The much anticipated earnings season has begun, with blow-out quarters from the likes of IBM, Apple and Coke. The markets did rise based upon the news, however remains mired in the twists and turns of Washington and Europe as each tries to figure out their own debt issue. Like sausage making, knowing how to “make” debt go away is a very messy process and one that the markets evidently don’t like, given the declines associated with announcements from both sides of the pond. Earnings are nice, but where is the beef in the economy? Many of the economic figures domestically as well as around the world remain well below where we “should be” at this point – two years into an economic recovery. Yet, two years in, bond yields remain well below “normal” – in fact stuck near zero out a ways on the yield “curve” (more like a line from near zero out to 3-4 years, then straight up to 3% at 10 years). Is this the new normal, will the economy ever get back to “normal” or is normal now being spoken of in historic terms – “remember when things were normal?” The next few paragraphs I’ll discuss some of the points in this recovery and where things may be headed over the next few years.
Recessions/depressions are a buildup of excess “inventory”, whether internet data lines, railroads, or debt (compounded by leverage). At some point, the excess inventory gets worked off, after much discounting and many business failures, and the economy once again begins to function “efficiently” (or at least what passes for normal). It has been argued that the Great Depression was a function of similar characteristics to today – excessive use of debt and leverage. The key difference is the real estate built during this bubble that was not present during the depression – today’s inventory. The failure of banks (which was allowed) and “restarting” the economy, whether helped by our entry into WWII (which many will argue) or that economic recovery was already underway as the newly created Fed pulled liquidity from the financial system – creating a second economic downturn. The wiping out of many banks during the depression, forced the deleveraging that has yet to occur today – and many believe is being avoided today to provide “assistance”, avoiding the mistakes of the depression.
Unlike the depression, today’s Fed Chairman Ben Bernanke has learned some of its lessons and is doing everything in his powers (and some that are not part of the power of the Fed) to avoid the “mistakes” of the depression. Unfortunately the arteries remain clogged and nothing has been done to cleanse the system to allow for a more normal functioning financial system to take place. Whether here or in Europe, the answers to the problem are the same: provide assistance to the entities that abrogated their responsibility to make loans that actually could be repaid. Meanwhile the borrowers, allowed to borrow above their ability to repay remain under duress and are also on the hook to provide the funds for the bailouts. The Fed’s answer to the problem was to load on additional debt by keeping interest rates abnormally low. Since May 2008, the Fed Funds rate has been below that of core CPI, an indication of just how low rates have been kept in the name of stimulus.
What is evident from the economic reports nearly three years past the financial collapse is the economy has bounced, but that bounce has been very muted. Corporate earnings continue to grow, thanks to expansion overseas, while domestic markets are growing at very modest rates, if at all. Investors have struggled to figure out how to value the markets in a mandated low interest rate environment combined with a more global earnings stream. A few givens when looking at earnings – margins continue to be well above average, in what has been a mean reverting series, also top line growth remains well behind bottom line growth – a condition that mathematically cannot continue forever. So valuing the equity markets in these conditions are much more complicated than looking at price to earnings vs. interest rates, earnings growth rates vs. historical norms or even discounted cash flow.
Getting back to the issue of debt in the marketplace, it is evident that the transfer of debt from the banking system to the Federal Reserve has done nothing to improve the consumer’s ability to spend money. Corporations have been hesitant to expand plant and equipment, as well as take on additional employees, as they remain unsure that whatever improvement they are seeing in the marketplace may be fleeting – so why ramp production if it will be sitting on the shelves? The current conundrum in the economy is a heavily indebted consumer that is unsure of an improving job and earnings situation reluctant to spend any additional funds not committed to debt reduction. Corporations have been holding the expense line (keeping hiring to a minimum) and not willing to expand production due to still fairly soft end markets. This stalemate is being played out in the markets on a daily basis with sovereign debt problems compounding the problem. In the short-term, the market will move with the news of the day, whether from earnings or news on sovereign debt – and many times the daily moves are very volatile in either direction. Over the long-term however, debt issues and lack of financial wherewithal from consumers will be a headwind for significantly higher stock prices over the next 3-5 years. Without a solution to the illiquid consumer, economic growth will be sub-par and equity returns are likely to follow, providing an environment very similar to the past 20 years in Japan – some very terrific equity markets following some terrifically bad periods that result near zero equity growth over a long period of time.
