How to rebuild the middle class

The COVID-19 pandemic and the related economic shutdowns and fallout has greatly exposed the deep class divisions in our country. The divisions have been there for decades of course. The “hollowing out” of the middle class has been occurring in waves throughout the long period of economic transformation that began in the early 1970s, as the industrial age gave way to the information age. For most of this period, the hollowing out has been explained away by many as the natural forces of economics at work. The pandemic, on the other hand, is a true “Black Swan”, an event exogenous from the economic system, shining a light on our society from a completely different angle than usual.

The vast iniquities are now on full display. The majority of those in the upper reaches of our economic system work from home and home school on broadband connections with adequate savings to stock up on supplies; large businesses serve us via ecommerce and delivery. The fate of the working class is laid bare for all to see: lack of savings, reliance on school for day care and meals, poor access to health care, no sick leave, high fixed costs tied to rent and debt service, jobs that don’t provide benefits even when employed, the risk of bankruptcy in the event of a personal or health crisis. The small proprietor faces many of the same challenges, with the risk of starting a business so high that entrepreneurship in the United States is a record low levels as a percent of the population.

Yes, these issues have been there for a generation or more, but when endogenous to the economic system the meritocratic elite of the country attributes the disparity to a natural outcome of personal choices and talent in the free market for labor. When the trigger is an exogenous shock like COVID-19, the random nature of fate reveals itself to the fortunate as well.

The U.S. government’s historical role in promoting the middle class

The Founders believed that the fate of the Republic lay in the hands of a virtuous middle class (even though that term was not used at the time). From the Founding forward the government of the United States has usually had a program to promote the middle classes. In the beginning the debate was between Alexander Hamilton’s “American System” of protective tariffs, a central bank and funding of internal improvements and Thomas Jefferson’s vision of an agrarian republic built by yeoman farmers. Both systems had influence over the early republic, with Jefferson’s vision having the upper hand through the Civil War and its aftermath. Eventually, when the Republicans took power following the Civil War, Hamilton’s vision won out, with high protective tariffs, the promotion of railroads and industrial development and eventually restrictive immigration to protect workmen’s wages.

During the Great Depression, Franklin Roosevelt’s New Deal promoted unionization for the working class and the beginning of a social safety net in the form of Social Security, supports for farmers, banking regulation, promotion of single family housing and culminating with Medicare under Lyndon Johnson’s Great Society. The economy was dominated by big manufacturing and consumer products companies that, through a quirk of law and history, became the providers of employee benefits: pensions, health insurance, sick leave, paid vacation, etc. Industries tended to be consolidated into a small number of large companies with strong unions and what was effectively regulated or managed competition.

Today’s hybrid system

In the late 1960’s and early 1970’s the New Deal system became harder to maintain. Why this happened is beyond the scope of this essay, but in the effort to advance our economy in the face of competition from our NATO allies and Japan, the government began deregulating industries, finance and the labor markets. As a share of the economy, manufacturing began to decline, and the service industries began to rise. Many of the larger service businesses, particularly those in higher margin industries like finance, technology and entertainment could afford to maintain the old system of company-provided benefits. But many smaller businesses and those in lower margin sectors like retail, hospitality and restaurants could not, especially as benefits like health insurance became more expensive. The post Cold War period of globalization and high levels of low skill immigration brought many benefits but also accelerated the pressure on the U.S. working class.

During the period from the 1970’s to the 2010’s we have maintained the basics of the New Deal system of employer-provided benefits plus certain universal benefits like Social Security, Medicare and unemployment insurance. Many social safety net programs added in the late 1960’s and later, on the other hand, have been non-universal benefits to support those that fall out of the employer-provided benefit system like Medicaid, welfare and food stamps. Because these programs would benefit only subsegments of the population, they have been easy to scapegoat as political payoff for the undeserving and have therefore never been particularly popular among the general public. Hence the relatively low popularity of the Affordable Care Act, while theoretically available to all, is also seen as benefitting only a few at the expense of many.

