The Economy: "What to Do About the U.S. Stock Market Panic"

by Bill Bonner

TIVOLI, New York – “The Dow plunged 588 points yesterday – a nearly 4% drop… and the second straight day of losses of more than 500 points. The rich made money on the way up. Now, they’re giving it back. About $250 billion has been erased from the value of the U.S. stock market in the last two trading days. Meanwhile, Shanghai stocks sank another 8% on Monday. And they fell again by another 7% overnight. A desperate plea came in from our office in Beijing: “What do we do? Just tell investors to hold on?” Today, we offer some simple advice – make sure you’re holding plenty of cash in your portfolio.

A Rookie Market: China’s big problem is that its stock market investors are mostly neophytes. Its Communist government only permitted capitalism after 1979. That’s when Deng Xiaoping emerged as the dominant figure in the Chinese leadership and drove through his economic reform programs. And the Shanghai Stock Exchange has only been in operation since 1990. 

In the U.S., there were always a few old-timers who remembered earlier periods before the fix was in… and the Fed started to concern itself with stock market prices. Also, professional investors account for more than 90% of daily trading volume on the New York Stock Exchange… with individual investors responsible for the remainder. 

In China, this situation is reversed. According to Reuters, individual investors account for more than 85% of daily trading volume. And more than half of them are absolute rookies. China has roughly 200 million brokerage accounts. And according to data from the China Securities Depository and Clearing Corp., about 90 million of those were opened in 2014… and another 30 million were opened in the first five months of 2015. But all 200 million of them are convinced (as near as we can determine) that China will continue to grow – economically and militarily – until it rules the world. That may still be true. But even so, Chinese stock market investors are discovering that even if you’re marching uphill you can still sprain your ankle and scrape your knee.

America’s “Bubble” Years: The U.S. boom came in stages… The first began in 1982 and was healthy and reasonable. It lasted until 1987. Interest rates and inflation fell; stocks rose. Then on October 19, 1987, the Dow fell 508 points, which back then was a 22% plunge. In the aftermath, Alan “Bubbles” Greenspan made it clear that the Fed would no longer play the role of honest custodian of the nation’s money and indifferent observer of its capital markets. Greenspan’s 50 basis-point interest-rate cut saved the day. Henceforth, the Fed was in Wall Street’s pocket… and Wall Street was in everybody else’s pockets. 

After 1987, cutting interest rates to stimulate the market became Fed policy. It also responded with interest rate cuts following the 1990-91 recession, the blow-up of hedge fund Long-Term Capital Management, and the Asian financial crisis in 1998… The EZ money passed through the banking sector, which profited handsomely, and raised capital asset prices, which benefited the rich. One of the richest of the rich is 2016 presidential hopeful Donald Trump, said (by himself) to be worth $10 billion. Monetary stimulus was supposed to be balanced by monetary tightening. But the Fed was soon stimulating far more than it was tightening.

A “Financialized” Economy: This was the second stage of the boom… The most dramatic event of this stage was the dot-com crash in 2000. Many of the highest-flying dot-coms went out of business… and the tech-heavy Nasdaq lost 78% of its value from peak to trough. But Greenspan was on hand with more interest-rate cuts… and U.S. stocks were soon on the rise again. 

It was in this period that the U.S. economy began to look as though it should wear a bag over its head. In the popular jargon, it was “financialized.” By 2002, the Fed had dropped interest rates all the way down to 1%. Retail sales increased as households spent money they didn’t have on things they couldn’t afford and didn’t need. Much of this money was gotten by “extracting” equity from houses. This was Greenspan’s doing, too. He believed the drop in interest rates would lead to a surge in mortgage refinancing. As he put it at the time, this would facilitate the “extraction of some of the equity that homeowners have built up over the years.” 

Sure enough, mortgage finance boomed as lending practices loosened up… malls and housing developments were built all over the country. companies – notably GE – changed their business models to take advantage of easy credit… and the great houses of Long Island changed hands – from the tycoons of commerce and the titans of industry to the bankers and hedge fund managers of Wall Street.

A Tidal Wave of EZ Money: This second stage of the boom ended in 2008, when the housing bubble popped. Then began an even more grotesque phase. In Stage III, the river of EZ credit flowing into the U.S. became a tidal wave. And from its low in March 2009 to its record high in May of this year, the S&P 500 soared 220%… causing even more rot in the economy. There are roughly the same amount of Americans now on “disability” (8.9 million) as those who got new jobs. The median household income, after adjusting for inflation, fell. And the main buyer of U.S. stocks became U.S. corporations! This was when the Fed gave up all pretense of operating a sensible monetary policy. Instead, it dropped the Fed funds rate to near zero and kept it there for six years. 

This stage is not over… but the end must be coming. When? Well… we never know. But yesterday’s stock market rout was just a warning. Most likely we will see some dillydallying… a bounce… some nervousness… but no panic. The talking heads on TV will explain that there is nothing to worry about. We’ve seen these corrections before. The best thing to do is to buy and hold. That has always worked in the past. It will work again… etc., etc. And then, suddenly, we’ll get a few days when the Dow will close down 1,000 points. That will be the end of this third stage. 

What then? Well, that’s when Saint Janet will ride to the rescue. We can almost see the Time cover already. Saint Joan of Arc on a white horse… with the reins in her left hand and a banner in her right. But wait… This time it won’t be so easy. Interest rates are already at zero; what’s she going to do? Drop them below zero? Loosen margin requirements? Prohibit us from making negative comments? Give Americans a tax credit so they can spend money? Introduce QE4, wherein the Fed not only buys bonds… but stocks, too? 

For now, the best protection is cash, cash, cash… Cash is king. But that will change when the Fed swings into action. That will be the fourth and final stage of the great boom – when the zombies and cronies counterattack… with a massive barrage of inflation. Hang on to your hats!”

- http://www.thedailyreckoning.com