Greed versus Fear
By Travis Baugh (11/21/2008)

There is no question that we are in the midst of a significant economic turndown. The core of our financial systems has been battered by the subprime mortgage meltdown. Unemployment is presently at 6.5%, the worst it has been in 14 years, with 240,000 jobs shed nationwide just last month. The stock market is extremely volatile, with the bellwether Dow Jones Industrial Average having recently gyrated wildly between a high of 11,388 on September 19 to a low of 8,175 on October 27.

As regular readers of this column know, I was not in favor of electing Barack Obama to the presidency. However, that is now past history. I genuinely hope his presidency succeeds beyond my wildest expectations. We have some problems that need to be addressed and he will need all the help and luck he can get to help the country successfully navigate through these waters. But before we start forming soup kitchen lines, maybe we should take a deep breath and put our current situation in perspective.

After all, what really is the difference between a recession and a healthy economy? It can be summed up in one word: CONFIDENCE. Think about it. Is there less currency around than there was before? No, in fact there is more currency available right now, given the Federal Reserve and Treasury policies of late. Are there fewer people available for work? Has there been some sort of planetary natural disaster that wiped out our ability to produce products? Some leapfrog change in technology that rendered our factories obsolete? The answer to all of these questions is clearly “no.” The only thing that has changed is our perception about what is going to happen in the future.

We have been told for the past two years by the mainstream media that we were in a recession. Haven’t you all felt bad about the economy for as long as you can remember? Well guess what folks: Until very recently, the US economy has not been in a recession. The definition of a recession is two consecutive quarters of decline in Gross Domestic Product (GNP). Did you know that the first decline in GNP that we have had in the past several years happened just this past quarter ending September 30, 2008? So much for the recession that never was. Why would the mainstream media want to convince us that things are terrible when they really are not that bad? The answer is quite simple: bad news sells advertising better than good news does. Consider your own reaction to news teasers. When are you more likely to tune in to a news program or focus on a newspaper article, when things are running fine or when you have been told a disaster has occurred? The simple unfortunate truth is that media companies prey on basic human emotions to help them sell their agendas. Add to that the recent political season where all of the candidates were harping about how bad things were and how much we needed change, and presto: we started to believe it. Perception becomes reality.

There is no question that we are in a recession now, possibly a severe one. All three of our major automobile manufacturers are in deep trouble, as they are selling no cars right now. Retailers are expecting a terrible holiday season. Some economists are predicting unemployment will rise above 8% before the end of 2009. So what is it going to take for us to pull ourselves out of this recession? The basic problem is CONFIDENCE. Apparently no one is buying anything that they don’t absolutely need to buy because they are afraid of what might happen in the coming months.

So what do we do to regain our confidence and restart the economy? It will definitely not help to get another economic stimulus package, where we open up the Treasury and send small checks to people in hopes that they will all go out and buy big screen TV’s or something else. We have tried that already and all it accomplished was increasing the federal deficit and making our dollars cheaper against all other currencies. What we need to change is our collective confidence level about the future of our economy. The heart of that process is job creation. Manufacturers and other businesses have to regain confidence that the market for their products and services will reappear and stabilize before they start hiring people. When the job market begins to pick up steam, our national psyche will also. If people have confidence that their jobs are not in jeopardy, they act a lot differently. They start coveting material goods and services again. Behavior is contagious, regardless of whether it is negative or positive.

The mental tug of war that we are currently waging within ourselves illustrates a phenomenon that an investment banker friend of mine recently referred to as “Greed versus Fear.” (Note: the word “greed” has a bad connotation, but it is a genuine, basic human emotion which cannot be ignored. As with most things in life, greed is only bad in excess). Simply stated, there is a direct, inverse relationship between how markets and the general economy react to society’s collective desire for goods and services (greed) and the feeling that bad things are going to happen in the future (fear) which dampens desire for goods and services. See the graph below:

It seems pretty simple, right? Note that as “fear” increases or “greed” decreases, economic activity decreases. Logically, the opposite happens when “fear” decreases or “greed” increases. Right now we are skewed heavily into the “fear” sector. But what everyone needs to understand is that the economy is going to continue to suffer and the financial markets are going to continue to gyrate wildly until we collectively start believing it is time to stop being afraid and start desiring goods and services again.

