A Time of Uncertainty
“The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our affairs.” Warren Buffett 2017 Berkshire Hathaway Annual Report to shareholders
The current economy and markets exhibit a disturbing phenomenon: a truly stark divergence between faltering long-term economic growth fundamentals (asset valuation, economic class participation, international integration, and pillars of low debt/demographic growth/productivity), and ebullient short-term market, inflation, earnings and employment trends. Typically, when GDP growth slows or contracts, the markets anticipate that trend, usually with either a very lack-luster trend, bear markets, increased volatility or violent market crashes. We do not anticipate a bear market or crash in the coming year, but the four trends outlined below indicate a healthy reason for cautious, lower risk, investing with a healthy cash balance. Reversing these four growth headwinds make take a decade or more. We believe that active portfolio management is preferable to passive investing, as security selection is the starting point for lowering risk. Cash of 30% should currently be the base case, but asset class diversification into lower duration bonds is also a risk reduction technique. Though we do not predict the market future, the blue-sky investment advice often given in financial networks and media outlets regarding the stock market should be balanced against major impediments to growth and the importance of preserving wealth during volatile market periods as the economy re-balances.
Much rationalization has been offered of the growing U.S. economy with low volatility and appreciating asset prices, as unemployment has continued to trend downward, and business confidence is strong. The recent tax cut has further stimulated growth. This expansion, at eight years, nine months is the second longest in recorded U.S. history, and will be the longest if it last until July 2019. Yet there is an air of dissatisfaction, frustration and even anger that permeates both social and economic trends, making this growth period seem somewhat superficial and ephemeral. Short-term indicators are positive but fly in the face of the following four long-term trends.
Four Long-term Trends
The following trends often precede market and economic contractions.
Asset Valuations: Stock, bond and real estate aggregate valuations are high. For instance, the ten-year U.S. Treasury interest rate, the inverse of treasury bond market prices, is 2.8% compared to records of 16% in 1981 and 1.6% in 2016 (1). Thus bond prices in aggregate are near record highs. Stock market valuations are measured historically in the aggregate by an indicator known as the Cyclically Averaged Price Earnings (CAPE) ratio (see Robert Shiller (2)), measuring S&P 500 price earnings ratio averaged over ten years. CAPE was recently at 31.50 the second highest level on record after a record of 44.5 just before the 2000 dot-com bubble, and higher than a peak of 30 preceding the 1929 market crash. Finally, real estate tracked by the Case Shiller (3) index values median home price in 2016 at 3.1 times median family income. The historic index average is 2.6; the 2006 high before the housing crisis was 3.8.
Insider Money Movement and Class Stratification: An emerging trend over the past forty years has been economic stratification. Wealth accumulation by the very wealthy as the middle and lower classes have either maintained or lost wealth, historically spikes at market and economic cycle peaks. New York State Comptroller statistics on Wall Street compensation, reported average Wall Street bonuses for 2017 of $184,220 approaching a 2006 record of $191,360 (4) . Investopedia, an on-line database of financial information, indicates that in 2017, the top 100 CEO’s have retirement funds equal to 41% of all other American retirement funds combined (5). These stunning wealth figures come as median, after inflation, family income for the U.S. has only increased 5.9% from 1967 to 2015 according to Census Bureau data (6). The destabilizing forces that create these wealth extremes appears to be spiking.
