Perma Bulls and Perma Bears
Right now, it feels like the financial world is divided into two camps:
- “End the Fed” Perma Bears: They think that the Fed engineered a series of asset bubbles and is responsible for the subsequent crash of those asset bubbles. We just had a big asset bubble and this bubble is now collapsing. The Fed is an unholy abomination that does more harm than good. “Fiat” is a cursed word. The perma bear view of monetary policy is best channeled by this Onion article. The old ones like gold. The young ones like Bitcoin. They both think stocks are terrible to own.
- “Always Buy Stocks” Perma Bulls: They think that the market is mostly efficient and the Fed helps the market avert crises and is a positive force. Buy an index fund and stop obsessing over the Fed, they say. Earnings will increase over time, stocks will pay dividends, and it’s best to just ignore the noise, buy-and-hold. They like to advertise that they don’t bother with macro forecasting and focus on the long term trajectory of stocks.
The two camps disagree with each other pretty intensely. Perma bulls look at most perma bears as either idiots or charlatans. Perma bears look at perma bulls as naive fee-hungry AUM gatherers.
I disagree with both camps about a lot of things and I agree with them about a lot of things.
I think they both have valid points. I also think there are things that they’re wrong about.
I value flexibility.
I occasionally find myself dragged into a dogma or a point of view. I think it’s really important to fight that tendency.
This is a pretty good quote from Charlie Munger on the subject:
“Another thing I think should be avoided is extremely intense ideology, because it cabbages up one’s mind. You’ve seen that. You see a lot of it on TV, you know preachers for instance, they’ve all got different ideas about theology and a lot of them have minds that are made of cabbage.
But that can happen with political ideology. And if you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind. So you want to be very careful with this ideology. It’s a big danger.”
As someone who has had my own dalliances with intense ideology, I can completely relate to this.
Once I develop a worldview, it is very easy for me to be trapped by that worldview, particularly when I only absorb content from sources that I agree with.
I have my biases and so does everyone else.
I don’t think there is a silver bullet to avoid hot-blooded emotional biases completely, but I think it’s important to always consider how I might be wrong.
Perma Bulls and Perma Bears would probably benefit from a similar approach. I’m usually perplexed by the iron-willed certitude that they’re right. Ya’ll really never have doubts that you might be wrong?
What I think the perma bulls are right about
1. Markets are efficient over the long run
Bulls often point out that markets, over the long run, reflect economic reality. Over the long run, they are mostly efficient.
They are mostly correct.
Markets, over the long run, are going to reflect economic reality. This is even true during the last 10 years: the era of quantitative easing and zero percent interest policy.
Perma-bears argue that this boom has been all smoke-and-mirrors and doesn’t have anything to do with what’s happening in the real economy.
Well, what’s a pretty good proxy for what’s going on in the real world?
I think truck tonnage is a pretty good example. Truck tonnage closely tracks actual stock market performance.
It seems like stocks mostly track what’s happening in the real, physical, economy.
Over the long run, the S&P 500 closely tracks the earnings growth of the companies within the S&P 500. This includes the boom of the last 10 years that the perma-bears think is utterly nonsensical Fed manipulation.
Earnings grow over time. This does provide an upward trajectory to the market over time.
Peter Lynch sums this up pretty well in this clip:
2. The Fed does a decent job
Cullen Roche had a great tweet thread the other day, in which he examined the role of the Fed in the nation’s economy.
To sum up the tweet thread, the role of the Federal Reserve is to serve as a clearing system between banks and ensure that the system continues to function correctly.
Before the Fed, busts were always horrifying. This is because any contraction in the US economy turned into a banking crisis, which made everything worse than it needed to be.
The Fed prevents this from happening.
From Cullen’s thread:
As the above chart shows, the Federal Reserve largely succeeded in reducing the volatility of the economy. Now that the Fed intervenes when the turds hit the fan and prevents the banking system from falling apart, recessions are a lot less severe than they used to be.
The Fed was created out of the panic of 1907. JPMorgan stepped in and saved the system. Realizing that we couldn’t rely on one man to save the system forever (JPMorgan wasn’t an immortal Highlander, as far as I know), we needed an institution to prevent these panics from raging out of control.
(Side note: I love at the center of the 1907 panic was the “Knickerbocker Trust.” Is there a more old-timey name for a financial institution?)
