Wednesday, September 30, 2015

The Beatings Will Continue Until Morale Improves

The U.S. stock market took a beating in the third quarter of 2015.  Most indexes fell around 10%.  Trading volume wasn't particularly high, moreover.  So the raw material exists for additional declines.  China was blamed more than anything else.  And the Communists who rule the country certainly deserve some criticism.  They tried to rig the Shanghai stock market, which backfired.  The Government continued to manipulate the real estate market and a range of other industries.  That central management worked well when China was transitioning from a rural economy, and the path forward was clear cut.  Now that China has grown more developed, its economy is more complex.  Policies that look promising on the surface sometimes create unexpected side effects.  Still, the basic approach remains intact.  China's new president is opening up more of the economy to private companies.  State owned enterprises are being streamlined.  The courts are being made more honest.  And a shift is underway to allow the citizens to enjoy the fruits of their labors.  In the past workers were paid short money.  Much of that went into savings because their was little to buy.  President Xi is raising incomes, expanding benefits, and re-orienting the entire economy towards consumer goods and consumption -- and away from industrial production and exports.

That's bad news for companies -- and entire countries -- that supply commodities that used to be consumed by China's industrial juggernaut.  In the past, when bankers from Boston ran the financial system, an adjustment process might have occurred.  But it would have been nothing compared to what Bill Clinton, George Bush, and Barack Obama have engineered.  Interest rates have been suppressed since the mid-1990s, when Robert Rubin left Goldman Sachs to become Secretary of the U.S. Treasury.  Capital was and continues to be mis-allocated as a result.  It was especially bad in the commodity sector.  Easy access to low cost credit caused a massive build-up in mining, energy, and even semiconductor facilities.  In the past those Boston bankers would have said, "Nothing lasts forever.  Your cost of capital is going up.  We won't be a party to some mindless expansion."  Benjamin Bernanke, Janet Yellen, and to a lesser degree Alan Greenspan went the other direction.  They kept interest rates artificially low to "stimulate growth," even if the growth was based on unrealistic projections.  Like corporate CEOs, they had to make their numbers, too.

Over-investment is not a problem in the United States.  Our financial policies created an enormous increase in liquidity.  But much of that went overseas.  And the rest disappeared in the bowels of the Federal Reserve.  The U.S. Government bought up nearly $4 trillion in bonds since 2008.  The Fed issued money to buy those securities.  But then it outbid the market for the freshly minted cash that stayed home, burying it away in "excess reserves" instead of leaving it in the economy.  Money supply growth remains 6% a year despite the so-called "money printing operation."  While much of the world is entering a Boom-Bust cycle, the United States is poised for something more along the lines of a Bust-Bust.  U.S. output remains far below its potential as a result of the misguided policies.

The U.S. economy has been struggling since 2009.  Bank regulations have prevented small business from building momentum.  That's enabled large corporations to impose a private regime of wage controls.  Anti-trust regulation hasn't been pursued at all.  That's allowed the big companies to control prices, too.  Ask anyone who gets cable television or takes an airplane flight.  The Legacy of Robert Rubin is amplifying the pressure.  When Rubin took charge Bill Clinton was in the same boat as Barack Obama -- Neither cared a whit about economics, finance, and business.  They took advice from "experts" and put on their stamp of approval.  The problem is, those experts have their own agenda.  In Rubin's case, he persuaded President Clinton that, "It's the bond market, stupid."  The official inflation target came down from 3%-4% to 2%, courtesy of Alan Greenspan -- who understood which side his bread was buttered on.  That helped Goldman earn a fortune with its bond trading.  It helped its rich customers.  It boosted merger fees.  It helped underwriting.  It also facilitated additional maneuvers, like eliminating Glass-Seagal.

