Notes from Client Event on June 17, 2009
Summary of Liz Ann Sonders' Presentation
by Chuck Hipp, CFA
On June 17th, TFC Financial Management and Aequitas Investment Advisors co-hosted a Client Event featuring Liz Ann Sonders, Senior Vice President and Chief Investment Strategist at Charles Schwab & Co.
Introduction:
The main take away from Liz Ann Sonders' presentation was that the U.S. economy and perhaps many economies worldwide are in "less terrible" shape today than they were twelve months ago. Admittedly, that statement does not immediately give good reason to cheer. However, it does give reason to argue that the U.S. economy may already be well into a recovery.
Economists and professional investment managers use many quantitative indicators in attempting to assess current economic conditions. These indicators are segregated into three categories; leading indicators, coincidental indicators and lagging indicators. Leading indicators tend to move ahead of the economy. The stock market is a prime example of a leading indicator. Coincidental indicators, as the name would suggest, tend to move coincidentally with the economy. And lastly, lagging indicators tend to trail the economy. The unemployment rate is a popular example of a lagging indicator.
Unfortunately for all of us, mainstream media and perhaps the majority of investors tend to focus much of their attention on the absolute level of lagging indicators. Although important, basing investment decisions on the absolute level of any indicator, let alone lagging indicators, is a strategy that will assuredly lead to disappointing investment returns. More important than the absolute level of any indicator, is the rate of change in that indicator or the direction in which it is moving.
Ms. Sonders highlighted many of these indicators to demonstrate where we are in the current economic cycle, how we got here, and where we are heading.
A brief summary of some of her major points and comments follows.
Private Sector Deleveraging/Public Sector Leveraging:
Over the past fifteen to twenty years, foreign countries have been increasingly willing to lend money to the U.S. and its consumers. This willingness to lend flooded the financial system with liquidity which in turn set interest rates on a secular downward trend. With money readily available and interest rates at historical lows, the U.S. consumer was more than willing to oblige, and did just that, by increasing their borrowing to historically high levels. At the same time, consumers were also decreasing their savings rates. These two actions in tandem sent the average household debt as a percentage of disposable income to all-time highs in 2007.
The problem was not necessarily that consumers were borrowing too much money. The problem was how they were spending this money. More so than any other time in history, consumers were simply borrowing to consume, rather than to invest. In the end, this helped drive asset prices to their inflated levels. To make this point, consider the following figures. During the 1950's it took $1.36 of borrowing to increase GDP by $1.00. Since 1999 that same measure was 5.81, meaning, it took $5.81 in borrowing to increase GDP by $1.00. This trend was truly unsustainable!
As troublesome as that may sound, once the rug was pulled out from under the feet of the U.S. consumer, they reacted in an aggressive fashion. The U.S. consumer dramatically decreased borrowing and increased savings rates from a range of negative 4 to 5% to positive 5 or 6%. Both moved to levels not seen since the early 90's. This drastic change in consumer behavior, which occurred over mere months, bodes well for the U.S. economy and is perhaps a sign that we are indeed poised to climb out of the current recession.
The flip side of this equation is lending. The U.S. consumer was not the only party to react. As U.S. capital markets seized and the economy fell into recession, foreign investors also pulled back, drastically decreasing the amount of money they were willing to lend. With that, somebody was forced to step in and become the lender of last resort. Who better to fill those shoes than the U.S. tax-payer?
Treasury Yields:
As U.S. capital markets were paralyzed, the U.S. government stepped in and provided the necessary capital to get credit markets moving again. Having turned on the printing presses to flood the system with money, Treasury yields fell to nearly zero.
Treasury yields have been on the rise over the past few weeks. This is construed by many as a negative sign for the economy and the stock market. Upon a closer review, economic recoveries have almost always been accompanied by a spike in yields. Spiking yields also typically mean good news for the stock market. Going back to 1966, the average gain of the S&P 500 for the twelve months following a 100 basis point spike in yields has been 6.4%.
