Stock Market Meltdowns - Why they will happen again and again and again

http://www.blogmaverick.com/2008/09/15/stock-market-meltdowns-why-they-will-happen-again-and-again-an/

by astrec • 18 years ago

76 93 18 years ago

The 2nd option would be to prevent certain types of companies from being or going public. Law Firms can;t go public. Investment firms like Goldman Sachs used to not be able to go public. They were partnerships. Partners were paid for the most part in cash. If the partnership had money to pay, it got paid. If not, not. I promise you, their tolerance for risk was far lower than it is today for Goldman because there was a direct link between the risk and reward for partners.

we need a rollback to direct incentives.

ojbyrne4• 18 years ago

Personally I have a different theory. The supply/demand curve for investments is shifting as the baby boomers retire - instead of investing money they're drawing down their investments. And that means 20 years of boom for Wall St, largely driven by a huge demand for investment products, is turning into 20 years of bust as that demand turns into essentially, negative demand, because behind the comparatively wealthy cohort of baby boomers, comes a smaller, and poorer cohort (Gen-X). Yet there's still pressure to produce reasonable returns for those same baby boomers and the people following behind them. This results in increasingly risky investments being sold to people nearing retirement who are depending on the kinds of returns their parents saw.

nostrademons9• 18 years ago

I like your theory, but I'm not sure it'll stand up to (future) history. Baby boomers aren't retiring - instead, many plan to work until they drop dead, either because they have no retirement savings (and hence can't withdraw them) or because they have jobs that they enjoy and can remain effective in even until old age. The latter group of people are most likely to have significant retirement savings, so they may just end up passing their assets to their kids.

A lot of predicted demographic time-bombs may not materialize because of this. The social security crisis may be a nonissue - if every retiree worked just 2-3 years more, social security remains solvent for the forseeable future, and many retirees plan to work more than 2-3 years into retirement age.

ojbyrne4• 18 years ago

I like your theory too, though I fear it may be wishful thinking. Those that do continue working are working at lower-paying jobs, and continue drawing down their savings. And if the jobs aren't that much lower status (i.e. McJobs) then they just put more pressure on the income of the generation behind them.

But certainly demographics have failed to predict the future in the past, and personally, I'm amazed at what's happened to my income in the past 5 years or so (I'm in my 40s and saving like mad - though all in cash right now).

bokonist13• 18 years ago

I think there is a lot of truth to this. From the early 80's to the present, individuals, pension funds, and endowments moved savings from bonds and savings accounts into the stock market. I believe this reallocation caused a one time run up in stock prices. In the process, people grew so used to price appreciation that dividends disappeared. Since, traditionally most of the value of owning stock comes from dividends, I expect stocks to under perform until dividends return.

helveticaman5• 18 years ago

Agreed. After a number of thought experiments involving dragons that hoard gold, defunct Buddhist temple construction companies, and irrational exhuberance, I came to the conclusion that owning stock makes no sense if there are no dividends.

quasimojo16• 18 years ago

wrong. most boomers are still in fixed retirements. some of those pension fund managers got suckered into subprime, but not many

eru2• 18 years ago

Capital markets do not stop at borders. The American/European baby boomers are not as important may not be as important as they seem.

eru2• 18 years ago

Please pardon my garbled post. I did not edit carefully enough.

kingkongrevenge2• 18 years ago

> The supply/demand curve for investments is shifting as the baby boomers retire

It's well researched that the number of 45 year olds is a major important economic variable. They're at their peak earning, investing, and consuming stage.

Japan's baby boomer 45 year old peak came a bit over ten years before ours, which is passing now. Not a good sign considering what has happened in Japan.

swombat2• 18 years ago

Over-simplified. There will be bubbles and meltdowns as far as the eye can see, simply because the boom-bust cycle is built into the capitalist model.

And it's fine that way. Far better than the dull, grey unproductivity of all other known alternatives.

That said, I agree with his point, to an extent. One of the things that keep people from declaring bankruptcy is that it would have severe, lasting consequences - destroying their credit record, and preventing them from being a director of a business for quite some time. Some similar system should exist for any corporate leaders. You don't want to go too far in that direction either, though - otherwise, you might stifle the risk-taking that does get us to interesting new places.

nazgulnarsil2• 18 years ago

the booms and busts have been continually made worse by government intervention. governments try to alleviate the effects of the bust and in the process make it worse.

swombat2• 18 years ago

Sure, but my point is, they're inevitable.

run4yourlives• 18 years ago

Actually, since the depression one could argue that they've may each bust since infinitely more bearable for a whole host of people.