Everybody always regales Ronald Reagan for crushing inflation.  And there is no question, he did bring it down from Jimmy Carter's double digits.  In 1981 inflation in the U.S. was 10.3%, Reagan's first year.  There typically is a 12-month lag for financial policy changes to take effect.  The next seven years inflation went 6.2% - 3.2% - 4.3% - 3.6% - 1.9% - 3.6% - 4.1%.  The one low number foreshadowed the 1987 market crash.  Reagan kept inflation at 3%-4%, courtesy of Alan Greenspan.  He knew that growth would be higher if there was more money in circulation.  People would use it.  They'd live their American Dream.  It worked.  GDP grew 2.6% in 1981 and declined -1.9% in 1982 as the adjustment took place.  Then GDP expanded 4.6% - 7.3% - 4.2% - 3.5% - 3.5% - 4.2% through the end of his presidency.

Today, the Wall Street - MIT - Princeton axis has decided the correct inflation rate is 2.0%.  When Ronald Reagan shot for 4.0% and came up short for some reason, the economy still had ample money to work with.  Under the Clinton-Bush-Obama slave ship approach there's plenty of money for Apple Computer and Google.  But nothing for the average American.  Barack Obama has made things worse, moreover, by implementing a raft of regulations on top of his unfair financial scheme.  Instead of stepping in to help the American people directly, his actions interfere with their ability to enjoy life.  He's as deluded as The New York Times and the rest of the Ivy Leaguers who can't or won't do the math.  "Reduce interest rates and our work is done!"  Well, not exactly.

At this point we'll interrupt the story with our market forecast.  Stock prices have marched higher since The Obamanomics were installed in 2009.  That trend should continue.  Interest rates will remain lower than their natural level.  P/E multiples will be artificially enhanced, as a result.  Fortune 500 level companies are likely to experience earnings slowdowns, perhaps a decline, due to their far-flung operations.  The strong U.S. Dollar causes foreign income to be translated at a lower rate.  Business activity is moderating overseas, although not as much as the Ivy Leaguers think.  Energy companies are under the gun.  Rather than enact an import quota on oil and help the domestic industry thrive the Administration prefers it drop dead.  (Nancy Pelosi - "Oil and gas is a Republican industry.")  Banking earnings are stymied by the interest rate policy and Dodd-Frank lending restrictions.  A cornucopia of rules and regulations block other efforts.

If earnings stall the indexes probably won't go anywhere, either.  We doubt that situation will be long-lived.  Low oil prices already are driving economic growth around the world.  Europe is improving.  China, for all its perceived problems, continues to expand at 7% according to the Government and 3%-4% in reality.  Not bad for a recession.  Once the earnings picture improves the Fortune 500 types will resume the stock buybacks, mergers, and special dividends.  That money will flow to institutional investors, who will reinvest it -- pushing the market back up again.

Small cap growth stocks are likely to roll sooner and faster.  Those stocks have been hurt by knee-jerk reactions.  They are are less liquid and more vulnerable to fleets of fancy.  When the first pigeon sells they all sell.  The underlying fundamentals are stronger than the Fortune 500, though.  Exports in total account for only 13% of U.S. GDP.  Many of these companies do less than that.  Even the ones that do conduct lots of international business should do well as the world economy rebounds.  Smaller companies are more nimble and often respond with superior products and services.  Well run operations have a great opportunity, one that promises to continue through the end of the decade.

Don't worry about the stock market.  Stay invested in a diversified portfolio of high potential Special Situations.

Back to the story.  Yes, we are a big fan of Donald Trump.  Right now he's acting up, to get attention and solidify his place in the presidential race.  But he'll settle down when push comes to shove, and he knocks out Jeb Bush and then Hillary Clinton.  The Trumpster is a real estate guy.  He makes things happen.  It's all about doing stuff, making the country great again.  Donald Trump isn't tied up with the bond traders like Bush and Clinton.  He sees the MIT economists as a bunch of losers.  Jeb Bush says he'll grow the economy 4% a year.  But he can't, not with his ties to Wall Street.  Neither can Hillary Clinton.  The Trumpster will clean house, put money back into the hands of the average American, and supervise an explosion in economic growth.  The rest of the world can join up and play along.  Or they can go screw.  If you're an American it's a winner either way.

Walter Ramsley
Executive Editor