A spike in yields also tends to signal a steepening of the yield curve. Historically, this has been a positive for the S&P 500. Using the difference in yields between the 10 Year Treasury Note and the 3 Month Treasury Bill (the spread) as a proxy for the steepness of the yield curve, we can measure the performance of the S&P 500 under different yield curve scenarios. Going back to 1968, at times when the spread was less than 0.6 (flat) the average annualized gain for the S&P 500 was -3.3%. During times when the spread was greater than 0.6 (steeper) the average annualized return for the S&P 500 was 9.1%. This seems to be another positive for the stock market and the economy.
Leading Economic Indicators:
In total, there are ten leading economic indicators; unemployment claims, vendor performance, stocks, money supply, interest rate spread, consumer expectations, average workweek, new orders - consumers, new orders - capital goods, and building permits. Of these ten indicators, the first six are currently categorized as "Stabilizing/Improving". The last four are currently categorized as "Still Weak". The Leading Economic Index, which was created in the 1960's, aggregates all ten indicators into one summary value. That value has recently moved above the level that has historically marked the end of all previous recessions.
Coincidental Economic Indicators:
In total there are four coincidental economic indicators; real manufacturing and trade, industrial production, personal income less transfer payments, and payrolls. Currently, the first two indicators have moved into the "Stabilizing" category while the last two remain in the "Still Weak" category. The Coincidental Economic Index, which aggregates all four of these indicators into one summary value, has breached a level which on average has marked the end of all previous recessions.
Housing: A Light at the End of the Tunnel:
An additional leg down in housing prices is still quite possible but there are signs that the end of the decline in housing prices may be in sight. The major issue has been an excess supply of homes. Between 2000 and 2005 the number of new homes for sale essentially doubled from 300,000 to 600,000, or a 10-11 month backlog at today's rate of sales. Needless to say, much of this increase in supply was driven by speculative building. Over the past two years the number of new homes for sale has been roughly cut in half and is now at its lowest level in 37 years. This is a clear sign that the market should begin to stabilize. The problem with this is that new home sales only represent 15% of total home sales. Existing home sales represent the other 85% of total home sales. The number of existing homes for sale also doubled over the past six to seven years. However, the excess inventory in existing homes hasn't been worked off nearly as much as new homes. The number of existing homes for sale is still at an all-time high.
Inflation or Deflation:
Another debate capturing much attention these days is whether inflation or deflation is the bigger threat to the stock market and the economy. The rate of inflation, or the change in prices, is predominately driven by a simple equation: the monetary base multiplied by the velocity of money. As we discussed above, the monetary base, which is the amount of money available to the economy, is currently very high due to recent Federal Reserve actions. The money multiplier, or the velocity of money, however, is still very low. This means that although there is plenty of money in the system, it isn't going anywhere.
A simple comparison of two scenarios helps to make this point. If you were given $1000 and you simply stuffed it under your mattress the multiplier effect would be zero. However, if you took that same $1000 and went to Best Buy and bought a new flat screen television, the effect on the economy would be very different. When you give your $1000 to Best Buy, they turn around and order another $1000 worth of flat screen televisions from Sony. Sony, in turn, orders an additional $1000 worth of silicon chips. The silicon chip maker then turns around and orders $1000 worth of silicon, etc, etc. The result from this scenario is clearly different from simply stuffing the money under your mattress.
Currently the money multiplier is much closer to levels associated with people stuffing money under their mattress. To help put this into perspective consider the following. MZM (money with zero time to maturity), which is the broadest measure of cash (think savings accounts, checking accounts, money market funds, money under your mattress) is at an all time high. As of the last reading, MZM was approximately $9.8 trillion. That means there is enough money sitting in cash to buy the entire U.S. stock market one and a half times! Eventually this money will have to go somewhere. The stock market should be one of the major beneficiaries. That said, until this trend changes and people start to spend, inflation does not appear to be a severe risk in the short to intermediate term.
In regards to your stock investments, the question becomes do you root for inflation or deflation? It turns out that in moderation neither is particularly bad for the stock market. Stock market returns have been reasonable under the majority of past inflationary/ deflationary scenarios. In fact, the only environments in which the stock market does not perform well are periods of hyper-deflation (-2.5% or less) or hyper-inflation (12% or more). During all other scenarios the stock market has returned on average roughly 10%.