kingkongrevenge2• 18 years ago

Don't conflate the business cycle with boom-bust. Business cycle downturns are inevitable, as misallocated resources are redirected. Big busts require government. There really aren't any examples of major boom-busts happening without the hand of government.

gills2• 18 years ago

Interesting, but only part of the problem. Regulators need to actually do their jobs and enforce transparency of Wall St. balance sheets. Oh, and Congress? No more campaign contributions from corporations. You work for the voters, and if enough of them want you to prop up some company or repeal banking regulations, they'll tell you.

anamax• 18 years ago

Corporations actually can't give all that much money, something like $3k/candidate/election. However, their people can, which is what you see when you see "Enron contributed $2m to senate Dems". (PACs don't change this - they just bundle.)

There may be special rules for giving to parties, to "got into office" parties, and for Fannie Mae and Freddie Mac.

gills2• 18 years ago

Right. The Seattle Times had an article a while back (http://community.seattletimes.nwsource.com/favorfactory/), which has a database of earmarks and contributions from companies and executives/owners/etc. of companies. Often you will see contributions from high-level company officers. The data isn't good enough to show causality, but some correlation.

Anyway...interesting stuff.

mrtron• 18 years ago

Great post - and I would find him to be on the mark here.

Interestingly enough, Cramer (who is not really well liked in this community) was trying to be a whistleblower a year ago on this very issue.

http://www.youtube.com/watch?v=I1eSlYtXiro

I liked the 'I wish I could go tell people to buy Wa-mu' part...check out the one year on that.

http://finance.google.com/finance?chdnp=1&chdd=1&chd...

byrneseyeview• 18 years ago

Cramer was saying to cut rates. That would have delayed the problem in exchange for exacerbating it. Lehman would not have been leveraged 30 to 1 if they didn't think the Fed would cut rates in the event of a downturn.

quasimojo16• 18 years ago

cramer was right that an emergency rate cut was needed, and i say this as someone who thinks low rates created this entire mess. at the time he has his tantrum, the market needed a massive cushion regardless of the consequences. the problem is, the Fed is finding it hard pressed to take away the stimulus. with commodity prices getting killed, the pressure is off for now

what does it all mean? DEFLATION IS HERE. even near-zero real rates can't elevate prices. deflation is here, depression2 cannot be avoided

bokonist13• 18 years ago

Cuban's call for more regulations displays some naivete about how Washington works. Lobbyists from big companies have no problem twisting regulations to serve their own interest at the expense of the public. For example, read about how easily Fannie Mae pushed the right buttons in Congress to manipulate regulations in their favor: http://billburnham.blogs.com/burnhamsbeat/2008/07/fannie-mae.... This happens again and again, thanks to the actual mechanisms by which Congress works. Government's End by Jonathan Rauch and The Triumph of Conservatism by Gabriel Kolko are great treatments of the subject.

The real solution is that we need someone like Mark Cuban to start a competing stock market. He could create listing requirements that would include mandatory rules such as 1) requiring that companies only pay dividends (instead of doing stock buybacks 2) CEO's must get paid based on how the company does for the decade after they leave 3) all shareholders must either vote for the board members or hire a proxy voting firm, etc. etc.

I don't know what the exact rules would be, but I'm sure someone could design a set of rules that would be both less obtrusive and more effective than our current regulations. If the rules are designed well, this new well managed market will give investors higher returns. That will force the existing markets to shape up or lose their investors.

mhartl3• 18 years ago

I certainly agree with you about how Washington works, but I'm not sure it means that Mark is naive. Saying "Congress should pass a law that does X" is different from saying "I expect Congress to pass a law that does X". Only the latter is potentially naive.

bokonist13• 18 years ago

No, the problem is that Congress does end up intervening, but the intervention is manipulated to favor the perpetrating companies. Read the Kolko book. Or if you want, I could link to a dozen real world examples.

Brushfire• 18 years ago

Only a little related, but everyone needs to remember good ol' Mr. Market.

http://www.sandmansplace.com/Mr_Market.html

rrf• 18 years ago

I agree that personal incentives are part of the problem. I’d also suggest that going public is another significant part of the problem. The public company becomes beholden to its shareholders and is pressured/incentivised to continually deliver growth in the value of the company or dividends, often in mature markets, which in turn can lead to the implementation of riskier strategies for delivering growth.

