the Dynamist

2012 Election Preview (and quasi-endorsement)

My core theory of US politics can be summed up with two, very optimistic principles. The first is that the US electorate as a whole is very wise, notwithstanding the less-than-wise nature of many individuals. The second is that the US political system, as devised by the Constitution and its collective amendments, is self-healing; it is the greatest application of complexity theory in the history of the world. I realise these two principles go against the grain of much educated thought, but they have proven themselves over time, having really failed only once (in 1860). I can go more into these principles and why I believe in them in some future post.

Previous writings from the Dynamist: from realignment to backlash

Back in 2010, I wrote two pieces analyzing the state of politics. In the first from March 2010, "The GOP will not repeal ObamaCare", I first walked through why I thought the outright repeal of Patient Protection and Affordable Care Act ("PPACA" or "ObamaCare") would not really be a winning political issue for the GOP in the end, even though the nature of the Democrats' overreach on the issue was certainly helping the GOP in the 2010 midterms. I then ran through the laundry list of remaining issues (from the perspective of the electorate) and found 4 favoring the Republicans, 2 favoring the Democrats and 3 mixed. In the second from October 2010, "The Middle Class is Still Up For Grabs", I previewed the Democrats' upcoming defeat (where I believe I was the first to use the term "shellacking", but received no attribution from President Obama). I put that defeat into the context of building political coalitions, and how neither party had built a platform that truly builds up the middle class.

Both of these articles represented an adjustment from my 2008 writings which posited that 2008 might have been a "realigning election" that created a new majority coalition in favor of the Democrats and the northern, "blue" states. If I had to reflect on the realignment theory today, I would instead say it happened in two steps. First, in the late 1960s and early 1970s, when the "New Left" was forming in opposition to Vietnam and Jim Crow and in favor of women's rights, environmentalism and affirmative action, it could just as easily formed within the Republican Party as the Democratic Party. At the time, it was the Southern, socially-conservative Democrats that had gotten us into Vietnam and had defended segregation in the South. The Republican Party made the choice, however, to shortcut a longer term realignment in favor of uniting with Southern conservatives to implement an economically conservative agenda which has since become dominant in our politics, achieving realignment in 1980 with Ronald Reagan and gaining in strength during the 1990s and early 2000s under Clinton and Bush II. While the New Left would become marginalized during the Nixon and Reagan years, it eventually mellowed a bit and strenghened during the Clinton years before achieving realignment status under Obama.

The political framework today - stalemate?

Demographic changes have given the New Left its boost over the top in the Obama years, as the coalition of strong support for Obama among African-Americans, Latinos and single women on social issues will likely outweigh the decay of Obama's support among white men and married white women over economic issues over the past four years. The other factor keeping the Democrats in the game, however, appears to be the holdover of the economic Old Left in the industrial Midwest that is not being won over by the GOPs purist free market orthodoxy, particularly led by a former leveraged buyout impresario.

In many ways, the GOP has become a victim of its own success. It's dominant Presidential or Congressional coalitions of the 1970s through the 2000s faded as the party racked up victories on the wedge issues that divided the Democrats: deregulation, free trade, monetarism and inflation, income taxes, the Cold War and defense, urban crime, gun control, illegal immigration, welfare reform, capital gains taxes, the estate tax, the War on Terror and gay marriage. In each case, either the Democrats conceded the issue (gun control, crime, welfare reform, defense) or the GOP took the issue too far (illegal immigration, the War on Terror). Now the parties have fought to a draw on defense (both basically settling in on the center-right) and social issues (by region, with a slight center-left electoral college advantage to the Democrats).

I continue to believe that the economic agenda of the future is still up for grabs, however. The Republicans have become too rigid in their free market orthodoxy, being overly focused on promoting capital formation while mostly ignoring human capital development, which in the new economy can just as, if not more, important as pure capital formation. This is why the regions that have benefitted the most economically from the new economy like New York, Boston, Chicago, the Bay Area, Los Angeles, greater DC don't favor the GOP even though they have done very well under the era of conservative economics. As discussed above, the nearly complete victory of capital over labor in the old economy in the last thirty years has also weakened the GOP economic argument in electorally-rich Midwestern industrial states like Michigan, Ohio, Pennsylvania, and Wisconsin.

The Democrats, on the other hand, still have vestiges of the Old Left in their approach to economics, favoring the kind of centralized approaches to problem-solving that served them well in the industrial, mass-market world of the 1930s through the 1960s, but that are less appropriate for the decentralized, networked world of today. In the long term, the Democrats have an advantage in that they have more flexibility with their base on economic issues than the Republicans, while the Republicans have an advantage in that their basic philosophy is closer to the ulimate endgame if they can back off their fealty to capital and focus more on the middle class (promoting progressive goals with conservative, market-driven means). Until one of the parties seizes the advantage, we have basic stalemate with plodding progress.

Scenarios and issues

With a pretty evenly divided electorate we can be highly confident that the GOP will retain control of the House. Because of two decades of GOP-friendly redistricting, the Democrats need to win the generic House vote by more than 3% or so to flip control. This is pretty important in that the President really doesn't have that much power on domestic issues, and with a GOP House (particularly this GOP House), there isn't much chance of Obama passing any more big agenda items over the next four years. In addition, the Senate is likely to remain evenly divided, so no matter which party nominally has control, there isn't much chance of a president Romney getting the 60 votes necessary to pass any radical policy changes either.

For the next two years at least, the electorate is not voting for either Obama or Romney's agenda. It is instead voting for the type of compromises it wants to see occur. If Romney is elected, the compromises will be as center-right as the Senate will allow. If Obama is reelected, the compromises will be as centrist as the House will allow. If you think about it, this makes much of the apocalyptic rhetoric we've been hearing from both parties seem pretty silly, doesn't it?

Through that lens, the issues:

