Young Research & Publishing Inc.

Investment Research Since 1978

Disclosure

The Crash

By

The Regional Economist from the Federal Reserve Bank of St. Louis is a must-read for any serious investor. The quarterly review provides business and economic commentary for the states in the eighth Federal Reserve District—which are “central to America’s economy.” I’ve been studying the most recent review and want to discuss with you a table in the cover story, “Economic Hangover: Recovery is Likely to be Prolonged, Painful ,” by Bill Emmons. I’ve customized the table to help illustrate that easy money and out-of-control government spending lead to reduced stock-market returns. The crash was inevitable, and returns will continue to disappoint as long as we continue down the same path.

Over long periods of time, say 10 years, the stock market will get valuations right. Excessive consumer and government spending will never create a nation full of wealth and prosperity. You and I know the country has been on the wrong path for some time now, and for evidence we need not look further than the S&P 500’s performance of 5.7% for the 1998–2007 period compared to 11.4% for the post-WWII period of 1950–1987 and 17.6% for 1988–1997.

It’s clearly not the economy, as the first column shows that annual GDP percentage growth has been 3.7%, 3.1%, and 3.0%—or is it? Not all 3% GDPs are the same, as the next column helps illustrate. Thanks to Greenspan’s low interest rates and loose lending requirements by banks, housing helped consumer consumption balloon to 82.5% of GDP during 1998–2007—a huge jump from 63.4% during 1950–1987 and 64.9% during 1988–1997. Government fueled the fire with its own spending spree of 13.9% in 1998–2007, up from only 7.4% the previous decade. What’s important to note is that the sum of consumer and government spending was only 81.2% from 1950–1987, compared to 96.4% from 1998–2007—a level indicating a tapped-out consumer and out-of-control government spending.

When money is easy, misallocation of capital is not too far behind. All three periods have similar business investments, at 13.0%, 20.1%, and 18.1%. Yet the S&P 500 gained an average of 11.4%, 17.6%, and 5.7% annually, respectively. Why so low in the last decade? Easy money during the 1998–2007 period caused broad misallocation of capital, especially when compared to a company that allocated capital well. Consider that Apple, whose business investment created iPods and iTunes, returned a 9.8% average annual compound return for the 1998–2007 decade. By comparison, the misallocation by banks led them to underperform the market, returning only a 2.29% average annual compound return from 1998–2007 (as measured by the S&P 500 Banks index).

What are we buying with all that credit? The erosion of net exports of -15.5% during 1998–2007, compared to net exports of -2.1% for 1950–1987 and 3.3% for 1988–1997, is due in most part to China selling us goods and financing our debts. A well-written article from 2004 by Andy Kessler makes the case that not all trade deficits are bad. He points out that Apple profits by e-mailing software to China, which manufactures an iPod that is exported to the U.S., which we buy, thereby boosting Apple’s earnings, and essentially its stock price. In the case of Apple, “A $1.5 billion trade deficit increases wealth in the U.S. by some $16 billion,” writes Kessler.

Twenty-twenty hindsight leads me to ask: what happens if China decides no longer to be the world’s manufacturer and also decides to become a Steve Jobs? China isn’t terribly excited about just being the world’s manufacturer, and if you haven’t noticed, their ranks are increasing at our best universities. Deficits that looked OK in 2004 look a lot different today with the U.S. consumer tapped out and China still willing to finance our debt—for now. Does the current administration’s spending trajectory give you much confidence in this game continuing forever?

There are still wonderful businesses in the U.S.—Caterpillar, for example—making sound business investments as world-class companies. If we want to create more Caterpillars in the world, we must reduce government spending and maintain a neutral interest rates environment. The current out-of-control trajectory of government spending, combined with interest rates that are too low, is a formula for disaster and will make the weak stock market performance of 1998–2007 look good. It doesn’t have to be this way.

The following two tabs change content below.

E.J. Smith

Editor-in-Chief
E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@youngresearch.com.