We are doing a series on my basic investment premises: the themes which drive my overall investment strategies. Last week we looked at some of the reasons why I think we are in a secular bear market. This week we look at my Major Premise #2: We are in a long-term Muddle Through Economy.
A few years ago, many readers thought I was far too optimistic thinking things would not get worse than Muddle Through. Now I seem like some troglodyte bear as the economy is doing well (see more optimism below). But I think the case for my Muddle Through scenario is stronger than ever. This week's letter will be the basis for my speech next week at George Gilder's Telecosm. George, that unrepentant bull, has asked me to make the case for a Muddle Through Economy. It may not be the most receptive of venues, but it should be a lot of fun.
But a little history first. A reader sent me a note a few years ago, asking if I had seen what George said about one of my recent letters discussing the poor quality of earnings in the NASDAQ 100 after you account for options expense. Not surprisingly, he disagreed. But he started the letter with what is my favorite and may be the best back-handed compliment I have ever received.
"I have a confession to make, a sinful predilection to divulge. Every week as I sweep through my emails, inadvertently zapping precious letters from my children... I find myself helplessly clicking through to the weekly commentary of John Mauldin... thus joining some million morbid folk avidly consuming his casual doom-laden prose." -George Gilder.
George and I later met and have become friends. He was kind enough to write about my book, "Bull's Eye Investing is a lucidly written, lambently cautionary, edifying, and diverting must-read guide to the ways and means of hitting the gyrating target of a 'Muddle Through Economy.' Mauldin is the Ben Graham of the new millennium, but unlike Graham, he combines investment savvy with a sense of humor and a gift of style."
The Perfect Economic Environment
Other than disappointing employment numbers and oil prices, you can make a case that the last year has been pretty good. In fact, Larry Kudlow did just that in this week's Wall Street Journal. Let's look at his list of the good things that has happened in the last year:
- Inflation-adjusted consumer spending is up 3.6%
- Residential housing investment is up 13.2%
- Capital-goods investment by business is up 13.9%
- Spending on machine tools for heavy-industry manufacturing is up a whopping 54.2%
- Exports and imports are up nearly 11%
- After-tax corporate profits are up 19%
- Industrial production is up 5.2%
- High-tech production is up 23.7%
- Productivity has reached an astonishing 4.6% rate
- Household wealth is up 11.1% hitting a record high of $45.9 trillion
- The GDP deflator is up only 2.2%
- The core consumer-spending deflator (excluding food and energy) is up only 1.4%
- Interest rates are at 45-year lows, with short-term rates at less than 2%
- 15-year mortgage rates are just above 5%
- Home ownership stands at a record 69.2%
Not much of a case for a Muddle Through Economy. And George Gilder (that name again) wrote a powerhouse op-ed piece on Kerry's economic advisors in the Wall Street Journal on Friday, October 8.
"While regularly incurring trade gaps and budgetary deficits, our economy has grown since the early 1980s from a level, depending on dollar valuation, between one-fifth and one-fourth of global GDP to close to one-third of global GDP last year. During this upsurge entirely unexpected by the same economists now advising Sen. Kerry, U.S. per capita GDP surged from 4.7 times per capita global GDP in 1980 to 6.5 times per capita global GDP in 2003. The U.S. created some 36 million net new jobs at even higher levels of productivity and earnings, while Europe and Japan created scant employment at all outside of government and entered a productivity slump that continues today. Meanwhile, the U.S. won the Cold War, and since 1990 its stock markets soared from less than one-third to roughly one-half of global market cap. The net wealth of U.S. households in real terms trebled to all-time records ($45.9 trillion at last report). Debt has been shrinking as a share of overall national assets, which now stand at a level near $80 trillion."
If you want more optimism, I highly encourage you to read the latest 75th Anniversary Issue of Business Week on the Innovation Economy. (It's also somewhat amusing to look at some of their covers from the last 75 years, although I note they did not mention the infamous "Death of Equities" cover from 1982.) Research and Development funding, as an example, is up 10 times in real terms, to over $250 billion, in the last 50 years.
In short, there is no end of good things to encourage us to believe the economy is going to do well in the coming years. And that's good, because we are going to need every positive force we can muster to offset the problems we face. It is the juxtaposition between the extremes of optimism and pessimism that persuade me to believe we can Muddle Through. The "good stuff" combined with American entrepreneurs and free enterprise will balance the "bad stuff."
