October 27, 2009
This article originally appeared in Wealth Manager Magazine:
Long-term equity investors face a critical juncture. They can believe a V-shaped economic recovery is imminent, if not underway, and valuations for broad-based equity indexes properly reflect an end to the “decrepit decade” of return-less risk in US markets.
Or they can believe true economic recovery – growth, not just stability – is still a long way off and US equity valuations are in bubble territory, not reflective of the rough terrain ahead.
For index-based investors, getting this decision right is critical. Outperformance in the equity markets over the long term (by which I mean at least 10 years) is a byproduct of one’s entry point, as Yale economist Robert Shiller has shown in his studies. Superior long-term performance is highly dependent on buying when the market is cheap.
The case for economic recovery, at least one of the V-shaped variety, is difficult to make. First and foremost, one has to assume that the rise in unemployment will end, not just decelerate, as has been the case. Strong forces, however, make that unlikely.
We are losing more than 200,000 jobs every month. As John Mauldin of Millennium Wave Advisors has documented, an average of 250,000 jobs need to be created every month over the next five years to return the economy to 5% unemployment – the level associated with “full employment.” Since the beginning of 1999, however, there have been only 19 months (out of a total of 128) where at least that many jobs were created. To flip current job losses into an era of job creation of that magnitude is highly unlikely.
Before employers hire new workers, they will increase hours for their current workers. That has been the case as we emerged from most past recessions, but has it yet to occur this time around. The average worker is putting in only 33 hours per week, down from 39 hours in 1965.
Consumer spending, the traditional engine of the US economy and driver of employment, is 10% below its historical trend line. From 1950-1980 consumer spending was remarkably stable, amounting to 62% of GDP. In the last three decades, as personal debt rose from 55% of national income to 133% of national income, consumer spending rose to 70% of GDP.
That debt binge is over and has been replaced by a new frugality.
Don’t assume that this new frugality affects only luxury products – it is affects virtually every segment of the consumer economy. McDonalds recently announced disappointing earnings, and revenues for NASCAR, the all-American blue-collar pastime, are declining. We are still learning just how frugal Americans can be.
Debt-fueled consumer spending created an abundance of retailing venues, and now many will be forced to contract or will cease to exist. The automobile industry figured this out the hard way, as Chrysler’s and GM’s bankruptcies forced them to close thousands of dealerships. Similar consolidations will wrack the retail industry, leaving many more unemployed.
Problematic excess capacity exists in financial services, housing and construction-related industries, automobiles, and in other major sectors of our economy. Manufacturing utilization in the US, which some call the “output gap,” is at 65%, its lowest point in 60 years.
High unemployment and low capacity utilization are combining to prevent inflation. The US has never had an episode of inflation that was not driven by wage increases, and capacity utilization historically must reach 80% before inflationary pressures are felt. Very few companies can increase prices in the absence of inflation, impairing their ability to grow revenue.
Even the airline industry, which seems to have largely rationalized its overcapacity (when was the last time you saw more than a few empty seats on a flight?), still cannot raise prices without suffering adverse consequences.
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