• Foreign affairs - Here is an area the president does control. Obama is operating in the non-ideological conservative internationalist tradition of Dwight Eisenhower, Richard Nixon (perish the thought) and GHW Bush. After the adventurism of the GW Bush years, Obama's approach pretty well suits the country's mood, which is probably why you saw Romney embrace Obama's positions in the third debate. Despite some of Romney's hawkish talk on the campaign trail, I doubt he would differ much from Obama, but you don't really know, so advantage Obama.
• Social issues - If you vote on social issues, you know who you're voting for. It appears that these issues are helping Obama a bit more, but I'm not going to wade into this, because I don't really vote on social issues and you don't know who won these until you see the turnout on election day.
• Individual Taxes - Polls say people favor seeing the wealthy pay more, which is why Obama isn't being hurt by his stance. Although we can quibble with the math, I think Romney's general approach of flatter rates with less deductions for wealthy is superior. Since I highly doubt the Senate will pass a 20% cut in nominal rates most of Obama's attacks on Romney's "$5 trillion tax cut" aren't really operative. I also think the odds of a "fiscal cliff" disaster would be much lower under Romney as there would be less of a fundamental standoff between him and the House. By the way, this is under the radar screen but both guys are planning to let the payroll cut lapse this year. Advantage Romney.
• Corporate Taxes - Both parties realize that the nominal corporate rate needs to come down to be internationally competitive, offset by a reform of loopholes. Romney favors moving to a territorial tax (focusing on domestic activities only), while Obama wants to tax overseas earnings like domestic earnings (as opposed to only when they are repatriated). While Obama's plan sounds better (taxing companies that "move jobs overseas"), it's not very realistic, since no other country does that and it would therefore encourage foreign takeovers of US companies to save on taxes by moving the corporate domicile abroad. In the end, under Obama, the House will either insist on a territorial tax or nothing will happen. Under Romney, I'm pretty confident we'll see reform pass, so advantage to Romney.
• Fiscal policy in general - I don't think the markets or the economy want a sharp fiscal consolidation in the near term. I think the combination of a slightly revenue-positive tax reform, long term entitlement reform and discretionary spending controls without sharp cuts (aka something like "Simpson-Bowles") is probably the best outcome. While I think Romney would be better at finding a compromise on taxes, I think Obama would have a better chance to craft a broadly-acceptable reform of entitlements if he's willing to do so. Obama has the opportunity to reclaim the Democrats' brand equity on fiscal prudence by crafting a "grand compromise" and a GOP House is likely to go along with it this time around. Advantage Obama.
• Trade policy - Both candidates would be more activist on promoting US exports than the Clinton and Bush administrations, with Romney promising to get tough on China's currency (which I agree with). In the end I think they would both be fine. Toss-up.
• Monetary policy - The next president will get to appoint the next Chairman of the Fed. I would be in favor of reappointing Ben Bernanke or someone like him. It is no longer 1980, where inflation was the big threat and taxes were too high. Now deflation is the threat and tax collections are the lowest since before World War II. We need to move from the default of tight monetary policy and loose fiscal policy favored by the Republicans to a default of loose monetary policy and tighter fiscal policy more favored by Democrats. Advantage Obama.
• PPACA / ObamaCare - The idea of repealing the PPACA with nothing to replace it doesn't seem realistic in the context of our history. Besides, since the Senate is unlikely to repeal the non-budget items, the idea of just starving it seems like a recipe for chaos. While it's a deeply flawed bill, it is probably among the least bad of a bunch of crappy options available to us until we reform the way health care is ultimately paid for. Since the PPACA maintains a "competitive" private system, it leaves the door open for pro-market reforms that could bring costs down while sustaining innovation. If Obama is reelected, keeping the PPACA is place is the only thing that he could really describe as a mandate. Advantage Obama.
• Medicare reform - Medicare will bankrupt this nation if it is not reformed. I actually like the Paul Ryan voucher approach for Medicare in the long run, but ironically I also think that it would need the PPACA in place to succeed. Basically there needs to be a competitive marketplace for individual coverage that can't deny you for pre-existing conditions (like being old). The only way that really works is to have the individual mandate for the PPACA so everyone is in the pool. Ultimately we need to reform the way Medicare pays for health care to move away from the current fee-for-service if we ever want to use competition to drive down costs, so the Ryan plan and ObamaCare go hand-in-hand. Kumbaya! Toss-up.
• Social Security reform - We only need to tweak Social Security to make it solvent. Everyone knows the ultimate solution will be a combination of reduced benefits for the wealthy and a gradual increase in the retirement age, so let's just get on with it already. Advantage Romney.
• Education - Obama and his Education Secretary Arne Duncan have been doing a good job building on Bush's No Child Left Behind reforms, gradually introducing competition to the system. Obama has coopted a bit of the GOPs reform mantle here, but it works. Otherwise, most of the real battles in education reform are at the state and local level. Advantage Obama.
• Energy - We need to ride the fracking, shale oil and deepwater drilling boom as hard as we can without harming the environment too much. While Romney would let it run harder, Obama gets more cover from environmentalists. While I think the idea of millions of "green-collar jobs" is a joke, I'm not totally against investing in research on green energy (solar and wind, not biofuels) and conservation (electric cars, green architecture). Toss-up.
• Infrastructure investment - Obama blew his big opportunity here with his boondoggle of a stimulus bill. If he has focused on bread and butter spending like bridges, airports, roads and local transit, he could have built a strong coalition for a multi-year increase in infrastructure spending. Instead the bill was known for esoteric stuff like high-speed intercity rail and poorly-invested green energy loan guarantees that left people scratching their heads. To me this was the biggest disappointment of Obama's first term. Romney doesn't really talk about this, so I'd still say advantage Obama.
• Financial reform - The Dodd-Frank financial reform bill is a bad bill that can rightly be attacked from both the left and the right. I would have focused on simpler, but more fundamental reforms (like limiting the size of an bank's liabilities relative to GDP and increasing the required capital cushion beyond what is currently contemplated). Instead we have a byzantine mess that was nevertheless better than no reforms at all. Since the GOP hasn't articulated a realistic alternative, I'd have to begrudgingly say advantage Obama.
• Other stuff - Beyond the above on budget issues I'd prefer the GOP's approach. The Federal government should be made to be better at a smaller number of things, with more devolution of responsibility to the states (or to international bodies, where appropriate). I know not everyone agrees with that, but I think it's more appropriate for the decentralized world we live in today. Advantage Romney.

My quasi-endorsement of Mitt Romney

So looking at the above, it looks like I favor Obama, but I don't. While I voted for Obama last time, I intend to vote for Romney this time around. Personally, I am most focused on macro economic issues where I tend to prefer Romney's approach. I also think he will be better at crafting compromises with Congress and therefore there would be less of a chance of the kind of stalemate disaster scenarios that have a small chance of occuring under Obama. I am also more familiar with Romney's business background than most and so respect his skill and acumen and think he might make a better problem solver than Obama. That said, I also think neither party nor candidate really has a set of policies to build up the actual employment and earnings of the middle class. I like Obama enough and think he has done a good job on some things and I understand why he is favored to win reelection. As I said before, either man would be pretty hemmed in by Congress if elected. So while I slightly favor Mitt Romney, I'm probably one of the few people in the country who thinks it won't really matter that much in the end.

All opinions expressed herein are my own, and are not meant to represent the views of any organization with which I am affiliated.

5 Questions Every Private Equity Investor Needs to Ask

The following article originally appeared in Fortune.com on July 9, 1012. The original article can be found here.

Many institutional investors are convinced that the days of easy money are over in private equity. Managers need to distinguish themselves through their ability to add actual operating value to the underlying portfolio companies.

Private equity firms are generally active board members of their portfolio companies. Nearly every investment firm spends a great deal of time monitoring the tactical performance of their portfolio companies: Performance vs. budget, sales pipeline analysis, cash flow monitoring, margin assessment, capital structure optimization, valuation, etc. The tactical performance of a company is important, of course. Ultimately, however, as an investor and board member, a private equity investor's role should be more strategic than tactical. It is easy for investors to get lost in the tactical minutia and forget to ask themselves the big strategic questions.

The following are five key strategic questions private equity investors should ask themselves about each of their portfolio companies -- or prospective portfolio companies -- at least every 3 to 6 months.