The tension between employer-provided benefits and non-universal benefits will continue to grow if the current trends are allowed to go on. Free-market conservatives have traditionally disliked non-universal benefits as they are perceived, with some justification, as paying people not to work. But in the highly-globalized, highly-competitive, free-market economy the pressure on margins, wages and benefits faced by businesses outside of technology, finance and certain large enterprises will continue. Couple this with the highest health care costs in the world and the trend toward service economy work and more people will be forced into the haphazard system of non-universal benefits or no benefits at all…a barbell system of a protected upper middle class, a dwindling cadre of manufacturing workers clinging to the Post World War II system in the middle and a growing class of unprotected service workers.

The way forward

To rebuild the middle class we need to both slow the decline of manufacturing work and make service work pay. The economy is going to keep transforming into a service economy whether we like it or not, and that does not mean that the only good jobs need to be in technology and information. There is no reason that we can’t set up a system to put pride and remuneration into service work, no reason we can’t build a solid middle class that includes not only manufacturing, government and health care workers but also waiters, fitness instructors, hairdressers, hospitality workers, retail and wholesale workers, sanitation workers and so on.

The policies needed to build this middle class are all on the table now and being debated individually, but not as a cohesive program. The program would basically be a fusionism between the policies of Trump and Obama:

  • Core protections for U.S. workers
    • Higher minimum wages, so those who work in service businesses make enough to not have to rely on non-universal benefits while employed;
    • Moderate tariff protection, to encourage more production in North America;
    • Restrict low-skill, particularly illegal, immigration, so there is less competition for low wage or off-the-books labor;
  • Encourage key areas of investment
    • Invest in basic infrastructure, to encourage more construction work and make our economy more productive;
    • Encourage more housing construction, particularly in cities and inner suburbs by reforming land use regulations that discourage construction, thereby keeping housing costs reasonable and encouraging construction work;
    • Create an industrial policy for key sectors to move production to the U.S., as the crisis has exposed the weakness that comes from reliance on global supply chains. There is no long-term economic reason that we can’t produce the medical devices, pharmaceuticals, semiconductors, communications equipment, defense goods, auto and aerospace parts, appliances, furniture, capital goods, aluminum and steel that we need in the U.S. or North America;
  • Beef up the social safety net to add universal, portable benefits
    • Build on the Affordable Care Act, mainly the exchanges, to create a system of universal health care that is portable and not employer-based. Health care premia should remain tax-deductible for all, so there is no disparity between employer-based and ACA policies. The Medicaid portion of the ACA should be reduced to encourage liquidity in the exchanges;
    • Build on the 401k system, to provide a universal system of portable savings accounts with policies that encourage savings among the general public;
    • Provide universal day care and pre-school, to reduce the stress on two-income households or single parents;
    • Create a policy of universal sick leave, to prevent workers from having to come to work sick (but being careful to not encourage abuse, which may be difficult) while also reforming the disability insurance system to discourage abuse;
  • Tackle two areas of extreme inflation that are a result of our hybrid system
    • Regulate health care costs, to rein in health care inflation since Americans already pay more for health care than any country in the world;
    • Reform and regulate higher education funding, to reduce indebtedness and rein in higher ed inflation, including adding training credits to the unemployment insurance system;

I have been a free market capitalist my whole life and am well aware of the economic arguments against the programs highlighted above. The economic transformation of the last 50 years has brought many great benefits, including technological innovation, cheaper consumer goods and a huge reduction in poverty around the world. I have also seen the negative side effects as we have created a winner-take-all economy where vast swaths of our country and people are left behind with declining towns, stagnant wages and soaring costs for necessities like health care and education.

