Falling Bear Markets are sending some important messages

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Markets are in an ugly, bearish mood in 2008. They are down 20% on average across the world. So what are the markets telling us? Is it that we are in a recession, depression or an economic trough? Or is it that monetary, fiscal and trade policies in the major countries, especially the US, are wrong. Count on the latter and discount the former. Markets are telling us some very important lessons.

It is doubtful that with full employment, strong corporate profits; increasing net incomes of 5% per year, and 5% GDP growth world-wide, that the economy - any economy - is in a recession. An economic downturn or less than robust growth certainly, but not a full recession of two subsequent quarters of negative GDP growth. So if the economy is not as bad as the media experts keep telling us that it is, why are markets retreating at a panicked rate?

Markets are sending three important messages. The first has to do with taxation levels. Tax levels across the industrialised world are far too high. Government share of GDP keeps rising, not falling, and in the US and Europe governments now consume 35% and 44% respectively, of the total gross economy. So when it appears that the US Democrats, poised to win the next election, constantly discuss raising taxes, tariffs and putting trade agreements in jeopardy, the markets will sell off.

When politicians in the US and Europe discuss increasing spending to offset economic weakness, the markets send a second important message. Fiscal stimulus which means handing people money and cheques, paid for with deficits and debt and ergo higher taxes, damages the economy. This demand-side Keynesianism has always been a failure.

From 'Great society' make-work projects like digging holes or building roads, to mailing cheques to people, fiscal stimulus does nothing to stimulate real private sector business activity. It simply transfers money from one group of people to another, and takes money from the right hand and gives it to the left hand. The end effect is actually negative, and like papering over dirty walls full of holes, fiscal stimuli are ephemeral measures which do nothing to address the real economic problems and threats to longer term economic growth.

The third point the markets are sending is that monetary policy is confused. As the economy slows, which it is surely doing in the US and Europe, two great and opposed ideas come into focus. Inflation as given by record high gold, oil and commodity prices, not to mention rising health, education and food costs, is a threat. High interest rates are needed to tame inflation, but such rates deter economic growth and capital investment.

What markets don't like is when central banks are indecisive, weak, or contradictory. The US central bank or Federal Reserve is a case in point. For some reason this central bank has decided that it must talk more, provide forecasts and reveal all its details to public scrutiny. The end result is predictable.

Every time the Fed talks it sends markets lower. The very nature of a central bank makes simple forecasting and easy analysis impossible. So they must talk in code and hedges. Markets don't like uncertainty. In this regard central banks would be better off saying less and doing a little more. In times of an economic slowdown and inflationary risk, the central bank must necessarily lower rates but only to prudent levels. It must also loosen monetary policy and provide some capital stimulus.

Neither the European nor the American central bank is doing what markets expect. The European central bank is concerned about inflation far more than it is about economic growth - which is its single mandate. So rates if they come down in 2008 will come down too little and too late to stimulate the economy. In the US, the central bank has bizarrely loosened money supply; lowered rates to unacceptably low levels thereby deflating the U$ and generating inflation. This plan is not something that any prudent central bank should be doing. US rates must rise to ward off 7% inflation and restore confidence in the US$, but given that the US is in an election year, the earliest rate support for the U$ will come in 2009 - by then inflation will already have destroyed literally trillions of dollars in wealth. Inflation is after all just another tax. The markets view all of this rather dimly. Markets recognise that a US election will offer up cheap populism including spending promises and certainly under Hussein Obama massive tax increases.

The predictable result of poor central bank and fiscal management is a market sell off.

Certainly other factors affect the markets. The 1% or worse of US mortgage debt going bad, along with the associated financial instruments or derivatives, is a good reason for market concern. When the financial and banking system comes under duress the markets will sell off. There is a direct corelation between the health of the financial system and market performance.

Yet when viewed in context these problems are reasonably minor. Of the 10 major economic sectors, 8 are healthy and have posted reasonably strong results in 2008 and are set to have good years in 2009. Corporate and income growth are certainly slowing along with general economic growth, but a massive general recession it is not. We are witnessing another crisis of confidence in central banks and politicians and this is reflected in a pretty mild economic downturn.

One of the signal lessons of the Great Depression was that governments cause economic contractions. The 1929 stock market crash occurred because of massive tax increases, higher tariffs, and more government spending. Investors saw what was going to happen and sold off in anticipation of lower profits and economic growth. Capitalism per-se had nothing to do with the onset of the 1930s Depression. Bad government fiscal and monetary policy and the rigid inflexibility of the Gold Standard caused the Depression.

The same rules apply today. The markets are anticipating a rancorous victory in 2008 by the European socialist party of the United States. When that transpires taxes and tariffs and government spending will rise. Every time an American politician or the US central bank discusses 'stimulus' or 'solving' economic problems, the market sells off. The message is clear.

What we need are tax cuts on income and investments, lower interest rates and more liquidity. This stimulates economic growth, not government handing out money to people. Populist politics might make good TV with air-head talk about hope, change, renewal, and 'stimulus', but it is the anti-thesis of what markets need and expect.

That in summary is why 2008 will be a rough year overall for investors. Simply put - we are in an election cycle and have incompetent central banks to contend with.

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