Longer for Stronger – The Unintentional Tradeoff?
Third Quarter 2013
Maybe Copernicus was wrong—the earth does not revolve around the sun. Instead, the entire universe revolves around Washington D.C.
Or so one would believe if current headlines and the 24/7 “news” coverage are any indication. Nearly all media focus has been on: the drama surrounding Washington D.C. budget battles, the two “downs”—as in government shutdown and the looming debt ceiling showdown, and when the Federal Reserve will begin “tapering” their bond buying actions.
These are important issues to be sure, but they are not the only important topics shaping the investment environment.
Much as the magician diverts an audience’s attention with one hand while the other hand performs the trick underlying the magic, we suspect the tapering and D.C. drama will prove to be short-term diversions from the issues likely to shape the investment landscape for the next few years.
Here is our list of issues and trends that are creating investment opportunities and risks:
- The great escape from heightened fear, uncertainty, and doubt continues to unfold.
- The economic expansion is built on sufficiently solid (and improving) fundamentals.
- Emerging markets have structural economic issues that will likely persist for an extended time.
- China’s economic developments are a “big deal”, but perhaps not in the way conventional wisdom suggests.
- Slow economic growth may well foster a long expansion.
What follows is a relatively brief discussion of this list.
We have noted in prior Perspectives the damage done to the collective investor psyche by the Financial Panic of 2008. As Chart 1 reflects, the heightened fear, uncertainty, and doubt has taken a toll on confidence about all things economic.
Chart 1: Consumer Confidence – off bottom but still well below pre-2008 levels
Since 2008, the financial markets have had recurrent bouts of “nerves” about such things as a possible Great Depression rerun, deflation, double-dip recessions, Eurozone meltdown scenarios, debt downgrades, stock market “death crosses” and the dreaded Hindenburg Omen, end of the Mayan calendar, stagnating innovation, the fiscal cliff, and perhaps now the debt ceiling drama.
Also adding to the uncertainty have been fiscal policy and, more recently, monetary policy. (For those seeking a review of how policy has contributed to the fragility of confidence, we offer our thoughts in Appendix 1.)
The Standard & Poor’s 500 Index’s returns in 2013 are tracking day-to-day price moves in 1954 almost identically, according to data compiled by Bespoke Investment Group and Bloomberg. In no other year are the trading patterns more similar to 2013 since data on the index began 86 years ago.1
On prior occasions we have pointed out that the 1950s began with similar levels of investment fear, uncertainty, and doubt as those prevailing in current times. While nostalgia may cloud memories (Appendix 2 lays out some of the 1950s investment challenges), President Truman’s Council of Economic Advisors warned him in the late 1940s of a “full-scale depression some time in next one to four years.” And, the following quote reflects investors’ sentiment towards stock investing back then.
Only in the mid-1950s, as one of the biggest bull markets in history roared ahead, did individuals return to stocks in earnest. By then, stocks were roughly twice as expensive as they had been when individual investors told the Fed they were a ‘gamble’.2
Despite all the worries—and actual troubles along the way in the form of three recessions, rising interest rates, a hot and cold war—the stock market registered an annual average gain of close to 20% during the 1950s. The stock market rose as investor confidence underwent what economic historian Robert Higgs3 has called the great escape from overly pessimistic expectations of the economic future which was pervasive upon entering the decade of the 1950s.
It has been our thesis for the past few years that another similar great escape from general investor anxiety is underway. The escape is occurring not because the economic picture is either wonderful or free of worries. The escape is underway because economic growth is—like the 1950s—exceeding investors’ excessively gloomy expectations.
By suggesting the similarities between the current and 1950s investment climates, we are not saying current economic conditions are the same or that stocks are going to rise 20% as they did back then. We are, however, suggesting that even as the stock market has risen in recent years, investor confidence remains both fragile and depressed—and conditions remain ripe for fueling still more great escape action in the period ahead.
While the focus is on Washington D.C., the private sector remains hard at work figuring out ways to grow and prosper. What areas are powering growth? The emerging industrial renaissance that is being driven by game changing technology applied to manufacturing processes, the domestic energy revolution (see IEA quote below), recoveries in “high-economic-multiplier”4 industries like housing and autos, and favorable demographics (Charts 2 and 3).
-International Energy Association (IEA)
Chart 2: Lots of pent-up demand for housing
(Chart comment: In 1963, housing starts were approximately 1.5 million when the U.S. population was 189 million. Today, the U.S. population is over 300 million and housing starts are less than 1 million.)(Chart source: government data and Morgan Housel)
Chart 3: U.S. demographic trends are more favorable for growth than those existing in other nations–even China!