quasimojo16• 18 years ago

okay explain to me how a company like google could have been privately funded to its current level. you think a bank is going to write a check for $800 million to buy servers? go ask a C-level exec at wells fargo

nostrademons9• 18 years ago

It probably couldn't have grown as fast as it did, but it certainly could get to it's current size. Many of the largest companies of the industrial revolution used mostly retained earnings, sometimes supplemented by small bank loans or equity investments from private individuals. American Tobacco, which captured 90% of the tobacco market before being broken up into R.J. Reynolds, Liggett, and others. Almost the entire meatpacking industry. The Mars candybar company, which is still privately owned. Ford Motor Company, still controlled by the original founding family.

time_management• 18 years ago

It's true that there are inevitable conflicts of interest regarding risk tolerance. This is especially true, for example, in hedge funds: the manager takes a 20% cut of the upside, but has no downside. Hence, there's an incentive for hedge funds to be risky. (Excluding a few top performers, hedge funds are not great investments.)

However, I strongly disagree with this article. First of all, bubbles and crashes seem to be an inherent property of market economies. They've existed for at least four centuries (tulip bulb, anyone?) and possibly longer. Overreaching optimism seems to be an inherent human trait. Overpaid CEOs are a relatively new (few decades) phenomenon.

The OP asks: Would you let someone fire and embarass you for a check for $20mm dollars ? So would CEOs.

I'm not sure this is true. The CEO is going to be out of work for a few years, and possibly be unemployable at his current level in the future. Given that he already makes $10 million, a potential five-year setback is not worth that amount of severance.

I agree that large company CEOs are overrated and overpaid, but I can't assign them all the blame for current economic problems, the sources of which are a lot more complex than the OP seems to think.

quasimojo16• 18 years ago

It's true that there are inevitable conflicts of interest regarding risk tolerance.

lets ask ourselves WHY the bankers took such risks

because they just wanted to have fun? get real

how do you make money as a banker when the Fed has lowered "real" rates (rates adjusted for inflation) to ZERO???

you have to make riskier loans. you sure as shit can't make money in a low interest rate environment lending to credit worthy people

the Fed prodded bankers to make these risky loans

sorry cuban, any cub reporter for the WSJ could tell you this

First of all, bubbles and crashes seem to be an inherent property of market economies

indeed, but we've had two massive bubbles in ten years. the nasdaq bubble was 10x the size of the 1929 bubble (ref: bob prechter). the housing bubble dwarf the florida bubble of the 20s...you must admit that this is curious

mhartl3• 18 years ago

I'd like to put this in a slightly broader context. Meltdowns such as the credit crunch and the housing crisis are often used by self-styled 'progressives' to attack capitalism itself. But implicit in Mark's argument is the refutation of this accusation: such meltdowns are only possible because of the moral hazard induced by de facto government (i.e., forced taxpayer) bailouts of the guilty parties. In other words, it's precisely the lack of proper capitalist institutions that enables crises of this type.

nostrademons9• 18 years ago

History doesn't really bear out the "meltdowns are caused by moral hazard" theory, though. They happened like clockwork, every 20 years, during 19th century America, a period where there was no safety net and no significant government intervention in the economy.

I'd attribute bubbles and meltdowns to flaws in humanity itself. They happen because people have to make investment decisions in the absence of perfect information, using thought processes that have evolved to take into account peers' opinions as much as hard factual data. Inevitably, some of those decisions will be wrong, and that wrongness appears as a large number of firms going bust at once.

The way to avoid financial meltdowns is to make every human a God. However, if we did that, they could just snap their fingers and get what they want, so their wouldn't be much need for an economy at all.

bokonist13• 18 years ago

Read some DeSoto and Rothbard ( Money, Credit and Economy - http://mises.org/resources/2745, America's Great Depression http://mises.org/rothbard/agd.pdf and History of Money and Banking -http://mises.org/books/historyofmoney.pdf ). They both make a pretty compelling case that government played a major role in the 19th century busts.

Pretty much every single bust since 1870 has been the explosion of a credit bubble. Cheap credit is the heroin of democracies. In the short term, it's like free money. It's cheaper to buy stuff, and it doesn't result in higher taxes. Politicians are always for it. The cheap money will endear them with the population in the next election, and they won't be around for the bust ( or no one will remember who's at fault). In the long run, cheap credit leads to too much debt and people can borrow no more. This leads to two choices. Choice one, the borrowing must stop, and with it consumption. This sends the economy into recession or depression ( this is heroin withdrawal, the Volcker strategy in the 1980's). Or two, the government must make credit even cheaper ( higher doses of heroin - the Alan Greenspan strategy in 2001).

michaelneale3• 18 years ago

>The way to avoid financial meltdowns is to make every human a God.

