The U.S. stock market ended the year with many of the American indexes reaching record highs on the final trading day for only the sixth time in its history. The market chose to ignore such uncertainties as:
- Government shutdown
- Boston bombings
- Ongoing Syrian uprisings
- Debt ceiling debates
- Federal budget debates
- NSA revelations
- Lingering economic aftershocks of Superstorm Sandy
- Nuclear standoff with Iran
The S&P gains were the highest since 1997 and the third highest since 1970. The small cap returns are the third highest since 1980, and the NASDAQ returns were the seventh highest ever.
Is this a bull market? Commentators, investment strategists and economists don’t agree on whether we are experiencing a temporary rise in the midst of a long-term bear market, like that during the Great Depression, or the strong early stirrings of a long-term bull market, like the one that started in 1982. The truth is, nobody knows, just as nobody knew that the U.S. stock markets would reel off such strong returns after the near-collapse of the global economic system.
Many feel the strong performance was a result of the easy money policy of the Fed. New variables introduced in late 2013 were the Fed’s reduction of bond purchases (which may result in higher interest rates) and the question of how Janet Yellen makes her mark as the new Fed Chair.
Long-term investors are frequently compared to farmers, who plant seeds with no foreknowledge of the weather during their growing season, or any sense that what happened this year has an impact on what will happen in the next one. There will be bad years and good years, but over time the good years tend to outnumber bad ones, which is why it makes economic sense to continue planting the seeds each spring—or to stay invested in the stock market when each coming year is a mystery.
Numerous articles have been written about what has changed since the time Lehman Brothers collapsed until now. The tone of most headlines is pessimistic. A couple of examples: “How Financial Reform Became a Fiasco” (Research Magazine, August 2013) and “Five Years Later, The Plumbing is Still Broken” (New York Times, Gretchen Morgenson, September 15, 2013). Below we will take a brief look at the major issues that led to the collapse of Lehman and subsequently the financial system.
- Leverage: In 2008, one of the biggest problems was the depth of bank borrowing. In 2008, it was up to 50 times what they were worth in net capital. While net capital has increased, there is still no restriction on leverage.
- The Volker Rule: The rule limited bank activities to earning money by making loans and taking companies public. It was removed from Dodd-Frank. Investment banks can use our money in the stock market, derivatives, etc. The JP Morgan Chase Trader – “London’s Whale” is the most recent example of the lack of risk management. He lost $7 billion of the shareholders and company’s capital.
- Complex Derivatives: This is the activity that guaranteed payment if derivatives defaulted (think AIG). There is some progress on this front. Interest-rate-swaps must now go through a central clearing house which tracks who owes what to whom. The Wall Street Lobby carved out significant loopholes. Banks and hedge funds continue to actively trade in derivatives without oversight and are unregulated.
- Rating Agencies: They gave AAA ratings to the toxic mortgages. The companies issuing the products paid the rating agencies (conflict of interest). No change.
- Wall Street Incentive System: The toxic products were sold by brokers, traders, etc. and the compensation was based on the sale. The more you sold, the higher the bonus. When these products fell apart, there was no penalty. The money was kept. Nothing has changed.
- Too big to fail: Nothing has changed. Risky bets can be made with the expectation the government will bail them out again.
Intense lobbying by Wall Street has succeeded in blocking most of the changes to the financial system. This does not mean the financial crisis is going to occur again, but it isn’t very encouraging that Congress is bullied by the lobbyists into inaction.
We can all find things to complain about. The dysfunctional government, our education system, stalled wages, etc. HOWEVER, compared to the rest of the world, we are in great shape for the future. Below are some of the reasons why.
Demographics: Despite the debate about immigration, the U.S. still has one of the most open immigration policies in the world. Only Canada and Australia are as open as the U.S. (Japan for instance, has no immigration which causes economic problems). Immigrants tend to be younger and of birthing age. This keeps the fertility rate in America close to 2.1 births per child-bearing woman. By comparison, Japan is 1.4, UK is 1.9 and Germany 1.4. Aging populations need young people in the work force to pay taxes and produce. Immigrants are fulfilling this role.
Entrepreneurial Spirit: Our country’s culture encourages challenging the status quo, questioning, and the ability to fail and try again. This is unique to the U.S. Other countries discourage individuality. The Chinese have an expression, “The nail that sticks up must be hammered down.” Not so here.
Labor Flexibility: We may not want to but we can work part-time, take less for wages, or retrain for other jobs. This isn’t done overseas. Lifetime employment is the rule in many countries.
Strong Dollar: It is still the world’s primary trading currency. While we might complain about economic, political and financial strength, compared to the rest of the world, we are the most stable.
Foreign Dependence: The need for foreign financing is declining. The deficit is decreasing; energy independence is increasing; and robotics and capital intensive manufacturing are increasing. The U.S. will become the world’s largest energy producer in 2013. This changes the political and economic dynamic of energy-rich nations as our independence increases.