How this get paid for will have to be the topic of another essay, but it should be noted that we are paying for most of these things already anyway, and in the case of health care are paying more than other countries that have universal health insurance. Universal social insurance taxes should be preferred, with subsidies from taxes on higher incomes as the secondary form of funding, rather than the other way around. Such a system, as is used in Europe and in the U.S. for Social Security and Medicare, has proven much more durable and popular than making one group of people pay for the other.

I am not calling for an end to the free market, or even globalism, but am calling for a shift in the balance between economic efficiency and looking out for our fellow countrymen. We should be focused on building a middle class for the information age, one based on remunerative work, healthy families and strong communities.



Back up and running

Hard to believe my last post was in 2015! Ugh. When I moved over to a new platform way back when, I lost my charts and graphs. I will eventually get them back up, but with that task hanging over my head and the other things going on in my life I started slacking on the blog. Now that we are once again in the midst of great historic events, I would like to start back up again. I will gradually fix the old posts, but in the meantime please pardon their appearance.

A Grand Unified Theory of US Politics, Part One


Conservative or Liberal? Those seem to be the two ideological choices that face voters in the US these days. What if I'm neither? Then you are "moderate" or "independent". If I'm an anti-union, anti-tax businessman that favors abortion rights and votes for both parties, then I'm a moderate. What if my neighbor is an anti-abortion member of a private sector union that votes for both parties? Then she's a "moderate", too. But aren't we like, opposites?

You'd think Presidential candidates Mike Huckabee and Bernie Sanders are political opposites. Huckabee is a socially-conservative Southerner and Bernie Sanders a socially liberal Northeasterner. But both have strong approvals from the NRA, both look fiercely protect Social Security and Medicare, both are protectionist on trade and loudly anti-Wall Street. Are they really opposites? 

Let me throw one more brain twister at you. Did you know that Vermont used to be the most reliably Republican state in the nation? And that South Carolina one of the most reliably Democratic? In what world did that make sense?

So enough with the questions. The point is that much commentary on US politics is overly simplistic and informed by inherent bias. As we head into the long presidential election season, I'd like the readers of the Dynamist to be armed with the right framework through which to analyze the different candidates and their positioning vis-à-vis the electorate.

Here are the four key laws in my Grand Unified Theory of US Politics:

  1. Ideology isn't a left-right line, it's a circle;
  2. Each voter is a member of an interest group, whether they like it or not;
  3. The ideology of the electorate is more stable than the ideology of the political parties; and
  4. Neither party is right and neither is wrong…they are more like yin and yang, bringing balance to each other. 

Let's start with law #1, ideology isn't a left-right line, it's a circle. In my first paragraph above, I contrast two theoretically moderate voters of archetypes that most would recognize: the "economically conservative, socially liberal" businessman and the "economically liberal, socially conservative" private sector blue collar worker. To use now nearly passe terms, the "country club Republican" and the "Reagan Democrat". Very different types of moderates, but both who largely voted for Reagan and Clinton, GW Bush and Obama. Of course it is also possible to be both socially and economically conservative or liberal as well. So here is how we should look at the ideological continuum:

Figure One: The four poles

(click to enlarge)


The lower right pole is "Socially Conservative", which is centered around conserving traditional values and the traditional economy. Also focused on security. The church. Farming, ranching, mining, oil and gas. Military and police. Anti-immigration. NRA. The traditional Right.

Its opposite is "Socially Progressive" in the upper left. These are folks concerned with looking out for marginalized social groups and the environment. Also those in newer professions like technology, media, higher education. Women's rights, LGBT rights, abortion rights, climate change, hackers, immigrant rights, trial lawyers, college professors.

The upper right pole is "Economically Libertarian". (I don't use "conservative" because they are actually in favor of dynamic economic change, not protectionist conservation.) These are folks that focus on making sure that businesses and the economy can function in an unimpeded manner, which they believe produces faster economic growth. Large and small businessmen. Anti-federal government activists. The Tea Party.

