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November 15, 2004

Ignoring Equilibrium

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

It's amazing how many financial debates could be ended with nothing but a supply-demand chart. As the stock market has moved from very overvalued to dangerously overvalued conditions, analysts have increasingly resorted to non-equilibrium arguments to support a bullish perspective.

A few from the past week include a) the argument that higher oil prices will at some point reduce demand, leading to falling oil prices, b) the argument that a falling dollar makes it cheaper for foreigners to buy our Treasury bonds, which should lead to a stronger dollar (both arguments articulated several times on CNBC), and this from Barron's; c) price momentum has “made the market into what economists call a Giffen good, something for which demand rises as the price goes up. Or maybe it's a Veblen good, a status item whose appeal rises with price.”

Man, you know something's not right with the market when normal people start talking about Veblen goods.

[Geeks note: Giffen goods are products that are so important as staples and yet so inferior that the income effect of a price rise completely reverses the normal substitution effect away from the good. With Veblen goods, price is actually an argument of the utility function, resulting in a demand curve that bends forward where price is high and quantity is low, so you can get multiple points where the demand curve meets the supply curve. Technically, these are equilibria, but they're basically theoretical curiosities. The Veblen argument is interesting though, because to the extent that investor's risk preferences may increase simply because prices are rising, you could very well get a Veblen-like effect, which we normally call a “bubble.” Since it's momentum and not price that impacts risk preferences, however, that argument also implies that the bubble can burst at the first sign of flagging momentum. Something to remember even if you like the argument.]

While non-equilibrium arguments often seem intuitively plausible, they are usually just analytical errors. I blame Keynes, who taught us all that the world is one big demand curve.

The problem is that as economists, we analyze price as being determined by supply and demand. We put quantity on the horizontal axis, and price on the vertical axis, and then draw a little upward sloping supply curve and a downward sloping demand curve. But once you put price on that vertical axis, you no longer get to use it as a factor that will shift demand! Once supply and demand intersect to produce an equilibrium price, it is only non-price factors (income changes, interest rates, Martians landing in Kansas) that get to change that equilibrium – which they can do only by shifting the supply and demand curves to another position.

So we don't get to say that supply and demand have resulted in a high price for oil, and now the high price for oil will reduce demand for oil. We don't get to say that supply and demand have resulted in a weaker dollar, and now the weaker dollar will lead to higher demand for dollars. We don't get to say that supply and demand have resulted in higher stock prices, and now those higher stock prices will lead to higher demand. Once supply and demand intersect, the argument stops.

Aside from these, the most common errors of economic analysis are ones that fail to take the entire equilibrium into account. These so-called "partial equilibrium" models are, again, usually a reflection of the Keynesian demand-is-everything mentality.

A personal favorite is the idea that reducing deficits by raising taxes will lead to lower interest rates. Think through this. If you increase taxes, yes, you can reduce the supply of government bonds, which you might think would lead to higher bond prices. The problem is that you've also reduced the income of people with high propensities to save, which would have otherwise been used to buy bonds, so the demand curve for bonds also shifts back. The clear result is a reduction in the quantity of government bonds, but the effect on bond prices (and interest rates) is not clear at all. As an empirical fact, you'll find no obvious relationship at all between interest rates and government deficits. It doesn't work that simply. You have to think through the whole equilibrium, including both the supply and demand for funds, as well as whether those funds are used productively or unproductively.

Similarly, while you can certainly get an economic pop with a lump sum tax cut (though they tend to die off over several quarters, as this one threatens to do), you certainly don't stimulate gross domestic investment or economic productivity by doing so. The reason is that if you haven't cut government spending, the lump sum tax cut must be financed through an increase in Treasury bond issuance. In equilibrium, the extra money in the hands of the public must be used to buy the extra bonds issued by the Treasury. No doubt in the current instance, China and Japan have delayed our full realization of this harsh fact. But with the current account deficit now bursting at the seams, it's likely that weak growth in gross domestic investment will weigh on U.S. growth prospects for years to come.

Reforming Social Security

A good understanding of equilibrium also helps in evaluating proposals for Social Security reform. First, Social Security is essentially a promise of real goods and services in the future. Because the majority of consumption involves services, which cannot be held in inventory, and even manufactured goods would be subject to obsolescence if held in inventory, it's fair to say that the only thing that will determine the nation's ability to provide real goods and services to future retirees will be the productivity of the nation in the future. To the extent that future productivity depends on current investment and (via the savings-investment identity) current savings, any plan that fails to raise the nation's propensity to save is useless in terms of making the Social Security program solvent without increased taxes.

Second, without cuts in federal spending elsewhere, privatizing Social Security will neither increase the “rate of return” on Social Security investments nor increase its solvency. This is the cruel fact of equilibrium. Barring current spending cuts, any diversion of Social Security taxes toward private accounts must be offset by an increase in the issuance of government bonds. No new net savings are produced by this shift. While private investors may buy more stock in their Social Security accounts, this stock will be sold by other investors (indeed, must be sold, in equilibrium) in order to buy the increased supply of government bonds. At the margin, there may be a small benefit to stocks to the detriment of bonds in order to accommodate that portfolio shift, but since stocks compete with bonds as investments, the change in their relative valuations need not be large. In any event, there is no reason to believe that partially privatizing Social Security will increase the net demand for stocks, nor that it will be a massive benefit to the stock market, particularly without cuts in federal spending elsewhere.