1. What is the company's core strategic plan? Investors need to evaluate tactical performance within the context of strategic goals. The lifecycle of a company or operating division is basically a series of 3- to 5-year strategic plans. The plan may be to develop a prototype product and win some key first customers. It could be to expand internationally, scale revenues and cash flow or expand the product set into adjacent markets. It could be to manage the transition from a growth to a value orientation by rationalizing the cost structure, or to successfully transition a company from a corporate spinoff to a standalone entity. It could be to narrow the company's focus to a core set of products in a declining market. There are numerous core strategies that are potentially appropriate 3- to 5-year plans for a private equity or venture-backed company. Investors must also consistently evaluate whether the strategic plan remains appropriate if there have been changes in the portfolio company's operating and competitive environment. Companies that clearly identify their core strategic plan almost always execute better than those that do not.

2. Are we the right owners to execute on the strategic plan? This is perhaps the hardest question for investors to ask themselves, but it is fundamental. Private equity firms are generally pretty good at screening deals that don't fit their strategies at the time of acquisition but they don't always recognize when the strategic environment has shifted post-investment. A growth equity firm with a company that has shifted into slow-growth maturity; a company in a consolidating industry that would better off as a product or division of a larger company; a company embarking on a new 5-year product strategy with an investor near the end of their fund life…

These are all situations in which the right decision may be to seek a new owner. Sometimes answering this question requires admitting relative defeat on a certain investment but that is preferable to spending years working on a portfolio company that is outside a firm's investment strategy.

3. Does the company have the right CEO to execute on the strategic plan? Most private equity investors are good at figuring out when a CEO is underperforming. It's more difficult to determine whether a good CEO is in the wrong role, particularly if the core strategy has changed. Sometimes a company needs an entrepreneurial visionary, other times it might need an operational "Mr. Fix-It." Sometimes a company may need a turnaround specialist, other times it may need a sales and marketing expert. A visionary's talents are not appropriate for a turnaround strategy, nor should a sales and marketing guy be focused primarily on operational efficiencies.

4. Is the company earning an appropriate return on invested capital? The key unit economics of the company's products must be earning more than a sufficient return on invested capital. The ROIC methodology varies by industry (a mature product manufacturer needs to monitor different metrics than a growth-stage online software company, for example), as does the cost of capital. No matter what the stage of business, however, at some point the core business must be able to profitably generate revenue. There is no point investing in revenue growth if the unit economics won't work.

5. Is the company gaining market share? If the unit economics are working, a company must assess its total addressable market and its share within that market. If the competition is growing more quickly (while also earning sufficient returns on invested capital), then the investor must figure out why and help look for solutions. It could be a sales and marketing execution problem, or a product problem. It may be a market power problem that can only be fixed by pivoting to a different or more specialized niche. If a company is having difficulty gaining market share in a certain market, then it has to question how long it should remain in that market.

Investors with the discipline to consistently ask these five strategic questions will have a framework to evaluate a company's tactical performance, which in turn will enable the investors to create more portfolio company value. After all, creating portfolio company value is what private equity investors are paid to do.

Q2 2012 Market Update: Have Corporate Profits Peaked?

This post is an installment in a continuing series supported by The Dynamist's Market Valuation Model. Please click the link to see past installments.

Interest Rates

As usual, we start by examining the current state of the interest rate complex, which gives us the market consensus of underlying economic policy. The breakdown of the yield curves of US treasury bonds, muni bonds and corporate bonds is shown below.

If we look at the market's inflation expectations, it is generally assumed that the Federal Reserve will succeed at maintaining inflation right around its target range of 2%-2.25% over a variety of time horizons. Real interest rates (the inflation-adjusted rate on the Treasury Inflation Protected Securities or TIPS) are expexted to remain low for the forseeable future, averaging NEGATIVE -0.5% over the next ten years. This implies that the sluggish economy will force the Fed to maintain nominal interest rates below the rate of inflation for more than five years at least. This would be consistent with my view that we are in a long down cycle as the world economy struggles under its large debt load, resulting in weak demand relative to supply. (The phase known as the Kondriatev Winter to you cycle theory buffs.)

The combination of below equilibrium real interest rates and equilibrium inflation expectations results in nominal treasury yields well below equilibrium. And even though the spreads of municipal and corporate bonds relative to treasuries are currently attractive, their resultant nominal yields are relatively unattractive. While this would normally singal that fixed income in general is overvalued at this time, I believe the bond market is accurately reflecting the likely long term economic scenario, meaning that bond yields are unlikely to rise significantly in the intermediate term at least. Overall, I am overweighting cash and intermediate munis and corporates and underweighting treasuries (and I have sold all of my TIPS).

I'll discuss what this rate structure means for the dollar, gold and commodities in a future post.

Stocks

As long time readers of these columns are aware, I base my assessment of equity values on the S&P price relative to the long term trend in inflation-adjusted earnings. Using long term returns that fail to take into consideration the unnaturally large surge in inflation during the 1970s will overstate the long term earnings growth assumption. It was the great surge in prices (and thus nominal earnings), followed by the long decline in interest rates that underpinned the massive bull market since the 1980s. I tend to believe that it would be folly to expect a repeat of those extreme conditions.

The long term chart of inflation-adjusted S&P 500 earnings is shown below, along with the calculated trend line.

So while the earnings of the S&P500 were $86.95 in 2011 and are expected to be $97.98 in 2012 (according to S&P analysts, not Wall Street analysts) and $108.76 in 2013, the trend earnings were only $64.88 in 2011 are only $67.73 over the next twelve months.  In this view, the trend market PE is about 20, as opposed to 13 or so on projected forward earnings.

The chart below breaks down the components of the projected S&P return, which I calculate to be 7.6%. This return is below what I believe to be the equilibrium return of 8.3%, but is not wildly off.

If you want to earn an 8.3% return, you would have to wait fot the S&P500 to drop to a PE of 16 on trend earnings. That level is currently 1104, about 19% below where it currently trades. That said, given today's interest rates, a 7.6% return sounds pretty good. In fact I calculate the current the equity risk premium (the spread of the expected equity returns over the risk free rate) to be 5.4%, above the proper premium of 4.0% (according to my read of the literature, at least).

Another way to look at PE is to reverse the ratio to earnings to price, or earnings yield. The chart below shows the earnings yield of trend earnings over time. The current yield of 5.2% is more in line with the late stage bull market of the 1960s than the bear market or early bull market valuations of the 1970s or 1980s.

One potential flaw in my model is that my trend earnings could be too low, dragged down by artifically low earnings in the 1970s and 1980s and ignoring the structural changes like globalization that have permanently increased corporate earning power. There may be some validity to this view, but I could easily counter with the theory that recent earnings have been artificially inflated by financial earnings and the effect of the weak dollar on foreign income.

Have corporate profits peaked?

Let's see what the statistics say. If I take the level of corporate profits in the economic statistics and compare them with GDP, we can see that corporate profits are indeed at record levels.

The trend for corporate profits has been on the way up for the past few decades, now exceeding the levels from the mid 1960s. If we break down corporate profits into domestic profits vs. financial and "rest of the world" profits, however, we come up with a different story.

Domestic corporate earning power relative has remained in the same "trading range" since the early 1970s, oscillating between 4% of GDP at lows to around 7.5% at highs. The level is currently 7.3%, signalling that they may be near a cyclical peak. The big change over time has been the increase in financial and rest of the world profits. Financial profits have increased steadily with the long bull market in treasuries, which we can probably safely say has likely run its course. As interest rates flatten out and as Dodd-Frank and Basel III regulations are implemented, it is highly probable that financial profits as a percent of GDP will decline over the next decade.