It's opposite is the lower-left, "Economically Communitarian" pole, which favors government or union intervention in the economy to provide regulations and a safety net. Unions, the working class, minority groups, the dependent elderly, public sector workers.

Law #2 is that each voter is a member of an interest group, whether they like it or not. Each of us has one or two issues that we actually vote on. I have a whole variety of nuanced views on a variety of subjects, but when push comes to shove my default vote is generally for the GOP because I am anti-tax and anti-Federal government. I have good friends that I agree with on 85-90% of issues, but they almost always vote Democratic because they tend to vote based on whether a candidate supports abortion rights. There are the people that seem like economically communitarian Democrats in every way, except they vote Republican because they vote on Second Amendment rights. The chart below takes a stab at further segmenting the ideological continuum based on voting interests.

Figure Two: The Interest Wheel

(click to enlarge)


In the above chart each of the quadrants is broken up into four interest groups. While I don't know how large each group is, the idea is that if you can build a coalition that includes more than half of the interest groups, you can win. The problem is, of course, that adding any group on the wheel to a coalition alienates that group that sits as its opposite. You can't please both the religious right and college professors on social issues. You can't please both blue collar unions and the corporate elite on economic issues. You can't please both the dependent elderly and small government libertarians on entitlement reform. The interest wheel is why no party seems to be able to build a "permanent majority". Temporary majorities fade when the relevant issues of the day change.

Understanding the GOP primary

Looking at the Interest Wheel helps us better understand the GOP primary. The oft-referenced "Republican Establishment" are the interests in the top middle to upper right. The Establishment-style candidates are Bush, Kasich, Christie and Fiorina and in 2012 it was Mitt Romney. The Establishment candidates usually prevail because they have the easiest time raising money and because they can win primaries in the populous "blue states" and swing states in the Northeast, Midwest and West coast.

From the upper right to middle right are States Rights Conservatives, traditional small government conservatives with traditional values. These types of voters are the original "Tea Party" supporters, although that term is now used (inaccurately in my view) to describe all non-Establishment conservatives. The Tea Party standard bearer is currently Ted Cruz (and to a lesser extent, Rand Paul) and in 2012 it was Newt Gingrich or Herman Cain. Marco Rubio started his career as a Tea Party candidate and has learned to straddle the Establishment and Tea Party blocs.

In the lower right you get the Social Conservatives and traditional rural/ small town voters. Right now they have coalesced around Ben Carson. Rick Santorum was this constituency's candidate last time around.

In the bottom middle to bottom right you have the Conservative Populists…Appalachian Jacksonians, blue collar social conservatives, police and military…that used to be the heart of the Democratic Party as recently as the early 1960s. This is where Donald Trump is getting his support, and is where Jim Webb was making his play on the Democratic side before he realized that that Democratic Party is long gone. While the 2012 election didn't have a strong GOP candidate for this constituency, you can think of Sarah Palin as a good example of this type of politician. Mike Huckabee tries to straddle the Conservative Populist and Social Conservative constituencies, but is currently getting overshadowed by Trump and Carson.

If you start at the bottom and move counter-clockwise, you can see the poll standings of the candidates…Trump, then Carson, then Cruz and Rubio, then the other establishment types splitting up that vote.

What about the Democrats?

The Democrats are a little easier to understand. From the upper middle to upper left is the Liberal Elite. White collar professionals, old money, Hollywood, Silicon Valley and many Wall Street folks that vote more based on social issues than economic issues. This was the constituency that Bill Clinton and Barack Obama have successfully solidified into the Democratic Party but with whom Ronald Reagan had success.

Moving counter-clockwise from there you have the New Left…academics, environmentalists, minority rights groups, women's and LGBT rights groups. This group is the heart of the Democratic Party and it gets its money and support from the Liberal Elite. Hillary Clinton has her base of strength in the intertwining of these two groups…think the Clinton Foundation writ large.

