Review & Outlook

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An Essay on Where Things Stand, Economically, This Day in Late June

28 June, 2011 by Ben O'Brien in Commentary

Foolish me: in the aftermath of the Great Sell-off of March 2009, when so many people bailed out of the market at the very low, I thought that investors might change how they look at portfolio performance. I thought that perhaps in the future people might be more interested in evaluating portfolio performance on the basis of  income (dividends plus interest income), which is stable and relatively unchanging,  rather than on the basis of price change, which can be up and down and all over the place. Wrong.   As I write, investors show themselves fully attached to price change, as though it’s the only way to measure performance.  Too bad.  I don’t think people would panic quite so quickly if they realized their portfolio income is unchanged, even as its price is gyrating.

Speaking of stocks, they have of course doubled since the March ‘09 bottom, bearing out those who stayed the course during the darkest days.  But if one class of investor is feeling all right now, another is feeling cheated.  I am speaking of the so-called little people of America who have always put their life savings in certificates of deposit and money market funds sure that they would receive a small but real rate of return.  Now these souls are watching their savings dwindle away in the face of annual inflation of 3.5% a year.  And the situation is getting worse. Since the beginning of the year, the yield of a 1-year Treasury note has fallen from .27% to .14%; the 3-year note from 1.01% to .61%, the 7-year note from 2.73% to 2.15% and the 10-year note from 3.34% to 2.88%.

The upshot is that collapsing short-term rates are forcing cautious investors into risky asset classes where they probably do not belong.  As the expression goes, they are “weak hands.”  The low rates are the result of government policy meant to shore up banks.  But the practical result is to make the stock market even more skittish than it otherwise would be.

Thus I find myself critical of policymakers in Washington.  I think they are temporizing, not as naively as FDR, who set exchange rates on the basis of favorite magic numbers, but almost.  Also, there’s a good deal of dissembling going on.  For instance, why are wages included in the calculation of everyday inflation? I think the government has an interest in understating the figure, and including wages in the calculation is one way to do that. Most people don’t have to pay wages to other people, though they do have to pay the higher price of oil and gas and bread.  If the price of oil, gas and bread have gone up 40% in the last year, and wages have held steady, or shrunk, I call this inflationary, indeed, I call it a diminished standard of living, whereas the government trumpets it as proof of a healthy, low-inflation environment.

While I am at it, the unemployment statistics strain credulity too.  No need to go through the detail: Suffice it to say, unemployment is a lot higher than the government lets on. I am reminded of one wag who observed that the only numbers one should believe coming out of Washington are the route numbers, as in I-95.

So what does the big picture show? The best I can see is that big C Capitalism is going through one of those times. Capitalism does not have a fixed meaning, rather it is always a work in process. This process of redefining capitalism for the current age is not a bad thing.  In fact it is a good thing.  Altogether we tend to emerge from these times of re-evaluation stronger for the effort.

As proof of this optimism consider that the private sector went through a great wringing out in the 1970s.  In my hometown of Bethlehem, PA, Big Steel did not survive.  In the flush times of the 1960s it had given workers excessive benefits, like a ten week paid vacation (the despair of housewives throughout the community).  We know the rest of the story, not only for Bethlehem Steel, but for the rest of the rust belt.  The point is that the industries that survived are competitive in our present global economy, but it took the great wringing out to get them that way.

What happened to the private sector in the 1970s now seems to be happening to the public sector.  And as painful as it is, we will be stronger for it. Furthermore, it seems easier now than it was in the 1970s.  I mean that now at least the productive parts of the economy, namely business, are the healthy part, not the sick part as they were in the 1970s.  The S&P 500 (AKA the stock market companies) enjoy near record profitability. More on this later.

We are three years out of a big recession, but this is still a strange time. In a word we are in a credit-less recovery, which may explain why it is so weak.  Always in the past, at least in my 35-year experience, the banking sector has led the economy out of recession.  This time around the banking sector is on its back, suffering from grievous self-inflicted wounds.  To the extent that the banking sector is involved at all in the recovery, it is as a drag.  This is extraordinary state of affairs and I do not know what to make of it, for it is capitalism without the capital, and what is that, exactly?

About this capitalism without the capital: One consequence is that the government has lost a powerful policy tool.  That is to say, if companies don’t need to borrow money, then it doesn’t matter what the government is doing with interest rates and the money supply.  Some observers characterize the government’s current policymaking as “pushing on a string”, which is to say you cannot do it.  But whatever you call what the government is doing, or trying to do, it is not working and we are in a subpar recovery.  Typically the economy is growing at 4 to 6% at this point in the economic cycle; presently we are limping along at 1.8% growth.  Is it a bad thing to be limping along at 1.8% GDP growth?  Yes, because part of that subpar growth is low employment.  Unemployment is a scourge on society.  The costs in terms of lost human flourishing, quite apart from the wages lost, are huge and long-lasting.

But if the economic recovery is so weak, how come corporations are making so much money?  Yes, it is true that corporations in the Standard & Poor’s 500 Index are enjoying near-record profitability.  These big companies do business with China, India, Brazil, Indonesia and other emerging market nations, which are industrializing right now.  But little domestic companies don’t tend to do business abroad, and they are struggling. New business formation is weak. Entrepreneurs are not getting out there getting their swing on the rope, and of course it is with these people that we have job growth.

The pain clearly is uneven.  There’s been a big shift in purchasing power from workers to capital.  For instance, global price competition has kept the costs of technology down; businesses can increase productivity that way.  At the same time, though, the working man  has had to absorb the full impact of rising food, energy and health care costs, to cite just a few.  It is another instance of the little guy really taking it on the chin.

What’s up with Europe? I do not see how the Economic Union (EU) can hold together.  The Unites States benefits from the European disarray.  Indeed the rest of the world is betting that the United States will be different.  How do I know this?  Because the rest of the world is buying our debt, even at rates as low as 2.8% for ten years.  That’s confidence. Meanwhile the Greeks cannot sell a two-year note at 29%.  So the United States is a big beneficiary of the EU mess, both in terms of the cautionary tale and the flight to the relative security of the dollar.

Time for a conclusion here; let me provide one with these words.  Stay with high quality U.S. stocks.  They are, as the current expression goes, the best house in a bad neighborhood. They trade at single-digit price-earnings ratios, which means they are relatively inexpensive on a historical basis.  The take-away line is this: When stocks are cheap, as they appear now to be, and when there is a lot of fear, as there is now, and when bonds offer nothing in the way of current income, as is the case now, then stocks tend to do all right – – regardless of all the other things you can worry about. How do you quantify “do all right?” A return of at least 5% looks very doable for the next year.  Stocks have dividends on average of 2%.  If stock prices go up 3%, roughly the rate of economic growth, then one gets a total return of 5%.  Not great but it is almost twice the return of a  10-year Treasury note.  I think the surprises will be on the upside.

Mark O’Brien