The events of 2007 and 2008 have shown the limitations of the mathematical method. The credit crunch was not foreseen by anyone that I read, but it came as a shock to the number crunchers — it took them completely by surprise.

It did not come as a shock to the economic historians, who happily settled down to discuss the resemblances between this credit crisis and earlier ones, going back to the South Sea Scheme in 1720 or the Wall Street Panic of 1907. The economic historians know that similar events had happened before, and had also learned, often by painful experience, that such events are quite common.

Neither group foresaw the actual events of August 2007, but the historians were quite able to put the credit crisis in a context of other crises. Even though both groups were taken by surprise, it was the mathematicians whose previous forecasts were stood on their heads.

By and large, historical economists, who follow the example of major English economists such as Maynard Keynes or W.S. Jevons, do not regard timing as any more predictable for economic shocks than for earthquakes.

One can say that there is a build up of stress in the system that will eventually have to be released. One cannot say that the release of pressure will occur next Tuesday or next August or even next century.

Some say the big earthquake will happen along the San Andreas Fault in California. It may come tomorrow; it may come before 2050; it may not happen for 500 years. We can usefully predict what and where, but we can very seldom predict when. This makes expectation difficult to quantify, though all markets are based on expectations

What we do know from economic history is that there is a cycle of debt that has to be relieved. In twentieth century history the war debts of the first war played their malign part in the European depression of the 1920s and eventually in the Great Depression of the 1930s. The Austrian School of Economics, and particularly Friedrich von Hayek, developed the Debt-Deflation theory of the business cycles. Hayek indeed foresaw the risk of a deflationary crisis as early as 1927.

Keynesian economics, as expounded in his General Theory, 1936, were criticized at the time for an inadequate appreciation of the negative aspects of excessive debt. Bankers of the Gold Standard era attached great importance to the balance sheet rather than the profit and loss account. I get the impression nowadays that people read the current account much more carefully than they do the capital account — partly because they think that off balance sheet financing has reduced the transparency of the balance sheet itself.

As a result, government balance sheets, bank balance sheets, corporate balance sheets and personal balance sheets have all deteriorated. Finance ultimately depends on the security of capital, and weak balance sheets, at any level, are exposed to risk and to problems of opportunity cost.

An old-fashioned banker would now be calling for strengthening of balance sheets at every level. But the liquidation of debt takes years to accomplish and diverts fund from current consumption. The 2007 credit crunch calls for liquidation of debt, but that is bound to have a deflationary effect.

Regards,
Lord William Rees-Mogg
July 17, 2008

Economic Schools of Thought was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

He had a lot of success managing money in the happy market before things turned ugly in 1973-74. “Stocks we had went from 10 times earnings to six times earnings,” Sosnoff reflects. “There I was, Ahab, tangled in my own harpoon whale lines and being carried down to the depths by the malevolent great white whale. Of what did it avail that all my earnings projections were uncannily accurate? We were buried just the same.”

All of which is to say there is nothing quite like the right stock at the right time. One interesting guidepost to look at is the longer-term market cycles of what’s in fashion and what’s not.

Which brings me to one of my favorite charts. It is a conceptual portrait of market history — stretching back to 1977. Take a look at “The Tree Rings of Markets Past.” This chart marks off the booms and busts of various sectors. You see fat eras of plenty, bulging like swollen rivers after a rain, and you see thin areas of hardship, like parched desert sands:

It shows you the market capitalization share of the S&P 500 by sector. The S&P 500 Index, a popular stock market index made up of 500 stocks, is broken down into 10 sectors, as you can see. Market capitalization is the value of the sector in the marketplace. As stocks rise, market caps swell.

Looking at the chart, you can see what’s been popular. In 1980, the energy sector was hot and grew to represent nearly one-third of the S&P 500. It collapsed thereafter, and energy sector investors took a beating.

In the 2000 bubble, you can see how technology stocks came to represent an even greater share of the stock market, nearly 35%. I’m sure I don’t need to recall how badly mauled investors in technology were as the bubble popped.

The folks who make the S&P 500 Index are always adding and subtracting names from it, so it’s not a true representation of what these sectors did. But the Index still manages to capture the spirit of the past rather well.

I love this chart for all that perspective it gives in one glance. And because it shows how great tides shift in the market. Now unfolding is another great shift.

You can see how financials have come to represent a sizable piece of the S&P 500. Today, they make up over 21% of the whole. Financials have enjoyed a long stretch of prosperity. If the past is any guide, you want to avoid the dominant sector.

Even if you didn’t know anything about the market’s tree rings, you’d want to avoid most financials now. With cracks in the mortgage business giving way, the financials are under significant pressure for the first time in a while.

As John Hussman of Hussman Funds shows, financial stocks have many marks against them, generally speaking. Bank reserves against loan losses sit at a 32-year low. Yet overall net charge-offs are up 50% from a year ago. “Given the thin coverage of the banking system for such losses, rising charge-offs and loan loss reserves are likely to bite deeply into earnings,” writes Hussman.

Historically, the best time to buy financial stocks is when the group trades for about book value. Yes, as Hussman point out: “Currently, the typical multiples are two and often three times that level.” Most financials, he says, “are only ‘cheap’ based on comparisons with very recent norms and on the assumption that the high profitability levels of recent years will be sustained indefinitely.”

But let’s get back to that chart for a minute…

The energy sector — even after taking a much larger part of the pie — is far from danger levels. As recently as July 2004, energy was sitting there at only six and change. It has expanded since by a sizable margin. Yet even today, it’s less than 10% of the S&P 500 — far from bubble levels.

If avoiding the fattest sectors proved helpful, then perhaps giving the skinny sectors a good look might be a good idea. In that vein, note the squeezing of basic materials so tightly it barely registers on the chart.

What is the basic materials sector? It’s all the companies that do the dirty work and bring up metals like copper, nickel and zinc. It’s all the stuff that we need to build pipelines and power grids and more.

Nothing lasts forever. Things won’t always stay bad and can’t possibly stay good. This is some of the most elementary investment thinking but is painfully true. If you can keep an open mind and remain patient, the goldmine you missed years ago may be right in front of your face before you know it.

Sincerely,
Chris Mayer

December 5, 2007

Sea Change was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.