I am a fan of Iain M Banks - in his "Culture" series novels, thats pretty much what happens to the dominant "Culture" - people can get whatever they want when they want, so they turn to art and fashion and fads to occupy themselves (one such one was voluntarily catching cold/flu just to feel what it is like to get better).

vitaminj• 18 years ago

Warren Buffett says this far better in his 2005 letter to Berkshire shareholders.

Relevant excerpt from CNN: http://money.cnn.com/2006/03/05/news/newsmakers/buffett_fort...

Original source: http://www.berkshirehathaway.com/letters/2005ltr.pdf (you'll have to wade through to page 17)

helveticaman5• 18 years ago

I see one flaw here: having people pick the best stocks can increase wealth by allocating money to where it is most efficient. For instance, going back in time to 1965 and investing in Toyota instead of GM would not only have been a very lucrative move, but increased Toyota's ability to create wealth by increasing its access to capital.

quasimojo16• 18 years ago

GREENSPAN GREENSPAN GREENSPAN

who do you think put the US on a "low low low rates" regime?

who do you think CREATED THE DOTCOM BUBBLE and the HOUSING BUBBLE?

not CEOs, GREENSPAN

and bernanke is just playing the hand he was dealt

the problem isn't CEOs who are out of control, it is central bankers who blow bubbles without consequence. the Fed has power these CEOs can't even fantasize about

go ask any of the serious financial journalists at thestreet, marketwatch, wsj, nytimes....without hesitation they will all tell you that low rates set by the Fed created this mess.

rms• 18 years ago

I swear I remember Alan Greenspan being quoted as saying that he know the low rates would create a housing bubble, I haven't been able to find it though so it may just exist in my memory. Any idea?

Also there's absolutely no need to shout here.

quasimojo16• 18 years ago

well what he is also famous for is the prediction years ago (when he was hanging out with the objectivist pseudo-intellectuals) that a kondratieff winter (bad downside in the economy) could be nullified by very low rates. he did his best to prove it

greenspan adored low rates. he set the too low and then was too late in raising them. poor ben bernanke...given a corpse and told to make it ready to run a marathon. not much choice for ben but to lower rates again. once again, he was too late in raising them.

its all in the Feds rate-setting power folks. THEY are the ones who dictate the level of risk in the economy. why do you think so many people call for the abolishment of the Fed?

trivia: did the US economy grow faster and with more stability pre-fed (pre 1913) or post-fed?

quan• 18 years ago

I think this theory is on track but not complete. It's correct that the risk and rewards for CEO are decoupled. However, the people who continue to hire and pay ridiculous amount to these CEOs are no other than the investors and consumers. Yes, that's us. As investors, we irrationally pump money into growth sectors during the boom, into companies that can outperform expectation and increase profit margins, directly voting for 'talented' CEOs who can cut cost and increase revenue by all means. As consumers, we chase the best deals. Would you go with banks who only let you borrow a tiny amount in line with your credits on strict terms? Of course not, not when you can flip for a quick 100% gain within the next 6 months. We go with the most outrageous deal and lenders in turns have to create more outrageous deals to compete. Market behavior reflects the behaviors of its participant (duh). As long as investors and consumers indulge in irrational exuberance like there's no tomorrow CEO will continue to be overpaid and bubble will burst. Robert Reich says it best in his book Supercapitalism.

drubio• 18 years ago

There is even a simpler explanation: 'Fear is temporary, greed is permanent'

scudco• 18 years ago

I think I can agree that CEOs will always take the highest-risk/highest-reward these days because the government continually bails-out this kind of bad behavior. However, I think it is the government itself which is the root cause of all these failures. We have a fractional-reserve banking system propped up by a fiat currency. This means credit is easily created and when the government decides that everyone should own a home (Fannie and Freddie) then we use our fractional-reserve system to lend money which, frankly, does not exist. This leads to the business cycle of endless booms and busts. I think that rich people will take advantage of this system of easy credit. This is exactly what happens when you subsidize something--you get more of it. In this case we are subsidizing risky financial behavior. If the government did not run the banks in this country then Fannie and Freddie would be forced to default on a majority of their loans and a lot of people would be hurt, but we're essentially just making our children and grandchildren inherit our debt because we believe that home ownership in 2008 is more important than long-term financial stability. We should work to end the monopoly the federal government has on the banking industry so that consumers can demand more fiscally responsible credit managers (or riskier ones if they so choose). Right now we all have to put our faith in a currency backed by winks and nods rather than something with implicit scarcity. And beyond that, we put the printing presses under the control of the government, which has most assuredly wasted more money funding a welfare/warfare state than any bailout would ever amount to.

Stock Market Meltdowns - Why they will happen again and again and again

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