Let's start with what I mean by Muddle Through: I see it as a long period of below trend growth caused by a series of economic headwinds and the potential/probable return of stagflation. The highest probability is that we do not slide into a soft depression, but neither do we see a return of the 80's and 90's, at least not for a long period of time. I do believe there is yet another boom in our future, and possibly an even bigger one than we have ever experienced. But it will not be this decade and maybe even well into the next one before we return to normal growth patterns.
The 80's and 90's were the opposite of the Perfect Storm. So many things came together to create the Perfect Economic Environment. Ronald Reagan's tax cuts provided a powerful economic stimulus. Paul Volker's (and later Greenspan') successful war on inflation and a two decades long drop in interest rates boosted corporate profits, lowered consumer costs, spurred investment and housing and provided a relatively stable and predictable business environment. We saw the birth of the Next New Thing - The Information Age - which drove investment and resulted in the highest productivity growth in history.
We started with the lowest stock market valuations in decades and watched those valuations rise five times in the next 20 years. We witnessed the evolution of the US financial markets, which provided the capital necessary for business to invest and added monster numbers to our national net worth. As Gilder noted, our share of world market cap has risen to one-half.
But it was Nobel laureate Hyman Minsky who noted that the longer things remained stable, the more likely it was that things would become unstable. And the longer the stability, the more unstable the period which would follow. Greenspan failed to increase margin requirements in the late 90's and gunned the money supply in the face of Y2K, thus inadvertently encouraging a stock market investment bubble. The dotcom mania separated people from rationality and their money. And then came the Crash and the recession of 2001.
When coupled with 9/11, we should have seen one of the worst recessions in five decades. Why didn't we? Because we had a massive arsenal of recession fighting weapons: George Bush's tax cuts; Alan Greenspan's aggressive interest rate cuts; the stimulus of deficit spending and massive mortgage refinancing.
So what now? As I noted, the Muddle Through Economy is a long period of below trend growth caused by a series of economic headwinds and the potential/probable return of stagflation. Let's look briefly at just 9 of those headwinds, though each one could be several letters (or books!) in and of itself. Remember, not all of these headwinds happen at once (thank God!). These are forces that will play out over longer periods of time, but each will have the effect of slowing the economy.
Headwind #1: The Next Recession
When we come to the next recession, the recession fighting arsenal is bare of conventional weapons. There are no more tax cuts to be had, mortgage refinancing is essentially over, we are at a limit (I hope) of increased deficit spending and there are only a few potential and meager interest rate cut bullets left.
Therefore it is reasonable to assume the next recession is going to be worse than the last two we have had. Recessions by definition are deflationary. The Fed, viscerally afraid of deflation, will provide massive stimulus probably by fixing the ten year bond at ever lower rates. They will not protect the dollar. They will force inflation into the system which will ultimately increase interest rates.
Headwind #2: A Secular Bear Market
We covered this in detail last week. Summarizing: when starting from the valuation levels we have today, history would suggest that we will see modest, if any appreciable returns for the next 10 years. The last bull market cycle was characterized by rising P/E valuations, which accounts for well over half of the current market values, let alone the market tops of March, 2000. If today's valuations were at 1982 levels, the S&P 500 would be below 450 (from today's 1100). Over the long run, Value is King, and the market will revert to the mean and then go far below trend. For it to not do so would be without historic precedent.
If the broad stock market does note rise significantly over the next ten years, that will mean much pain for pension funds and future retirees. Corporations will be forced to dip into profits to meet their obligations, taxes will be raised by states and cities to pay for dramatically underfunded public pension plans and consumers will be forced to save more and work longer. We are now at the lowest level of personal savings in US history. We have dropped from over 12% during the Reagan era to under 1% today. Which brings us to:
Headwind #3: Consumer Spending Will Slow Down
By definition, if consumers begin to save more, they will consume less. I am not suggesting a fall-off-the-cliff type moment, but slower consumer spending growth will mean a slower growing economy. We are now at the lowest levels of saving in modern US history. When rising savings are coupled with rising oil and energy prices, consumers will have less to spend.
Unless we see far lower rates than today, there is little room for any significant stimulus from refinancing our mortgages. We have run through that well-spring. Debt levels are at all-time highs. While I don't see that as a current disaster, as we have the ability to service current debt, the problem is that we cannot add nearly as much debt in the next five years as we did in the last five years without creating real problems. Since increasing our debt was a large part of the equation for the continued rise in consumer spending, that source of funds is drying up.
Nonetheless, consumer are now borrowing to keep up their spending. Sadly, we are not seeing personal income rise significantly nor as much as consumer spending. Year over year rises in income is less than 2%, while the number of hours worked is down. This is a trend which cannot continue. Since two-thirds of the economy is consumer spending, this will have a major impact.
