April 2010 |
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“It was the best of times. It was the worst of times.” It seems appropriate to quote these lines from Charles Dickens to describe the current U.S. economy especially if you are comparing the lives of Wall Street investment bankers to the 15 million people who are still without a job. The same extreme difference of opinions is occurring in the financial markets. The bulls in the stock market believe the economy is following a normal recovery path. We see a very different economy with longer-term structural challenges that will limit its growth and even make it vulnerable to another recession by next year when the government stimulus has been taken away.
Having seen a few bull market rallies and economic recoveries in my 28-year career, I wouldn’t have believed that I would ever find myself in the position of having missed an opportunity to be fully invested in one. But it happened. We made the decision a year ago to not jump into the rally and to remain protective of our clients’ assets because of our concerns for what was happening to our government’s finances and the economy.
While we have regret that we did not capture a much larger portion of the gains for our clients, we stand by that decision today in light of our mandate to first protect our clients’ assets.
That decision was made because our view of the economy during this past year has been very different than what the consensus has been seeing. We have never been able to get comfortable from any indicators that we follow that the economy would be able to sustain enough growth to warrant the valuation levels it has been trading at since last summer.
We have believed for a while that this economic recovery is heavily dependent on government stimulus programs for it growth. We worry that as these programs wind down over the next few months, the economy’s growth rate will subside along with them.
The Great Recession was different from other post World War II recessions and more severe. It was caused by credit contraction and falling asset prices after many years of easy credit policies from every institution that was lending money. A recovery was not just a matter of working off bloated inventory levels following an economic slowdown as in past cycles.
Since the U.S. economy had expanded over the last 20 years on increasing amounts of debt, it was logical to us that the deleveraging or debt-reduction process would entail a shrinking of the economy. And a shrinking of the economy would cause high unemployment and a great deal of excess production capacity that would probably take years to reduce.
An economy with much less credit availability and limited income growth from high unemployment would be one that would exhibit lower growth going forward than what it had experienced in the past. Lower GDP growth would translate into lower revenue growth and lower earnings growth. It then followed in our analysis that the stock market would place a lower price/earnings (P/E) multiple on the markets future earnings, which would reduce future stock market returns.
In our minds, the federal government’s efforts to offset the lower demand from the credit contraction in the private sector of the economy with deficit spending and credit expansion from the public sector was not actually adding long-term value to the economy. We also felt this policy action would be of a temporary nature and would probably only shift demand forward for cars, houses and appliances and not really add new demand for these products.
In addition, we were concerned about the trillions of dollars of new debt that the government was expected to create on top of an already leveraged balance sheet. We knew it could cause the U.S. to pay higher funding costs especially if foreign investors began to lose faith in our ability to manage our finances in a responsible way. To prevent that from happening, we expect to see significant increases in taxes and cuts in spending in an effort to reduce the deficits and debts in the future. Those actions will also hurt future economic growth.
While the Federal Reserve’s unprecedented actions in 2008 rescued the financial industry and contributed to the recovery, it has caused the investment community to add inflation risk to its list of future worries. That is because of the massive amount of liquidity that has been created with the huge expansion of the Fed’s balance sheet. The Fed is going to have to prove to investors that it knows how to manage this situation without causing higher inflation or disrupting the markets.
We frankly are not currently worried about inflation with all of the excess labor and production capacity in this economy. We fear more for deflation in the near-term especially if the economy slips into another recession.
That in a nutshell is how we view what has been going on in the economy over the past year and some of our concerns going forward. The recent economic numbers pertaining to employment, personal income, consumer spending, capital investment, real estate prices, and bank credit over the past few months have not changed our views despite some signs of faster economic growth.
The bulls in this market would obviously describe the economy in a much more positive light. They would highlight the fact that corporate earnings have consistently beaten expectations, which we would counter was primarily from cost cutting. They would point to the cyclical improvements like recent increases in production to replenish inventories as well as the gains in jobs in the first quarter. They would also point to the better than expected retail sales in February and March.
The fact is, at current prices in the stock market, the bulls have to be assuming a normal and fairly strong economic recovery and expansion. There is no other way they could justify the multiples that they are paying for current earnings on those stocks.
While these cyclical aspects of this recovery have helped to support the bull’s position up to now, we think that will change in the second half of this year. With the end of the stimulus programs and the expected increase in income taxes in 2011, we expect to see the stock market begin to factor in much slower growth in the years to come which will bring an end to what we think is just a bear market rally.
In the meantime we will continue to live up to our mandate to protect our clients’ assets first and then to look for ways to make money when the conditions are right.
