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The Visible Hand

Second Quarter 2010

Where should the dial be set?

People face this question constantly. In most cases it’s probably within the context of relatively mundane activities; the station you listen to on the radio, the volume control on some electronic device, the thermostat setting in your house, and so on.

Other times the implications of the question are much more significant. Where to set the dial in the work/life “balance”? And important investment related examples including; where should the asset allocation dial be set in my portfolio, or where should my spending dial be set so I won’t outlive my assets?

Another dial question has again risen towards the top of country’s collective consciousness. Where should the dial be set in terms of government intervention within the economy?

We said “again risen” in regards to this last question, for the history of capitalism since the Great Depression has been marked by a recurring tension over the “appropriate” government/ private sector dial setting. In today’s context, we’re mindful that even examining this issue runs the risk of alienating people along political parties.

Our intention here is certainly not to alienate. Instead, our objective is best captured via an adaptation of an old investment adage: “there may be two sides to everything, but there is only one side to the stock market; and it is not the bull side or the bear side, but the right side“.1

The “right side” we’re seeking has nothing to do with the political right or left. What’s important is assessing the potential investment rewards and risks in the environment ahead.

A quick look at economic history

Perhaps you’ve heard the term, invisible hand used as an economic metaphor. The phrase has its roots in the late 1700s writings of the Scot Economist, Adam Smith.

Smith postulated that the competitive forces underlying free markets guide the economy-as if by an invisible hand-towards general economic progress. The “hand” creates a spontaneous order2 within the allocation of ever-scarce economic resources. This in turn, drives both innovation and, most importantly, advances in the general standard of living.
A bar chart showing depressed twentieth century growth rates for China as a percentage of global GDP
The invisible hand metaphor has endured because Smith was right. The history of capitalism has, indeed, been marked by both the dramatic innovation and the astounding advances in the general standard of living. The vast majority of those living in “capitalistic” economies today enjoy a standard of living that likely far exceeds even the wildest dreams of the fabulously wealthy and most privileged “classes” of earlier eras.

By contrast, people living within economies where the economic dial had been turned all the way towards the visible hand of government, have experienced slow growth, stagnation, or outright declines in their standard of living.

One doesn’t have to look much further for such examples than post-WWII Berlin where German families became separated by the Wall. The answer to which economic experiment was “better”-East or West?, was likely answered by the very necessity of a wall to keep people from fleeing the East’s visible hand.

A similar “story” emerges from China’s economic history (see chart). Admittedly, one would be hard-pressed to describe the Chinese economy of centuries ago, as guided by the invisible hand framed in today’s context.

However, it’s more than coincidence that China’s economic standing within the world could only muster a bounce along the bottom when the economy was under complete command of the visible hand during the 20th century. We also don’t believe it’s a coincidence that China’s recent emergence from that state of economic torpor occurred as it allowed some elements of the invisible hand to be unleashed.

No economic utopia on earth…

Of course, capitalism is not perfect. As we’ve noted on previous occasions, the problem with capitalism is capitalists (humans). Humans remain imperfect beings displaying recurrent patterns of greed, fear, and “herding” tendencies.

Capitalism also does not, and cannot, guarantee equality of outcome among members of an economy. The dynamism of capitalism creates an unparalleled opportunity for many to climb the economic ladder of success. The very same dynamism leaves others behind.

Because of these aspects of capitalism, the reality has been a mixed economy of private sector and government influences. With many believing capitalism failed during the 1930s for example,3 the dial moved abruptly towards increased intervention in the economy by the visible hand.

The Great Financial Panic of 2008 has evoked similar cries that capitalism failed and the latest expansion of the government’s involvement in health care is yet another major move in the dial towards the visible hand.

However, it’s important to recognize that mixed economies are not without “issues” either. As libraries (and Kindles, Nooks, and iPads) rapidly fill with books diagnosing the causes of the recent Financial Panic, we suspect (and hope) the visible hand’s role in shaping and distorting resource allocation in housing and risk-taking will become better chronicled and understood so mistakes are not repeated anytime soon.

