Posted By: Matthias Paul Kuhlmey
… oh, you bubbly liquid – let’s celebrate! As we prepare for this blog/economic outlook, the Dow Jones Industrial Index (Dow), comprised of the 30 highest capitalized (i.e., largest) companies in the U.S., has marked new historic highs, above the 14,000 level. Last time around, in 2007, some clever garment producers made T-shirts to celebrate the Dow’s second “lofty” record (the first being the year 2000), with the slogan, “Dow 14,000 2.0.” Before fully embracing the “3.0 version” of today’s market environment, let us introduce a rather captivating data set, and only after understanding the fine nuances of the new “3.0,” we may decide to join the celebration … or maybe not.
In 2006, the Dow closed the year at 12,463 points, setting a new historic high a few months later, on October 9, 2007 at 14,164 (not very dissimilar to 2012/2013). The years 2006 and 2007 also manifested the peak of the U.S. housing market, which later became one of the supreme asset bubbles to deflate, partially contributing to the most severe financial crisis of our modern era. In 2006, the total market value of the housing stock owned by private households and non-profit organizations amounted to nearly $25 trillion, and listed corporate equities (owned by the very same group) totaled nearly $9.7 trillion. The unemployment rate was marked at 4.43% and “safe money” invested in bonds allowed for acceptable return opportunities, with the U.S. 10-year Government Bond yielding 4.7% (year-end 2006). Life was good.
At the end of 2008, the year that became known as a “shock to the financial system,” the housing stock collectively held by our group (as above) was down about $5 trillion (-20%), and their listed equity holdings were down nearly $4 trillion (-40%). The loan-to-value ratio of the real estate portion, when adjusted by respective mortgage debt, was at 53%. What followed was the onset of a fierce deleveraging cycle, marked by foreclosures, personal bankruptcies, and an ailing society. The real issue, nonetheless, was at the very core of the U.S. economy, or what had contributed to its success over the years: the U.S. consumer. Between 1947 and 2000, personal consumption spending averaged 64% of GDP, and over the economic cycle (beginning in 2001) leading up to the financial crisis in 2008/2009, it averaged 70%. Something had to be done to stimulate the consumer and economy.
Under FED Chairman Ben Bernanke’s “accommodative leadership,” U.S. interest rates have reached a historic low, and the FED balance sheet was expanded from approximately $800 billion (pre-crisis) to $3+ trillion today, mainly in support of additional stimulus to commercial banks, the broader economy, and the U.S. labor market. Considering an approximate 85% (!) correlation between the rate of change of the expansion of the FED balance sheet and equity market performance, U.S. stocks (when measured by the Wilshire 5000, the broadest of all U.S. equity indices) have increased by about $11.3 trillion since their lows in March 2009. Our “exemplary group” has gained back the $4 trillion previously “lost” in their equity portfolios and re-financed their real estate allocation at a significantly better “cost-of-carry” (lower mortgage rates), both aspects resulting in greater flexibility as it relates to consumption and, hence, the stimulus of the U.S. economy.
What remains a concern is the apparent disconnect of equity market performance vs. the state of the real economy, leaving room for the argument that stimulus provided to the financial system may have resulted in asset price inflation, and not necessarily to the capture of “good value” in equities. Another consideration supporting this theory is the absence of meaningful return possibilities in fixed income markets, leading investors to consider assets with far less favorable risk characteristics, specifically stocks. Some market observers see the recent rise of the Dow as just the beginning of an extended equity rally, due to the fact that the index, when measured on an after-inflation basis, should be 8% higher, or at approximately 15,400. Interestingly enough, when the same argument is applied to an investment in Gold, it’s often dismissed as a laughable concept. According to the “after-inflation approach,” Gold should be trading at $2000 to $9000/ounce (depending on method), and not at current levels of $1583/ounce.
Another pressing question is whether or not consumers are better off when compared to the “Dow 14,000 2.0 area.” Aside from an unceasingly difficult unemployment situation, the following data points provided by the FED, comparing the status-quo to the “peak bubble” year of 2006, are of interest: Our above cited “exemplary group” has restored wealth in listed corporate equities (in aggregate, not considering exact distribution) but remains in negative territory, down -22%, with respect to real estate owned at market value. At the same time, mortgage liabilities are nearly identical to their 2006 value (at $9.5 trillion), but are now applied to this significantly lower housing stock ($19.5 trillion vs. $25 trillion at the 2006 peak). In other words, the consumer now has a higher degree of mortgage leverage, and this aspect is also true when considering consumer credit, up 12.8% vs. 2006.
Yet another “layer” of data magnifies the issue: According to a year-end 2012 update we provided, consumer spending has increased to a 3-year high against a significant reduction in the personal savings rate and steady increase in consumer credit; this, paired with countless transfer payments has left Americans more reliant on the U.S. Government than ever before. In contrast, the top 20% of earners in the U.S. account for about 38% of all spending, based on data provided by the Labor Department, a figure nearly equal to the total consumption of the bottom 60% of earners combined. The same “angle” is relevant when considering aspects of investing. The current environment is not supportive of investors that wish to build wealth while minimizing risk, and, more importantly, it will stimulate profits for investors with a significant capital/wealth base to begin with, i.e. supporting the more often publicly criticized aspect of the “rich getting richer.”
We will have to conclude with a potentially circular argument: Higher equity prices, once again, may lead to stronger consumption patterns (a phenomenon known as the “wealth effect”); stronger consumption will lead to a “perceived” recovering economy and presumably better corporate profits (at already “stretched” profit margins), more or less a repeat of the last few years, but with an increasingly inherent risk to the overall stability of the financial system. It is a proven fact that, when “suppressing” a wider range of outcomes (or, in our example, suppressing market volatility, as policy makers have attempted to do), the inherent risk of any given system will increase “underneath the surface,” thus leading to an amplified potential of higher volatility and severe market shocks.
In essence, wealth accumulated on the basis of “loose” monetary policy, and, to a degree, asset price inflation, will prove to be illusionary in the end, at least when considered from a real purchasing power perspective. Our collective focus needs to shift from an entitlement-driven, socio-economic sentiment, to growth and income generation from real and fairly-valued investments within appropriately aligned economic-incentive structures.
This is the time to “check the boxes,” and verify if your financial plan is still aligned with the status quo, a perceived economic reality, and your aspirational goals. To understand the concept of risk-adjusted returns vs. “risky” nominal returns is, without question, desirable. … Now let’s celebrate!