Profiting From Loss
No matter the state of the market or the world economy, some people are making money and others are losing. Not everybody wins at the same time and neither does everybody lose at the same time.
Certainly, it is more reassuring to imagine that “we are all in this together” or “everybody is in the same boat,” but it is not true. This is why we have a federal system with checks and balances to prevent any one party from dominating every branch of government at every level.
Partisan bickering is a good thing because capitalism must generate opposing parties (for example, “creditors and debtors,” “nationalists and internationalists”). Worse than gridlock and bickering is an uncompromising rule by one party to the detriment of the other.
If the people who own assets and benefit from their rise in price rule for too long, the consequence is inflation, asset bubbles, and mountains of debt. If the skeptics rule unchallenged, the result is a sluggish economy at best and quite possibly an economic crash. But neither becomes too strong; they are each the antidote to the excesses of the other.
Also, keep in mind that, much of the time, investors are bearish in some assets and bullish in others. During ordinary times, there is no clear strategic direction. Some assets, such as Lehman Brothers stock or Greek government bonds, may come under a bearish attack even while the prices of other assets are still booming bullishly.
However, when a general economic crisis hits, it is because there are powerful bears making strong bets that broad classes of assets will decline, dragging down the entire economy. During such time, the bears are rampaging. Of course, these strategies would not work if the previous bull market wasn’t built on shaky speculative foundations, but powerful bear interest can provide the force to push the bull over the edge.
Bears can profit from declining asset prices or a bad economy in several ways. They can invest in anticipation of that result and even help bring it about, creating a self-fulfilling prophecy.
Broadly speaking, there are four bearish tactics: the short position, credit rationing, price war, and liquidity.
A short sale is the oldest form of short position, but in recent decades it has become more common to short an asset using financial derivatives, such as put options or short futures. In principle, “going short” is betting that some asset price will fall. The profits can be quite substantial and, more importantly, very quick.
Credit rationing is hugely important yet barely mentioned in most economics and finance texts. Anyone lending money always has the power to say no to a particular loan.
Thus, lending is not a market like the markets for rice or rubber. It is a relationship of power between the creditor and the potential borrower. The power to advance or deny credit is the single most important cause of the business cycle.
When credit is denied broadly, when it becomes scarce, that is sometimes called a capital strike. Not only workers go on strike. Capital can strike, too, and may have the incentive to do so when bulls are overextended with debt. Depending on the market, if credit is rationed, it will most certainly result in stagnating prices where they have previously risen.
Subprime is a good example of this. Prices stagnated for a while as banks and mortgage lenders stopped issuing loans. Once the first people started to sell because they needed rising prices to make their investment strategies work, the market started to plunge in earnest. So while credit rationing takes longer to come to fruition, its impact on the market is more devastating than a mere short position.
A price war is a bearish tactic designed to coerce competitors. A company or cartel may cut prices and increase output, flooding a market with cheap goods. The object is to either bankrupt competitors or force them to restrict output to allow the aggressors to raise prices again and restore their cartel. Here, a good example would be Chinese solar panel manufacturers who managed to bankrupt more of their competition in Europe and the United States.
A price war is bearish because it forces down the prices of both the products and shares of stock of the companies involved. Everybody is losing money (unless perhaps the aggressors established a short position before starting the war), but the point of the war is to achieve a strategic effect: either destroying competitors by bankruptcy or forcing them to accept your ultimatum about cutting their output to form a cartel and thus raise prices above what they were before the onset of the war.
A cartel raises prices by restricting output for all producers. The threat of a price war helps enforce a cartel. In international trade, a price war is called dumping.
The Bear Effect
Holding liquidity is another bear strategy. It means holding cash, or other assets easily convertible to cash, in order to retain maximum flexibility. It is bearish because if you expect the price of most assets to fall, it is better to hold cash than to hold other assets.
Alternatively, think of bulls as bullish in illiquid assets, like real estate, factories, and other investments that might be harder to sell without a loss in an economic downturn, whereas bears are bullish on liquidity. There is a strategic reason for this: They are building up their reserves for the day when asset prices crash and they will then be the ones with cash on hand to buy up the assets of distressed or bankrupted bulls at fire-sale prices.
Instinctively, people who know about bears generally tend not to emulate their methods because bears profit from loss, but this is a necessary part of capitalism’s two-party system. Just as forest fires are a necessary part of a healthy natural forest cycle, throughout history, bears have been much more effective than government regulation in limiting the excesses of bulls run amok.
James H. Nolt is a senior fellow at the World Policy Institute and author of “International Political Economy.” This article was first published by the World Policy Institute.