Investing

Everything’s Fine Until It’s Not

Market-based economies are driven by the laws of supply and demand which are driven by consumer preference and producer capacity. High consumer demand for scarce products will result in rapid and extreme price increases. The opposite is also true. Think of fads like beanie babies that came and went fairly quickly. One minute they were all the rage, costing a bundle and the next they were just another stuffed animal.

Financial markets work in a similar manner but with potentially more dire consequences when preferences change. In the case of financial markets it’s not necessarily a preference but underlying confidence in the value of an asset or a borrower’s ability to meet its obligations. This underlying confidence can change overnight and suddenly everything that seemed to be okay yesterday isn’t today. There may be a rational reason for the loss of confidence or there may not be one. It doesn’t really matter. Once the herd mentality shifts and begins to move hard in one direction it’s hard to reverse course, let alone stop the stampede. Think of the classic bank run. Depositors collectively begin to be concerned about the solvency of a bank and begin to attempt to withdraw their money all at once. The bank isn’t able to fill all of the depositors’ withdrawal requests at once. Not necessarily because it is in financial trouble but because it has lent the money out. The bank may or may not be in financial trouble before the run but when all of the depositors demand their funds at once the bank finds itself in a precarious and potentially fatal situation.

Confidence is so fragile and underpins so much of our every day lives from monetary systems to credit markets to stock markets. Most of us aren’t directly involved in these financial activities but our lives are directly impacted by them whether we realize it or not. From the general availability of credit to interest rates on our home mortgages and car loans to the prices we pay for those same homes and cars. They’re all impacted in some way by the financial markets.

The confidence many of us have today in the United States, its currency, economy and financial markets may not be based on as firm of a foundation as we think. The U.S. has been the lone unchallenged superpower for 30 years. China is challenging that status now. The US Dollar has been the world’s reserve currency for decades. Foreign countries have reduced the amount of US government debt purchases in recent years and have been ramping up gold purchases, giving the appearance of diversifying away from and reducing dependence on the US Dollar. The US Government historically has been able to meet its obligations. Today, government debt levels are noticeably increasing to levels of concern as the federal deficit continues to grow. The stock market has had an incredible run over the past 10 years. Current valuation levels are elevated and earnings growth is noticeably weakening. The Federal Reserve has been able to stimulate the economy out of recession during most of our lifetimes. Rates are at or near long-term cyclical trough levels, suggesting the Fed may not have the same tools at its disposal it’s had in the past to fight recessions.

Nothing may come of these concerns and the current world order may march on with business as usual. However, 15 years ago nobody thought home prices could go down. But they did. In 1999, many thought the Dow was on a non-stop climb to 30,000. The index went on to lose 30% from its late 1999 peak and still hasn’t reached 30,000. The history of financial markets is littered with unmet expectations that in hindsight were deemed to be unrealistic. I’m not suggesting the US is on the precipice of collapse or a fall from grace. I’m simply throwing out there that confidence can appear to be very strong and stable but may be unknowingly built upon a very shaky foundation that only needs a little nudge to falter. Everything is fine until it’s not.