The story of the last year has been “mixed” signals where many investors have chosen to focus on the good while explaining away the bad. Hope has overcome fear and markets in the aggregate have moved up. This is not to say that all stocks rose. My post in May indicated a lot of volatility with many stocks falling by more than 20%. This trend continues into July. While averages have risen, many individual stocks have fallen significantly. (There has already been a form of “rolling” correction by stock and segment.) The problem with the past few years is that everyone is attempting to predict an outcome without admitting that the economic environment is so unusual and extraordinary that outcomes are unknown and unpredictable:
A) There has
never been any period in history where a credit bubble has been followed by
prolonged global monetary stimulus with artificially low interest rates—for years.
What happens when the stimulus ends and interest rates rise? Answer: Nobody
knows.
B) There has
never been any period in history where labor force participation has declined
significantly. What happens when the baby boomers have all retired and
residential construction becomes a permanently smaller part of the economy?
Answer: Nobody knows.
The US economy, as measured by GDP declined by 2.1% in
the first quarter of 2014. (Many choose,
myself excluded, to explain this as simply the result of a bad winter.) The economy in the second quarter is reported
to have grown by 4%. But, 1.3% of this increase can be attributed to building
inventory. So in the first half of 2014, the economy really only grew by 4%
minus 1.3%, minus 2.1% or 0.6%. That is only 1.2% per year growth—not a
recession, but not a booming or even an accelerating economy either.
Employment is increasing. Wages are increasing. (Corporations
have reached the end of increasing profits by simply cutting employees.) Yet, the Federal Reserve claims that there is
still a lot of “slack” in employment, justifying more stimulus and near zero
short term interest rates. The largest effects so far from the stimulus appears
to be higher stock prices, more “financial engineering” by corporations, and
more cars being sold. These effects are likely to evaporate as soon as the
stimulus is withdrawn. Continued stimulus may not eliminate the “slack” in
employment markets—it may simply overheat the demand for employees that are
presently working, resulting is rising wages and accelerating inflation. Accelerating inflation will lead to rising
interest rates.
The Fed is correct to be careful about withdrawing
stimulus too fast. Governments will have a very hard time raising taxes enough to
cover higher interest rate costs on bloated government debt. And, astonishingly, 30% of the people in the
US are “in collection” meaning they are technically behind in paying off debts.
Nobody knows the short term effects of
allowing interest rates to rise in such an environment.
Corporate earnings are beating estimates on an
Earnings Per Share basis. But, much of
this is because of reduced estimates and financial engineering--share buy backs
that reduce the number of shares.
Earnings are really not up by much—just there are fewer shares. Then, if you “normalize” interest rates,
corporate earnings would actually be lower by almost 10%.
Given so much uncertainty, it seems foolish to be certain
of the near and medium term future. It
has been said, there is the unknown (what we know we do not know) but also the
unknown, unknown (what we do not know we do not know). In times like these, it
pays to be prudent and cautious.
I think it unwise to join the group who thinks the
world economy is “accelerating” in rate of growth. I also think it unwise to be
overly pessimistic about the long term. The evidence I see seems to indicate a
high probability of steady but very slow growth over the next few years but
with an “adjustment” in the short term as we digest the reality of rising costs
and interest rates. When that adjustment
is coming is the unknown. What exactly will trigger the onset is the
unknown-unknown.
Be patient, careful and prudent.
