In this ‘Stranger Things’ market, risks can look like safety
Did you notice the weird stock market that emerged, Demogorgon-like, from the Upside Down in December?
We’re living this “Stranger Things” market because the Federal Reserve holds all the keys. The December panic — a 15 percent peak-to-trough drop in the S&P 500 — scared all the adults so much that over the past seven months we’ve been living the chain reaction. When I say adults, I mean the Federal Reserve, which sets short-term interest rate policy.
The July 30-31 meeting of the Federal Reserve next week may set aright this Upside Down world. By Upside Down, I mean all that traditional good news for the economy is bad for stocks because interest rates might stay the same or go up, which in turn could tank the market. Bad news for the economy, on the other hand, is good for stocks because the Fed could cut rates and therefore juice markets further.
Got it? It’s the Upside Down. Love is hate, no is yes, war is peace. I’ll come back to that upcoming Federal Reserve meeting, but first …
I have a weakness for counterintuitive truths, contrarian wisdom and oxymoronic statements, especially when it comes to money and markets. This week’s summer reading was Wall Street Journal reporter and economist Greg Ip’s 2015 book “Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe.”
Of course I would fall for a book with that subtitle.
Ip’s main point is that when we act to reduce risks in one place today, we may create greater risks tomorrow. Or we may unknowingly create risks for other people, in unexpected ways or places. When we seek perfect stability or the absence of volatility, we create unstable systems. Ip cites mid-20th century economist Hyman Minsky, who summarized this big idea as “stability is destabilizing.”
A few analogies Ip employs:
1. Suppressing natural forest fires on national park land may create the conditions for uncontrollable wildfires in the future. Small controlled burns, by contrast, reduce the chance of big conflagrations.
2. The introduction of padded helmets in professional football may have increased the risk of both brain and bodily injury in players, because bigger and faster players — comforted by the presence of “protective” headgear — tackle head first. Rugby players, by contrast, don’t suffer the same types of brain and spinal injuries because they don’t play with the same headfirst recklessness that helmets encourage.
3. Our reaction to catastrophic risks such as airline crashes and nuclear power plant meltdowns can increase risky behavior, such as driving more or shifting to other, deadlier energy sources.
4. The Federal Reserve historically has attempted to lower the risk of big blowups by inducing smaller economic slowdowns, like setting a controlled burn to reduce the chance of a big, outof-control forest fire.
William McChesney Martin, former Federal Reserve chairman (1951-1970), described this action as “take away the punch bowl just as the party gets going” by raising rates when the economy gets too strong. This sounds good in theory, although it’s always controversial and based on guesswork when implemented in real life.
Incidentally, about that July 30-31 Federal Reserve meeting, markets clearly anticipate a rate cut.
With risky asset prices (real estate and stock market indexes) at an all-time high and unemployment at a 50-year low, the traditional macroeconomic case for a Fed interest rate cut his month is absent.
In the past, we’d expect a rate hike, not a rate cut, under these booming economic conditions.
Interest rate cuts, by contrast, were a rarely used emergency tool for cushioning against recession, boosting confidence in the face of tight lending or adverse shocks to the economy. None of that is apparent now.
Under similar situations of asset price inflation and low unemployment — 1991, 2000, 2006 — the discussion was always about raising interest rates. By classic standards, a rate cut at the end of this month seems insane. But what the heck do I know? It’s what markets expect in our “Stranger Things” economy.
By the way, moving from macroeconomic theory to personal investments, I think the most important application of Ip’s thesis, although he never spells it out in his book, is in our personal asset allocation choices.
Specifically, should we choose “dangerous” assets like stocks or “safe” assets like bonds and annuities? The perceived riskiness or safety of these assets seems clear in the short term, but counterintuitively flips in the long term.
The truly dangerous investment, if we’re talking about a long-term project like living comfortably in retirement, comes from “safe”-seeming assets like bonds and annuities. For middle-income folks, the true investment danger is that we will outlive our money, a danger that bonds and annuities tend to aggravate rather than alleviate.
Stocks, when diversified and given decades to grow, tend to lower our personal risk of outliving our money. To be safe in retirement, we need to choose “risky” in our investments.
Taylor is a columnist for the San Antonio Express-News and author of “The Financial Rules For New College Graduates.” michael@michaelthesmart money.com | twitter.com/michael_taylor