Furthermore, the great escape is spreading beyond investor behavior. Since the 2008 panic, balance sheet repair (Chart 4) and cash hoarding have been the emphasis for most consumers and businesses.
Chart 4: Household debt service burdens are in good shape
This is changing. Surveys of small business confidence, small business employment, and CEO confidence in general, are staging meaningful advancements. As businesses’ “animal spirits” lift, it is reasonable to expect significant increases in business capital expenditures, merger and acquisition activity, and hiring.
A major inflation issue may be brewing that could rival that experienced during the 1970s. Only it may not be in the country where it is most feared—the U.S.
As Chart 5 reflects, U.S. money growth is running at a pace consistent with the trend that gave us the relatively modest inflation of the last 20 years.
Chart 5: Domestic money growth doesn’t look too worrisome(p.a. = per annum)
The Fed’s actions (to this point in time) are more consistent with “filling a hole” created by the fallout of the 2008 financial panic rather than building a 1970s-like “money mountain” that triggers an inflation problem. It is a different situation, however, in many emerging market economies.
Due to the export orientation of emerging market economies, these countries have, for the most part, linked the exchange value of their currencies to the U.S. dollar. As a result, they imported U.S. monetary policy. And while Fed policy may have been appropriate for the U.S. economy, it has created problems for emerging market economies. They are experiencing wage price spirals that are eroding their export competitiveness and are struggling with bad debt problems that typically accompany excessively “easy” monetary policy.
This places those countries in a structurally difficult situation. If their policymakers try to stem inflationary pressures, growth abruptly slows, bad debt pressures escalate, and economic hardship and social friction result. If they try to ease policy to promote growth, inflation accelerates.
The combined inflationary pressures and eroding competitive positions is weighing on the profit margins and attractiveness of emerging market stocks. Chart 6 reflects how corporate earnings growth is surprisingly on the “downside” for emerging market stocks. Until the structural inflation issues are defused, this trend is likely to remain in place.
Chart 6: Faster growing economies (especially those with inflation problems) do not always translate into fast growing stocks
Many investors have been conditioned by the 2000-07 period to believe the emerging markets are the ticket to strong stock returns. However, underlying conditions have changed. “Shooting where the duck once was” is not the key to success either when hunting fowl or hunting for successful stock investments. (For more on our take on international investing see International Investing: Think Globally, But Invest Locally.)
China fits into the emerging market economy group saddled with inflation and bad debt issues. But it represents a very special case for investors as well.
Over the past decade or so, it has been the primary “price setter” for nearly all commodities in the world. With the build-out of its economy, its voracious appetite for commodities ranging from oil and iron ore to cement has driven commodity prices markedly higher. These higher prices have, in turn, sparked commodity price inflation in much of the developed world economies.
Moreover, higher commodity prices have driven strong earnings growth for commodity producing companies and countries, but have also stifled the valuations (price/earnings and price/cash flow ratios for example) of most other stocks traded in the U.S. (Chart 7).
Chart 7: Stock valuations can expand significantly as inflation remains tame
(Chart comment: Commodity inflation depressed P/E during the 2000s—line 1 in graph. P/E may now expand as commodity inflation cools—line 2. “Rule of 20” suggests P/E = 20 minus inflation rate. Read more about the “Rule of 20”).
With growth slowing in China, its appetite for commodities is ebbing. This means commodity price relief and lower inflation impulses sent out to the rest of the world.
The investment implications of this are significant. For the U.S., modest inflation and low and stable commodity prices coupled with durable growth are a favorable environment for businesses and consumers.
If history is any guide, valuations of U.S.-traded stocks should expand in such an environment, as will profit margins for many companies as input costs stabilize and/or decline. This would be good news indeed for investors as well.
It is no secret that the current U.S. economic expansion is one of the slowest on record. What is not widely considered, however, is that with the slow growth comes little accumulation of the type of excesses that typically make the expansion “brittle” and vulnerable to the next downturn.
Typical excesses that accumulate to unsustainable levels near the end of an expansion include: large expansion of debt (remember our old banking adage—bad loans are made in good times), inventory overhangs, an overexposed financial system, and rising inflation. Actions designed to reign in these excesses (particularly inflation), like concerted and prolonged interest rate hikes by the Federal Reserve, ultimately become the “straws” that break the expansion’s back.
