As we all know, there are many problems facing the economy and financial markets right now. One of the longest-lived and most pernicious problems is one of the least discussed — or even recognized. For example, this problem is responsible for many American’s longstanding (and misguided) obsession with cutting taxes, which is the primary reason the federal debt has been allowed to explode out of control (and California is on the brink of bankruptcy). This problem fueled the market’s overvaluation in the 1990s, culminating in the infamous tech bubble. It lent a significant tailwind to the crazy lending standards and housing bubble that propped up the bull-market-that-wasn’t from 2003-2007, and the problem is still with us today, preventing us from clearly evaluating conditions in the economy and financial markets — particularly how we arrived at our current state of affairs. Behavioral psychologists bestow two technical terms on this problem — cognitive dissonance and cognitive consonance — but they are two sides of the same coin, or in this case, two sides of the same problem. To understand these terms is to understand one of the major roadblocks preventing us from moving forward decisively as an economy and as a nation.
People are probably more familiar with the term cognitive dissonance — the tendency to ignore, or underweight, information that contradicts our current opinion or set of beliefs. Cognitive consonance is the “flip side” of dissonance — we also have a tendency to overweight information that reinforces our opinions and beliefs. And, with our consciousness severely crippled by these two flaws, we bravely venture forth into the world as consumers and investors, fated never to live up to John Stuart Mill’s vision of homo economicus (“economic man,” the hyper-rational decision-maker in which most microeconomists still believe). Unlike Socrates, however, most of us don’t even know what we don’t know. The tendency to prefer dogma to facts is, in my opinion, one of the main factors that threatens our future prosperity. We can’t embrace a way forward until we fully appreciate the deep hole capitalism has dug for itself.
The Market’s Emotional Roller Coaster. I gave a talk on the economy recently, and my last slide was borrowed from Liz Ann Sonders at Charles Schwab Market Research (reproduced below). It’s entitled “The Market’s Emotional Roller Coaster,” and it depicts 12 stages of emotion that investors go through in a full bear-to-bull-market cycle.
Someone asked where I thought we were in the emotional cycle. Without hesitation I answered “We never finished the capitulation phase back in March, so we’ve been stuck at that point for months,” and everyone groaned — they wanted me to say we were almost through with the despair phase so they could justify not having to experience any further pain, and instead sooth their psyches with false hope for a big bull market in late 2009 or early 2010 — the bull that will bail out their 401(k)s and allow them to resume their borrow-and-spend consumerism. But I don’t think we’re anywhere close to that point yet (and I’m in good company — more on this below). The market lows of March 2009 represented a brief moment of realism, as equity valuations were accurately discounting the torrent of bad economic news we’ve had from just about every indicator — real estate values, consumer spending, employment, corporate profits, etc. But we couldn’t “bear” Dow 6,400 or S&P 666 (yes, that was the March low), so our collective consciousness created a better narrative — a market rally that sparked 3 months of drivel about “green shoots.”
This is as good a place as any in this little tale I’m telling for you, the reader, to wake up to the reality of our current situation. The average 1-year trailing P/E on the S&P 500 has remained in the low to mid teens during this bear market (see the graph below). The last recession and bear market that approached this one in severity, during the 1970s-1980s, resulted in a market P/E ratio of less than 8. The current recession is far more severe than that one, yet equity valuations remain far above their levels from 1981-82.
If estimates of Q2 corporate earnings are reasonably accurate, the current level of the Dow and S&P imply a trailing P/E ratio of approximately 40! Without a dramatic rebound in earnings in the next couple of quarters — and how likely is that? — the implication is that stock prices could fall another 50-60% before equities are priced to deliver their “normal” long-term annual returns of about 7% (real). And even from much lower levels, earning 7% per year from stocks would require that GDP and corporate profits resume growing at their rates from previous decades — something few respected forecasters believe is possible (elaborated on below).
To understand why equity values discounted economic events more realistically in previous bear markets we need to ask “what’s changed since the 1970s?” The answer is “us.” Or, more precisely, the media we consume and the way many of us use it to fuel our dogmatic fantasies. We use our media subscriptions, the internet and television to indulge in cognitive dissonance and consonance to the point that many of us have talked ourselves onto a precipice of dogma. For those of you balanced on this precarious ledge, I’m going to try to talk you down. Why do I care if you jump or fall, someone might ask? Because, like it or not, we’re all in this together. If the dogma-addicted don’t get themselves into rehab they’re going to pull us over with them.
What are some of the dangerously dogmatic opinions I’m referring to? Well, here are a few. Have you not figured out by now that Ronald Reagan is the engineer of our crushing federal debt? You might have to read that one again — Ronald Reagan is the inventor of borrow-and-spend government. He was a Keynesian, but instead of tax-and-spend, he preferred to borrow-and-spend; it’s basically the same recipe. The data are in, folks — $14 trillion of debt and counting — the fictional Arthur Laffer “tax-cuts-pay-for-themselves” narrative has been proven false beyond a shadow of a doubt. California tried its own version of this with Proposition 13 and they are on the brink of bankruptcy. It’s not unthinkable that our federal government could be in similar straights soon. If a household cannot escape this basic common sense, then neither can a business or a government — you have to pay your bills as they come due. You either raise taxes or cut spending, but you have to live with a balanced budget every year. But once Reagan’s minions got us believing that a different alchemy existed, hundreds of politicians have reinforced that dogma in their hollow campaign promises to the point where about a hundred million Americans now accept something false as true. And these believers find it too painful to look at the simple, factual history of the situation — that’s cognitive dissonance. They instead prefer indulging in even more Laffer and Grover Norquist — cognitive consonance. Many would rather “feel” right than have to pass through a phase of recognizing previous opinions as wrong to ultimately arrive at opinions and views that are more accurate.
