Dream On

Though most of us are all sobered up, there remains in the minds of many investors the whispered questions: “Is it time to get back in?” “Will I miss the big move that gets me back to even?”

We’re often still susceptible to the siren call of the markets, despite the costly lesson of believing in the “The wisdom of crowds,”  “Dow 36000,” or the so-called “the risk-free premium.” We want these things to be true. Who wouldn’t want to live in a time of endless prosperity – in a world where all problems vanish as the magic of the market provides the plenty from which flows more jobs and goods? This yearning – this uncritical belief system – underpinned the conviction that the magic of markets could lead to wealth for all (see privatized Social Security), and the less regulation the better (see your daily newspaper, if you still have one).

In this sense, the Madoff melt down was a metaphor for the larger fallacy that we can all consistently beat the market (as in Lake Wobegon where the children are all “above average.”).  A large number of cheerleaders for this notion (George Bush, Henry Paulson, Martin Feldstein, etc.) tried very hard to convince the nation that prosperity in the future was dependent on shifting more risk to wage earners.

But studies by economist Dean Baker and others have shown that for the stock market to enjoy steady real returns of even seven percent would require, eventually, the share of wages to be negative. That is because over time the return on stocks would so exceed the growth of the economy generally, becoming larger than total GDP --- an anomaly that is lost on the market’s most fervent enthusiasts.

Historically, even long periods of stock growth have included surprisingly painful setbacks. The 20th century was good for stocks overall. But it is also true that there were three 20-year periods when the market return was negative. Timing may not be everything, but it’s right up there. In fact, bonds have outperformed stocks for the past 40 years.

Ultimately the growth of stock market values must bear some hailing distance relationship with the growth and productivity of the whole economy – and also a relationship to the amount of debt embedded in corporate balance sheets.

Of course, much of the equity crash reflected the collapse of other markets. The stock market decline was a reaction, not a trigger. Leading the way to the Great Recession was the realization that many asset-backed securities were badly mispriced and shockingly risky.  Assets can represent pieces of land, bricks and mortar, equipment, and devices.  Assets also have their sublime side: what can organization, imagination, and creativity do with  physical assets to make them generate income?

We never know what any particular asset might deliver in the future.  There are enough examples of new ideas in railroads and telephones and computers in the history of the last few centuries to confirm that some special assets could be worth a fortune in a few years.

But if any one asset could be The Next Big Thing, over all, economic activity is not constantly reaching for the stars.  When things are going great, the economy advances fairly rapidly; in bad times, it stumbles and sometimes falls.

Asset values represent claims on various parts of this system over the long run.  The economy as a whole grows by 4 percent in a great year and not at all in a lousy year.  If history is of any value, the economy will grow at something like two to three percent on average for the foreseeable future.

These averages, these unexciting historical patterns are what unexciting financial experts call the fundamentals behind a diversified portfolio.  One can assume that every asset will be the next Microsoft, but that is a pipe dream.  One can assume that, on average, profits (which are the fundamental source of value of equities) will grow faster than total income.  But, rapid profit growth by the whole equity market is not a constant state.

Today, housing prices are realigning with rents.  Stock prices are realigning with realistic expectations about the growth of future profits.  For a while, we will remember this reality check.  But then someone will tell us that he can pick only winning assets or that only the hopelessly old-fashioned think that the future will resemble the past.  Fashionable, optimistic financial experts will displace the bores with roots in accounting.  And once again greed and hope will blow hot air into an asset price bubble.  Once again, for a few years, even perhaps for a few decades, the law according to Ponzi takes over from the law of gravity -- and we shall learn anew that every boom gives birth to a bust.