longer for stronger the unintentional tradeoff?“u.s. stocks are trading virtually in lockstep with...
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A Quarterly Publication September 30, 2013
Capital Investment Services of America, Inc.
700 North Water Street, Suite 325 Milwaukee, Wisconsin 53202-4206
414/278-7744 800/345-6462
[email protected] www.capinv.com
In This Issue . . .
The great escape from
heightened fear, uncertainty,
and doubt continues to
unfold.
The economic expansion is
built on sufficiently solid (and
improving) fundamentals.
Emerging markets have
structural economic issues
that will likely persist for an
extended time.
China’s economic
developments are a “big
deal”, but perhaps not in the
way conventional wisdom
suggests.
Slow economic growth may
well foster a long expansion.
Longer for Stronger —
The Unintentional Tradeoff?
Maybe Copernicus was wrong—the earth does not revolve around the
sun. Instead, the entire universe revolves around Washington D.C.
Or so one would believe if current headlines and the 24/7 “news”
coverage are any indication. Nearly all media focus has been on: the
drama surrounding Washington D.C. budget battles, the two
“downs”—as in government shutdown and the looming debt ceiling
showdown, and when the Federal Reserve will begin “tapering” their
bond buying actions.
These are important issues to be sure, but they are not the only
important topics shaping the investment environment.
Much as the magician diverts
an audience’s attention with
one hand while the other
hand performs the trick
underlying the magic, we
suspect the tapering and D.C.
drama will prove to be short-
term diversions from the
issues likely to shape the
investment landscape for the
next few years.
Cartoon: Watch Both Hands
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Here is our list of issues and trends that are creating investment opportunities and risks:
The great escape from heightened fear, uncertainty, and doubt continues to unfold.
The economic expansion is built on sufficiently solid (and improving) fundamentals.
Emerging markets have structural economic issues that will likely persist for an extended time.
China’s economic developments are a “big deal”, but perhaps not in the way conventional wisdom
suggests.
Slow economic growth may well foster a long expansion.
What follows is a relatively brief discussion of this list.
The great escape
We have noted in prior Perspectives the damage done to the collective investor psyche by the Financial Panic of
2008. As Chart 1 reflects, the heightened fear, uncertainty, and doubt has taken a toll on confidence about all
things economic.
Chart 1: Consumer Confidence—off bottom but still well below pre-2008 levels
Since 2008, the financial markets have had recurrent bouts of “nerves” about such things as a possible Great
Depression rerun, deflation, double-dip recessions, Eurozone meltdown scenarios, debt downgrades, stock
market “death crosses” and the dreaded Hindenburg Omen, end of the Mayan calendar, stagnating innovation,
the fiscal cliff, and perhaps now the debt ceiling drama.
Also adding to the uncertainty have been fiscal policy and, more recently, monetary policy. (For those seeking
a review of how policy has contributed to the fragility of confidence, we offer our thoughts in Appendix 1.)
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The damaged investment psyche condition is not
without investment precedent. Consider the
following observation:
“U.S. stocks are trading virtually in lockstep
with 1954, the best year for American equity
and the time when shares finally recovered
all their losses from the Great Depression.
The Standard & Poor’s 500 Index’s returns
in 2013 are tracking day-to-day price moves
in 1954 almost identically, according to data compiled by Bespoke Investment Group and
Bloomberg. In no other year are the trading patterns more similar to 2013 since data on the index
began 86 years ago.” 1
On prior occasions we have pointed out that the 1950s began with similar levels of investment fear, uncertainty,
and doubt as those prevailing in current times. While nostalgia may cloud memories (Appendix 2 lays out some
of the 1950s investment challenges), President Truman’s Council of Economic Advisors warned him in the late
1940s of a “full-scale depression some time in next one to four years.” And, the following quote reflects
investors’ sentiment towards stock investing back then.