It’s also important to carefully examine where we really are right now and compare it to the past so we can put things in proper perspective. It is very important to note that the current financial crisis does not approach the levels we have had (and survived) several times in our past. The Dow Jones Industrial Average (DJIA) peaked at 14,164, an all-time high, just over a year ago (10/9/07). This past Friday, it stood at 8,944, a decrease of 40.1%. Ouch! But take note of the changes that occurred in 1929-1932, 1987 and 2002. Between September 1929 and July 1932, the DJIA fell over 89%. In 1987, the DJIA fell over 31% from the beginning of September to the end of October. In 2002 (following the 9/11 attacks), it fell 30% from May to October. So we are certainly not in totally uncharted territory in regards to the stock market.

At some point, the “greed” factor is going to start outweighing the “fear” factor. Specifically, in regards to the stock market, one important data point to consider is the price to earnings (PE) ratio of stocks. The PE ratio is simply the price of the stock divided by the earnings for the previous year and is an indication of how expensive or cheap a stock is, particularly in relation to other stocks in the same business or sector. Using the PE ratio of the Standards & Poor’s index of the 500 largest stocks in terms of market capitalization (market value) can give us an idea of how the overall market is priced, in historical terms. The average PE ratio for the S&P 500 the past 25 years is 21.01. As of September 30, 2008, it stood at 22.14. Although the exact number as of this writing cannot be precisely determined, we can extrapolate from current data. The S&P 500 index value as of this writing is $898.95; as of September 30, 2008 it was $1,166.36. This represents a 30% decrease in the “price.” Extrapolating, that means that the PE ratio today is likely somewhere around 16. That would place it well below the 50 year PE average of 17.71. There is a lot of money out there on the sidelines. At some point, some stocks are going to look very cheap to investors, particularly considering the paltry interest rates that are available today. So “greed” will eventually win out over “fear”

Things are also not as bad as they have been in the job market.

Unemployment in the 1930’s was over 20%. In the recession we experienced in the 1980’s, unemployment peaked at 10.8%. As previously mentioned, the current rate is 6.5%, a long way from the previous low points.

The point of all of this: We have been here before and have always come out of it stronger than ever. So let’s see what happens over the next few months. One positive step would be to repeal the Democratic Party’s Community Reinvestment Act and stop forcing banks to make subprime loans, the primary cause of the mess we are in right now. President-elect Obama has also said he intends to postpone any discussion of tax increases and focus on policies that create jobs. That is also a step in the right direction. The $700 billion Troubled Asset Relief (TARP) program should start helping unfreeze the credit markets in the near future. Making credit more available should enable some of our basic industries to get back on track, like manufacturers of automobiles and other hard goods. And there are still some positive things going on, even in the current economy. The energy sector is still adding jobs, as is the health sector. Of course, Congress could snuff out the light in those sectors with a windfall profits tax, drug price caps or loosening drug importation restrictions of US produced drugs from foreign countries. But Congress and President-elect Obama will hopefully recognize the foolishness of trouncing the only healthy sectors of our economy in the current economic crisis when beacons of hope are so scarce.

It is a simple fact that economic conditions don’t change overnight, either for bad or good. We all just need to have patience and faith that we can and will get back on a positive track in due course. And after things do recover this time, as they most assuredly will, the next time we hear the mainstream media start again to tell us that we are in a recession, we may want to think twice about it. Maybe things are not as bad as they are trying to make us believe.

(email me at travis@travisbaugh.com or go to my website www.travisbaugh.com)