Economist Alan Meltzer recently offered some perspective on this topic:4

“The market is not perfect. It is run by humans who make mistakes. But the same humans run government where they make different, often more costly, mistakes for which the public pays …Even the smartest of bureaucrats and politicians have only a fraction of the intelligence of free markets.”

No free lunch

As Meltzer implies, there are tradeoffs and costs in most every economic choice. The costs to a mixed economy may not be those associated with the iron hand of communism, as noted in our Berlin Wall and Chinese examples earlier. But a price tag still exists when the allocation of resources is shifted from the invisible to the visible hand.

Some years back, economist Richard Rahn theorized about this price tag. Rahn suggested economic growth is initially aided by government intervention in the economy. One can readily point to the role initial public education efforts, road construction, and other basic government sponsored infrastructure played in the history of U.S. economic development.

However, beyond some (“optimal”) point of government intervention, growth slows following a path similar to that depicted in the chart below.
A bar chart showing depressed twentieth century growth rates for China as a percentage of global GDP
Subsequent empirical studies provide support for the general shape of Rahn’s curve. Fierce debate remains of course, over where the “optimal” dial setting exists along Rahn’s curve.

The “optimal” point is somewhat moot for the major “mixed economies” around the world-the U.S. included. At current government spending levels (40%+ of GDP) we are already well along the downhill portion of the curve. Recent actions to move the intervention dial further towards the visible hand, puts us even further into the long-term, slower growth zone.
A table presenting the percent change in total outlays, discretionary, nondefense discretionary, and mandatory spending between U.S. Presidents

Many European countries have been far along the downhill side of the Rahn curve for an extended period of time. These countries have been marked by chronically high unemployment and much slower economic growth than has the U.S. over the past decades. No free lunch indeed.

Another price tag of the expanding girth of government relates to its financing needs. A growing visible hand must be financed. Tax burdens rise, as do government debt burdens. As this occurs, the issue of sustainability of public finances rises as well.

As sustainability becomes an issue, social unrest increases as governments forced to make cutbacks in services upset those who have come to depend upon government programs and initiatives. Riots in Greece, and California student sit-ins provide real time examples.

We’ll discuss the sustainability of the government spending issue a bit more within the bond market section of this report.

But first, we also want to point out that when it comes to political parties; it’s generally been a choice about the speed at which the dial has turned towards the visible hand. Consider the following table which presents the inflation adjusted (“real”) spending record during Presidential terms over most of the past 50 years.

The pace of government spending has well exceeded the overall economy’s growth rate over this period. Administrations from both parties-and Congress of course-have consistently moved the dial towards the visible hand.

We further note that big sustained bull markets for stocks occurred during the two administrations (Reagan and Clinton) that slowed the speed, and restrained non-defense, discretionary spending and mandatory spending (blue highlighted columns in the accompanying table).

Is the stock bull market/restrained visible hand relationship coincidence? We suspect not. This doesn’t inspire thoughts of a sustained bull market in the years ahead, does it?

Stock market strategy; the invisible hand strikes back

But wait. If there ever was a time to separate longer-run economic trends from short-term cyclical economic trends, it is now.

First, consider the present “state” of expectations as they relate to the economy and the financial markets. The multi-colored chart below reflects a recent Pew survey that assessed general perceptions across a number of economic dimensions. Fears of economic Armageddon so prevalent during the Financial Panic may have faded (size of the red areas in the chart). But less pessimism certainly hasn’t given way to anything resembling optimism ahead (black areas in the chart).
A column chart presenting the changing dynamics within the news cycle from June 2009 through March 2010

Though probably for different reasons, general expectations already incorporate the grudgingly slow growth implied by the Rahn curve analysis from earlier. This is important from an investment perspective, because expectations-which are reflected in current bond and stock prices-make little allowance (in our assessment) for a near-term economic rebound of the magnitude we’re likely to continue to experience.