Currently, end-of-expansion excesses are absent. In the shadow of the 2008 panic, the prevailing “wisdom” remains that the economic and financial world is a fragile and dangerous place that is teetering on the brink. The result is a condition summarized by the following:
• “Consumers in the U.S. are spending more closely in line with their incomes than in the past 48 years” (Bloomberg story headline from 9/12/13).
• Banks are better capitalized than they have been in many decades.
• Inventories all along the supply chain for nearly every industry are extremely lean.
• Auto supplies for many models are in short supply with only a few days of inventory versus the normal unit of weeks of supply.
• Home builders are reporting a shortage of buildable lots.
This backdrop of few troublesome excesses, solid underlying fundamentals, low inflation, commodity price relief and more great escape behavior on the part of consumers, businesses and investors suggests the expansion has quite some time to go yet.
Unfortunately, the government’s reach into the economy is too large to ignore the Washington D.C. drama completely. But the real action—and multiyear, investment trends and opportunities—lie in the considerable activity being created away from D.C.
We believe fiscal and (recently) monetary policy have reinforced the pervasive fear, uncertainty, and doubt that has marked the period since 2008.
We hear it from business leaders all the time—“we just want to know what the rules are and the costs associated with them. Whether we like them or not isn’t the issue from a business perspective. We will adapt, but we need to know what specifically we need to adapt to.”
On the fiscal side, sweeping, complex legislation involving significant segments of the economy with critical details still being worked out “on the fly”, exemptions from the new rules granted for some (including Congress) but not others, the rapid expansion of the future liabilities of the government, tax hikes and calls for more, open animosity among the major parties of government, and tromping on bondholders’ legal claims in the auto bailouts, have all significantly contributed to the prevailing uncertainty during this period.
Chart 1: American belief that government is too powerful is at record level
On the monetary side, we believe the “unconventional” policies of the Bernanke-led Federal Reserve did not repeat the mistakes of their Great Depression predecessors that allowed the collapse of the financial system in the early 1930s.
However, by extending “crisis” monetary policy for so long, the Fed has likely reinforced general apprehension. Many fear that the Fed’s actions have sown the seeds of hyper-inflation (we do not agree). Others doubt that the weak economy can stand on its own “two feet”, and fret that the stock market is on a sugar high that will end in a crash as the Fed stimulus is “tapered” (we also do not agree). Still others wonder if perhaps the Fed is maintaining its stance after giving contrary signals recently about tapering because it now knows something (bad) about the economy that the markets do not.
Adding to the present level of monetary policy anxiety are questions about an impending change in the Fed leadership as Bernanke’s term expires early next year.
We believe economic conditions will require Fed tapering soon. Divided government hopefully means Washington D.C.’s reach into the economy will be capped so the private sector can do what it does best—innovate, experiment, grow, and create wealth.
Nostalgia for an earlier time when things turned out well can cloud the memory. The 1950s reality itself was not free of bad news, trouble, and fear. A partial list includes:
• Two recessions during the decade
• The Korean War
• Fears that communists were infiltrating government
• Cold war with the U.S.S.R.
• Fears of nuclear attack (building of bomb shelters, kids in school practiced attack drills, etc.)
• The “mighty” Soviet Union took a seemingly insurmountable lead in the space race
• Interest rates rose significantly over the course of the decade
Despite all this, reality still exceeded the low expectations initially impounded in stock valuations when the decade of the 1950s began. As conditions proved better than expected, confidence rose and a massive stock bull market ensued, as the following table reflects.
Table: The 1950s investment experience
Like the 1950s, current economic reality does not have much of a hurdle to clear to deliver favorable surprises. If the current “crisis about everything mentality” proves unfounded, investor confidence could easily move up many more notches—even with the inevitable troubles that will be experienced along the way. This backdrop provides U.S.-traded stocks with a favorable risk/reward profile, in our estimation.
As always, we remain focused on understanding the current trends in fundamentals because it gives us the best probability for success. And if you’re an active social media user, please consider sharing this topic with your acquaintances.
1 Bloomberg, 30 September 2013.
2 Zweig, Jason, “Will Small Investors Ever Warm Up to Stocks Again?”, Financial Times, 14 April 2013.
3 Higgs, Robert, “Regime Uncertainty, Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War”,The Independent Review, Vol.1, No.4, Spring 1997.
4 According to the National Association of Home Builders, the construction of a new single family home creates, on average, three jobs.