Another reason that the booms and busts are less severe is the fact that the Fed generates inflation.
Perma bears hate inflation and usually cite inflation as the reason that we should end the Fed and tear the whole system down.
The reality is that a little inflation isn’t a bad thing. In fact, it’s a wonderful thing. One of the reason that those 19th century recessions were so severe is because when recessions arrived, prices usually declined. This means that everyone was incentivized to delay purchases, hoping for cheaper prices later. This magnified the decline further, creating a deflationary spiral.
Does $1 need to buy the same amount of goods from one year to another? Why? What’s the point? If wages and financial assets increase with the rate of inflation, what does it matter if cash stuffed in a mattress can buy the same goods that they could in 1955?
Even though the Fed existed in the 1930’s, they didn’t intervene appropriately. They let banks fail and it was their job to make sure that the system didn’t collapse. They allowed the money supply to shrink, making the deflation worse.
They had a role and they abdicated it.
No one explains this better than Milton Friedman:
In other words, by abdicating their role, the Federal Reserve allowed what would have been a very severe recession to mutate into the Great Depression. If they stepped in and did their job, they could have saved the system. Instead, by allowing the money supply to shrink and banks to fail, they made the problem worse.
It’s also worth noting that the Great Depression was exacerbated by the gold standard, which prevented us from expanding the money supply in a manner that was necessary.
There is a reason we ended the gold standard: it never worked particularly well. It also broke down in the early 1970’s, when 40 years of an artificially suppressed gold prices started to lead to problems with the US treasury.
What the perma bears are right about
1. Markets enter bubbles
Efficient market theorists will outright deny the existence of bubbles. In fact, they did a good job of bullying everyone from using the term until the early 2000’s after the internet bubble shook out. After the financial crisis, we went to another extreme and started calling everything a bubble.
Eugene Fama, for instance, claims that there wasn’t really an internet bubble. Or, more specifically, that it was impossible to identify the bubble until after the prices collapsed.
This is obviously wrong. Many people predicted there was a bubble.James O’Shaughnessy is one example.
There are often very obvious extreme bubbles. Japan in the late 1980’s is one example, which John Templeton correctly identified. The internet bubble is another. Bitcoin in 2017 was another very obvious bubble. Housing was another bubble, which was predicted by a number of people, including Michael Burry.
The wild swings in the multiple that investors are willing to pay for stocks is a sign that markets are not perfectly efficient and don’t always carefully estimate the present value of future cash flows.
The below is from the data on Shiller’s website:
Does this look like a market that is always rationally calculating the present value of future cash flows, or one that often gyrates between bouts of extreme greed and despair?
The change in multiples reflects that bubbles happen. They aren’t a figment of people’s imagination.
In fact, at extremes, bubbles are predictable. They do happen from time to time and they are possible to identify before prices collapse.
The market in the late 2010’s entered bubble territory. By pretty much every metric available, the market in the late 2010’s was at an extreme of valuation.
2. The Fed makes mistakes and contributes to bubbles
Does the Fed contribute to the cyclical nature of the US economy? Does the Fed contribute to bubbles? Does the Fed make mistakes?
Yes, yes, and yes.
While the Fed does a very good job at containing the effects of panics and ensuring that the system doesn’t go off the rails, they do make mistakes. This isn’t because they are evil. It’s because they are humans. Humans have biases, make errors, and get things wrong.
The Fed probably contributed to the bubble of the 1920’s.
They let the party go on too long and let things rage out of control in the late 1920’s. They should have taken the punch bowl away. Like a 20 year old managing risk at a frat party, they spiked the jungle juice with more Everclear instead of letting things calm down. Then, in 1929, someone called the cops and the fun was over.
The Fed also contributed to the inflation of the 1970’s.
Richard Nixon was dead set on winning his 1972 election and did everything possible to ensure victory. While he was having his cronies break into hotels to help make this happen, he also put pressure on Arthur Burns to ease monetary policy.
We were already experiencing the early stages of inflation, but Nixon wanted to win and didn’t care. He did not want the Fed to apply the brakes. He wanted a booming economy by the time that the election came around. Arthur Burns complied. The economy was doing well once election day came and Nixon won in a 49 state landslide.
Inflation then grew out of control and the Fed started raising rates to deal with it. Then, as if delivered by fate, we faced an oil crisis at the same time. The economy plunged into the horrible recession of 1973-74.
