The following is excerpted from a letter to investment clients sent out on January 20, 2010.
In a client letter written in April 2009, we made the bold (at the time) suggestion that regardless of the long-term structural issues facing the US economy, it was entirely possible that the jaw-dropping levels of economic stimulus underway at the time could create some sort of cyclical economic rebound. This claim seems less crazy now, as there has clearly been a rebound in various sectors of the economy.
People focus on unemployment, which remains quite high, but employment is a lagging indicator of economic activity. This graph that I put up at voiceofsandiego.org shows that going as far back as the data allows, unemployment has never begun to decline until after the recession was over. (I even checked this for the Great Depression and got the same result).
In contrast, many of those data points that tend to be leading indicators of economic activity have rebounded strongly. There's little question that an economic rebound of some sort is underway. The question is how strong and enduring that rebound will be.
That is a valid concern. As I mentioned, the US faces deep structural issues that will almost certainly impede future growth in a significant way. The most important of these is the tremendous amount of debt we owe to foreign nations, but others include our giant deficit, our unfunded entitlements, heavy-handed government intervention in the economy, potential state and municipal bankruptcies, the complete lack of a private-sector mortgage market, and a political class that is bent on propping up asset prices to the detriment of real productivity and a stable currency.
It's difficult to envision a truly robust economy under these conditions. But the fact is that a sufficient amount of debt-financed government stimulus and money printing can create a cyclical boom even under (shall we say) less-than-optimal circumstances. We think this is what's happening now. It doesn't fix any of the deeper problems, and as a matter of fact, it makes some of them much worse. But on the long path towards working through our issues and imbalances, it's entirely possible that we could get the occasional stimulus-driven cyclical boom here and there.
People talk about what "shape" a recovery might be. A V-shape (a rapid recovery), a U-shape (a slower recovery), or an L-shape (no recovery at all, just stagnation). The best shape-metaphor we have heard, however, is a square-root symbol.
Don't worry, I'm not going to make you do any math. The square-root sign (which looks like this) is simply a good shape to trace out potential economic activity. It would entail a fairly sharp recovery, engendered both by government stimulus and inventory replenishment as a world that had ground to an economic halt gets moving again. However, the recovery wouldn't last for too long, and it would be followed by stagnation (the flat part of the square root symbol) as the structural issues come back into play and put downward pressure on economic activity.
To that last point, the problem is that economic recovery in this situation is self-limiting to an extent. As the economy improves, the likely outcome would be that energy prices rise, general price inflation increases, and rates rise on the heavy debt load we carry. These factors would all be bad for economic growth. The result is that as soon as the economy started getting a head of steam, rising rates, energy prices, and inflation could arrive to a degree that could arrest further growth or even smack the economy back down again.
So, unfortunately, we think that the square-root recovery is probably the best that we can hope for. It's certainly possible that the economy will do worse than that, and dip back into outright recession -- though it's also possible that it could surprise on the upside, at least for a while. The recovery-to-stagnation scenario seems most likely to us, but in such a huge, complex, and heavily government-manipulated economy, nothing is a sure thing.
Fortunately, from an investment standpoint we don't need to depend on a given economic outcome taking place. We invest based on fundamentals and valuations and on the long-term returns they portend, not on being right about every shorter-term twist and turn in the economy.
The US Stock Market
From a fundamental standpoint, the US stock market as a whole does not hold much appeal. I recently put up a website article noting that the US stock market was overvalued by our favorite measure. When I wrote the article in October the market was about 28% overvalued; at this point the market is closer to 38% overvalued!
This just isn't a market where we want to have a lot of exposure. Our country's massive debt load will provide a major headwind to future economic growth, so if anything, this climate would call for lower-than-usual stock valuations. Yet here we are with stocks being 38% overvalued based on their historical relationship with underlying earnings.
This explains why we were reducing our stock exposure (and especially US stock exposure) in the latter half of 2009. Of course, the market proceeded to increase further -- and it may increase further still. But holding an overpriced asset in the hopes that it will get even more overpriced is not the kind of investment we like to make. We have to be prudent about prospective risk and reward, and the elevated valuations tell us that it's best to err on the side of caution as far as the broad US stock market is concerned.
Of course, it is a giant market consisting of many different industries and businesses. While we think the US market as a whole is overvalued, we continue to believe that certain sectors and companies are priced to deliver very good returns. These include those sectors that are poised to benefit from higher inflation and so-called "quality" companies with reliable cash flow and low levels of debt. Additionally, we expect better potential returns in many international stock markets, especially from emerging markets and other countries that are not huge external debtors like the US.