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Has the Boiling Pot Already Evaporated?

economy , market risks , The Black Swan

Predicting markets is a fool’s game. Understanding how the economy works is slightly less of a fools game as reality and theory rarely coincide. Yet, there are signs of growth and contraction if we are only open to seeing their signals.

economy , market risks , The Black SwanI have several significant biases when it comes to the markets and their movements: first is that our ability to understand market risks is vastly overestimated. We frankly overstate our ability to grasp what Nicholas Taleb refers to as Black Swan events (see his excellent book The Black Swan and his previous book Fooled by Randomness) where he methodically documents that pure luck is more at play than our planning and predictions when it comes to making correct market choices.

I believe that the ultimate value of any security is zero. The value of any security is what a willing buyer is willing to pay at the moment you seek a sale. No buyers, no value. And downward movements accelerate like rockets while upward movements rise like a kite – moving sideways and small upward movements with some downward ones as they ultimately climb. The key is that down is fast and up is slow.

With the failure of the repeal and replacement of Obama Care this past Friday, it is clear there is discontent in the Republican Party and if the GOP won’t rally around their own Party’s President, then more trouble is afoot.

In market parlance, these biases refer to the Bears (decline) and the Bulls (incline). Now I am an openly optimistic voice. However, even optimists recognize that a boiling pot soon evaporates without additional liquids. And now, I am concerned we are running low on new liquids and hence our pot is about to become dry.

I have no secret sauce to my thinking. Mostly, just what I am seeing. I am seeing a nearly 9 year Dow Jones rally from the post-2008 crash (bottoming out around 7,000 to nearly 21,000 today. Now the Dow is not the economy but it is a representation of what investors feel about the direction of the future economy – it is a canary in the coal mine. It is a predictor of future direction and not actual movement.

Markets overreact, as they are only rational over the long term and never the short term. The difference between a correction (say less than 10% decline) is arbitrary. When is a correction a full-blown Bear Market? When should you sell if you dislike the downward trend?

What I do know is that the USA is the number 1 economy in the world by double of number 2 (China). We produce more new ideas. We produce more productivity. We produce more profits. We feed more people. We hold more wealth. We are the innovative and economic engines of the world. And that can change. It did for Britain. We aren’t invincible but we are overly strong. Even in a downturn, we are the economic engines of the world.

Some of the challenges I see include that too many Americans confuse what I term the psychological economy with the actual economy. The psychological economy is how we feel about our personal lives, about our local economy, about the direction we are headed. It is a lagging economic measurement as our feelings are generally delayed unless violently disrupted (e.g. 9/11). The actual economy is what it is. More like the kite. It moves up and down and sideways and for the past 9 plus years, it has been moving upward. It is why people were happier with President Obama at the end of his term compared to George W. Bush’s term. We felt better and the markets were up. We feel better whenever markets are upwards. It is the emotional connection between value rising and how we feel.

My advice is to review your portfolio. Confirm you have a year’s cash flow in the bank. Look at your market investments and shore up some profits and look to protect your downside.

Now, the challenge is when does our Pot boil dry? I don’t know. I do know that since the November elections, the markets have been having a holiday on perceived changes they believe the Trump Administration will provide. Well, this holiday may be over.

With the failure of the repeal and replacement of Obama Care this past Friday, it is clear there is discontent in the Republican Party and if the GOP won’t rally around their own Party’s President, then more trouble is afoot.

If the President isn’t able to enact health reform, how will his administration be able to handle tax reform? Tax reform makes health care seem simple. The current tax code is effectively 65 plus years old (circa 1953). It was last dramatically changed back in 1986. It is a hodgepodge of special interests, social meddling, and short-term plugs and incentives. It creates compliance nightmares and manipulated behaviors. It attempts to raise revenues and change behaviors. It is insular and protected. The real and radical change will be vastly more difficult than modernizing health care.

And if the Administration’s goals of tax reform and health care reform are rebuked by Congress, what does that mean for the other Administration goals and objectives. This isn’t a support of or rally call against the Administration’s objectives it is merely an observation.

Housing is another sensitive matter for our economy. In many areas (especially the West Coast) housing prices are at or above their pre-2008 levels with some areas nearly double what they were at their recession period values. Interest rates are rising fueling a last-minute push for new buyers to hop in before costs increase and that leads to frequent multiple offers where prices spiral upwards.

Variable interest loans will begin to creep upwards yet incomes aren’t rising as fast. The increasing pressures on family incomes will reduce their ability to spend as much on luxuries. Such decline in voluntary luxury spending habits will reduce employment that then cycles downward.

Now we aren’t in a 2008 meltdown. Our financial situation is better. Our controls are more effective. We have been in an effective zero interest rate environment since 2008 and that is unlikely to be sustainable. Rising interest rates will help retirees and pensioners but will hurt business and consumers. This is never a good sign.

My advice is to review your portfolio. Confirm you have a year’s cash flow in the bank. Look at your market investments and shore up some profits and look to protect your downside.

Consider that fixed rate mortgage or at least a 5 or 7-year lock. Reduce debt loads and harbor cash. There will be deals if the markets shrink and cash and timing are invaluable for excellent buys.

The point is – always be aware. Don’t jump to any conclusions but like any good athlete, keep your legs bent and shoulders wide to provide the most strength, flexibility, and balance for movement and avoid being easily defeated.

caution, economy , market risks , The Black Swan

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Dan Morris is a founder of VeraSage Institute, a think tank dedicated to promulgating and teaching Value Pricing, Customer Economics, and Human Capital Development to professionals and businesses around the world.

Dan presents frequently at national and regional conferences.

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