BUD BREWER
One Man's Opinion
No Facts about the Future
Has the economy really turned around and if it has, should one start reinvesting their cash in equities now or stay put on the sidelines with higher than normal allocation to cash or short term bonds. This is the question I hear from most investors. But I think they are asking the wrong question. The question all portfolio managers need to answer is, as stock prices in markets around the world stabilize, what will be the average rate of growth experienced by the U.S. economy over the next five to ten years? Some important factors that impact the rate of economic growth have changed. In recent history, the average annual growth rate in our Gross Domestic Product has been about 5% per annum. This rate has been sustained fairly evenly over the past two or three decades. This standard for growth has been used by corporate and private business managers as a basis to justify the hiring of workers, the building of new plant capacity and the assumption of additional debt with the full expectation that such “normal” economic growth will generate the necessary profits to service that debt, pay the additional worker’s salaries and make use of the increased capacity it provided. Consumer demand rose steadily during this period prompted by high employment and the general feeling by the average individual that their retirement accounts and the value of their home would continue to appreciate by high single or even double digit annual rates of growth. This assumed growth in their balance sheets motivated many to raise their standard of living funded by monetizing the increase in home equity and security portfolios by assuming additional debt. Refinancing homes and running larger and larger balances on credit cards for a number of years generated incremental cash flow for the financing of the things they wanted to buy or do.
The economic set-back currently being experienced was caused in large part by business managers and individuals expecting the norm for economic growth to continue at the historical rate they had been used to. But the underlying basis of that growth rate was the rising amount of consumer spending bolstered by the addition to their debt utilizing the appreciated value of securities and home values as collateral.
Today, the prices of securities as measured by the Dow Jones and Standard and Poor stock indices have recovered almost half of the valuation lost since October of 2007. Corporate earnings for the most recent three months were higher than the same period last year. That’s good right? Well yes it is good but before we draw any conclusions about the economy being back on the historical growth rate trend, we need to understand that these earnings were achieved when total revenues were down and by no small margin. This just goes to show what corporate managers are capable of doing when they have to in order to survive. Profit margins were up due to personnel layoffs deferring replacement of inventories and the slashing of operating costs, none of which are going to enhance the company’s future revenue growth or contribute to an increase in the GDP. The economic growth as measured by increases in GDP is dependent upon the increase in jobs as business employs people to meet rising demand for their product or services. These employees then have income to spend on goods and services thus increasing the consumer spending sector of the economy. But even when this “Great Recession” is over, the defensive nature of the consumer is likely to continue for several years. As a result, the only source of meaningful increase in employment is probably going to be realized from the Federal Government’s stimulus program, bureaucratic offices created to administer increased regulation, perhaps a new government health insurance program, and the staffing of the President’s industry Czars offices. Guess what! All these new government programs and the additional people hired to administer them are going to have to be paid for by tax revenues from the private sector and the increase in government debt from the issuance of Treasury bonds to be sold to the very people whose rate of consumption is already declining. When the American economy is burdened with rising taxes to fund ever increasing federal debt, the amount of capital available for investing and creating jobs in the American economy must abate. This lower rate of available capital puts downward pressure on private investment and lower job growth.
For these reasons, Investors must recognize that the next several years will probably experience an average growth rate well below that of the historical rate experienced. If investors conclude that the economic growth of our economy will be 2% rather than the 5% we have experienced valuations or price earnings multiples must reflect this by being lower than they have been, perhaps a lot lower.
This suggests to me that a major portion of any positive return on capital in the next several years will be realized in the form of dividends. A “safe” dividend rate of five percent looks very attractive. Bond yields from securities issued by large corporations of companies with a solid operating franchise should deliver a very satisfactory return, at least for the next several years. This suggests to me that while I believe equity investments are going to be necessary over the long term in order to protect the real value of one’s assets during the inevitable price inflation that will occur due to a decline in the value of our dollar, we probably will not experience too much until employment rises and prices rise to offset wage increases or excess demand over supply of goods and services. But this Administration and the Democrat controlled Congress’ huge spending programs, do threaten the purchasing power of the dollar if global confidence in the dollar as the primary currency of the world weakens. For this reason equity investment in selected domestic companies that have reasonable prospects to generate growth of earnings by improved productivity or new products should be a part of investor’s holdings. Some investment in developing economies should also be held. But the cash returns from high grade fixed income securities are likely to compare favorably with the returns on stocks as measured by the Standard & Poor index for some period of time. To sweeten the return a bit, it might make sense to hold a small percentage of assets in a carefully managed portfolio of “B” rated or lower rated bonds. The debt securities of some small companies may, in reality, be safer than those of some large companies since although an issue of debt securities may be unrated, the issuing company could be in an early stage of development that will allow them to pay higher interest and yet generate enough income to service that debt and still pay off the principal at maturity or earlier.
While it is reasonable to conclude that the American economy will have some difficulty growing at a rate in excess of 1-2% per annum for the foreseeable future, “there are no facts about the future”. The ingenuity of the American entrepreneur could cause our economy to grow at a higher rate than that projected. If it does, and our federal and state governments become thrift minded, we could get back on tract to reduce our budget deficit as the President has forecast. You be the judge.