Rest of world profits have recently caught up with financial profits (they are roughly equal now). Foreign profits could fall with a strengthening of the dollar or any sort of rollback of globalization, either of which are possible or even likely in this environment. 

Teed up for disaster?

While not necessarily likely, the outlines of a potential meltdown scenario for earnings is becoming more clear: the quagmire in Europe, leading to banking problems, leading to a crash in Chinese real estate, leading to a rising dollar, leading to a crash in commodities, leading to a bout of deflation, leading terrible earnings, leading to a stock market swoon.

The alternative scenario is that we are headed for a weaker version of the late 1990s, where after a mid-cycle slowdown the US economy steams ahead on the back of a powerful investment cycle as real estate investment recovers and business investment picks up its pace. The US could be able to prosper even while Europe languishes, with US imports keeping Asia afloat. In my last post "Atlas Done: The US Can't Carry the World Economy" I argue why this scenario would be difficult to achieve, but I have been wrong before. In this event, we could see domestic profits continue to head higher and to reach the levels to the late 1960s relative to GDP, rendering my trend earnings too low and making stocks a screaming buy at these levels.

The other perhaps most likely scenario is that the US real estate market, Europe and China can all muddle through for the next year or two. In this case, the market would trade choppily for the next few years as time continues to heal the wounds of the credit bubble. Private sector debt levels would gradually decline until the point that the private sector is able take the growth baton back from the public sector. In this scenario, an investor would want to be modestly underweight equities and overweight fixed income. This is the "Rounded Bottom" scenario that I view as my base case.

I continue to believe that we are riding a cyclical bull within a secular bear market and that investors need to be careful here. The chance of a deflationary crash probably exceeds that of a powerful second leg to the bull market. The most likely scenario is more of the same. The good news is that we are likely nearer to the end of the long bear market than we are to its beginning. In the meantime, caution should rule the day.

I am not your financial advisor and I write these articles purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations or views made in this article.

 

Atlas Done: The US Can't Carry the World Economy

Today's release of the May jobs report showing that the economy only created 69,000 jobs and that the unemployment rate rose to 8.2% confirms what the equity markets have been hinting at for the past month...that the world economy is starting to slow down, perhaps dramatically.  Europe's slow-motion financial crisis is dragging down its economy, which is in turn dragging down Asian export economies, who are  cutting their commodity imports and hitting commodity-producing economies like Australia and Brazil in turn.

Once again, the entire world is depending on the profligacy of the United States to keep the global economy afloat. It doesn't have to be this way, and frankly at some point the US should stop putting up with it. I will get to how the world can fix the current state of affairs later, but first, I must pose the question as to whether the US can continue to muscle through a global slowdown given the state of its own economy.

The common complaint among Keynesian-oriented commentators is that we are suffering from insufficient demand. On the surface this would appear to be true. (All GDP figures reported on a nominal basis and sourced from www.economy.com.)

• Industrial capacity utilization stands at only 79% as of April 2012, up 67% at the trough of the crisis in 2009 (a record low for the post-war economy), but below what used to be considered a normal level of 81-84%.
• Unemployment stands at 8.3%, above a full employment level of 5% or below. If anything unemployment is being understated due to a large decline in the labor force participation rate and the large number of workers working part-time who would like to work full time.
• Wages and proprietors' income as a percent of GDP is at a near-record low level of abut 52%, down from 57% in the early 2000's and the around 60% that frequently prevailed in the 1960's.

Yes, but...

• Personal consumption as a percent of GDP is at a record high of nearly 72%.
• Personal income as a percent of GDP is at a near-record high level of 86%, right around the levels that prevailed in the late 1990's and higher than the levels of the 1960's.
• Personal disposable income as a percent of GDP is at 89%, which is right around the level that has consistently prevailed since the 1960's. Basically the decline in wage income as been continuously offset by rising transfer payments from the government and for health care, and in the past by a large decline in personal tax collections.
• Personal saving as a percent of GDP is at only 3%, below an equilibrium level of 4-6% (although higher than the levels that prevailed at the end of the housing boom).

So basically the government has done a good job of propping up consumer demand with unemployment insurance, transfer payments and tax cuts, just like a good Keynesian should want. Consumers have even kicked in a bit extra by cutting their savings to drive consumer spending to record levels. Consumers, neither rich nor middle class, can be accused of irrationally hoarding cash and holding back our economy.

Another source of demand is private investment.

• Business investment including software, equipment, mines and wells, is running at 7.6% of GDP, firmly in the equilibrium range of 7-9% that has largely prevailed since the early 1970's. It can go higher, but is not irrationally low.
• Real estate investment on the other hand, is at only 4.3% of GDP, far below a more normal range of say 6.5% to 7.5%. Commercial real estate investment is about 1% of GDP below a normal level and residential real estate investment is about 2% below a normal level.

Given the large amount of overbuilding in the 2000's and the slower growth in the working age population now that the baby boomers are starting to retire, there is no way for policy makers to force real estate investment to meaningfully higher levels until consumers' balance sheets are cleaned up and excess inventories have been worked off.

My overall view on real estate has been that investment bottomed in 2011, but that the market would not start clicking until 2013.

• Government expenditures (federal, state and local) are about 19.5% of GDP. (These are direct expenditures and don't include transfer payments.) This figure is about average for the period from 1980 to the present, but lower than the prime Cold War years when the defense budget was far higher as a percent of GDP. The US has room to increase direct government spending, but combined with the massive deficits it is running to support transfer payments, the US government is not being parsimonious.

In addition, how can the US economy be accused of having insufficient demand when...

• The trade deficit is 4% of GDP, meaning we spend 4% more than we produce.
• Our imports are 2% of GDP too high relative to the long term trend of US international trade and our exports are about 2% of GDP too low.
• Running a trade deficit means that our investment is greater than our savings. But, as we established above, our investment is running about 3% of GDP below normal levels. Private saving (business plus consumer) is running at levels slightly higher than normal, so more than the entire trade deficit can be accounted for by a higher-than-normal government deficit.

If demand for investment is outstripping savings, even at abnormally low levels of investment demand, we would expect interest rates, particularly real interest rates to rise. Instead, however, real interest rates are not only negative, but projected to remain negative, on average, over the next 10 years. The cause is of this paradox is that global savings flowing into the US (i.e. the demand for dollar-denominated savings) chronically exceeds the demand for dollar-denominated investment, even during the great business investment boom of the 1990s and the great real estate investment boom of the 2000s.

For the US to bring trade in to line it would either have to cut domestic demand and/or increase exports. Domestic demand can be cut by raising taxes, cutting government spending, and/or raising tariffs to shift demand to domestically-produced goods.  Exports can be increased by running an aggressive trade policy that steps up against those countries that are manipulating trade via their capital accounts (more on that later).

The US has geared its economy to a level of demand, for both consumption and investment, that outstrips its ability to produce. In this case demand equals standard of living. The US needs more investment to make its workers more productive, but it is already operating with excess industrial capacity and high unemployment, which circles back to the fact that domestic demand is insufficient to match domestic supply. In other words, international demand is too low relative to international supply more than US demand is too low relative to US supply.

