Earlier this week, I made a very clear and public call that the markets will not retest the lows.
It's a hard call to make! Most capitulatory bottoms are followed by a retest of the lows. Market history flies in the face of what I think will happen.
And it might. If anything it would be a technical retest, and I'll look stupid, and we'll move on.
The big risk is a long, protracted bear market that spills over into the economy.
How does that risk show up? It's not COVID. it's something else.
So to start we're going to dive down into a very deep rabbit hole to find out what could truly break this market.
The Grand Unifying Theory of Economics and Society
Sounds fancy, doesn't it?
This is not a new concept, yet I want to completely layout the foundation of how I view the relationship between stock markets and the economy.
This is Bob.
Bob is our everyman. Wife, 2 kids, house, steady job.
Bob is not an island. He works for an employer. Bob has a Job.
This is the labor-capital model. Or you could call it employer-employee relationship. Bob works at his Job to make something, and the Job gives him money.
Bob also owns a house. Well, he doesn't technically own a house he has a mortgage on a house. A bank owns that mortgage debt and Bob pays the bank.
These are all economic relationships, yet they also have trust involved. The employer trusts Bob to come to work and help the company. Bob trusts the company to meet payroll. The bank trusts Bob to make his mortgage payments.
Bob has many other money-trust relationships.
He trusts his wife won't divorce him and take his money, and helps to build that trust by buying her diamonds.
He trusts his cell phone will work, even on the interstate, and pays for that service.
He trusts the Chinese Buffet will give him more happiness than food poisoning, and he tips extra well.
He trusts that the news is fair and accurate, and in return he is willing to watch commercials that pay for the airtime.
He trusts that the taxes he pays to local, state, and federal governments provide services and protection.
Bob is not an island.
And neither are the other entities out there.
Bob goes to the Chinese Buffet to pay for lunch. That money (trust) goes to many different places:
That restaurant has payroll, rent, food service, and taxes. Lots of other things too, and in turn each of those entities have relationships.
You know what this starts to look like?
A neural network.
That's right, the economy is one giant abstraction of a brain.
How Do We Know When The Economic Big-Brain Is Healthy?
We're going to beat this analogy to death.
Think about the human brain-- the squishy one-- and translate it over into the economy.
A healthy brain has many connections between nodes. They are actively communicating and sharing information-- in our case "money and trust."
A healthy brain has good nerve connection. The myelin sheath is strong, allowing for efficient transmission. My view of "strength" has to do with the level of trust one node can have with another. "Rule of Law" comes into play here, with the ability for two entities to enter a contract with clear terms.
A healthy brain can quickly move information between nodes. In economics we call this "money velocity," or how many times the same dollar is transacted, and is actively measured.
A healthy brain should be able to change over time. Yes, you can learn guitar at the age of 40 if you would just put in the practice and stop letting your guitar collect dust in the corner of your office.
With economic plasticity, the ability to change nodes is crucially important.
Don't like your cell phone plan? Move to another company. Don't like your house? Then sell it and move on. Don't like your wife? Cut your assets in half (or more) and find another one.
That doesn't mean Bob should have a mid-life crisis. It's a bad idea for Bob to leave his family and go tour with the Grateful Dead.
Yet marginal economic plasticity is a good thing. Maybe he finds a better job, or a better house.
The only relationship where plasticity doesn't exist is government. There is some level of it in democratic nations where you can petition representatives to change things, but on a whole... taxes are taxes.
It's also why you want as many free markets as you can. If your economy is run by the state then you lose plasticity because you have no other choices to make.
Take that, you commie fucks.
A healthy brain has the right kind of chemicals. Dopamine, serotonin, oxytocin, cortisol, hormones, endorphins... balance matters.
Too much or too little can throw the brain out of whack.
(Yes, we're going to torture the analogy further, because it's a useful model.)
Debt is a kind of dopamine.
A cup of coffee can increase your dopamine levels to feel good. So can cocaine, but the crash afterwards is ugly.
You want a proper balance of debt to help your "brain" improve.
When you have more nodes, higher node density, faster node speed, high plasticity, and balanced brain chemicals... then good things happen. Your economic "brain" can grow. Sure, sometimes the brain will go on a bender and have a "hangover," but that's part of the normal economic cycle.
The "Strange Loops" In Our Brain
Back in 1979 a book was published called "Gödel, Escher, Bach: an Eternal Golden Braid."
It is a beautiful attempt to string together multiple disciplines-- math, art, and music-- as way to show how cognition develops.
I've tried 3 times and could never finish the damn book.
A concept is in the book is the idea of a "strange loop," where a system can reference itself. It's a crucial element in human consciousness and also within our Economic Brain.
It's also where the biggest risk lies.
Information And Neural Structure
I'm a fan of positive thinking. I don't do enough of it.
Simply put, the things you think about can alter your brain structure. If you think positive thoughts, your brain chemicals can change. Your neuroplasticity can change. The structure of your brain can change over the long term.
We also need to have self-awareness-- knowing when we are feeling good or bad. That's a skill to build and really stinking hard to do on a personal level.
Let's make this a little more abstract so we can transfer it over to our Economic brain analogy.
Richard Dawkins coined the word "meme" -- referring to a unit of information that can propagate through a culture.
These memes can be self-referential, pointing out something in our society... and it has the ability to influence it.
(Don't lie... you did the Macarena in the 90s.)
In the Economic Brain, memetic information can directly influence the chemistry and structure of the brain.
The most well known information is the stock market.
If the stock market is going up, then the CEO of a company sees her vested options rising. She is willing to take more risk and hires more people. Those people now have more money and go to restaurants or buy houses.
The number of nodes increases, node density increases, plasticity increases (you have more options available), and the "brain" grows.
