Barack Obama: Buy on the Rumor, Sell on the News

Today, Barack Obama was sworn in as the 44th President of the United States. The Dow Jones Industrial Average closed at 7949, or 1676 points below the 9625 level where it closed on Nov. 4, 2008, the day he was elected. That 17% percent drop shouldn't be taken as a negative reflection on President Obama. It's really variant of the stock market following the old adage of buying on the rumor and selling on the news. Buying on the rumor is a way to profit from hope. Selling on the news--in this case, recent negative financial reports from major banks and business corporations--is what you do when reality looms.

Reality is that the banking system still harbors hundreds of billions and perhaps trillions of dollars of losses. The real estate and credit crunch losses of last summer have been supplemented by more broadly based losses resulting from the recession. Many different companies in many different industries are now hurting, and banks will probably be measured by the size of their loan loss reserves as much as by their earnings (or losses). Even though the banks have written off hundreds of billions of dollars already, new losses are springing up like the heads of the Hydra.

Reality is that the mortgage mess and credit crisis have morphed into a general, widespread recession. Unemployment is rising rapidly, not only in financial services and real estate-related industries like construction, but also in manufacturing, retailing and many small businesses. Things in Europe and Asia are, if anything, sliding faster than they are in the U.S. The U.K. is moving toward an expanded bank bailout. The Euro is dropping sharply against the dollar. Russia's ruble is under enormous stress. Japan's export-based economy may be shrinking at an annual rate in the double digits. China's government is implementing a stimulus package that, proportionately speaking, is larger than President Obama's stimulus proposal.

President Obama's stimulus package may give the stock market a lift (or not, if the news from the real economy continues to be bad). Whether it provides lasting support is a different question. The devil is in the details. Two basic things must be done to turn the economy around long term. First, federal fiscal policy should focus on encouraging productive economic activity. Production is the heart of any industrial economy. For much of the past 10 years, federal policy has been to boost real estate prices, counting on rising values to induce consumers to buy more homes (fueling the construction, finance and related industries) and to spend their home equity (fueling retail activity of all sorts). But, bottom line, this was just a speculation in commodities prices--in this case, the price of real estate instead of tulip bulbs. Except that at the peak of the frenzy, real estate and tulip bulbs amounted to the same thing--assets whose value depended on finding increasingly foolhardy buyers. No economy builds true wealth by trying to inflate asset prices. Doing so only results in price bubbles that painfully burst. Many oil producing nations have boom-bust cycles because they are too dependent on petroleum prices. The U.S. will be unable to establish sustainable economic growth if it continues its dependency on real estate prices. We need to focus on producing more things that can be sold domestically and overseas.

The second essential step is to establish a functioning financial system, one that manages and invests savers' money in reasonably prudent ways without creating systemic risk to the entire economy. It should be doable, but recent history is disheartening. Wall Street made massive amounts of money in the short term by creating huge risks for other people's money in the long term. What we need is a new Wall Street. The Obama administration and new Democratic Congress will endeavor to achieve that through increased regulation. It worked in the 1930s and could work again. After all, the unregulated derivatives market was the source of most of the trillions of dollars of losses that bedevil banks today. Market forces have also imposed reform. The most successful firms in financial services today are the plodders: the purveyors of index funds and low cost target date retirement funds. The tortoises beat the hares.

Note that we said restoring production of goods was the first step to recovery, and that salvaging the financial system was second. That's because you can't have a sound financial system unless you have a sound underlying economy. The Bush administration's policies of throwing unlimited quantities of cash at every financial institution in sight have failed to revive lending because the banks want borrowers that are creditworthy. And there are many more creditworthy borrowers when underlying economic conditions are strong, than when the economy is riven by layoffs and bankruptcies. The financial system is, in the final analysis, an adjunct to and service industry for the real economy. We can't become economically healthy if our economy is based on banks shuffling paper around (Iceland's recent collapse is Exhibit A in this respect).

Many observers viewed the yellow-gold dress Michelle Obama wore to the Inauguration as a symbol of hope and optimism. Maybe so. It certainly wasn't Republican. The real symbol of hope and optimism was the election of her husband, a nonwhite man, as President of a majority white nation. America today remains perhaps the only nation in the world that is truly based on democratic principles, rather than tribal or ethnic ties, or arbitrary borders left as an unfortunate legacy of European colonialism. The brightness of America's freedoms has attracted numerous talented and ambitious people from around the globe, whose energy and abilities provide a synergistic boost to its economy. America has a flexibility and capacity for innovation, improvisation and creativity that is unmatched anywhere else. Changes are good that ten or fifteen years from now, our economy and financial system will be quite different from what they are today. But chances are also good that they'll work, because that's America.