The last week of February 2020 was a wild week in world equity markets. The Dow Jones industrial average dropped over 3500 points and the S&P 500 Index dropped over 11%.
The markets were jolted by fears of a coronavirus outbreak and reacted accordingly.
But wait, I have always been taught that markets were efficient. Markets are supposed to be rational or so I thought. The reality is that the markets were being efficient with the reaction to the coronavirus. The markets were free to react as the buyer and sellers wished based on what they perceived to be the risks to the economy. The theory never mentions that buyers and sellers will act rationally but only that they will act.
The Efficient Market Hypothesis (EMH) “does not require that investors be rational; it says that individual investors will act randomly, but as a whole, the market is always “right.” In simple terms, “efficient” implies “normal.” For example, an unusual reaction to unusual information is normal. If a crowd suddenly starts running in one direction, it’s normal for you to run in that direction as well, even if there isn’t a rational reason for doing so.” (source: www.thebalance.com)
The significance of understanding the emotions and emotional responses behind buying and selling decisions in world markets is to help us put in perspective that market prices and stock markets are not always rational indicators of economic performance. Understanding free markets helps us navigate the newly restored liberties to our economy since President Trump was elected.
With the coronavirus outbreak, world markets are reacting to what may happen and not what did happen. We have had these types of events before and it is important that we lead the event rather than the event leading us into a recession.
There are certain rules of law that fall within the purview of man and there are significantly more important truisms of markets that defy the laws of man. Whenever man attempts to interfere with these truisms, chaos ensues. During the presidency of Barack Obama, he managed to violate many free market principles which had previously guided our economy. The Trump presidency has reversed many of his predecessor’s policies leading to significant economic expansion.
This phenomenal economic expansion is due to adhering to certain truisms affecting all markets. These principles are based upon economic self-interests which influence the performance of free markets. President Trump is attempting to reassert the economic principles behind these truisms.
The first principle is “Governments can never react as quickly as free markets”. Despite efforts by government to react, the reactions are just what the name implies – a reaction. Free markets, however, can be proactive. Governments solve yesterday’s problems with yesteryear’s solutions thereby setting the stage for tomorrow’s crisis. Government provides the framework for the economy but cannot control it. President Trump understands that and is asking for calm from market participants and not more government intervention.
The second truism is “Free Markets will always win”. The concept of a black market is deliberately designed to circumvent the rules that government’s put into place to begin with.
Our government’s attempt at Prohibition is perhaps another example of this second truism. After much fanfare, all Prohibition managed to do was organize crime in this country. The real issue, alcoholism, was barely impacted at all.
The third rule of free markets is “You cannot tax your way to prosperity”. Taxes are an expense to individuals, corporations, and the public. If your taxes are too high, capital will flee your markets, investment will slow, and economic problems will follow.
A fourth principle is “Governments always overreact and under perform”. President Trump is asking us to remain calm because we hold the key to how this coronavirus crisis affects us. Government can facilitate remedies but “free markets will always win”.
Finally, the last principle is one that I hope all will consider very carefully. That principle is “Nations can fail”. Governments should provide the framework for how we live not interfere in our economic lives by attempting to control the economy.
With the principles that I have observed it is obvious to me why our Founding Fathers wrote the Constitution the way they did. I would encourage all citizens to read our Constitution very carefully. Our Founding Fathers understood the role of government. Governments should provide for common defense, the framework for commerce and provide for the rule of law. Nothing more and nothing less.
Frank Ryan, CPA specializes in corporate restructuring and lectures on ethics and corporate governance for National and State CPA Associations. He is on the boards of numerous non-profit and publicly traded companies. He can be reached at [email protected]