Here’s another one — are you all riled up over “news” stories about the shocking involvement of government in business? Especially those Karl Rove psycho-torials in The Wall Street Journal? Well, here’s another little fact you need to digest. Government gets involved in business because business asks them to. That’s right — pop your eyes back in your head and read it again — it’s another undeniable truth. Businesses in the U.S. spend billions every year begging politicians to intervene on their behalf. It goes by the politely sanitized term of “lobbying” — but we all know it’s a legalized form of bribery. Moreover, the worst-performing industries that wreak the most havoc on the lives of citizens spend the most. That’s right. It’s well-known that banking and finance spent at least $4 billion (officially) in the past decade lobbying politicians. Banking and finance — the industry that’s been in a crisis every 10 or 20 years since the 1800s! In second place is — you guessed it — the health care industry. This is the industry that charges Americans more for prescriptions than the citizens of all other countries. It’s also the industry that makes us pay almost twice per capita for health care compared to Canadian and French citizens. It’s the industry that’s engineered a massive propaganda campaign to convince Americans that it would be too expensive for everyone to have health insurance and access to health care. Too expensive? How hard-bitten of a nation have we become when we elevate an economic issue (health care profits) over a human rights issue (access to affordable health care)? If we took a fraction of those lobbying fees and used them to hire consultants from Canada and France, not only would we have more affordable health care with better outcomes (Americans are unhealthy!), our housekeepers, landscapers, restaurant waitpersons and the person who cooked our dinner the last time we ate out could afford to take their kids to the doctor! Approximately 1 million Americans declare bankruptcy each year because of medical bills — and many of them have insurance!
So what type of cognitive dissonance are we engaging in regarding the economy? The carefully-scripted narrative that’s broadcast every day on Fox Business and CNBC must be recognized for what it is. Under the guise of “objectivity,” every negative opinion is immediately balanced by a guest suggesting that he sees “green shoots,” and the next great bull market is right around the corner. The market will come back because it’s always come back. We have forgotten the useful cliche, “Consider the source.” The programming on these business channels first and foremost serves their advertiser base — the financial services industry. The industry that wants to gather assets, at minimum, and even better, get you to trade as much as possible, while it continues spending a significant fraction of its considerable profits to buy the political influence that ensures that they’re free to do it again and again, regardless of the havoc they wreak on our economy and way of life. Thus programs with names like “Fast Money” and actors like Jim Cramer, who 5 days a week stars in a sitcom where an escapee from a lunatic asylum sneaks into a television station, raids the wardrobe department, dresses up as if its Halloween, and speaks in tongues.
In a world too full of mis- and dis-information, may I instead suggest that you let yourself be guided by the opinions of long-term thinkers with successful track records. They do exist. People like Warren Buffet (who warned us that “derivatives are weapons of financial destruction” many years ago), Jeremy Grantham, Bill Gross, and Mohamed El-Erian, all of whom are on the record regarding “green shoots” — they never existed. Bryan Marsal — whose firm is overseeing the unwinding of Lehman Brothers, which is about as close to the smart money as anyone gets — told CNBC on July 6 that he doesn’t see spending coming back — ever. In the past weeks and months, every one of these individuals has tried to guide our view of the future of capitalism to more realistic expectations. The rampant consumerism and the leverage that propped up the economy for the past decade was not sustainable — game over. Corporate profits, when they begin growing again, will grow more slowly from their 2009 lows. Like Japan, we’re going to get older and save more. And that’s the good news. The United states may have recently passed into what I believe to be the ultimate indignity — we now have to manage the value of the U.S. dollar to please the Chinese, so that we can entice them to keep buying more of our nearly worthless debt. And the Chinese keep buying it — at least for now — but in ever-shorter maturities, which provides them with the option of not rolling over their holdings when these shorter-term T-notes come due over shorter horizons. Much of the recent steepening of the yield curve is due to financial, not economic events — when the Chinese buy shorter-maturity debt and shun longer-maturity debt, the yields on short-term debt stay low while the yields on long-term debt rise, and voila, we have a steeper yield curve. Not one that’s forecasting a recovery, however — one that sadly depicts how, like any profligate debtor, the U.S. is now forced to manage its financial affairs to please the whims of its foreign lenders rather than benefit its citizens.
The first step towards breaking free from this sad reality is to recognize it. The U.S. cannot make a shred of progress until we realistically assess what we’ve become as a nation, and how we got here. Tax cuts aren’t going to save us, nor is denying our neighbors and fellow citizens access to health care. That’s more dangerous dogma that will just dig us in deeper. When we embrace the same values that we claim to admire in the Great Depression/WW II generation — thrift, economy, modesty, charity, generosity and a strong work ethic — we’ll have taken at least one authentic step on the long path to being a great nation of great people again.