Headwind #4: Stall Speed on Employment
We need to create 150,000 jobs a month just to keep up with population growth. Clearly, we have not done that for the last four months. Producing less than that is what Dr. Lacy Hunt of Hoisington Investment Management calls stall speed for the economy. Given today's large rises in productivity, the economy needs to grow at 3.8% in order to produce enough jobs to keep unemployment even.
Obviously, if we are not adding enough jobs and unemployment starts to rise, pretty soon this pushes the economy over the edge into a recession.
Why, if the economy is so good, are we not adding jobs? I can think of several reasons. As noted above, average work weeks are around 33 hours. Why would employers add more workers if there is plenty of under-utilized time from current employees? It costs a great deal in benefits to add new employees. The international labor arbitrage is holding down wages or allowing some jobs to be outsourced. Current employees are far more productive and new ones are not needed even as demand may be rising for certain products.
Headwind #5: Interest Rates Will Rise over the Longer Term
I believe rates will fluctuate modestly in the short term and actually drop during the next recession, possibly to the lowest long-term levels of our lifetimes. But over time, rates are going to rise as a Fed-induced return to inflation will push rates back up. After we come through the next recession, higher rates will not be good for housing, consumer spending or corporate profits. They will be a headwind for the stock market as well.
Headwind #6: The Federal Deficit
Briefly, the US government is running large deficits. We must lower spending (or at least the rate of increase) or raise taxes. The adjustments, which will be necessary if we are ever to be able to deal with the $60 Trillion problems of Social Security and Medicare, will not be easy. They will be a drag on the economy. We are going to need some pretty powerful forces for good to get us out of this one.
Headwinds #7 and 8: The Dollar and the Trade Deficit
If we do not see 4% inflation and 4-5% short term rates between now and the next recession, which I do not think will happen, the Fed will be forced to use what Ben Bernanke calls "Unconventional Weapons" to keep from having an "unwelcome drop in inflation" otherwise known as deflation or Japanese disease. As I noted in a recent letter, he suggests moving out the yield curve and possibly fixing the rate on ten year notes for a period of time at a rate which would significantly lower mortgage rates and encourage investment (or at least speculation).
Of course, this will not be good for the dollar. The normally upbeat (and always on target) Martin Barnes of Bank Credit Analyst recently released a report on the problem of a low US savings rate. Since I cannot come close to doing as good a job as he does, let's look at how he summarized the problem:
"From a medium-term perspective, the problem of low U.S. savings and a large external deficit can play out in one of three ways. Let's call these scenarios the good, the bad and the ugly.
"The Good - In this scenario, the adjustment to lower imbalances is entirely benign. Continued strong productivity gains support steady growth in real incomes, and allow profit margins to hold at a historically high level. Steady income growth allows consumers to both gradually rebuild savings and sustain spending at a decent pace. Meanwhile, the government takes action to cut the deficit in ways that do not overly restrain private sector demand. Finally, strengthening overseas demand boosts U.S. exports, and a steady but panic-free drop in the dollar helps boost U.S. competitiveness. In this near-perfect scenario, the pace of economic growth averages close to potential and inflation stays low. Equity prices grow in line with corporate earnings, and overseas investors are happy to keep buying U.S. assets. The current account deficit slowly shrinks.
"The Bad - This scenario involves more pain for the economy and markets. Consumers embark on a more determined rebuilding of savings, causing a major headwind for spending, undermining profits and leading to below trend economic growth. Weaker corporate cash flow and a rising federal deficit make it harder to rebuild national savings. The dollar suffers a much steeper decline than in the previous scenario, to the detriment of the stock market and credit spreads. A slowdown in U.S. demand growth does curb imports and, together with the much lower dollar, reduces the current account deficit. However, the world economy is adversely impacted by U.S. trends and export growth is also affected. The ultimate outcome is a U.S. recession and an equity bear market.
"The Ugly - This is where the markets riot in order to force a change in trend. A vicious plunge in the dollar triggers a crash in equity prices and risk spreads spike higher. A credit crunch takes hold as the credit markets seize up. The Fed eases aggressively, but that just feeds further dollar weakness. Central bank intervention is not able to stem the hemorrhaging of capital leaving the country. The economy grinds to a halt and a long-overdue consumer retrenchment occurs with a vengeance. With profits also imploding, employment falls sharply, encouraging further consumer cutbacks. The economy is at the edge of a deflationary precipice and policymakers are relatively powerless because there is not much fiscal or monetary ammunition to deal with the crisis. The current account improves dramatically, but the adjustment is extremely painful. The global economy is severely impacted, not only by a U.S. economic downturn, but also by the deflationary effect of a sharp appreciation in overseas currencies. This encourages protectionism and attempted competitive devaluations in the major regions, but that just makes markets even more volatile.
