s “ability” to construct low volatility portfolios that would ensure growth with reduced risk.  The permanency of this low volatility market would be assured to investors, traders and speculators through the implementation of similar strategies by monetary authorities (Federal Reserve Bank).

Unfortunately, There is no such thing as a forgotten lesson in finance. To paraphrase James Grant, “In science knowledge is cumulative, in finance knowledge is cyclical.”  The cycle is, as the market climbs new attitudes take shape about what is to come.  Conversely, as markets descend new and different attitudes take shape about what the future holds.  Lessons are strictly for people who want to learn and therefore are willing to look well into the past to understand where the “new attitude” stands relative to what history has shown us.  We don’t think there are any lessons in finance that are forgotten, only new attitudes that shape misguided outlooks for future prospects.

“Monetary Policy Guides Markets”

Stock Markets

As much as there are no forgotten lessons in finance, only new attitudes, so too is there an unwillingness to look too far back in history to check the claim.  According to Koldus, the stock market is set for a “Minsky Moment” due to the actions of monetary policy makers (e.g. Federal Reserve) based on the recent experience of 2008.  A “Minsky Moment” is supposed to be “…a sudden major collapse of asset values which is part of the credit cycle or business cycle.”  There are many reasons why this view seems legitimate on the surface but does not explain the many instances where it isn’t just inaccurate but potentially false.

First, let’s start from the premise of the often cited claim that the Federal Reserve policy is the primary reason for the stock market rise since 2009.  This could be true except, the current rise is not exceptional when compared to previous declines.  As an example, of the previous 28 major stock market declines since 1835 until the present, the current rebound is exceeded by previous market rebounds of 1864, 1835, 1981, 1852, 1923, 1929 and 1987.

What in the world does this mean?  First, it means that the current rebound (2009 to 2016) has not been as phenomenal as some have touted. Looking at the above chart of market trough to peaks starting in the indicated year followed by the subsequent rebounds, we see that the 2007 decline of –54.46% was not exceptional and thus far, when ranked against other market rebounds, is only ranked 8th.

Second, three prior rebounds occurred when there was no central bank in existence (1864, 1835 & 1852).  Let’s assume that the Federal Reserve really has as much control or power as some claim.  If this is true and we excluded all market performance from the year 1987 to the present as Fed dominated markets (Greenspan era and after), 1987 and 2007 would be excluded as the top performing markets to rebound.  This leaves three pre-Fed periods of exceptional gain (1864, 1835 & 1852) and three post-Fed periods of exceptional gain (1981, 1923 & 1929).  Basically, there is not much to the claim of the Fed’s superiority to control markets to the upside when the performance without a Fed is equally as dominant.

But wait, where do claims about Federal Reserve dominance in stock rebounds really stand?  On very unstable ground simply because, no one seems to be accounting for the fact that the declines are just as recurrent as the rises.  You would think that if the Fed is really in control they would be more concerned with stemming market declines as much as they are at stimulating any rise.  So let us humor the crowd that says a bear market begins when the stock market declines by -20% or more.  After reviewing the list below, ask yourself this, has the Fed been negligent in its duties when it comes to controlling stock market declines (blue/bold text pre-Fed era)?

If the theory of market control by the Federal Reserve were true then the regularity of market declines of –20% or more should have been reduced after 1914.  No such luck, as large stock market declines have been fairly consistent.

According to Koldus:

“Throughout market history, large booms have been followed by large busts, and everyone should realize where we are at in this inevitable market lifecycle today.”

Although Koldus mentions “market history”, there is scant evidence that supports this claim.  In addition, of the scant evidence provided, the majority of it falls within the period from the year 2000 to the present (2016).  To address this lack of market history we refer back to the period from 1824 to the present and then ask  “Does the bigger the boom equal the bigger the bust?  We don’t think so as the chart below ranks market declines with the preceding cyclical market gains and subsequent decline.

Again, we don’t think that the bigger the boom equals the bigger the bust.  Looking at the period after 1929, the decline of –88% in the Dow Jones Industrial Average was a reflection of a policy that was flawed and has since never been repeated on the same scale, as discussed in our articles titled “Recovery From 1929 Crash Was Quicker Than Most People Think” and “Dow Jones' Decline Largely Impacted by Index Changes”.

Look Secular, Not Cyclical

Now, let us make a point that is required but might be dismissed.  Market declines don’t matter when we review the market from a secular perspective and not a cyclical standpoint, which is only offered up in Koldus’ article.  A secular market trend usually last from 16 to 24 years.  In a secular bull market, there has been a tendency for the market to rise 10-fold while in a secular bear market major stock markets will trade in a wide range.  Take for example the last secular bull market of 1978 to 2000 as seen below.

At any point within the secular trend of the market, investors were definitely worried and certain that a collapse was coming and those concerns might have been justified when viewed on a cyclical basis.  However, in the run up to the peak in 2000 with the subsequent collapse to the 2003 low, the 10-fold increase in the stock market was not what most investors were expecting.  Not to be outdone, how did the last confirmed secular bear market from 1966 to 1982 look?

