Graph showing the stock crashes for years ending in '7'. (From The Wall Street Journal, p. B18, Oct. 18)
Many headlines have been generated in the past nine months or so warning of an imminent stock market correction or even crash. Such headlines have included:
'A Case For The Bulls Is Hard To Warrant' - James Mackintosh
E'verything Is Awesome! Now Is The Time To Sell Your Stock' - James Mackintosh
'Warning Signs Mount As Stocks Stumble' WSJ, 'Business & Finance', Aug.. 21
'Crashes Are Inevitable But That Doesn't Mean Now' (WSJ, Oct. 9)
Perhaps the pithiest advice offered in these assorted stories was by Mackintosh in his 'time to sell your stocks' piece, noting:
"Investors believe that bear markets only come with recessions, and so reassure themselves that there is no sign a recession is imminent, repeating the mantra that 'economic cycles don't die of old age'. Unfortunately, this is both wrong and useless.
First, 20 percent drops happen outside recessions, as in 1987 and 1966. Second, economic cycles can be killed by a financial crash, and as the late Hyman Minsky pointed out, the longer a financial cycle goes on, the more likely it is to turn to excess and end badly. Worse, there is no reliable method of forecasting a recession, so even if it were true that only a recession can end a bull market, that isn't a lot of use to investors."
"When everything is awesome it is best to prepare for things being a little less awesome in the future, even at the cost of missing out on some of the gains."
A few months earlier, Mackintosh's column was preceded by one ('Do You Have The Stomach For The Next Stock Crash? ) in The Denver Post Business Section, written by Charlie Farrell, the CEO of Northstar Investment Advisors LLC, wherein he writes:
"For the past eight years, investors have enjoyed a steadily increasing stock market. Memories of the 2008 crisis have largely faded and many investors have forgotten that sinking feeling. But if you want to avoid the mistakes investors made during the last crisis, you should start thinking bad thoughts. Yes., bad thoughts. Start training your brain and your guts for the next stock market decline. Why? Because big stock market crashes and declines happen and they pose a big threat to your wealth."
Of course, Farrell is quite correct and it's been literally known since the birth of the stock market that all bull markets end in veritable crashes, the purpose of which is a massive transfer of wealth to the upper crust . (See e.g. George P. Brockway, 'The End Of Economic Man').
SO there have been endless warnings, some of which have come to pass, i.e. such as those who were correct about the October, 1987 stock crash. But what about the more recent one in 2008? Too many members of the "dismal science" missed it, perhaps because they didn't put 2 + 2 together to grasp that years of the Bush tax cuts - taking place during de facto 'war time' - preceded it. Add to that the fact that a bubble had been created and you had all the elements necessary for a crash. All that was needed was a 'trigger' and that was provided by the infusion of financial toxic waste known as credit default swaps. These unstable instruments (buried in bonds) found their way into everything from collateralized mortgage obligations to pension fund investments and most were classified as 'AAA' despite the fact there was no basis to do so.
The failure of the credit agencies themselves to be onto the junk bond nature of CMOs and allowing the presence of fractions of toxic CDS bonds in each – then designating the whole AAA - led directly to the collapse of the credit markets in 2008.
Fast forward now to the latest take: that the current market may well be on its way to defying a nasty "unlucky -sevens" trend (WSJ, 'Market's Unlucky -Sevens Streak In Danger', p. B18, Oct. 18). What ate we talking about? Basically, a pattern that has held for U.S. blue chip stocks for at least the last 130 years.
"For the past 13 times that a year has ended in seven, going back to 1887, the Dow Jones Industrial Average or its predecessor has suffered a sharp downturn at some point between August and November. The average downturn has been a little over 13 percent according to the research firm Leuthold Group."
The piece by Spencer Jakab goes on to note:
"The most memorable of those drops was 30 years ago. The 1987 stock market crash sent the Dow tumbling 22.6 %, its worst single day percentage loss ever, including a selloff that began earlier and wiped 36 percent off the Dow's value."
So the gist of Jakab's piece is this unlucky streak is "in jeopardy". But is it really?
The problem with all pattern -based reasoning or templates is that there is no bearing on actual causes, and causal relations. Theodore Moois, the author of the monograph 'Predictions', for example, (p. 156), observes that the factors that most impacted the 1987 crash were the energy oscillations at that time in terms of energy prices, relation to consumption, and lack of investment in new jobs. In particular "stock market plunges manifest themselves during the downward trend of the energy oscillation and hence correspond to a downturn in the economic cycle".
Let us also note in conjunction with this that the 1987 crash occurred after a major tax cut was enacted via the Economic Recovery Tax Act in 1981. Included in the act was an across-the-board decrease in the marginal income tax rates in the United States by 25% over three years, with the top rate falling from 70% to 50% and the bottom rate dropping from 14% to 11%. The cut itself may not have been as toxic, but Reagan also launched a $2.2 trillion defense spending spree - effectively burning the fiscal candle at both ends. This, I believe, set the stage for the 1987 crash.
