The Future of an Illusion 2012

Sigmund Freud
Dr. Freud

For reasons to be explained momentarily, it strikes us that today’s financial markets bear taking a peek at through the lens of no less than the immortal Dr. Sigmund Freud. In his 1927 book Freud relates man’s motives in creating religion and satisfying the need for that warm fuzzy feeling called comfort, security, that is all rapped up in something we call faith.

Now it is understandable that some would respond with: I don’t care what the stock market is doing, the stock market is rigged anyway. To you cynics of the market, I agree. At last count, 65% of the average volume was coming from so-called High Frequency Traders. For those curious souls that don’t TiVo CNBC for weekend viewing, High Frequency Traders (HFT) are not so much traders but incredibly well programmed machines that know little or nothing about economics, let alone price earnings ratios. HFTs consider Apple Computer to be in the same basket as Xerox.

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The modus operandi is all about using the proprietary formulas that have been designed to profit on an extraordinarily large number of transactions that may yield only the slimmest of profits for each individual transaction. The main reason for their success is getting information before the general public and acting on it before anyone else. Technically, folks, that is insider trading and one of several reasons why it is no illusion that people believe the market is rigged against them. But don’t look for anybody to go to jail anytime soon.

So with all of this going against it, why should we, or anyone else, give a damn about the stock market? Because the market has both a direct and indirect bearing on everything, from the value of individual retirement accounts to the price of gasoline.

In addition to its pure economic role, the market is always telling us something about our beliefs and ourselves. Most of the time, it tells observers viewing indices like the Dow Jones or Nasdaq what to think. It shouldn’t be this way, but it is. When the market is up, we think of things being good. When the market is down, therefore, we need to be worried. This is an illusion because many times the market is wrong, and I think that now is one of those times.

moneyrollLet’s put just a couple of things in perspective. Since landing in the crapper in 2009 (you will remember that was when the illusion of a world-ending financial crisis was staring us in the face), the value of the market has recovered nearly all that was lost, more than doubling in value in the interim. Not everybody back in 2009 was a doomsayer, but even the levelheaded types pointed out the likelihood that it would be a decade or more before losses were recovered. Particularly worrisome, we were told, were those individuals within less than 10 years of retirement, as these people had no hope. Now we know, even these level-heads weren’t so levelheaded after all.

Fast forward to the present. The market is chugging along toward new highs. We are well along the way to completing the months of September and October with nary a scary day or week. This by itself makes you want to cry Freud! Over the course of 50 years, these two months have featured more corrections, crashes and general misery than any other period of the year. Even during the best of economic times, September/October misery tends to rule the market. Clearly, these are not the best of times. Major issues are being ignored. This alone indicates that faith in the religion of the market has made a major recovery. Those poor hopeless soles approaching retirement have been saved. The expectation of a civilization-ending financial crisis has proven to be yet another illusion.

However, there is something more than a little different this time around. Plainly put, the world is worse off than in 2008. Credit goes to Jack Welsh for reminding us in a Wall Street Journal interview: there are 3 million fewer people employed today than in 2008. This important fact was completely ignored both by the White House and the media, whose only focus was on the jobs report that showed a sharp drop in unemployment from 8.1% to 7.8%. Additional credit goes to Welsh for pointing out the many flaws in the government data. Basically the unemployment rate, under any administration, is highly suspicious. For example, if a doctor is out of work but takes a job as a barista at Starbucks, he is considered employed. If the doctor decides to quit his barista job after two weeks and not look for another job, he is considered out of the labor force and not counted as employed or unemployed.

The present administration in Washington contends that the economic recovery is underway and that the employment situation will continue to improve. No matter who wins the election, this is unlikely to happen. The United States is facing structural unemployment to a degree unknown since the dawn of the industrial revolution more than 100 years ago. Employer demands and job skills are at a mismatch as the economy shifts to a post-industrial phase. Employers are unable or unwilling to do large scale retraining of the workforce, and heavily-debt-burdened laborers are hard pressed to pay for it themselves.

Sheep Cliff

The market also is either numb or under the illusion that two gigantic risks do not exist. Here we are referring to the so-called financial cliff at year-end, where the Bush Tax cuts are scheduled to expire and that mandatory government spending cuts takeover. Here we are also referring to the Euro debt crisis. It seems the obvious solution is for politicians to get together and come up with a compromise. After so many months of living with both issues unresolved, there is a tendency to ignore both the importance and the urgency of these two issues. Make no mistake, literally every other economic issue pales in comparison.

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But ignorance allows the illusion to be perpetuated; case in point is the presidential debates. We draw attention to the second session on October 16, at Hofstra University. The beauty of this edition was the town hall format that provided a reading on what issues were on the minds of a well-educated urban audience.

Amazingly, not once did either candidate get challenged with a question about the impending financial cliff! As previously noted, the financial markets are near an all time high, so we are supposed to feel a warm and fuzzy faith.

Isn’t it the media’s responsibility to relate important events to the public? Their post mortem on the Hofstra debate was focused almost entirely on the issue of who won the debate rather than the quality of the questions or, better yet, whether the candidates answered them.

And, let us not forget about the traditional leader of economic recoveries past: housing! There is a striking similarity between the stock market and real estate. Prices for both are rising for no apparent reason. Granted, prices of public equities started rising way back in 2008 and have performed far greater than real estate. Nevertheless, real estate prices in many areas started rising last spring and continue to do so. Why? There is still over 10 trillion in credit card debt, the average FICO score still stinks, banks lending standards have not been materially lowered and, with the exception of first time home buyers, most buyers have to unload a property in order to make the down payment on their purchase. Oh yes, there are still millions of homes in various stages of foreclosure. I think I need a session with Freud to figure the future of this illusion.

So in the final analysis, why are financial markets near record levels? Could it be caused by anyone other than the gods at the Federal Reserve with a third round of quantitative easing, commonly known as QE3? Simply put, QE3 creates an artificially low interest rate structure where the average investor is given the choice of investing in fixed income instruments, and losing money when interest income is adjusted for inflation, or investing in more risk oriented alternatives like the stock market and, more recently, real estate.

At some point, this giant illusion will come to an end.

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James Waggoner is a veteran of over 30 years on Wall Street as an analyst, banker, hedge fund manager and investment strategist. He left Bear Stearns in 1988, after a 10-year run to start his own hedge fund: The Kensington Group. He was a frequent contributor to CNBC and CNN. He is the founder and Managing Director of PCM Advisors where he works with companies at the angel capital, VC and Private Equity stages. After 32 years in New York and raising 2 outstanding sons, he relocated to the West Coast.