Scrambling to end the recession, the Fed started easing again. They never really got the inflation under control, but ending the terrible recession was a bigger concern.
The recession ended, but the inflation came back.
Inflation didn’t stop until Paul Volcker stepped in and engineered a recession in the early 1980’s to break the back of inflation. This is the recession we probably should have had in the early 1970’s, but Nixon and Arthur Burns didn’t have the political will to do it. Volcker and Reagan had the backbone that Burns and Nixon lacked.
The Fed typically contributes to the cyclical nature of the US economy. I think that the yield curve predicts recessions and booms because it’s a good proxy for how tight or loose monetary policy. They overshoot in both directions.
The Fed usually overshoots when they are raising rates, triggering a recession. Meanwhile, they can leave rates too low for too long, contributing to asset bubbles and inflation.
The bulls have points and the bears have points.
I agree with the bears that the Fed makes mistakes, but I also agree with the bulls that the Fed, for the most part, reduces the severity of booms and busts in the US economy.
Even though they make mistakes, they should also get credit for correcting those mistakes. Yes, the Fed was helmed by Arthur Burns and generated inflation. But doesn’t the Fed get any credit for Paul Volcker ending it?
I think that the 2008 recession could have turned into another Great Depression, but an aggressive policy response prevented that from happening. At the same time, I also think that the Fed contributed to the housing bubble.
I agree with the bears that markets enter bubbles, but I don’t think that the Fed is the sole cause of it.
Bubbles have been happening throughout the history of civilization, with or without a Federal Reserve. The South Sea Bubble and Tulipmania happened without a central bank, after all.
Bubbles happen because humans set prices in markets and humans are emotional beings.
Usually, bubbles start with a kernel of truth like:
1. 1999: The internet is going to the change the world. The companies that embrace the internet are going to dominate our future.
2. 2004: Real estate is a rock solid investment. It only occasionally declines violently. It’s less volatile than the stock market. You can apply leverage to it and generate income.
3. 1988: Japan is outperforming the United States. The country has a highly educated population and they have created an excellent and efficient business model.
4. 2017: Blockchain is a transformative technology.
5. 1980: Gold is a good hedge against inflation.
People take those kernels of truth and go too far with it.
Have you ever gone too far with a good thing? I certainly have! Markets do the same thing.
Does the Fed contribute to these bubbles? Does the Fed contribute to booms and busts? Of course, but they’re not the sole actor here. In fact, they’re probably not the dominant actor.
Our limbic system is probably more to blame for the internet and housing bubbles than Alan Greenspan.
Bubbles are a feature, not a bug, of financial markets. This is because fear, greed, euphoria, and despair are features of the human condition.
Markets are increasingly dominated by computers and algorithms, but that doesn’t stop the fact that the money belongs to human beings and human beings are intensely emotional. This is particularly true when it applies to money that they have suffered to earn.
The perma bears argue that the Fed is both the arsonist and the fire department, channeling the plot of Backdraft.
I’d argue that it’s an institution that has mostly done good for the country and occasionally makes mistakes because they’re controlled by human beings and nobody is perfect.
I think that we had a bubble at the end of the 2010’s and it is unwinding now. On this front, I agree with the bears.
I think the Fed probably made a mistake and waited too long to start raising rates. By 2013-14, the financial crisis was over and it was probably time to start tightening. The low rates led to mal-investment. The low rates probably contributed to the fracking boom, for instance.
I also think that the Fed is responding as it should to the current crisis, agreeing with the bulls.
The Fed is responding to the crisis aggressively, which is what they should be doing when faced with the worst recession in the last 90 years. They are throwing the kitchen sink at a brutal problem. They are doing everything they can to prevent the system from collapsing.
This is exactly what they should be doing!
However, I don’t think that the Fed is an all powerful wizard. For this reason, I don’t think that the Fed can prevent this bubble from unwinding, any more than the Japanese could prevent their market from eventually falling to a fair value.
(And yes, I know that the Japanese bubble was far more extreme than anything we experienced in the late 2010’s. I’m simply using this as an example that central banks aren’t all-powerful and mighty.)
It’s probably best to not be “perma” anything. I try to objectively look at the situation tactically and not through the lens of an ideology. There are times to be bullish about stocks and times to be bearish.
My favorite Pink Floyd song from an album that doesn’t get any respect.
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