It Will Fluctuate

steele-copyA reporter once asked J. P. Morgan, the most powerful banker in the United States, perhaps the world, what the stock market was going to do. Morgan looked at the hapless reporter with his famously blazing eyes and said, “It will fluctuate.” If there is a certainty in the financial world, it is fluctuation. Today’s bull market, when the sky’s the limit and baby’s going to get a new pair of shoes, can quickly be tomorrow’s bear market when it’s “Brother, can you spare a dime?”. The hedgefund genius who has made all his clients rich is suddenly a convicted felon, doing 150 years for fraud. General Motors was the very epitome of the well-run, profitable corporation in the mid-20th century. Today it’s a ward of the federal government. Ten years ago Apple was nearly bankrupt. Today, thanks to the iPad and the iPod, its market cap has passed Microsoft and is now second only to Exxon. The economic philosopher Joseph Schumpeter described capitalism as being a process of ‘creative destruction’. And what is true of capitalism as a whole is inevitably true of financial markets as well. As new technologies are born, they bring forth vast new opportunities to create wealth. But they also force old technologies to adapt or die. The automobile not only created fortunes for the companies that manufactured them, but also in steel, glass, cement, rubber, oil, and garages. However the automobile devastated the leather and horse industries and profoundly changed the economics of railroads. The decline in the number of horses in the American economy caused a radical change in agriculture. As the one-third of arable acres that had been devoted to hay and oats was shifted over to human food, the transition greatly lowered prices for such commodities as wheat and corn and caused widespread depression in rural areas in the 1920’s. But while technologies change, human nature does not and this greatly affects financial markets as well. Humans are sometimes too sanguine about the future, fueling bubbles. This is especially true about major new technologies. The promise in such technologies is obvious, but how to actually make money exploiting them often much less so. Railroad stocks in the early 19th century, franchised restaurants in the 1960’s, and dot.com companies in the 1990’s are examples of stocks that soared on the promise but then crashed back to earth on the reality. Equally people can be too pessimistic. And it is this alternation of too pessimistic and too optimistic that drives the business cycle, another certainty of the financial world. If you want to know why most financial panics happen in the autumn, the reason can be found in Aesop’s story of the ant and the grasshopper, written centuries before financial markets even developed. Psychologically, people tend to be grasshoppers in the summer – fiddling away, having fun, sure that the good times will roll on. But when the chill winds of autumn begin to blow, people turn into ants, looking to the onset of winter and bad times. They suddenly look on stocks that had soared as risky. It’s time to hunker down, so they dump high-flying stocks and if too many do so at once, the market crashes. Every great panic on Wall Street in the last 150 years – 1857, 1873, 1893, 1907, 1929, 1987, 2008 – occurred in either September or October. Humans are quirky as individuals and it can be very hard to predict their behavior. But humans in general are much less so. For instance, no one knows when an individual will die. But any actuary can tell you with astonishing precision how many people of a given age will die in the next year and what the life expectancy of the entire cohort is. Financial markets are nothing more than millions of human beings acting simultaneously. Alexander Pope in his ‘Essay on Man’ wrote that “the proper study of mankind is man”. If you want to make sense of financial markets – in other words, find the certainties – you could do a lot worse than follow the great poet’s advice.

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Published in the hard-copy of Work Style Magazine, Summer 2010