Finally, the belief that more stock market investment means more capital investment and higher future productivity is the result of confusion between financial investment and real investment. Real investment (capital spending, housing, factories, etc), as I continually pound away about, must be financed by real savings: private savings, government savings, and foreign savings – each representing an excess of income over consumption. In equilibrium, new savings result in new investment. Companies acquire these savings by issuing new bonds and shares of stock. So new net issuance of stocks and bonds goes hand in hand with new savings. But without new savings, any increase in demand for stocks from one sector must be matched by sale of stocks elsewhere, or by retiring existing bonds by issuing new stock. In any event, no new capital is formed.

Tax Reform

Fortunately, there are possibilities for changing tax policy in ways that could improve incentives, employment and the allocation of the nation's savings, even without changes in the level of federal spending. Most of this benefit would come from flattening the nation's tax structure.

While I'm a strong advocate of flat taxes with generous exclusions at low income levels, even flat tax advocates have got to begin by recognizing how Social Security fits into the tax burden. For example, it's quite true that the top 1% of income earners in America earn about 20% of the income. They also pay about 36% of the income taxes. So the income tax is progressive and does lower the burden at the lower end of the income scale. But if you include payroll taxes, the share of total federal taxes paid by the top 1% falls back to about 25%, which isn't much larger than their share of the income. In fact, if you consider employee contributions to Social Security (economists widely agree that the incidence does indeed fall on workers), roughly 75% of Americans pay more in Social Security taxes than they pay in income taxes.

So while you wouldn't notice it from the rhetoric, the nation's overall tax structure is already fairly flat. But that's like putting your feet in the fireplace and your head in a bucket of ice and saying that the room temperature is about right. Simply put, income taxes are progressive, but the Social Security tax is one of the most regressive tax systems on the planet. Regardless of the level of income, Social Security taxes only apply to the first $87,000 of wage income (not profits, not dividends, not capital gains). Warren Buffett and Bill Gates both max out their contributions to Social Security pretty quickly. This, as conservative economist Alvin Rabushka notes, serves “to maintain the fiction that Social Security is a retirement insurance program in which contributions are linked to benefits.”

Of course, wealth and income, like many economic variables, are lognormally distributed. Exclude the part of the income distribution more than one standard deviation above the mean (which is what Social Security does), and you lose about half the potential revenue. Want to get more revenue from Social Security and secure much higher national employment? Cut the Social Security tax rate sharply, but apply it to all income, including not only wages but profits and other non-wage income. This would also serve as an effective hike in the minimum wage, while increasing rather than lowering labor demand. And at that point, a national flat tax will make sense as well.

Market Climate

As of last week, the Market Climate for stocks was characterized by dangerously high valuations and moderately favorable market action. The price/peak earnings multiple on the S&P 500 is now 21.08, exceeding the peaks of 1929, 1972 and 1987, and revisiting the condition best known as irrational exuberance. The historical norm on prior peak earnings (whether or not earnings were actually at a current peak) is 14. The historical norm on actual record earnings (as is the case today) is 12. The current dividend yield on the S&P 500, despite substantially higher dividends, is just 1.71% (the historical norm is about 4%).

Look. Earnings remain well contained in the same 6% peak-to-peak growth channel that has contained them for the past century, including the roaring 90's. Even if we assume further growth to fresh peak earnings 5 years from today and a terminal P/E of 18 (which is still so far above the historical norm of 12 on actual record earnings as to make the assumption foolishly optimistic), the total return on the S&P 500 over the coming 5 years would be [(1.06)(18/21.08)^(1/5)+0.0171(1+21.08/18)/2 - 1] = 4.56% annually. When foolishly optimistic assumptions still produce disappointing conclusions, investors should be prepared for bad things to happen.

That's not to say that stocks cannot move higher, but we continue to observe speculative merit without investment merit. Indeed, investment merit is so lacking, and speculative conditions so extremely overbought (the recent, uncorrected spike is beyond belief on a P&F chart), that a vertical decline off of this “high pole” shouldn't be ruled out. Patently overbought conditions in patently overvalued markets are the stuff that ruined retirements are made of. Though many investment managers are frantic to “make their number” for the year, there's a certain recklessness in taking substantial investment risk here.

Of course, the fact that we still observe speculative merit means that we do continue to have a moderate exposure to the potential for further market advances. In the Strategic Growth Fund, this is accomplished by hedging our diversified portfolio of stocks with index put options without a fully matched short position in the corresponding calls. Equivalently, you can think of the Fund as fully hedged, but with a long position in call options sufficient to establish a positive exposure to further market advances, should they occur. Given very low option volatilities, the effective rate of time decay on those calls is quite small as well. So I still expect the Fund to benefit from further market strength, but we certainly don't rely on a renewed market bubble, which is what investors have to rely on if they take a lot of risk here.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations but modestly favorable market action. We increased our position in Treasury Inflation Protected Securities on recent weakness, and the Fund continues to hold about 15% of assets in precious metals shares as well. Clearly, with bond yields still relatively low, the current account deficit still enormous, inflation pressures still evident in commodity prices, and rising short-term interest rates likely to create further velocity-induced inflation on the monetary side as well, I am not comfortable with a large exposure to nominal bonds. Still, the continuing potential for a weaker U.S. dollar and a slower U.S. economy provides reasonable support for holding investments driven by real yields. Both TIPS and precious metals shares fit that bill well, which is behind our modest but comfortable exposure in those sectors.


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