As can be seen in the secular bear market from 1966 to 1982, the Dow Jones Industrial did not materially move above the 1,000 mark while trading in a range.

The difference between a cyclical market and secular market is that many cyclical moves up and down can exist within one secular market move.  In our article titled “Dow Theory: Secular and Cyclical Markets” we detail easily identifiable secular and cyclical market moves.  In that 2012 article, we suggested that the current secular bear market should come to an end in 2016 based on when the bear market began.  This means that the stock market would break out to the upside and establish a new secular bull market trend.

Koldus, like most investors, worries about the recent news associated with the last cyclical decline and overlooks what is the bigger picture. While there will always be large market declines averaging –39% on a cyclical basis, investors need to build this into their investment plans and move away from popular notions of bubbles which are predicated on nearsighted assessments which only induces fear and irrational responses rather than objective analysis.  The overarching theme of the markets are that, depending on the time and the timing, there is always risk and opportunity.

This leads to the most prominent problems with the secular view on stock market moves which are…time and timing.  First, few investors are able to have their money in the stock market for the full extent of a secular rising move which tends to range from 16 to 24 years.  Timing is another problem.  What if you’re in the middle of a secular bear market?  Do you invest or do you wait?  Trying to figure this out can be a headache.  In a secular bull market the answer would seem easy enough, just buy the market and stay the course.  For most investors, the real challenge is cyclical market volatility.

Bond Markets

As for the discussion of bond markets, Koldus has the following to say:

“The rationalizations of why money has been recycled back to the U.S. markets make sense on the surface, as does the logic of why U.S. bond yields could go lower, particularly since they offer relative value compared to most of the world's sovereign bonds. Having stated this, proponents of infinitely higher bond prices are generally not even open to debate”

In recent years, when talking about the bond market, it has been popular to refer to things like relative values and “papering over” any hiccups that might occur.  However, what is often overlooked is the fact that the bond market has been in a normal secular declining trend since 1981.

This declining trend in bonds isn’t some concocted plan to “paper over” recent catastrophes any more than the rising interest rate period from 1942 to 1981 was an effort to curb excessive boom periods.  Instead, what we’re witness to is the long-term cycle in inflation/deflation which lasts approximately 54-60 years, with interest rates and monetary policy simply being a symptom rather than a cause.

Being open to debate on the topic of whether interest rates will rise or fall is an exercise in futility when no acknowledgment of the long-term trend is forthcoming.  The concept of “papering over” current problems in the market by the Federal Reserve completely ignores the previous periods when the market was in the exact same position.  Analysis in a vacuum makes all interpretation interesting but ultimately wrong.

Again, what we’re witness to is only a reaction by the Federal Reserve to the current environment rather than the actual cause.  However, if, when speaking of the stock and bond market, your point of reference is only within a particular point in a cycle then the analysis can come up flat or meaningless but sound very convincing.

Much has changed since the early days of the American economy, chief among those changes is the fact that there is a highly diverse.   Such changes to the economy automatically reduce business cycle volatility.  For this reason, all emerging countries seek a diverse economy to experience the same smoothing effect on the business cycle.  However, a blind faith in the Federal Reserve’s ability to destroy or boost the economy through perceived powers applied to interest rates, “money printing” and guidance through telegraphing upcoming policy shifts places undue credit where it isn’t deserved.

“Good Dose of Volatility”

Koldus says:

“Central bankers have forced market participants to forget a crucial lesson that should have been learned by investors during the past twenty years. And that lesson is, give Wall Street or investment bankers in London, Tokyo, or Shanghai time and a sustained period of non-volatility, and these financial alchemists will create a bomb that has the potential to bring down the entire financial system.”

It seems that in the eyes of Koldus, the concept of a rising market is the absence of volatility.  However, markets run in cycles mirroring or preceding the prospects of the good, the bad and the ugly in the economy.  The changing cycles in the market are represented by volatility.  The absence of volatility can be found in a 3-month certificate of deposit or a savings account. If you’re an investor, you want volatility.  In financial markets, if there is no volatility there is no movement either up or down.  If volatility only came in doses we wouldn’t be investors we’d be “savers”.

On the matter of volatility to the downside, Charlie Munger (right-hand man to Warren Buffett) says the following:

“I think it’s in the nature of long term shareholding with the normal vicissitudes and worldly outcomes and in markets, that the long term holder has his quoted value of his stock go down and then by say -50%. I think you can argue that if you’re not willing to react with equanimity to a market price decline of -50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get, compared to the people who do have the temperament who can be more philosophical about these market fluctuations .”

Addressing the issues of downside volatility is important when considering investing, however, upside moves are equally as much a part of volatility as downside moves.  To perceive a (bond or stock) market that moves up and experiences few, if any, downside moves as low-volatility is mistaken.

Conclusion

Koldus’ work might be an interesting read.  However, fundamental issues are overlooked or simply ignored.  as demonstrated above, stock market history doesn’t begin in the year 2000 and “the bigger the boom” does not equate to “the bigger the bust”.  A near religious faith in the power of the Federal Reserve is undeserved and potentially harmful.  Any short-term analysis that doesn’t include long-term review does a disservice to the short-term assessment and conclusion.