Economic Globalization and Trade Dependency: Economic activity is increasingly global yet the opportunities for economic growth are increasingly in specific channels and economies of scale, especially in intellectual property. This search for productive enterprise is now a source of stress playing out in international immigration, trade tensions, nationalism and populism, intellectual property theft, rights control and information security. Trade wars are often a leading indicator of such ruptures. For instance, significant trade barriers were raised as England emerged as an international power from the shadow of Spain (1600), and likewise as Japan and Germany emerged as world powers just prior to the world wars. Today, tariff propositions of the U.S. and China ($200 Billion total on bilateral trade of $600 Billion in 2016) are not yet substantial enough to cause global economic dislocation, but bilaterally, it sets a tone for international trade conflict. The OECD is already seeing a slowdown in international trade growth at roughly 3%, below levels of 7% before the Great Recession though it is perhaps too soon to ascribe this to current trade policies, as it could as well be signaling a global reduced GDP growth pattern.(7)
Debt, Demographics and Productivity: Economic or GDP growth is based on human production, consumption and investment of capital. As such, the demographic profile of a nation, the level of debt load, and the productivity of labor are key measures of the ability of that economy to grow. In the U.S., the labor force participation rate is at a two decade low of 62% from a high of 67% in 2000. Historically, from 1950-2000, the labor force has grown at 1.6% rate, but the Bureau of Labor statistics expects to slow to below .6% in the first half of this century.(8) Hence, economic growth, consumption, and pay must either slow considerably or restructure even as our social safety net accounts for fewer workers. Standard and Poor’s data indicates the non-financial corporate debt ratio is 45% of GDP (9) matching the pre-2008 high point, while total public debt, according to Treasury Department date, is 120% of GDP, matching the record level at the peak spending of World War II. (10) We are becoming increasingly indebted, yet still need to spend $4.6 Trillion on our key infrastructure per The American Society of Civil Engineers. (11) Finally, productivity statistics from the Bureau of Labor Statistics report labor productivity grew at 1.1% this past decade, well below the historical average of 2.3%. (12) These demographic, debt and productivity data indicate a longer-term barrier to GDP above 1.5% unless trends are reversed.
Thus long-term trends will at some point have to be reflected in short-term performance. How volatile this short and long term reconciliation is and when it will occur are not clear, but that process will take time, energy and likely market corrections which are a risk for which we must prepare.
(1)St. Louis Federal Reserve historic data as of 4/17/2018: https://fred.stlouisfed.org/series/DGS10
(2)R Shiller CAPE SP500 rationale presented by Lyn Alden: https://www.lynalden.com/shiller-pe-cape-ratio/
(3)Current Case-Shiller data and Census Household Income data is presented by D H Taylor at https://seekingalpha.com/article/4118666-u-s-housing-bubble-never-less-affordable
(4)NY State Comptroller 2017 data: https://www.osc.state.ny.us/press/releases/mar18/032618.htm
(5)Investopedia data: https://www.investopedia.com/articles/personal-finance/010517/retirement-divide-ceos-vs-rest-us.asp
(6)Census/St Louis Fed data explained and charted by Wikipedia at https://en.wikipedia.org/wiki/Household_income_in_the_United_States
(7)The current slowdown in global trade and projections of structural shifts impeding trade are analyzed in the May 2015 OECD paper prepared by the IMF and World Bank found at http://www.oecd.org/tad/events/-WBG-IMF-G20-paper-Prospects-%20Global-Trade-29-May-2015.pdf
(8)Bureau of Labor Statistics at https://www.bls.gov/opub/mlr/2015/article/labor-force-projections-to-2024.htm and https://data.bls.gov/timeseries/LNS11300000
(9)The Economist summaries Standard and Poor’s data on corporate debt at: https://www.economist.com/news/business/21738397-total-debt-american-non-financial-corporations-percentage-gdp-has-reached
(10)Wikipedia summaries total public debt at https://en.wikipedia.org/wiki/National_debt_of_the_United_States
(11)Reuters report on ASCE infrastructure evaluation: https://www.reuters.com/article/us-usa-infrastructure-reportcard/u-s-infrastructure-gets-d-plus-grade-in-civil-engineers-report-card-again-idUSKBN16G21I
(12) Bureau of Labor Statistics: https://www.bls.gov/opub/btn/volume-6/below-trend-the-us-productivity-slowdown-since-the-great-recession.htm
KWM is a Member of Advisory Services Network, LLC, a Registered Investment Advisory in Atlanta GA. As we stated at the outset of this article, there are many uncertainties in our government, economies, global relations and public sentiment. There is no guarantee that these assumptions will manifest in reality, nor is there any reliable gauge as to the extent that they manifest. All views/opinions expressed in this newsletter are solely those of the authors and do not reflect the views/opinions held by Advisory Services Network, LLC.