E-piphany

Everything is moving in slow motion. To some degree, this is normal on 9/11, when many Americans, and especially those in the financial markets, have trouble concentrating fully; however, this goes beyond the anniversary of the attacks. Market volumes, which I expected to begin to pick up last week, remain anemic by any recent standard. Volumes last Friday, on the day of the Employment report that could well be the deciding factor in provoking QE (although I was already on record before the data as saying I thought the Fed would ease in September), were actually lighter than on Thursday. Only 641mm shares changed hands on the NYSE.

That was similar to the volumes on the two previous Employment Fridays: in July 561mm shares traded at the end of July 4^th week, and August 3^rd‘s 712mm shares was the second-lowest total that week. But I thought those were summer numbers – it is beginning to appear I was wrong.

The decline in volumes is either bad news or worse news, depending on the cause. If the cause is that market-makers and high-frequency traders have pulled back from trading, then it is bad news because that implies less liquidity. Of course, one can argue that having slightly wider and slightly less-deep markets is a reasonable price to pay for having markets that don’t advantage fast-twitch trading over longer-term investing; I don’t agree with that point but it’s a normative assessment and I won’t quibble with it. If that’s the only reason volumes have declined, then it’s bad news for investors (and especially large investors), but a solvable problem.

What concerns me is that if that is the issue, we still should be seeing volumes rise now as there is more news to trade – Employment, the Fed, ECB, the German high court, and so on. I pointed out in early August that when markets are less-liquid, as they often are in August, it can lead to lower volumes because the larger cost of initiating any move implies that it takes more certainty of the result before it makes sense to re-allocate any meaningful amount of a portfolio. True enough, but surely the Employment report, which caused a number of economists to change their call from “QE possible but not likely” to “QE is virtually guaranteed”, is important enough to cause some re-allocation of portfolios?

Well, perhaps not. If there is other uncertainty, beyond just the liquidity itself, then the hurdle for re-allocation (and thus, more volumes) goes still higher. We have all had moments like that, when the stock we want to sell has an earnings report out tomorrow, and even though we want to add or subtract from our position we often will choose to wait until that information is released – even if the expectation for the information itself ought to already be impounded in the price.

The uncertainty I worry about it the continued political uncertainty. I don’t just mean at the levels of the Presidency, although Obama in his convention acceptance speech mentioned FDR and applauded “the kind of bold, persistent experimentation that [he] pursued during the only crisis worse than this one.” It was, many people (myself included) now believe, the experimentation that helped extend the Depression by many years – for an excellent exposition of this argument, see The Forgotten Man: A New History of the Great Depression, by Amity Shlaes. But while the President is clearly the experimenter-in-chief, the dramatically (and frequently) changing landscape for financial services firms is causing a tremendous amount of certainty among market-makers of all kinds.

If investors get the feeling “why bother? The market is completely manipulated/screwed up anyway,” then we’re probably pretty close to the next bear market, with the good news being that it could be the one that truly wipes out the ‘cult of equity’ and allows the basing of a real bull market thereafter. I’m not about to try to call the timing of the next downswing of magnitude. I’ve been somewhat more (tactically) positive recently although stocks remain overvalued and analysts optimistic that the extremely wide current margins can be maintained. But for a bull market, you need people to buy because they think businesses have great prospects, not because stocks don’t look too bad if your alternative is nominal bonds. While certain businesses have good prospects (that’s always true), business as a whole doesn’t feel very good or look very good. Whatever the timing, I still think that valuations will have to retreat a fair amount before we can have a strong upswing again.

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There are other unsettling signs, involving inflation. The teacher strike in Chicago; the NFL referee strike: unemployment is at 8.1% (and practically speaking, the reality is worse than that), and yet unions are striking. This is why the data tends to show that wages follow inflation, and it’s also why I’m skeptical that the current high margins for businesses are sustainable. Now, teachers and referees don’t exactly work in free markets, but it’s still strange to see in this kind of environment. Or is it? The chart below (Source: BLS, and Devine, Janice M., “Cost-of-living Clauses: Trends and Current Characteristics”, Compensation and Working Conditions, December 1996.) shows the percentage of all employees under collective bargaining agreements covered (in the CBA) by a cost of living adjustment.

Incidentally, I should give a hat-tip to ING Capital Markets; I originally developed that chart for a presentation I was giving on their behalf.

The chart shows that in the weak, inflationary economic environment that prevailed in the 1970s, one of the things that happened is that even while the overall proportion of unionized workers was declining (as it has done more or less consistently since 1954), the unions were gaining strength relative to management and able to force into CBAs clauses that tended to institutionalize inflation. The key point here being that this happened even while the economy was in a growth malaise. When the economy is weak, the protections offered by unions seem more attractive, and businesses are less able to resist union pressures.

Surprise! A weak economy is actually bad for business, as well as employees. What is perhaps surprising to some is that workers don’t simply sit around and take what businesses dole out to them because they ‘re afraid of losing their jobs – they do in fact fight back. This is contrary to conventional wisdom, which occasionally defends the association of slow growth with disinflation by pointing to the fact that slack in the labor market implies workers cannot press for higher wages. As I’ve pointed out before, it is true that real wages can be slack when unemployment is high, but that is not the same as nominal wages being slack. This illustrates one mechanism by which employees can keep up, somewhat, in nominal terms when prices rise even if they lose on real wage growth.