“In early 1948—nearly two decades after the Crash of 1929—the Federal Reserve surveyed investors
nationwide about their attitudes toward stocks. Only 5% were willing to invest in equities, and 62% were
opposed. Asked why, 26% said stocks were “not safe” or “a gamble”. Just 4% felt that stocks offered a
“satisfactory” return.
Only in the mid-1950s, as one of the biggest bull markets in history roared ahead, did individuals return to
stocks in earnest. By then, stocks were roughly twice as expensive as they had been when individual investors
told the Fed they were a ‘gamble’”.2
Despite all the worries—and actual troubles along the way in the form of three recessions, rising interest rates, a
hot and cold war—the stock market registered an annual average gain of close to 20% during the 1950s. The
stock market rose as investor confidence underwent what economic historian Robert Higgs3 has called the great
escape from overly pessimistic expectations of the economic future which was pervasive upon entering the
decade of the 1950s.
It has been our thesis for the past few years that another similar great escape from general investor anxiety is
underway. The escape is occurring not because the economic picture is either wonderful or free of worries.
The escape is underway because economic growth is—like the 1950s—exceeding investors’ excessively
gloomy expectations.
By suggesting the similarities between the current and 1950s investment climates, we are not saying current
economic conditions are the same or that stocks are going to rise 20% as they did back then. We are, however,
suggesting that even as the stock market has risen in recent years, investor confidence remains both fragile and
depressed—and conditions remain ripe for fueling still more great escape action in the period ahead.
1 Bloomberg, September 30, 2013
2 Will Small Investors Ever Warm Up to Stocks Again?, Jason Zweig, Wall Street Journal January 22, 2011
3 Regime Uncertainty, Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War, Robert Higgs,
The Independent Review, Vol. 1, No.4, Spring 1997
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Resilient (and improving) U.S. economic fundamentals
While the focus is on Washington D.C., the private sector remains hard at work figuring out ways to grow and
prosper. What areas are powering growth? The emerging industrial renaissance that is being driven by game
changing technology applied to manufacturing processes, the domestic energy revolution (see IEA quote
below), recoveries in “high-economic-multiplier4” industries like housing and autos, and favorable
demographics (Charts 2 and 3).
“The supply shock created by the surge in North American oil production will be as transformative
to the market over the next five years as was the rise of Chinese demand over the last fifteen”. International Energy Association (IEA)
Chart 2: Lots of pent-up demand for housing
(Chart source: government data and Morgan Housel)
(Chart comment: In 1963, housing starts were approximately 1.5 million when the U.S. population was 189
million. Today, the U.S. population is over 300 million and housing starts are less than 1 million.)
Chart 3:
U.S. demographic trends are more favorable for growth than those existing in other nations–even China!
4 According to the National Association of Home Builders, the construction of a new single family home creates, on average,
three jobs.
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Furthermore, the great escape is spreading beyond investor behavior. Since the 2008 panic, balance sheet repair
(Chart 4) and cash hoarding have been the emphasis for most consumers and businesses.
Chart 4: Household debt service burdens are in good shape
This is changing. Surveys of small business confidence, small business employment, and CEO confidence in
general, are staging meaningful advancements. As businesses’ “animal spirits” lift, it is reasonable to expect
significant increases in business capital expenditures, merger and acquisition activity, and hiring.
Emerging market economies have structural issues
A major inflation issue may be brewing that could rival that experienced during the 1970s. Only it may not be
in the country where it is most feared—the U.S.
As Chart 5 reflects, U.S. money growth is running at a pace consistent with the trend that gave us the relatively
modest inflation of the last 20 years.
Chart 5: Domestic money growth doesn’t look too worrisome
(p.a. = per annum)
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The Fed’s actions (to this point in time) are more consistent with “filling a hole” created by the fallout of the
2008 financial panic rather than building a 1970s-like “money mountain” that triggers an inflation problem. It
is a different situation, however, in many emerging market economies.