What leads us to believe growth will provide more upside surprise over the next year?

You may recall the economic pluck model we introduced some time back. The underlying concept here is that the 2008 Panic created a downward pluck in economic activity analogous to a pluck of a guitar spring. Consumers-and particularly businesses-battened down the hatches on everything anticipating a Great Depression rerun.

When those expectations proved much too dire, the economy embarked upon a snap-back similar to the rebound that follows the guitar string’s downward pluck. The force of the downward pluck helps shape the force of the subsequent rebound.

As Charts A and B suggest, we’re still in the strong rebound phase. Economic growth over the balance of 2010 and into next year remains likely to exceed the still-too-low expectations that generally exist.

And most importantly, the upward phase of the pluck is morphing into a self-reinforcing economic expansion as job growth begins.

Chart A:

Firms slashed inventories in the Great Panic expecting a Great Depression Rerun. The “cupboards are bare” necessitating a sharp production rebound to meet demand.

(Chart Source: Morgan Stanley Economics)

A line chart showing year-over-year changes in inventory to sales ratios from 1993 through 2010

Chart B:

Firms also slashed employees during the Great Panic expecting a much sharper downturn than actually occurred. The unemployment rate is probably close to 2-3% higher than the downturn “warranted”. With growth resuming, expect hiring to occur to fill this gap.

(Chart Source: ISI Group)

A line chart showing year-over-year changes in inventory to sales ratios from 1993 through 2010

A strong recovery in the face of a lurch of the dial towards the visible hand is not without precedent either. In the appendix, we reproduce an earlier “dissection” we made of the 1930s to highlight the vigorous 1933-36 rebound.

We also note that the resiliency of the invisible hand is easy to underestimate. Humans may, indeed, be imperfect beings, but their basic drive to achieve a “better life” is a powerful force that-along with competition-never sits still.

It’s also easy to overlook a profound investment alteration that’s unfolding as a result of globalization. Business-and the fortunes of many companies-is less bounded by country borders. As one market observer recently stated:5

“…much of our economic data doesn’t matter to the prospects for the (stock) market. Corporate profits themselves bear more relation to an increasingly complex and interlinked global system than they do any national economy. Companies go where ihe growth is, and with leaner inventories than the world has ever known and sparser work forces, they can make profits even when national economies sputter.”

There are investment opportunities that offer the promise of sufficient growth to counteract a glide path towards slower domestic macro-economic growth. And these opportunities stand to garner increasing investor interest in a slow growth domestic environment. The following briefly outlines our stock portfolio strategy along some of these growth opportunity dimensions:

Multi-nationals-we own many companies that have significant and growing global business footprints. While many have U.S. origins, these entities are going “where the growth is” and are truly global versus U.S. entities.

Productivity enhancers-the “clock-speed” at which nearly all businesses must operate in response to heightened global competition is rapidly increasing. Wringing productivity gains out of everything they do, cost reduction and reduced time to market on new products and services is essential.

Many of our portfolio investments provide tools and services that enable other companies to compete in today’s marketplace. Whether it’s simulation software involving computational fluid dynamics, rapid prototyping using 3-D printing, predictive analytics, or highly sophisticated measuring instrumentation, exciting investment opportunities exist. While we all just witnessed how most everything stops in a financial panic, a slow growth economic climate by contrast, only accelerates the need for productivity tools.

Problem solvers-today’s world presents many problems…and investment opportunity for those businesses providing solutions. Whether it’s helping develop the educational skills needed to compete in the global labor pool, treating sleep disorders, or figuring a low cost solution for shipping goods from one country to another, problems solvers populate our investments.

Upward pluck beneficiaries-financial stocks have been the toxic waste of the Great Panic. We suspect that as the economic expansion congeals, bank loan loss provisions will abate and reveal (particularly at the regional bank level) franchise earnings power that will surprise many. Already this year, these portfolio “duds” of 2009 have become portfolio stock price leaders–and it’s still very, very early in their recoveries.

