Observing Today to See Tomorrow

In my previous post (“Seeing the Future”) I laid out a vision of the future and its implications for investing for the coming years and decades. For you hard core fin-geeks out there (like me), here is how I arrived at the conclusions listed in that post:

Observation #1: Our starting point for the future (i.e. today) has most of the developed nations of the world (US and Western Europe) in an extremely over-levered state, both at the personal and government levels. Individuals have already begun to cut back and de-lever, but still have a long way to go to get back to anything resembling the personal debt levels of the past. Governments may continue to do their best to offset the personal deleveraging of individuals, but even governments face pressure (from voters, from markets) to begin their own deleveraging.

Conclusion: All of this delivering will inevitably be a drag on the economies of the US and Western Europe.

Observation #2: Interest rates on all types of debt (government and corporate, long term and short term) are very low by historical standards. Many complain that debt is not available to smaller entities and individuals that need it, but that just goes back to deleveraging point above. For anyone who has debt or can get it, rates are low by historical standards.

Conclusion: Just mathematically speaking, rates can’t go much lower, and logic (and history) would say that they won’t stay the same forever, so the inescapable conclusion is that sooner or later rates will rise.

Observation #3: People are living longer all the time, and a huge wave of baby boomers is rapidly approaching retirement in the US and Western Europe. As currently structured in the US, Social Security and Medicare will see expenditures and distributions grow to a point that one, or some combination, of these four things will happen:
· Government deficits will become a huge problem
· We will encourage more immigration of young workers into the US to increase the tax base
· Taxes rates will go up
· The retirement age will be increased
Technology advances will probably help on the margin, but it seems pretty unlikely that we can come up with enough technological advances to grow our way out of the problem. It would seem that similar logic must apply to Western Europe, although they have never had the immigrant draw that the US has.

Conclusion: Given the unpopularity of the last two choices (and for some, the second choice as well), it seems that we will get option 1 (increasing deficits) until the deficits become so large that they begin causing real problems (e.g. increasing interest rates), at which point we will likely get some combination of the other three options (more immigration, increasing taxes, later retirement).

Observation #4: Developing countries (led by China, India and Brazil) have huge populations and far lower per capita GDP than the developed nations. These populations are rapidly “urbanizing” (moving to cities) in many countries. Furthermore their governments do not have huge looming obligations to retirees, and in many cases they do not have the problems of too much leverage and debt. All of this is positive, but over the long run the historical track record of developing nation economies and stock markets has been mixed at best. Many of these countries have not had (and many still do not have) the political, legal and economic systems in place to encourage growth and attract investment over the long term. While some countries have risen from the third world and richly rewarded investors (Japan through the 80’s, Korea and China more recently), history is also littered with examples of foreign investors in other countries being fleeced through currency devaluations, the local “legal” system, or just outright theft by national governments and their favored entities.

Conclusion: Developing countries have greater potential for growth, but investing in countries without adequate property rights, without a clear and fair legal system, and/or run by communists is also quite risky.

Observation #5: There are huge trade imbalances between countries, including (but certainly not limited to) the US and China. Using these two countries as an example, the US trade deficit with China means that China has a dollar surplus. Eventually those dollars must either be loaned to US entities (in practice this has mainly been to our Federal government) or they must be used to purchase US assets (real estate, stocks, entire companies, etc.). As a result, either or both of the following must occur:
· The dollar must depreciate against the currencies of China and other countries with which we have trade deficits (many in Asia).
· China and other countries with which we have trade deficits will have to continue funding Treasuries and other US debt and/or buying US assets.

Conclusion: We will probably see both, and both are inflationary. Consumer inflation is bad for the stock market because it drives down multiples and bad for the economy because it drives up interest rates. On the other hand, inflation of asset prices in US dollars is just another way of saying stock and bond prices rise. So it is unclear whether the net effect of this will be positive or negative for the markets.

Observation #6: Over the long run, it seems we continue to use more and more energy. Some would say God played a cruel joke on the US by putting much of the world’s oil under countries that don’t like us. Furthermore, China has become our new competitor for all of this oil. They want it for themselves and they are more than happy to trade with anyone (good or bad) to get it.

Conclusion: Sooner or later it seems we will wake up to all of this, and the right wing national security hawks and the left wing global warming hawks will team up to have the government provide the incentives needed to finally get companies working on the technology for alternative energy sources in a big way.

Observation #7: Historically, so-called “secular bear markets” (the long term bear markets that often last a decade or more, like the one that we can now see began in early 2000) have always been deflationary, although historically governments did not respond with the massive fiscal stimulus that is being implemented this time around.

Conclusion: While many people are worried about inflation, the evidence is not clear cut on this. Massive government deficit spending and a depreciating currency are indeed inflationary, but deleveraging, excess industrial capacity, and seemingly unlimited cheap labor from rural China and India are all deflationary. It seems an investor must be prepared for either.

Observation #8: Stock market multiples are not historically cheap right now. At 1100 the S&P500 is trading at a little over 14x estimated 2010 earnings. Throughout the vast majority of the 20th century, PE multiples of around 15x were about as good as it got for any sustained period of time, and during times of meaningful inflation or deflation multiples fell significantly lower, often times into the single digits.

Conclusion: Today’s market multiples seem reasonable given the current environment of very low inflation and very low interest rates, so these PE levels could be sustained for some time or even slightly improve. But just as with interest rates, history tells us that the market’s PE multiples don’t stay the same forever. Sooner or later they will change significantly, and when they do, unless there is another bubble (a la the late 1990’s), they could decrease a lot more than they could increase.

Observation #9: No new financial regulations have been implemented since the market meltdown. People disagree about what should be done, but there is no denying that so far almost nothing has been done.

Conclusion: Until new regulations are put in place, we will be at risk of a repeat of the financial meltdown of 2008 and 2009 that cut most portfolios in half and destroyed myriad financial firms.