Due to the export orientation of emerging market economies, these countries have, for the most part, linked the
exchange value of their currencies to the U.S. dollar. As a result, they imported U.S. monetary policy. And
while Fed policy may have been appropriate for the U.S. economy, it has created problems for emerging market
economies. They are experiencing wage price spirals that are eroding their export competitiveness and are
struggling with bad debt problems that typically accompany excessively “easy” monetary policy.
This places those countries in a structurally difficult situation. If their policymakers try to stem inflationary
pressures, growth abruptly slows, bad debt pressures escalate, and economic hardship and social friction result.
If they try to ease policy to promote growth, inflation accelerates.
The combined inflationary pressures and eroding competitive positions is weighing on the profit margins and
attractiveness of emerging market stocks. Chart 5 reflects how corporate earnings growth is surprisingly on the
“downside” for emerging market stocks (Chart 6). Until the structural inflation issues are defused, this trend is
likely to remain in place.
Chart 6:
Faster growing economies (especially those with inflation problems)
do not always translate into fast growing stocks
Many investors have been conditioned by the 2000-07 period to believe the emerging markets are the ticket to
strong stock returns. However, underlying conditions have changed. “Shooting where the duck once was” is
not the key to success either when hunting fowl or hunting for successful stock investments. (For more on our
take on international investing see the posting; International Investing: Think Globally, But Invest Locally
under the Recent Commentary section on our website at www.capinv.com.)
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China’s big implications
China fits into the emerging market economy group saddled with inflation and bad debt issues. But it
represents a very special case for investors as well.
Over the past decade or so, it has been the primary “price setter” for nearly all commodities in the world. With
the build-out of its economy, its voracious appetite for commodities ranging from oil and iron ore to cement has
driven commodity prices markedly higher. These higher prices have, in turn, sparked commodity price inflation
in much of the developed world economies.
Moreover, higher commodity prices have driven strong earnings growth for commodity producing companies
and countries, but have also stifled the valuations (price/earnings and price/cash flow ratios for example) of
most other stocks traded in the U.S. (Chart 7).
Chart 7: Stock valuations can expand significantly as inflation remains tame
(Chart comment: Commodity inflation depressed P/E during the 2000s—line 1 in graph. P/E may now expand
as commodity inflation cools—line 2. “Rule of 20” suggests P/E = 20 minus inflation rate. More about the
“Rule of 20” can be found at www.capinv.com under the Recent Commentary section, Rule of 20).
With growth slowing in China, its appetite for commodities is ebbing. This means commodity price relief and
lower inflation impulses sent out to the rest of the world.
The investment implications of this are significant. For the U.S., modest inflation and low and stable
commodity prices coupled with durable growth are a favorable environment for businesses and consumers.
If history is any guide, valuations of U.S.-traded stocks should expand in such an environment, as will profit
margins for many companies as input costs stabilize and/or decline. This would be good news indeed for
investors as well.
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An unintentional tradeoff between longer growth and stronger growth
It is no secret that the current U.S. economic expansion is one of the slowest on record. What is not widely
considered, however, is that with the slow growth comes little accumulation of the type of excesses that
typically make the expansion “brittle” and vulnerable to the next downturn.
Typical excesses that accumulate to unsustainable levels near the end of an expansion include: large expansion
of debt (remember our old banking adage—bad loans are made in good times), inventory overhangs, an
overexposed financial system, and rising inflation. Actions designed to reign in these excesses (particularly
inflation), like concerted and prolonged interest rate hikes by the Federal Reserve, ultimately become the
“straws” that break the expansion’s back.
Currently, end-of-expansion excesses are absent. In the shadow of the 2008 panic, the prevailing “wisdom”
remains that the economic and financial world is a fragile and dangerous place that is teetering on the brink.
The result is a condition summarized by the following:
“Consumers in the U.S. are spending more closely in line with their incomes than in the past 48 years”
(Bloomberg story headline from 9/12/13).