Finally, as we note in the bond section that follows, one by-product of the self-sustaining economic expansion we believe is underway will be the Federal Reserve (“Fed”) exiting from their ultra-easy monetary stance.

This will likely create some stock market trepidation as it unfolds. Fed interest rate hikes should not be a serious market obstacle, however, for monetary policy will be simply moving from “ultra-easy” to “accommodative” as the Fed’s abnormally low interest rate regime is no longer needed.

Which leads us to the outlook, and nimble strategy likely to be required, for the bond market.

Bonds, the proverbial canary in the coal mine?

We think it helpful to view contemporaneous bond market conditions through the long lens of interest rate history. Doing so reveals two salient things.

  • Never in U.S. or British history (since 1700 at least) have short-term interest rates been 0%.6 Until now (they have been 0% for over a year).
  • While rare, there are instances when yields on high-quality corporate debt are below those of the U.S.government bonds.

We’ll address each of these in turn.

Zero% rates:

While such extreme actions were required by the Fed to thaw the credit market pipes during the Financial Panic, the Fed has to normalize interest rates soon. Failure to do so will create a whole new set of problems.

We expect the Fed to begin to normalize interest rates soon. Trying to divine expectations once again, we see a (Treasury) bond market priced for little more than very slow growth, and with little expectation that the Fed will take action anytime soon (see accompanying chart).
A line chart showing ten year treasury yields and their relationship to the economic cycle beginning in 2005 through 2010

It’s not a popular viewpoint perhaps, but we believe the caution flag is out on bonds-especially with respect to Treasury securities. With yields so low, there’s little cushion in bond prices to absorb a rise in yields.

Until the potential risk/reward profile of bond prices improves, we recommend extreme caution with Treasury investments and caution with bond investments in general.

As a result, it hurts to have any commitments to cash investments yielding nearly 0%, but we suspect such “dry powder” will come in handy in three regards.

  1. As a shield against a downward adjustment in bond prices.
  2. As ammunition available to reinvest as interest rates and bond yields “normalize” and the risk/reward profile of bonds becomes more favorable.
  3. As the portfolio risk “thermostat” within balanced portfolios.

We’ve expressed many times previously that we prefer to execute our bond strategy using ultra-high quality Treasury and agency securities.

These securities-as perceived safe havens during periods of stock market duress-tend to provide reliable portfolio diversification when it’s most needed. As many investors painfully learned in the heat of the recent Panic, non-Treasury bonds are exposed to a weakening balance sheet environment and do not deliver the same diversification properties during periods of stock market duress.

However, the herd’s flight to safety in the Panic pushed the yields down (and prices up) of our Treasury and agency securities into an over-valued situation. We “took profits” and executed tactical investments in mortgage securities and corporate bonds-segments of the bond market all but abandoned during the Panic. These actions helped minimize our bond investments exposure to the damage of falling Treasury prices during 2009 but the trade-off (here’s that no free lunch thing again) was, and is, a potentially less effective portfolio risk thermostat.

Cash investments provide some measure of a thermostat. We also do not believe we’re in for a long wait for more favorable bond market opportunities in which to invest some available dry powder.

Is it rare when corporate bonds yield less than Treasury bonds-or is it the new normal?

In the early 1980s the then intractable economic problem was inflation. Policy markers and politicians had little will power (or political interest) in reigning in the excessive monetary growth that was at the heart of the inflation problems.

In another profound instance where the invisible hand of markets “struck back”, the bond market became a vigilante force. The so-called bond vigilantes took a role in shaping Fed policy by offering swift and often violent responses to the weekly releases of money supply statistics. The vigilantes would push bond yields higher in response to money supply readings consistent with rising inflation.