The 2008 crash occurred after years of the Bush tax cuts which drove the deficit even higher and also: "The 2000s- that is the period immediately following the Bush tax cuts – were the weakest decade in U.S. postwar history for real, non-residential capital investment. Not only were the 2000s by far the weakest period but the tax cuts did not even curtail the secular slowdown in the growth of business structures." (Financial Times analysis, in 9/15/10)
What one must conclude is that while the credit meltdown with CDS infusion was the proximate trigger for the 2008 crash, the Bush tax cuts were the effective distal cause - specifically on account of the lack of investment, which itself created an "energy sink" in terms of the transactions between workers-consumers and employers. Because many workers barely benefitted from the cuts , millions had to go into credit card and other debt to make up for the dearth in earnings. Much of this was needed for health care, and utilities. The narrow vision of these tax cuts - like the current ones on offer (giving those making over $5m /year a $200k cut) left the jobs-energy landscape as a wasteland. Also, the bubble created - including by selling millions of sub-prime mortgages to borrowers who couldn't really afford them, paved the way to a crash.
For reference, the top marginal tax rate during the Bush years (for income tax) was reduced to 36% from the 39.5% during the 1990s Clinton Years. Over the 1950s and into the 1960s (until about 1964) the top marginal rate was at 91%, going down to 65% by the mid -60s. The low level of 50 % wasn’t reached until Reagan arrived and passed his tax cuts in 1981. (And we note here that the debt as a percentage of GDP rose to nearly 30% during the Reagan years, caused by his tax cuts in conjunction with mind boggling military spending.)
Another telling statistic from the FT study is the growth rate for investment in equipment and software for business. They note that this ranged from 5.7% a year to 9.9% in earlier decades but was reduced to 1.9% during the 2000s. Meanwhile, “average growth in non-residential structures ranged from 1.3% to 5.7% from the 1950s through the 1990s but declined 0.8% during the 2000s.”
A fair and timely question must be asked at this point:
Why do Republican tax cuts lead, counter-intuitively, to industrial decline, stagnant wages, and finally financial collapse? The fact is that high marginal tax rates strongly correlate with economic growth. In December 2010 Mike Kimel examined the effects of cutting the top marginal tax rate:
….real GDP also grew faster under Bill Clinton, who raised taxes, than it did under Ronald Reagan. In fact, from 1981 to the present, the period in which Reagan’s philosophies have reigned triumphant, the correlation between the top marginal tax rate and the annual growth in real GDP has been positive. That is to say, higher top marginal tax rates have been associated with faster, not slower real economic growth. Conversely, lower top marginal tax rates have coincided with less economic growth.
The positive relationship between the top [higher] marginal tax rate and the growth in real GDP is very nearly bullet-proof. For instance, it extends all the way back to 1929, the first year for which the government computed GDP data. Additionally, higher marginal tax rates are not only correlated with faster increases in real GDP from one year to the next, but also with increases in real GDP over the subsequent two, three, or four years. This is as true going back to 1929 as it is for the period since Reagan became president. In fact, since the Reagan Revolution took hold, similar relationships have existed between the top marginal rate and several other important variables, like real median income, real private investment, consumer sentiment, the value of the dollar relative to other major currencies, and the S&P 500.
Lower tax rates in any given year are associated with slower growth rates for each of these variables, whether those growth rates are measured over periods of one, two, three or four years.
What is the takeaway here? Although Treasury guy Steve Mnuchin predicts a stock market crash if the Reepo tax bill isn't passed, e.g.
The fact is that all the historical evidence points to the opposite. I already referenced the lack of investment during the Reagan and Bush tax cut years, but less well known was what transpired before the 1929 stock market crash. Calvin Coolidge signed into law the Revenue Act of 1924, which lowered personal income tax rates on the highest incomes from 73 percent to 46 percent. Two years later, the Revenue Act of 1926 law further reduced inheritance and personal income taxes; eliminated many excise imposts (luxury or nuisance taxes); and ended public access to federal income tax returns. The tax rate on the highest incomes was reduced to 25 percent.
The result was a speculative frenzy in the stock markets, especially the application of structured leverage in what were called at the time "investment trusts." In September 1929, this edifice of false prosperity began to wobble, and finally crashed spectacularly in October, 1929.
Again, I submit that energy oscillations - usually as liabilities -are also tied to these tax cuts and lower tax rates. It takes energy, after all, to build new plant for labor or even less carbon -generating energy infrastructure, e.g. solar collectors, wind turbines.. But if corporations merely use the money to buy back shares as a form of tax avoidance, the energy goes nowhere useful. (As Joseph Stiglitz noted this morning on 'Morning Joe'). Lower tax rates encourage taking wealth out of industrial companies; the wealth taken out must then be "put to work." That means more money chasing "investment opportunities" (instead of real investment in capital goods and employees), leading to price increases in financial capital or real estate or some other asset. The end result? An energy use distortion in an environment of low aggregate demand and high deficits (set to get much higher) setting the stage for a deleterious energy oscillation leading to a crash later next year.
I predict that if this Repuke tax "reform" bill passes, then we will see a monster crash (up to 40 %) by October of next year. You can make book on it.