"Greenspan is banking on the 'Good' outcome, judging by the quote shown at the start of this article. However, the odds of this fairy-tale scenario may be no higher than 25%. The probability of the 'Ugly' scenario is also relatively low, perhaps also about 25%. That leaves a 'Bad' outcome as the most likely.
"In all scenarios, the dollar is headed lower. Also, it seems that a major adjustment to the saving rate and the current account will likely occur only in the context of a recession and equity bear market. That could still be a few years away, implying that the U.S. will live with its imbalances for a while longer."
Whichever scenario, and right now I think the bad scenario is more likely, it will not result in a powerful economy. All scenarios point to a Muddle Through Era.
Headwind #9: The Shakeout from the Information Age
There are five phases of the innovation cycle for every new "Next Big Thing." Whether steam engines, railroads, telephones, electricity, automobiles or airplanes, it is pretty much the same experience. We start with the (1) actual innovation phase and then switch to a (2) growth boom. This leads to too much investment and overbuilding and we get a (3) shakeout. After the shakeout, in which weak players go belly up or are swallowed by stronger players, we are ready for the (4) maturity boom, which is often as big as the original growth boom. Finally, the new innovation (railroads, electricity) reaches its (5) economic peak and is pervasive throughout an economy, and grows no faster than the overall economy.
We are now close to the end of period two, or the growth boom of the Information Age. We will soon enter the shakeout phase. Some might reasonably argue that we already have started that phase. But there is still much pain to be felt. Voice over Internet Protocol will change the way we talk to one another and is driving costs down. Wi-Fi and a hundred other minor Information Age innovations are changing the landscape.
And Why I am a Long Term Optimist
That phase will also beget a maturity boom and the information companies that survive will power a new growth phase for the economy.
But this time, 10-20-30 million scientists, inventors and entrepreneurs worldwide will also build on that success and launch not one Next New Thing, but several simultaneously. I don't know exactly what, but add a new (or several new) bio-tech discoveries, throw in a few world altering innovations from the nanotech world (and they are coming), add a new energy paradigm and stand back. The combined economic power of increased knowledge and multiple new innovations will surpass anything we have seen in the past.
Yes, first we have to Muddle Through a few very thorny problems. It will not happen overnight. It may last another decade or longer. It will not be fun if you are mired in the past or have no way to adapt to massive and ever accelerating change. But for those who are ready to adapt, and who can work their way through the Muddle Through Era, it is going to be a helluva ride. Our kids are gonna have fun. With a little luck and a few new medical discoveries, many of us boomers will live to see them work and play in the Millennium Wave - a period of time at the beginning of this millennium when multiple transformational changes all happen at once. But that's a subject for another book.
A Short Break, Stanford, and Points Beyond
As you read this, I am either on my way or already in Tahoe with my bride, taking a few days rest before speaking at the Gilder/Forbes Telecosm conference. I will probably make that the focus of next week's letter, and then back to our series on my major economic premises.
I will be speaking at Stanford November 12 -14 for the Accelerating Change 2004 conference. (www.accelerating.org). I will also be one of the keynote speakers in Toronto on November 18 at the Strategy Institute's conference on Alternative Investments for the High Net Worth Investor. (www.strategyinstitute.com/111804_hnwalt/dsp_hnwalt.php) After that I will be speaking in St. Louis December 6 (details later). Things slow up after that, although I am sure something will conspire to get me on a plane.
Fall is in the air in Texas. I love this time of year. Cool mornings, but not yet cold. The Dallas Mavericks will be playing in a week or so. This could be the year.
It's time to hit the send button and go home. #2 son is turning 16 in a week or so, and wants to continue intense discussions about a car. I think he should pay at least half plus operating costs. He sees that as a beginning point for negotiations. "You bought cars for my (4) sisters! And what about Henry?" Telling him I learned good lessons about over indulgence is not yet persuasive.
Of course, he has to get a job. In Texas, government "protects" our kids from working before 16. (Thankfully, I was not subject to their protection as a kid of 12.) I helped him fill out his first employment application this week. Although he didn't notice, it was quite the moment for Dad.
Your watching them grow up too fast analyst,