This is not a new observation. China, Germany and the OPEC countries need more consumer demand to sop up excess savings and to increase demand from chronic deficit countries like the US, UK and southern Europe. The US, UK and southern Europe need more investment to maintain or increase their competitiveness versus other countries, but need to fund those investments with more domestic savings.

Here's what needs to happen:

• Germany needs to step up to the plate. Yes, it must be annoying for Germany to have to bail out countries like Greece. Overall, however, Europe has a relatively balanced economy (i.e. a neutral trade deficit), so it has the power to fix its own problems. Germany needs to allow domestic consumption to rise and needs to invest more in southern Europe, which southern European economies need to cut back their state relative to their private economies. Otherwise the other countries are right to protest, as to date Germany has been just looking to cement its advantaged status and protect its own banks.
• The US needs to stand up to currency manipulators. The main culprits here are China and the OPEC countries. If the governments are the ones investing in US securities to keep their currencies fixed and suppress domestic consumer demand, then they are currency manipulators, plain and simple. Letting the dollar weaken won't help, particularly with the OPEC countries, because that just increases the price of oil, making the problem worse. The US should impose capital controls or tariffs on these countries while firming the value of the dollar instead.
• The US needs to cut its petroleum imports. Petroleum accounts for a large portion of our trade deficit. A firmer dollar and a concerted move to domestic natural gas (and electric cars) should do the trick.
• The US needs to increase its savings. It should not be up to the US to support the world economy by running up its debt. The US should implement policies to increase consumer savings, particularly among the middle class.
• The US should increase its infrastructure investment. Such investment should be able to put some construction workers to work while we wait for real estate investment to recover. Plus, its actually needed. This would not be spending money for spending's sake.
• The US should implement policies to encourage domestic investment and exports. Reforming our corporate tax code would be a great place to start.

I realize that many of these solutions sound nationalistic or mercantilistic by themselves. I hope, however, that the facts are pretty clear that most of the demand shortfall that the US faces is due to (i) a shortfall in foreign demand that is a direct result of mercantilistic trade policies, (ii) an excess of domestic demand driven by lower-than-market US interest rates due to excess foreign savings and (iii) a shortfall in real estate development that only time will heal. Outside of using tariffs and capital controls to reduce our trade deficit, the US government doesn't have much further that it can do to stimulate domestic demand without badly distorting the US economy. All of the other actions I recommend are meant to deal with long term structural issues that are also tied to our need to increase the international competitiveness.

Europe has the same internal issue that the US has with China and OPEC, where explicit policies need to be put into place to increase the competitiveness of southern Europe and the UK relative to Germany. These policies need to deal with the short term issue of debts and liquidity, but also with the long term issues of excessive labor regulations, weaker productivity and underinvestment in the tradeable sectors. These improvements will either require a tighter fiscal union or some really enlightened multilateral policy making.

These issues are all fixable, but they arise to remind us that we remain in a Kondriatev Winter, where the economy is consistently weighed down by high debt levels, weak demand and a tendency toward deflation without heroic measures by governments and central banks. Believe it or not, the US has struck the balance pretty well so far. It is now time for Europe to put their house in order before they drag the whole world into stagnation and deflation.

The Death of US Manufacturing has been Greatly Exaggerated

I often get comments from my friends that they look to my blog to get an optomistic viewpoint on the economy given all the "doom and gloom" that pervades most economic and political discourse these days. Seeing as that I call my base case view of the current economic situation a "Rounded Bottom", I figured optimism is clearly a relative concept. That said, I generally do believe in a self-correcting system, and so therefore counsel against panic and dispair. Tough times make people gloomy, and gloomy people call for more radical action than is generally needed. Often times, it is the very government action designed to goose the economy in times of distress that sows the seeds of the next economic downturn (see housing market, the).

It is in times like these that declinist theories roam the land. While I don't deny that the United States has faced a nasty cyclical decline in the housing market that may have led to a secular downshift in consumer spending and debt accumulation, I don't necessarily view that as a long-run negative. Consumerism, while beneficial to one's near term standard of living, can be carried too far if it becomes a debt-fuelled bacchanal that diverts resources from other productivity-enhancing investments like business equipment and infrastructure.

Exhibit A to most declinists is the supposed decline in American manufacturing. This seems like a no-brainer given our huge trade deficit, the large declines in manufacturing jobs and the visible industrial ruins in former manufacturing hubs like Detroit, Cleveland, Pittsburgh, Philadelphia and Baltimore. A closer look at the numbers, however, tells a much different story.

In October 2011, after one of the nastiest recessions and slowest recoveries in modern history, the United States produced $3.3 trillion worth of manufactured goods on an annualized basis (in 2005 dollars). To put this into perspective, the entire GDP of Germany in 2010 was only $3.3 trillion (in 2010 dollars, no less). China's GDP is only $5.9 trillion. The U.S. is thus by far the largest manufacturer in the world. While production is down about 5% from the $3.5 trillion produced at the end of 2007, and it is up 5% from what was produced in 2000. It is fully 80% higher, on an inflation-adjusted basis, than the manufacturing production in 1979, when manufacturing was still the centerpiece of the U.S. economy.

Look at the chart below (click to enlarge):

For comparison purposes, it is important to compare similar points in the business cycle. In the case of manufacturing production and capacity, it is most meaningful to compare cycle peak to cycle peak. I have also included the mid cycle break points (1984 and 1995) where the currency and policy regimes changed somewhat.

The things to notice in the chart above are (1) the long term decline in the peak capacity utilizations (meaning that capacity has increased faster than production); (2) the huge increase in manufacturing production per employee; (3) the decline in manufacturing employment as a percent of total employment from 24% in 1973 to 9% in 2011; and (4) the more modest decline of manufactured final goods production as a percent of GDP from 24% in 1973 to 19% in 2011.

Given the huge gains in technology, finance, professional services, leisure and hospitality, retail, healthcare and education since 1973, the fact that manufacturing has only declined by 4 percenage points from the 1973 peak to the 2007 peak is quite surprising.

In terms of employment, we have to look at manuacturing as the new agriculture. It is a hugely efficient, highly capitalized economic sector that just doesn't employ that many people anymore. I fully believe in supporting manufacturing as a way to increase national wealth, but any politician who tells you that we can bolster the middle class with tons of new manufacturing jobs is out of touch with reality.

Nominal numbers don't provide as much context as relative numbers, however. The following chart translates the numbers above into annual growth rates by business cycle (click to enlarge):

The interesting thing about the chart of above is how the numbers vary from business cycle to business cycle, but that they are pretty stable over the long run. The first thing that jumps out is the huge increase in manufacturing employee productivity since the early 1990s, particularly relative to employees as a whole (as defined by real GDP per employee). The second thing that jumps out is the huge surge in manufacturing capacity (5.4% annualized from 1995 to 2000) in the late 1990s bubble boom. Since capacity growth was so far above trend in the late 1990s, the relatively low levels of business investment of the 2000s is not surprising. The huge surge in the capital-to-labor ratio, combined with advances in information technology, has helped create a large increase in per employee productivity...also not terribly surprising yet highly beneficial for the long run health of the economy.

