Crashes are the result of a shift from a positive self-reinforcing cycle to a negative self-reinforcing cycle.
Cycles in business and investment tend to be self-reinforcing. That is true because most men don’t think, they imitate. Economics needs to revise its view of man as rational, because it hurts to think differently. It is much easier to go with the flow of your relatively successful neighbors, and imitate them. Thinking for yourself is needless effort to many. Why bother with that when doing well is a simple thing?
The trouble is, early imitators are few, because the signal is not so big. Late imitators are many; the signal is big, and wrong. The dumb money arrives at the end of a boom. At that time, asset prices are so high that the asset must make gains over the next ten years in order to cover the capital cost of the investment. At peaks, it would pay better to hold fixed income, and not play in the hot asset.
At the peak, it only takes a few sellers to overcome the market, because all of the dumb money is exhausted. They are fully invested. Valuation-sensitive buyers are wary. This is one reason why markets rise slower than they fall. Credit expands to aid the boom, but when the bust comes, new credit is cut off rapidly. Thus we have crashes, and the economy never moves as quickly as the market, but the economy moves with more persistence.
I want to attack this from a different angle. In 1929, before the crash, there was an article by J. J. Raskob in Ladies Home Journal entitled, “Everybody Ought to Be Rich.” Think about that title. Stocks flew as a result of the easy money policy of the Fed in the ’20s. Some had invested in the market and made a fortune up to 1929. Was that sustainable? No. Did many keep it? No, very few.
But now suppose that everyone *had* invested in the market in mid-1929, off of Mr. Raskob’s advice. Stocks would have soared further, and crashed worse. Why? The pricing of stocks is not arbitrary — a high price must be justified by high earnings relative to where an investment grade bonds yield. As it was, the highly indebted economy of 1929 was ripe for a fall, with earnings and bond yields falling dramatically. At least the Great Depression solved their debt problem — the Great Recession isn’t doing it for us.
But can everyone be rich? Gotta break it to you, the answer is no. Part of it is relative — there will always be some differences wealth/income because of a number of factors: some work harder, some work faster, some invest better, some get a better starting position, etc.
But part of it is absolute. Some jobs don’t make sense unless you have less-skilled workers to accept lower wages for picking fruit, daycare, delivering pizza, etc. In a society where almost all people marry and have more than two kids naturally on average, that means many of those low level jobs will fall to the young. In societies where the birth rate is low, a lot of those jobs go to immigrants from poorer nations. Now if you accept the idea that there is a spread of abilities in people, you know that there are less-skilled people by the time they arrive at age 25. Some of it is natural. Some of it is laziness. Some of it is bad planning. Many of those that are less skilled will occupy the low-end jobs, and in a society with reasonable population growth, there won’t be much room for immigration.
Everyone ought to be rich? Because they invest? If everyone were a value investor of high degree, and we parted with our excess income regularly to invest, where would the opportunities be? In a situation like that, brighter and more motivated people would try to start businesses where they levered their own abilities without trying to play on the secondary markets, assuming they could find people to work with them.
The idea that “everyone ought to be rich” is hooey. There are rare times when an asset class gets on a roll and seems invincible:
- Stocks in the 20s, 50s-60s, 80s-90s
- Bonds in the 80s-00s
- Commodities in the 70s, 00s
- Cash in the 70s
- Real estate in the 20s, 70s-80s, first half of 00s
But to profit in those eras, you would have to know the right place to be, have proper discretion make wise investments, AND have enough funds socked away in order to make the wise investments. By the time someone writes a book/article “Everyone ought to be rich,” or “How you can be rich by flipping real estate,” etc., it is too late. And please ignore the scam ads where penny stocks create millionaires — that applies to those few selling the penny stocks, not those buying.
Few people have achieved great wealth through investing. The ordinary sorts are those who manage other people’s money in public markets, and a lot of it, and do a middling-to-good job, so that clients don’t leave. Other do it through private equity, but there again, they are levering other people’s money. Then there are those that use mostly their own money, like Buffett, Munger, etc., and find undervalued situations relative to prospects regularly. Those are precious few.
Society has people that make money off of:
- Managing physical assets
- Managing businesses
- Managing financial assets
That last category gets too much attention. Most people have better advantage upgrading their skills, or owning private businesses that they understand well. That may not make them rich, but it might make them well-off.
There are booms and busts, and each period has self-reinforcing behavior. It is difficult to time booms and busts. Some get the booms; some get the busts; very few get both. It is tough to make money off of the boom-bust cycle and keep it. It is really tough to make your living entirely through investing, unless you inherit it. Work to enhance your skills to your best advantage wherever you work.
But no, everyone can’t be rich, and we have to accept that reality, and reflect that in government policy. Encourage free and fair competition; eschew crony capitalism. Don’t give anyone, rich or poor, an unfair advantage.
Finally, recognize what the neoclassical economists won’t admit — you can’t get rid of the boom/bust cycle. It is a fact of life, and all of the tinkering with policy will never eliminate it — it will only intensify it.
By David Merkel, CFA of Aleph Blog