This concept is called reflexivity.
It can also run the other way.
The Biggest Risk in The COVID Crisis
Right now people are sick. People are dying.
It goes beyond that. Many can't trust their employers that their job will be back in 2 weeks. Trust in the media is (deservedly) at all time lows. The government response to the COVID outbreak is (predictably) slow.
At some point the fever breaks. The question is... how fragile is the network?
This is Bob.
Bob has a job, and connections to other nodes.
COVID hits. It's a pandemic. Absolute disaster. Too many schmucks were overleveraged stocks and the market crashed. The media got their reporting COMPLETELY WRONG in February. The government is dragging its feet on getting a fiscal package together, and the measures the Federal Reserve are taking are trying to preserve network integrity... but it doesn't directly affect Bob.
The integrity of these connections are very weak, but they still exist.
Let's say that the owner of the company loses trust in things. Trust that the government will be able to pull this off, trust that COVID won't come back in November, trust that he can stay in business in the next 3 months.
The owner of the company has to cut payroll. Bob thought he would have a job after quarantine, but he's been cut.
One thing to understand here is that these neural connections take energy to create. It's hard to get a job, it's hard to change your cell phone plan, it's hard to buy a house.
The energy required to create a connection is MUCH HARDER than it is to destroy it.
So Bob loses his job. That means no discretionary spending on restaurants. He's got no income so he's not paying taxes. His wife leaves his broke ass. The bank forecloses on his house. He will never trust the media again.
Bob is now an island.
It's called an Economic Depression for a reason. When you're depressed, your brain chemicals change. Your total brain activity slows down. Your prefrontal cortex can literally shrink.
An Economic Depression causes the brain to become unhealthy. The number of nodes drops, the connection strength drops, money velocity slows, and the chemistry gets out of balance.
It's a very bad thing.
Reflexivity Will Save The Economy, or Crush It
At the end of 2019, there were some budding signs of economic instability. The yield curve inverted, we were at unemployment lows, and it had been over a decade since the last recession.
So yeah, it was possible that this would be a recession with a little "r."
Then COVID-19 rolled in and fucked it all up.
It is an exogenous event. Comes out of nowhere. Not just a black swan, but something beyond that, more akin to a terrorist attack.
I don't want to spread conspiracy theories. We have a pretty good idea on the origin of the virus. Just have a mind exercise with me.
Imagine that COVID-19 was man-made. That it was created by an Aztec death cult to bring forth the return of Quetzalcoatl. Instead of it being random biological chance, it's international terrorism.
How would our response change? We would have locked down faster. We would have tested faster. US fiscal reponse would have been faster.
Because it was just bad luck, we've not been very good at handling it. And justifiably so! It's been a century since a global pandemic.
What matters more is our response. Treat it as though the origin of COVID-19 was malevolent.
We would come together, not just in the US but globally. We would use the "strange loops" in our system to reinforce the network by generating trust and goodwill out of thin air.
The biggest risk to the markets is psychological. If we aren't aware of our own reflexivity, if we lose trust in our own network nodes, then it will get much, much worse before it gets better. This goes beyond stock market prices, although that does help.
The world will need symbols. The world will need mass psychological anchors to help kick-start those "strange loops" to preserve the system.
A month after 9/11, George Bush the first pitch at Game 3 of the World Series. The Yankees were playing, in New York.
The pitch was straight down the middle. An absolute heater.
Did it fix the economy? Hell no, it was another year before the stock market bottomed.
Yet it was an anchor, one of many to keep the neural net alive.
How Much Trust Is In Your Network?
The fever will break, literally and figuratively. When the US collects more test data, we will have a better handle on it.
In a disaster, there are two things predictable about the US government:
- It will be late to respond
- It will hilariously overreact after the event
After 9/11, we cranked up airport security to a hilarious degree. Most of it doesn't work, but at least we secured the cockpit doors to prevent forced entry. Hell, we invaded two sovereign nations to try to fix the problem.
Once the first round of COVID clears up, there will be fear of a second round that would shut down the economy... again.
It probably won't happen. The US will print one trillion masks. We will have a ventilator for every single person. The Department of Education will mandate that all children be screened for temperature, daily.
So I'm not worried about the COVID. Or any other stupid "novel" virus that shows up in the next decade.
The risk is psychological. Can you trust your employer to have a job open for when you get back? Can your employer trust their supply chain from being disrupted again?
The network has to be preserved. The Federal Reserve is trying its best (they really are) and a US Fiscal deal looks to be in place. Nobody will like the fiscal deal, but nobody ever does.
Leadership at the presidential level is... well it is whatever you want it to be. You either hate Trump or you don't, so the needle isn't going to move there. The smartest thing they've done is to put smart people on camera to give us the numbers. The numbers don't have to be good, they just have to be said by someone who looks like they know what they're doing.
On a national level, what can be done? The media can help by not being dickheads anymore. They got this story wrong in February and they're now overshooting by showing nothing but dead old people. The propaganda machine needs to run the other way for a while. Show the recoveries and the novel solutions.
We need the anchors to preserve network integrity, and if it's done well, then we will rocket out of the hole after COVID 19 is contained.
What if it's Different This Time?
There have been, and will always be, those who don't like "the system."
They'll blame the Fed, or the bankers, or fractional reserve banking, or wealth inequality.
What's true is they don't like the economic brain. They wish it had Alzheimer's so it would be more fair.
And once the market got crushed on a black swan event, they've come out of the woodwork talking about how the house of cards will finally collapse.
So will it? Will this debt-fueled economy stop being propped up by the evil central bankers so we can finally get "reasonable" stock valuations?
(Even though they will never buy stocks.)
Here's the answer to that:
Maybe. Maybe not.
Maybe go fuck yourself.