If we look at the longer 16-17 year Kuznets cycle of long-lived investment (consisting of three business cycles as I define them), we see consistent results. Real GDP grew about 3% p.a. peak-to-peak in both the 1973-1989 cycle and the 1989-2007 cycle. Manufacturing production grew 2.4% in the second cycle versus 2.1% in the first, even though manufacturing was viewed to be in decline in the 1990s and 2000s. Capacity grew 2.6% per annum in both cycles. The big difference between the performance under the two cycles is in employee productivity, which grew 3.9% per annum during the second cycle and only 2.5% in the first. Manufacturing productivity growth far exceeded productivity growth in the economy as whole over both cycles.

The good news is that were are now pretty close to having worked off the excesses of the late 1990s. For that reason, I expect the front end of the current Kuznets cycle to produce a powerful resurgence in business investment, which we should see accelerate over the next 6-8 years (with perhaps one recession occuring dueing that time). We can already see it in the numbers. While everyone is focused on the travails of the housing market, the U.S. economy has gradually become a lean and mean manufacturing powerhouse.

Catalyst Investors Blog: Understanding IT Outsourcing and Web Hosting

Cloud computing. Managed hosting. Managed services. Software-as-a-service.

There are lots of buzzwords that are both used and misused to describe the various types of IT outsourcing and web hosting. Back at the Catalyst Investors blog, I walk through the different layers of the IT outsourcing and web hosting landscape. I explain the difference between cloud computing and traditional computing, and compare and contrast the different layers of the technology stack, including co-location, dedicated hosting, hybrid hosting, infrastructure-as-a-service, managed hosting, platform-as-a-service, application hosting, software-as-a-service, business process outsourcing and business process-as-a-service.

To read the post, click HERE.

Q3 '11 Market Update: The Beginning of the End

The Beginning of the End

The world's economic and political tectonic plates are starting to shift. I believe the next 12-24 months will mark a major transition period for the markets and the economy, as we will see several long term trends reverse course. We may finally be working off the investment hangover from the late 1990s in the US, and are setting up for a revival of US business investment and manufacturing. The long term US dollar bear market may be coming to an end, as may be the boom in gold, commodities and emerging markets. While I think we have several years before the bear market in stocks comes to a definitive close, and the US economy still has years to go to work off its excessive debts, the US economy may start to shine on a relative basis. In addition, a number of very long term global trends may be turning, with the worldwide collapse of the welfare state and the end of the global debt buildup. While much of the transition to whatever new worlds awaits us will occur over the course of this entire decade, many market trends will likely be turning over the next 1-2 years. It is time to prepare.

Interest Rates

Using today's interest rates, the market rates of Treasury Inflation Protected Securities ("TIPS"), Treasuries, implied inflation rates, Municipal bonds, investment grade corporates and high yield corporates versus their equilibrium yields at 2, 5, 10 and 30 year maturities looks as follows (click to enlarge):

Chart 1

 
Treasury rates have plunged, driven by both a decline in inflation assumptions and in real interest rates. Corporate bond yields have come down less (and high yield bond yields have risen) as the market turmoil has increased risk perception.

With the possible exception of long term municipal bonds, there is very little of value in the bond market these days, unless you are extremely bearish on the economy, in which case long treasuries could rally from these levels. High yield bonds are close to being attractive, but are vulnerable if we enter a second recession.

Overall, the bond market is telling us that the supply of savings far outstrips the demand for investment, and you see very low or negative real interest rates and below average inflation assumptions out for a very long time. I think this imbalance may turn soon in the US, in which case most of the money from the great bond bull market that began in 1980 has been made.

Stocks

I've updated my numbers and methodology a bit since my last stock market update. The net effect brings the implied and equilibrium returns up, but my overall view on valuation is the same. 

As a reminder, I base my valuation off of inflation-adjusted trend earnings for the S&P 500. While Standard and Poors' analysts project $95.66 for 2012 earnings, the forward trend earnings number is only $62.64. As can be seen in the chart below, earnings in the past two cycles have been unusually high, much of which is due to a series of one-time factors like high oil prices and extraordinary bank earnings. In time, we should expect earnings to revert to trend.

Chart 2

 

Using trend earnings, I assess the value of the S&P500 as follows (click to enlarge):

Chart 3

If I use the long term equilibrium inflation assumption of 2.25%, the stock market is pricing in a 7.8% long term equity return. Under my updated methodology, I use 8.25% as the equilibrium return target (which uses a 4.0% equity risk premium on top of the equilibrium 20-year treasury rate of 4.25%). The equilibrium return would be earned at an S&P500 value of 1011, or 13% below today's level. If we assume the bond market's long term inflation projection of 2.1% is correct (it was assuming 2.7% just last quarter), then we arrive at a long term implied return of 7.7%.

Looking back at Chart 1, we can see that the market is actually pricing in an equity risk premium of 5.1% to the 20-year treasury rate, which would imply an above-equilibrium return. The same can be said for corporate and high yield bonds, who have above-average spreads to treasuries, but lower than equilibrium yields. The problem with the risk asset markets these days is that the base real interest rate is so low. Thus the return on equities and corporate bonds are strong relative to treasuries, but low on an absolute basis. My assumption is that all markets revert to the mean eventually, so unless you're a professional investor that can short the corresponding treasury with the proper duration relative to your investments, it is dangerous to rely on relative values rather than absolute values.

The next chart plots absolute values over time. In this case, it is the earnings yield of the inflation-adjusted S&P500 relative to inflation-adjusted trend earnings. (The earnings yield is the reverse of the price-earnings ratio.)

Chart 4

When the earnings yield gets above 6.5%, you can be pretty comfortable that you are buying stocks at a good value. It was above that level in the great bull market of the late 1940s and 1950s and during the bull market of the 1980s and early 1990s. That said, just because we get above that level doesn't mean we're out of a bear market, as we saw in the late 1970s and late 1930s and early 1940s. Also, just because the yield drops below 6.5%, doesn't mean the bull market is over, as stocks kept rallying in the early 1960s and late 1990s.

What I will say, however, is that a necessary condition for a secular bear market cycle (like the one that we've been in since 2000) to end is that stocks reach a low valuation on an absolute basis, like they did back in the great bear market of 1973-74. Stocks may still bounce along the bottom for several years thereafter (like the period 1975 to 1982 or from 1937 to 1942), but these can be great periods to accumulate stocks as we set up for the next secular bull market.

If I had to guess, I would posit that the market will put in a major bottom sometime in the next 12-18 months. It could be soon, if the European crisis reaches its climax, or it could be next year, driven by something else (a crash in China?) After that, retirees and investors will leave stocks for dead and they may stay cheap for the rest of the decade as the economy continues to deleverage. In the latter part of this decade, we will then be set up for a new long term bull market. I hate making predicitions that concrete, but let's just say that's my "base case" and I accept that the actual timing and magnitude of events may vary greatly around that.

Commodities

Commodities in general are expensive (click chart to enlarge):

Chart 5

In general charts that look like these don't end well. Can gold or oil or commodities in general (represented here by the CRB Futures index) keep rallying for a few more months? Sure they can. Is buying into a rally like this "investing"? No, it is not.