Washington got the will and Fed Chair Volcker administered the medicine the vigilantes demanded. As Clinton political adviser James Carville quipped years later:

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

We bring up the vigilantes because the long-building bubble in government spending may witness their re-emergence. We may already be seeing early signs of their return as some “normal” relationships in the bond market are tracking towards the abnormal.

Usually, national government debt is considered safer than corporate debt from the potential for default. As a result, corporate bond yields are higher than yields of comparable maturity Treasury securities. The yield difference-or spread as it’s often called-varies considerably over time as we alluded to in our earlier “thermostat” discussion.

The spread has been narrowing of late, as another sign of the fading Panic. This is all well and good, of course. However, some (admittedly esoteric) indicators in the financial futures markets are reflecting an usual condition-the normal spread has evaporated and gone negative, implying Treasury yields are moving to levels above the yield of high-quality corporate bonds.

In the 1960s, there were episodes when IBM debt (then the titan of AAA rated corporate bonds) yields were below comparable maturity Treasury securities. But this is a rare condition. Therefore, when negative “spreads” happen, it probably makes sense to pay attention.

If the sustainability of the expanding visible hand is nearing its end, it’s likely that the canary in the coal mine will indeed be the bond market. The financing burden of the spending beast is big and growing. So any rise in interest rates will have to bring the question, why are rates rising? Are they rising as part of the Fed’s normalization of rates as suggested earlier. Or are the bond vigilantes returning and trying to unleash pressure to exercise Washington spending discipline?

The tell signs will likely include the corporate bond/Treasury bond spread relationship. From a bond market strategy perspective, this is yet another reason for caution on Treasury securities and why nimbleness will be needed. Stay tuned!

Chart: Raising tax rates is a usual approach to help finance a growing visible hand.

But how viable is this option?

A line and column chart showing the growth of tax returns with zero or negative tax liability beginning in 1950 continuing through 2009

Appendix: Dissecting the 1930s

The Great Depression was marked by two severe economic contractions-the deflationary disaster of 1929-33 and the echo recession of 1937-38. Both of these downturns were preceded by declines in the money supply-courtesy of inappropriate Federal Reserve policies.

Below, we reproduce a chart we included in our Perspective from a year ago.7
A column chart showing period stock market returns from 1929 through 1945

We particularly want to draw your attention to the 1933-36 time frame. As we detailed in this earlier Perspective, immediately preceding this period, the Federal Reserve finally recognized its deflationary monetary mistakes and allowed the money supply to expand.

With their foot off the deflation brake, the economy over 1933-36 period staged a sharp cyclical expansion with (real) annual economic growth in excess of 9% per year. The unemployment rate dropped sharply from 26% to a still-nose-bleed-high, but “better” rate of 11%, and the stock market staged a 200% advance.

All this took place despite a huge crank of the dial towards the visible hand as FDR’s New Deal launched a major expansion of the government’s intervention in the economy.

In the contemporary situation, despite the slow growth implications of greater intervention of the visible hand, much more upward “pluck” in the economy remains yet ahead. Like the 1933-36 recovery, the current economic expansion is likely to continue to gather steam, despite government intervention.

Sources & Notes

1 Reminiscences of a Stock Operator, Edwin Lefevre, 1922
2 Adam Smith did not use this specific term. It was later popularized by the so-called Austrian School of Economics whose leaders were Frederick Hayek-the first Noble Laureate in Economics and Ludwig von Mises.
3 As we’ve described on previous occasions, we believe massive Federal Reserve errors in the 1930s turned a downturn into an economic disaster. The actions of the “Fed” in the recent panic are in stark contrast with their 1930s counterparts.
4 Market Failure or Government Failure?, Wall Street Journal. March 18, 2010
5 Zachary Karabell, Dow 11,000 Is Only the Beginning, Wall Street Journal, April 7, 2010
6 Grant’s Interest Rate Observer 2010
7 Pushing on a String or a Spring?, archived at www.capinv.com