Starting in the second quarter of this year, evidence began to pile up indicating that the U.S. economic recovery was losing momentum.  The stock market reacted in predicable fashion and sold off rather sharply.  The S&P 500 dropped 15% from its peak in late April to its low point in July.  Economic data since then have been mixed, and the stock market has vacillated accordingly. 

None of this is surprising to us as we have consistently argued that the economic recovery following the 2008 financial meltdown and recession would be anemic compared to historic rebounds.  The primary reasons are worth repeating.  First and foremost, housing which normally serves as the engine to pull the economy out of recession has been unable to serve this function following the vast over-building that occurred as a result of the irresponsible expansion of credit during the early part of this decade.  In fact, now that the government-sponsored tax credits for home purchase have expired, housing is again a drag on the economy.  Inventory of unsold homes remains near historic highs, not even counting the large number of foreclosed homes (and homes that should be foreclosed) that the banks are sitting on.  The other factors holding back the recovery are anemic consumer spending, chronically high unemployment, tight credit conditions and the resulting bias to save rather than spend, which is keeping consumer spending in check. 

Not only is the lack of new home construction weighing on the economy, but the drop in housing prices is also creating havoc for many consumers.  According to the Wall Street Journal1 “more than seven million borrowers are 30 days or more past due on their mortgage payments or in some stage of foreclosure (7/21/10).”  Additionally, an “unprecedented number of homeowners … are underwater or … owe more than their homes are worth.”  This has multiple implications for both the long-term health of the housing market and for consumer spending generally.

When one thinks about the U.S. economy over the past 20-30 years, several things become clear.  Economic growth was strong for a series of reasons which unfortunately are no longer operative.  First, financial institutions were aggressively leveraging up their balance sheets.  Banks ramped up from roughly 10-12 times debt to equity to, in some cases, 20-25 times.  Today they are deleveraging so credit is constrained.  Second, because of abundant credit and weakened lending standards, mortgage financing was extended to millions of marginally qualified or unqualified borrowers, resulting in a vast over-building of our housing stock.  Going forward we will need far fewer new housing starts for a number of years.

Third, because of rising home prices and at times an ebullient stock market, consumers experienced a surge in wealth and felt comfortable reducing their savings rate to 0%.  Now, with home prices under pressure and a stock market that has had negative 10 year returns, consumers feel the need to rebuild their savings.  The savings rate has gone up to around 5%, resulting in lower consumer spending.  Given our outlook for home prices and the equity market, we believe the savings rate may remain well above 0% for many years.

This is further underscored by an unemployment rate hovering just below 10%.  When lots of people are out of work, those lucky enough to have a job spend more conservatively.  They put money aside for a rainy day.  During the heyday of the high-tech and telecom boom, unemployment dropped to around 4%, while at the same time the stock market and housing prices both rose.  Consumers thus felt comfortable spending.  Today, that is not the case.

Fifth, lower taxes and deregulation supported aggressive business expansion.  Today our politicians want to raise taxes and re-regulate many industries.  This is throwing a dose of cold water on business investment.  We can never recall such a frosty relationship between Washington and the business community.  Consumers, too, feel anxious about the potential for higher taxes as they are fully aware of the long-term need to reduce the federal deficit.

Sixth, during the 1990s there was an explosion in new business activity as the high-tech and telecom revolutions introduced new technologies into our society.  These new industries engendered vast new investment.  Today, we see no new technologies on the horizon that could spark such an investment wave.  Someday there will be because that’s how technology works, but not just now.

Finally, when looking at the structural differences of the economy 20 years ago and now, one must also add demographics.  Simply put, our population and that of many other countries, including many in Europe and China is aging.  As a population ages it spends less on traditional consumer goods and more on health care.  This shift has profound implications for future growth.  As PIMCO’s Bill Gross2 wrote in August, “The danger today, as opposed to prior deleveraging cycles, is that the deleveraging is being attempted into the headwinds of a structural demographic downwave as opposed to a decade of substantial population growth.”

Taken all together, we believe these structural headwinds to growth portend an extended period of anemic growth.  Corporate profits, which enjoyed a surprisingly robust rebound this year because of strict cost cutting, are poised to grow more slowly going forward.  Cost cutting has its limits and, at some point, probably about now, the lack of strong top-line growth may mean slower bottom-line growth.  While this would ordinarily have ominous implications for the stock market, we would contend that much has already been discounted by the market. 

Stocks today are selling slightly below their long-term valuation levels.  They could go lower, of course, but we believe there is no “irrational exuberance” baked into stock prices today.  Second, dividend yields on many stocks now exceed interest rates on bonds, something not seen since 1958, when investors were just getting over fears of another depression.  Third, stocks are much more attractive than investment grade bonds unless, of course, one fears an extended period of deflation, something we are not predicting.  Finally, we believe U.S. stocks are no longer overpriced relative to emerging market equities. 

Coupling our restrained economic outlook with the reasonableness of stock market valuation, we come away with a moderately constructive view of the equity market.  As always, of course, we try to uncover and invest in companies with clearly improving fundamentals and reasonable, if not compelling, valuations.  We are also comfortable holding some cash both to cushion an unexpected market drop, and to have a buying reserve when attractive opportunities arise.

The overriding problem in investing today is the great uncertainty surrounding both the political and economic landscapes.  It seems likely that the Republicans will gain traction in November, leading to potential grid lock in Washington.  Investors may view that positively in the sense that grid lock could slow down the pace of re-regulation and cause Congress to rethink its efforts to raise taxes on the “rich.”  In other words, a Republican resurgence could reverse the perceived anti-business atmosphere in Washington.

The economy, as we have said, is likely to remain somewhat anemic.  We do not believe it is headed into a double-dip recession, but one cannot rule out such a possibility.   Moreover, there are still problems in Europe in the so-called “Club Med countries” and Ireland, which could undermine the strength of the European banks and cause an economic slowdown there.  In the U.S., many state and local governments are experiencing severe financial stress and will likely need to curtail services and lay-off workers.  This may entail headline risks and add to the unemployment problem.  Longer term, the U.S. federal deficit may become a greater issue and need to be addressed with spending cut backs, higher taxes, or both, unless the U.S. were to experience much stronger growth which would push up tax receipts. 

Amid all this uncertainty, serious observers worry about near-term deflationary forces and longer-term inflation.  Housing is still deflating, but commodities are mixed.  The concern longer term is that the Fed is printing money in order to stimulate the economy.  At some point, all this liquidity in the system could cause inflation to accelerate, perhaps to a level that the Fed cannot contain.  We are not forecasting either serious deflation or serious inflation.  On the other hand, we do not regard the probability of a negative outcome as trivial.

             

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1 Nick Timiraos and Robbie Whelan, Housing Market Stumbles, wsj.com, 7/21/10.

2 William H. Gross, Privates Eye, pimco.com, 8/10.

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Past performance is no guarantee of future results.  This commentary contains the current opinions of the author as of the date above, which are subject to change at any time.  This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. 

 

The S&P 500 is a market-capitalization weighted index of five hundred unmanaged common stocks and is widely recognized as representative of the equity market in general.  The index does not incur expenses and is not available for investment.  Index returns reflect the reinvestment of dividends and interest.

 

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