In the last chart I map the ratio of commodities prices relative to the consumer price index (CPI). Here you can see that the long term trend price of commodities relative to everything we spend money on has been going down. That makes sense, as mining and farming technology has gotten more efficient, more markets have opened up and global transportation networks have expanded. Also, as we get richer, we spend less of our incomes on basic commodities. During both the last decade and the 1970s, that trend was broken. In both decades, all sorts of theories sprouted up to explain why we were running out of resources relative to booming demand. In reality, both spells of commodity inflation were just that: inflation driven by currency debasement.

The Dollar

At last we come to one of the only truly cheap asset classes in the world, the US Dollar. I am on the record stating that a new long term dollar bull market is in the offing, commencing sometime in the next 12 months (if it hasn't begun already).

Charts 6 and 7

Both dollar indices (the nominal major currency index and the real broad dollar index) are near the bottom of or below their long term trend ranges. Why would the dollar go up? The dollar benefits from market turmoil, which could be a near term catalyst. Also, I think markets are going to come to the realization soon that the US's problems are manageable next to the alternatives, particularly Europe and Japan, and there is a decent chance that the bloom will come off the emerging markets rose (which becomes a self-fulfilling feedback loop when the dollar goes up and commodity prices fall). I addition, I also think the US is setting up for a major business investment cycle after a relatively weak 10 years (as we have now digested the late 1990s investment boom). Once these big currency trends get rolling, they tend to build on themselves.

OK, you ask, but how do I invest in a dollar bull market if I'm not a professional currency trader? Good question. First of all, don't be afraid to hold cash and to reduce exposure to commodity-based investments, foreign bonds and emerging markets. Second there is an exchange traded fund called the PowerShares DB Long US Dollar Fund (ticker: UUP). If you find this argument particularly persuasive, you can buy the PowerShares DB 3x Long US Dollar ETN (ticker: UUPT), which is a 3x leveraged version of the UUP. At the very least, the UUP provides a decent hedge against near term market volatility.

I am not your financial advisor. I write these posts purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations made herein.

 

The Dynamist’s Jobs Plan

President Obama is set to give his jobs speech tonight. In it, he will outline a series of proposals to stimulate job creation. I don't know what these are yet, but if I was appointed philosopher-king, the following would be my ideas to stimulate near-term economic activity and hiring while not exacerbating our long-term economic problems:

Employ construction workers by investing in infrastructure. The most obvious hole in economic activity is the smoking crater left by the collapse residential real estate investment. Construction employment has fallen from over 7.5 million in 2007 to about 5.5 million today. Of course with housing inventories well in excess of normal levels and with consumers overburdened by mortgage debt, re-inflating the housing bubble is not an option. The government could put construction workers to work by investing in infrastructure like roads, bridges, commuter rail, power infrastructure, broadband infrastructure, ports, etc. The focus should be on shortening commuting times, reducing trade friction and supporting export infrastructure…stuff that should be done anyway. Do not focus on controversial and dubious items like intercity high speed rail and solar power. The goal should be to employ about 1 million additional construction workers over the next couple of years. After two years or so the housing market will clear and the pace of infrastructure spending can be reduced. Yes, environmental and other types of reviews may need to be streamlined to make projects "shovel ready" this time.

Stimulate domestic investment by reforming corporate taxes. There is clearly an imbalance between the perceived return on business investment made abroad versus domestically. We need to change that. My solution would be to reform the corporate tax code by (i) leaving the rate where it is, at 35%, (ii) make worldwide earnings subject to the tax (now it is only taxed when brought back to the United States), (iii) make investment in research, development and capital expenditures made in the United States immediately tax deductible (as opposed to depreciated over several years) and (iv) make dividends tax deductible. The design here is to reward investment in the US while discouraging the hoarding of cash on corporate balance sheets (particularly in foreign banks) or squandering cash on empire-building acquisitions. Corporations should either invest their cash in the US or pay it out as dividends. If a corporation wants to make an acquisition, it should subject itself to the discipline of the financial markets and issue debt or equity. Because this reform encourages actual investment by businesses and would eliminate the double taxation of dividends, there would no longer be a need to give preferential treatment to dividends and capital gains for personal income taxes. In addition, the tax difference between corporations and "flow-through" business entities like LLCs would be dramatically reduced, ending a major distortion in the tax code.

Remove barriers to domestic energy production. The oil and gas industry is running at over 95% of capacity, the most of any domestic industry, so it needs more investment now. We need to remove barriers to offshore and onshore drilling and "fracking" and to encourage nuclear power and wind power, where appropriate. Within the energy complex we can encourage demand for domestic energy by putting a tariff on imported oil, which would also help fight the biggest source of our chronic trade deficit. The long term goal would be to move to a straight carbon tax. We can also raise revenue to offset other measures encouraged herein by eliminating the preferential tax treatment of oil and gas investment, which isn't needed given the tight capacity and proposed tariff. The tariff on oil prices would help encourage a transition to more fuel-efficient automobiles, whether hybrid or electric.

Encourage hiring by permanently cutting the payroll tax. We can increase the return on labor to businesses by permanently eliminating the employer side of the payroll tax (which is 6.2% of wages). It needs to be a permanent cut because businesses are otherwise rational and won't hire based solely on a temporary cut. The long term goal would be to replace the payroll tax (a regressive tax on hiring) with a carbon and/or consumption tax (a regressive tax on consumption). The cut would be partially offset by letting the temporary 2% cut in the employee-side of the payroll tax expire as scheduled.

Stand up to currency manipulators. There is no reason that an innovative, productive economy like the United States has to run a persistent trade deficit. We are being manipulated by the central banks and sovereign wealth funds of East Asian and OPEC nations, plain and simple. The inflow of these excess savings must be matched by an equal trade deficit, artificially suppressing American manufacturing. For example, there is no reason that manufacturing of high tech goods for American companies, which requires relatively little labor, should be done in Asia and not at least mostly in the United States. We are needlessly allowing excess capital formation outside of our borders. While I think the corporate tax reform mentioned above will help in this regard, we should also explore a wider array of "sticks" like currency interventions, tariffs and capital controls in addition to diplomatic "carrots" like trade deals in seeking to promote trade balance. (Our trade deficit is currently 4% of GDP.) I know that such a proposal will spark warnings of "trade wars", but in reality other countries use these types of tools all the time (Switzerland did this week) and if they are used to negotiate an end to market interference by the other country, there should be no long term repercussions.

Stop encouraging inflation. One of the biggest fallacies in all of economics is that you need positive inflation for the economy to work properly. It is absolute hogwash. Prices were basically flat for the hundred years prior to World War I and the US economy grew faster than ever. All inflation does is transfer purchasing power from ordinary people to the elites who know how to profit from inflation in the financial markets. Stopping inflation would also have the benefit of making finance boring again, which would stop the drain of talent and capital from the real economy toward non-productive endeavors like designing the latest hedge fund trading algorithm or speculating in commodities. While targeting zero inflation wouldn't create jobs per se, it would lift the real income of American workers, since prices have been rising faster than wages. I frankly don't understand what the Fed has been trying to accomplish lately. The dollar is already at the bottom of its long term trading range and gold prices are soaring. Asset prices are generally pretty expensive. It's time for a new approach.

