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Reflecting on 12,000

What lessons can we learn from the rapidly falling and slowly rising Dow?

On Jan. 14, 2000, the Dow Jones Industrial Average closed at a record high of 11,722.98. It took over six and a half years for a new record of 11,727.34 to be set on October 3, 2006. On October 19th, it closed above 12,000. Of course, this new record is illusionary as the index would need to cross the 14 thousand mark just keep up with inflation. Never the less this is a psychological barrier that represents a healthy recovery of the equity markets to sound fundamentals after flirting with inane ideas such as abolishing the business cycle and momentum investing. Still, there is an undercurrent of gloating that implies that the market collapse was driven by greed and manipulation instead of real economic conditions. While blaming the victims of economic collapse for their own indiscretion can provide a cautionary tale, it might be of more use to apply the lessons of too much capital chasing too little opportunity to other aspects of life.

The fall and rise of the US market disproves two commonly held ideas about markets. First, the notion that markets are efficient decision makers overly anthropomorphizes natural phenomenon. The language of investing has markets doing all sorts of things. The market discounts for an expected rise in interest rates or reacts to inflation reports. The truth is that a given set of circumstances sets the relationship between supply and demand. A market doesn’t think for itself. It is simply sum total of the actions of everyone participating in it and it certainly can’t know things the participants do not.

Second, is the fallacy that you can opt out of a market. While governments and industry can change the conditions in a market, it still exists. When a politician claims that something (say education) is too important to “leave to the market to determine its price”, you can bet that they are about to advocate manipulating markets without the foggiest idea of what they are doing.

So the question is what set of conditions led to the market suffering a loss that would take more than half a decade from which to recover? The late ‘90s were a prosperous time with large numbers of baby boomers suddenly realizing that retirement was coming faster than they expected. With news reports of big money being made in technology stocks and the financial press gushing about the new economy, income flow into 401Ks reached record levels. The problem was that few of these companies were actually making money, so fund managers searched high and low for investments for all that cash. Competing with tech indexes was not easy though and many funds required that their assets be invested despite the escalating prices. In the end, the money had to buy something and there was not much to buy. When the business cycle ebbed, as inevitably happens, money became tight and without buyers, prices fell.

The lesson to carry forth from this little morality tale is that pouring money into a market of fixed size causes dramatic inflation. This accurately describes the American health care system.

It is hard to imagine anything with more intrinsic demand than health care. If you need it or perceive you need it, you will pay what you have available to you to get it. Efforts to improve health care generally focus on making it “more affordable” by shifting costs from the consumer and holding down prices charged by providers. This has the effect of stimulating demand while constricting supply.

When consumers get a service without cost, they don’t evaluate how much value it provides. As more and more health care costs are shifted to insurance, consumers stop discriminating based on cost. This has a deleterious effect on the insurance companies that pay for the services. Eventually they attempt to ration care with limited success. They have better results negotiating price caps with hospitals, physicians, and other health care providers. The lost income from these deals has to be made up somewhere. That somewhere would be the charges to patients without insurance. Still the constant pressure to lower prices makes a career as a doctor less attractive than other more lucrative fields.

Essentially our health care system maximizes demand while discouraging supply. The mystery is not why health care experiences excessive inflation but why the inflation is simply accepted. The newspapers are filled with stories about rapidly rising medical costs. In each one the rising costs are treated as inevitable. They are not. Policies that increase supply while slowing growth in demand would control costs. A health care system that bleeds us of all of our resources is not necessary.

Every couple of decades, equity markets capitulate or OPEC stirs and reminds us what happens when growing demand meets constricted supply. What’s it going to take for these lessons to be applied to aspects of the economy we can actually do something about?



Re: Reflecting on 12,000

I've long thought that the reason for the exorbitant cost of health care was the virtually unlimited amount of money that the insurance companies were willing to throw at it, and you seem to be substantiating this to a certain degree.  My take is that when the "going rate" mark is set at a certain point by the negotiations of the insurance companies, then the uninsured are either going to a.) subsidize the going rate by paying an inflated rate or b.) succumb to the going rate as a minimum, and eliminate the possibility that the market will adjust the cost downward even if supply becomes more plentiful or the means of production become more efficient.  In other words, in this strange part of the economy, prices have a tendency to reinforce themselves, rather than being subject to market forces.

Eventually what's going to happen is the market WILL have its effect.  Just as water will erode granite over time, the market will erode the current situation in the health care system.  One scenario is that Insurance progressively becomes more and more expensive until it gets to the point that it is unaffordable.   When the money supply dries up, the providers will find it impossible to remain in business with the fixed overhead they are supporting.  Then there will be a health care crash as hospitals declare bankruptcy en masse.  What happens after that?  Probably socialized medicine, which likely means the end of U.S. leadership in medical research.  Yuck.

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