Defying Gravity

Overall, 2019 was quite a year with most indexes increasing by roughly a third.  From a historical perspective, the period from 2010 through 2019 was the first contiguous decade in the history of the market without a recession[1].  During this period, we had only one (2018) negative year.

The gains of 2019 were phenomenal in light of the many headwinds facing investors heading into, and throughout, the year:

  • Geopolitical uncertainty
  • A Global trade conflict
  • A Global economic slowdown
  • Brexit
  • Worsening domestic business profits
  • Weak fourth quarter U.S. company outlooks
  • Lethargic business investment (despite the promises of the 2017 Tax Cuts and Jobs Act)
  • Historically low unemployment that has been stymied by a lack of qualified, skilled workers

The performance of 2019 makes little sense given the noise in the background.  How are equity markets setting records with slowing profits, weakening company guidance, and seemingly continuous dour global economic news? 

The answer is likely that we are late in the business cycle and, with each year of the market setting new records, the Fear of Missing Out (FOMO) becomes increasingly high. With global interest rates at historic lows, pensions and retirees can’t rely on the safety of fixed income to meet their portfolio return requirements.  When rates on “safe” securities are ultra-low, investors feel compelled to take on greater risk to get an acceptable return on their money. They “reach for yield” to avoid missing out on the gains investors are seeing everywhere else.

Stable economies sow the seeds of their own destruction

– Hyman Minsky

Hyman Minsky was an American economist and professor of economics at Washington University in St. Louis. Minsky was also a distinguished scholar at the Levy Economics institute of Bard College where he was responsible for establishing two of the Institute’s ongoing research programs: Monetary Policy and Financial Structure, and The State of the U.S. and World Economies.  His research attempted to explain the characteristics of financial crises, which he attributed to swings in a potentially fragile financial system.

Minsky proposed theories which linked financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles. His theory stated that in prosperous times, when company cash flow rises beyond what is needed to pay down debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their normal income. This, in turn, leads to a financial crisis.

Minsky divided the economic cycle into three distinct phases based on how businesses (investors) seek financing/debt.  In the first phase, “Hedge Financing,” firms take on a small amount of debt where they have no trouble making both capital and interest payments.  The companies rely on future cashflow and healthy profits to repay all their obligations. In the second phase, “speculative financing,” the borrowing is a bit riskier.  Borrowers stretch their finances until they can really only afford to pay the interest on their debt. They have cashflow to pay the interest, but they have to roll over the debt to repay the principal.  This is manageable as long as the economy functions smoothly, but a downturn could lead to distress.  The third phase, “Ponzi Financing,” is the most speculative and dangerous.  Borrowers do not have cashflow to cover principal or interest and the prices have to rise to support their liabilities. If prices fail to rise, borrowers are left swimming naked.  Said simply, when economies feel stable, overconfident investors begin to take excessive risks that lead the economy to instability. These principles were highly applicable to the 2008 Financial crisis, and also to the Dot-com speculation and crash at the turn of the century. 

How does this apply to today?  While I don’t believe we are at a point of our Minsky Moment[2], I do see pockets of excess.  These include the Venture Capital and Private Equity subsidies which I mentioned in my last note, a return of covenant-lite loans to support the influx of investments into Private Equity, and a seeming glut of student loan debt which could lead to problems when the government is forced to foot the bill.  But the concept of “economic stability itself breeds instability” is not limited to businesses and borrowing.  Everyday consumers fall into this trap. My wife would say that it can lead to questionable decisions in romantic relationships.   I would also add that it can lead politicians to make destabilizing decisions. 

I continue to believe that we are not on as sound economic footing as the market rise would indicate.



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