All of these ideas are incremental steps toward what I think should also be America's new (or at least modified) long term economic strategy. I also include some revenue offsets designed pay for these programs in a way that would not harm the economy and would also serve our long term goals. I realize that some of these proposals cut strongly against the conventional "wisdom", and I don't care. The long term goals are to get more Americans working, to make sure they get paid more by their employers, to produce more domestic investment and to pay for it with more domestic savings. It can be done. We shouldn't expect miracles, however. The economy is going to be abnormally weak for some time to come. This is the time, however, that we can band together to build a long term foundation for strong growth and general prosperity.

Are stocks cheap? Not quite…but close.

Given the recent plunge in the stock market, are stocks cheap? That is the multi-trillion dollar question.

My base case is that we are part-way through a long term (or "secular") bear market that began in 2000. While inflation has masked a bit of the decline in the overall stock market, it is clear that we put in a generational valuation peak in early 2000 and have been grinding our way lower since. The bear market turned into a "Kondratiev Winter" or economic bear in 2008 with the collapse of the real estate and credit markets. Since that time we have been in a "deleveraging" phase, which would have been deflationary if not for the desperate money-pumping and fiscal stimulus that has occurred since that time. Interest rates have collapsed, yet demand for borrowing is weak as consumers and business focus on improving their balance sheets. Many lack the collateral to borrow even if they wanted to. In addition, the baby boomers are staring at retirement having under-saved. The brutal decline in their net worth and the proximity to retirement are pushing baby boomers toward safer investments like bonds, even while the Fed punishes these savers with super-low rates in a futile attempt to get people to shift back into real estate and stocks.

S&P 500 below trend

In addition, the high inflation of the last 50 years has actually made stocks look like a better investment than they really are. If we convert the value of the S&P to 2010 dollars (as measured by the CPI), we can see that its trend line has only gone up by about 2.5% per year in real terms since 1960.

Source: Standard and Poor's, economy.com, calculations by tylernewton.com

The good news is that the market is now below its trend line. The bad news is that in bear markets like the 1930s and 1970s (or in bull markets like the early 1960s and 1990s) the market can get very far from its trend line. The good news is that the double-digit deflation of the 1930s and the double-digit inflation of the 1970s are probably special cases. The bad news is that the 1990s bull market and the 2000s credit bubble were also of unprecedented magnitude and ought to be followed by a major bear market to undo the excess. The good news is that the bear market in stocks should bottom before the credit bear market (if that can be called good news).

Valuation based on trend earnings

So what about valuation? To smooth out the business cycle and to adjust for the effect of swings in inflation, I base my market valuation on inflation-adjusted trend earnings. A graph of inflation-adjusted (as-reported) earnings and the calculation of the trend line is shown below.

Source: Standard and Poor's, economy.com, calculations by tylernewton.com

Expected inflation-adjusted earnings for 2011 are near the peak of 2006. Trend earnings, however, are only $62.15 in mid 2011. If I take the historical dividend payout ratio of 42.8%, the 2.7% long term inflation assumption implied by today's treasury curve and the long term real earnings growth rate of 1.55% as calculated above, I calculate that someone buying the S&P 500 today can expect a long term return of 6.6%.

Of course, the implied return is highly sensitive to inflation. If the inflation assumption fell to 2.25% (near the Fed's long term target), the S&P 500 would need to fall another 100 points just to earn the same return.

The matrix below shows the different levels of the S&P 500 that would generate target returns ranging from 6.0% to 8.0%, assuming long term inflation of 2.7%. Many market prognosticators assume 8% to be the long term return on stocks (wrongly, in my view). I assume the equilibrium return is 6.8%. (I realize that is weirdly precise…there is no exact right answer). To reach an equilibrium return, we "only" need to see the S&P 500 fall another 5%.

The effect of inflation

I am on the record that I believe in the intermediate term, inflation is more likely to surprise the market on the downside than on the upside. The chart below shows the inflation assumptions for the next 5 years, for 5-10 years and for 10-30 years, according to today's nominal and inflation-protected treasury curves. (I also included the actual inflation rates for 2009 and 2010 for illustration).

Source: Bloomberg.com (for treasury prices), economy.com (for historical inflation), calculations by tylernewton.com

If we assume that long term inflation expectations fall to 2.25% sometime in the next year or two, we would need to see the market fall to under 1,000 (20% or so lower than today) to be comfortably earning a return of 6.8% or more.

Earnings yield on trend earnings

Another way to look at stock valuations is to look at the market's "earnings yield" using trend earnings (the inverse of the price-to-earnings or "PE" ratio).

Source: Standard and Poors, economy.com, calculations by tylernewton.com

Looking at the chart above, it appears that we can be reasonably comfortable that we will earn a strong long term return at earnings yields above 6% (a 16.7 PE or below on trend earnings). That would imply an S&P 500 of 1,036 at today's level of trend earnings.

Conclusion

Using the methods above, we can say that the S&P 500 is fairly valued on a long term basis somewhere between 1,075 and 1,000 or so. We are currently at 1,121, so a drop of another 4-8% would put us in a good range. That said, from a trading perspective, the market could punch through to well below those levels if we have a deflation scare (which is certainly possible in this environment). We could also have one more big rally before the big bear market bottom is put in (also highly possible).

Given the monster rally in bonds, my investment strategy will be to average out of my bonds and gold into stocks over the next two years as long as the S&P is below 1,150. (Thankfully, I have been underweight stocks and overweight bonds for a long, long time.)

Good luck out there. These are not easy markets to navigate.

I am not your investment advisor. All opinions in www.tylernewton.com are solely my opinions and are written for my personal enjoyment only. Do not act on any advice given on this site without first consulting your own investment advisor.

The market does not want austerity (now)

If one looks at both nominal and inflation-adjusted treasury yields for the next five years, the market does not think near term austerity is necessary. In fact, it is pretty clear that the market wants more treasury issuance not less, with negative real yields through at least the next five years. With fiscal stimulus being reined in, the market expects the Fed to be the stimulator of last resort (and all the Fed can do is try to promote inflation through bond purchases), hence the gold price is rising as the market expects an even longer period of negative real interest rates.

Our economic problem is simple, we went from a period of over-stimulated and debt-fuelled real estate investment running at 8.5% of GDP to a collapse in real estate investment down to 4% of GDP. The collapse in real estate prices reduced the collateral value on trillions of dollars of loans and forced austerity among consumers.

To deal with the problem we needed only three steps:

1. Recapitalize the banks to prevent an uncontrolled unwinding of leveraged positions (done);
2. Increase temporary transfer payments to individuals to prop up consumer spending while savings levels are increased (done, but in danger of being unwound); and
3. Increased government investment in infrastructure to put the millions of unemployed construction workers to work (not done, we focused on health care instead).

Business investment, exports and consumer spending have been doing fine since we came out of the recession, but the markets are fearing that a pullback in government spending worldwide, combined with continued weakness in real estate investment will tip the scales to recession.

I personally think the odds favor us muddling through for the next year or so and avoiding recession, and that the recent market correction is probably overdone. That does not mean I am calling a bottom, because the momentum could overwhelm the facts on the ground. I do, however, feel ok nibbling at stocks at this level.

With US banks in far better shape than in 2008, I don’t see a mini-replay of that crisis as the major threat to the economy. Europe has major issues, but they are also solvable in due course as long as Germany steps up to the plate. The next crisis may come from exactly where we don’t expect it today: a crash in emerging markets leading to global deflation.