Sunday, October 5, 2008

How to Play this Market


Lessons from '29, The New Deal I and II and The Great Society

image from http://stockcharts.com

This is not intended to be a definitive answer to what causes recessions and depressions and what policy ought to be. It is an observation of what the government did and when in terms of spending and corresponding moves in the stock market.

Immediately following the stock market crash of '29, then President Herbert Hoover was of a mind to let the market sort it out for itself. Most believe this was a big mistake, but in his defense, the market had bottomed and begun to recover by the time he left office. Franklin Roosevelt implemented the first New Deal in 1933. This included short-term measures like jobs creation programs, spending on infrastructure, generally getting money in the hands of the masses. The market responded very well to this. The second new deal was implemented in 1935 and 36 and included support for labor unions, the Social Security Act and the Work Progress Administration (a continuation of the jobs programs from the first New Deal). The market responded positively at first, with a big spike in the DJIA, but that was followed on shortly by just as big a sell-off. While still up substantially from 1933, the net gain in the market from '35 - '38 was nil.

Now take a look at the Great Society programs of 1964, introduced by Lyndon Johnson. This is where Medicaid and Medicare came from, as well as increased education funding. While the Vietnam War slowed down the implementation of these programs, spending on them ballooned under both Nixon and Ford. The market remained flatlined from 1964 until 1984 or so when deregulation seemed to finally spark the next big surge upward.

It seems as though putting money in the hands of individuals can actually have a positive effect. Companies must compete for this money and economic activity increases. When the government gives great big checks to specific industry groups, companies or bureaucracies, the numbers may be big, but the level of economic activity doesn't seem to be enhanced. It's essentially moving money from one account to the other and eliminating all the middle men. The problem is, all those middle men are what makes the wheels of this machine move.

Another way to look at it is in terms of something called the Marginal Propensity to Consume. Essentially, how much of each additional dollar of income is one likely to spend or invest? The answer is different depending on your circumstances. If you've gone without a working washing machine for six months and suddenly have a $500 windfall, you're probably going to go buy a new washing machine. If you're already well-to-do and see tough economic times ahead and get a $500 windfall, you'll probably tuck it away. In other words, if you give poor people money in tough economic times, they're more likely to spend it. If you give rich people money in tough economic times, they're more likely to hoard it. If your goal is to promote economic activity, it would seem to make more sense to give a little money to a lot of people than a lot of money to a few people.

The vast majority of new government spending so far is pegged for specific players in a specific industry. Don't look for a quick turnaround in the overall economy. There will no doubt be another round of "stimulus" out of Washington DC after the election. We're likely to have liberals controlling both the House, the Senate and the White House, with a mandate to spend as much as they want to "fix the economy". How this "stimulus" is doled out will be important. If it goes mainly to individuals to spend as they please, it may have a positive effect. If it goes to organizations and programs aimed at providing non-monetary assistance, it's likely to wind up in some big institutions' bank accounts and very little effect on the economy.

Of course I'd much prefer cutting taxes and spending to ballooning the money supply. Eventually, the hoarders will come out and spend. Why? Because for the real players it's not really about the money. It's about the game. If blowing a wad of cash on some crazy, labor intensive idea is what it takes to get the game going again, that's what they'll do. But it's not my call and that's not going to happen. Whichever way the government goes, the market in the short term should be very volatile. I'm going to bet on big swings up and down and try to have the discipline to periodically take some money off the table.

For the casual investor, I'd go with "dollar cost averaging". That is, put the same amount of money into a diversified fund each month over a long period of time. The only way you lose with that strategy is if the economy stays in the tank for decades, in which case your 401k will probably not be your biggest concern anyway.

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