Banks are better capitalized than they have been in many decades.
Inventories all along the supply chain for nearly every industry are extremely lean.
Auto supplies for many models are in short supply with only a few days of inventory versus the normal
unit of weeks of supply.
Home builders are reporting a shortage of buildable lots.
This backdrop of few troublesome excesses, solid underlying fundamentals, low inflation, commodity price
relief and more great escape behavior on the part of consumers, businesses and investors suggests the
expansion has quite some time to go yet.
Unfortunately, the government’s reach into the economy is too large to ignore the Washington D.C. drama
completely. But the real action—and multiyear, investment trends and opportunities—lie in the considerable
activity being created away from D.C.
Appendix 1: Policy as a wet blanket on economic activity We believe fiscal and (recently) monetary policy have reinforced the pervasive fear, uncertainty, and doubt that
has marked the period since 2008.
We hear it from business leaders all the time—“we just want to know what the rules are and the costs associated
with them. Whether we like them or not isn’t the issue from a business perspective. We will adapt, but we
need to know what specifically we need to adapt to.”
On the fiscal side, sweeping, complex legislation involving significant segments of the economy with critical
details still being worked out “on the fly”, exemptions from the new rules granted for some (including
Congress) but not others, the rapid expansion of the future liabilities of the government, tax hikes and calls for
more, open animosity among the major parties of government, and tromping on bondholders’ legal claims in the
auto bailouts, have all significantly contributed to the prevailing uncertainty during this period.
Chart 1: American Belief that Government is Too Powerful is at Record Level
On the monetary side, we believe the “unconventional” policies of the Bernanke-led Federal Reserve did not
repeat the mistakes of their Great Depression predecessors that allowed the collapse of the financial system in
the early 1930s.
However, by extending “crisis” monetary policy for so long, the Fed has likely reinforced general apprehension.
Many fear that the Fed’s actions have sown the seeds of hyper-inflation (we do not agree). Others doubt that
the weak economy can stand on its own “two feet”, and fret that the stock market is on a sugar high that will
end in a crash as the Fed stimulus is “tapered” (we also do not agree). Still others wonder if perhaps the Fed is
maintaining its stance after giving contrary signals recently about tapering because it now knows something
(bad) about the economy that the markets do not.
Adding to the present level of monetary policy anxiety are questions about an impending change in the Fed
leadership as Bernanke’s term expires early next year.
We believe economic conditions will require Fed tapering soon. Divided government hopefully means
Washington D.C.’s reach into the economy will be capped so the private sector can do what it does best—
innovate, experiment, grow, and create wealth.
Appendix 2: The 1950s great escape
Nostalgia for an earlier time when things turned out well can cloud the memory. The 1950s reality itself was
not free of bad news, trouble, and fear. A partial list includes:
Three recessions during the decade
The Korean War
Fears that communists were infiltrating government
Cold war with the U.S.S.R.
Fears of nuclear attack (building of bomb shelters, kids in school practiced attack drills, etc.)
The “mighty” Soviet Union took a seemingly insurmountable lead in the space race
Interest rates rose significantly over the course of the decade
Despite all this, reality still exceeded the low expectations initially impounded in stock valuations when the
decade of the 1950s began. As conditions proved better than expected, confidence rose and a massive stock
bull market ensued, as the following table reflects.
Table: The 1950s investment experience
Like the 1950s, current economic reality does not have much of a hurdle to clear to deliver favorable surprises.
If the current “crisis about everything mentality” proves unfounded, investor confidence could easily move up
many more notches—even with the inevitable troubles that will be experienced along the way. This backdrop
provides U.S.-traded stocks with a favorable risk/reward profile, in our estimation.
Compound Annual Returns*
1949 - 59
Stocks 19%
Bonds:
Intermediate Government 1%
Long Term Government 0%
Corporate 1%
50% bond/50% stock Portfolio 10%
*Sources: Ibbotson Associates, Bloomberg
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