In the lower left is the Old Left of unions, public sector workers, the dependent elderly and the working class. This constituency gets much less focus from the Democratic Party than it did in its heyday under FDR and LBJ, when the Old Left and the Conservative Populists were the core of the Democratic Party. This is where Bernie Sanders is making his strongest play and where Hillary Clinton is the most vulnerable. It has remained part of the Democratic coalition, because even though the Democrats have been more focused on the interests of the Liberal Elite, the GOP has been rigidly doctrinaire about protecting the interests of the Republican Establishment and the States Rights Conservatives, leaving the Old Left mostly out in the cold. That said, if the Democratic nominee was Sanders, the GOP would have an opportunity to make a play into the Liberal Elite, many of whom would vote their pocketbook as long as the GOP nominee was somewhat palatable.

Figure Three: The Party Factions

(click to enlarge)


Elites vs. populists

If we think about the groups that have been dominating politics over the past several decades, the New Left, the Liberal Elite, the Republican Establishment and the States Rights Conservatives, we notice that they fall along the top, or elite, side of the Interest Wheel. To the elites, the parties seem very different, vastly split on social issues. But together, they protect each other's core interests: progress on social issues and economic libertarianism. For the Old Left, Conservative Populist and Social Conservative voters along the bottom, or populist, side of the wheel, however, the parties seem largely the same, generally united on economic issues while letting the working class suffer a degradation in their livelihoods, communities and families.

This leads us to Laws #3 and #4, which will be covered in Part 2 and are about the strategy and tactics of coalition-building. Most of US history has been fought around 50-50, like what we have now. The Twentieth Century, however, had a few aberrant elections where the parties were able to build big tents with contradictory voters under the same roof. I'll talk about how this works and what it all might mean for the 2016 presidential election.


Have we entered a bear market? Probably not. What to watch for.

Over at Seeking Alpha, Eric Parnell, CFA, has written an interesting post entitled A Bear Market has Two Phases. In it he posits, based on evidence from the last two bear markets (early 2000s and 2007-2009), that there are two phase to a bear market. In the first phase, the leading sector(s) of the previous bull market breaks while other sectors hold up. In the second phase, the rest of the market follows suit in a general liquidation.

In the bear market of the early 2000s, it was technology stocks that were the first to break, beginning their decline in March of 2000. The great late 1990s bull market had been highly concentrated among technology, telecom and multinational growth stocks, while the rest of the market had been almost neglected. While technology stocks, represented by the SPDR Select Sector Technology ETF (XLK) had fallen 64% by August 2001, the rest of the market hadn't really declined much at all. The general market was attempting to rally in mid 2001. Then after the terrorist attacks of 2001, the general liquidation began, which carried right through until the announcement of the launch of the Iraq War in [   ] 2003.

The bull market in the mid 2000s was led by the financial sector, including it's close cousin, the homebuilding sector. In the bear market of 2007-2009, it was financial stocks that were the first to break, beginning their decline in 2007, culminating in the failure of Bear Stearns later that year. The market then attempted a rally, although financial stocks failed to regain their high. Stress returned in the summer of 2008, culminating in events around the failure of Lehman Brothers in September 2008 and the general liquidation and chaos which ensued after that.

Mr. Parnell shows good illustrations of the theory through use of the Sector SPDR ETFs. What he does not do, however, is lay the theory on top of the current business cycle. To look at the current cycle, one would have to (1) identify the leading sector and (2) spot its decline ahead of the rest of the market.

The Clear Bear Case: Energy is the Leading Sector

The easy case that we have entered a bear market under this theory would be to identify energy as the leading sector (and its relatives in materials and emerging markets). If we look at the energy sector ETF (XLE), we can see that it peaked in June of 2014 and is now off 40% from its high. The materials sector ETF (XLB) peaked in February of 2015 and is now off 20% from its high and industrials (XLI) also peaked in February and are off 15%. (It's also worth pointing out that valuations on speculative tech companies…the sector I am personally involved with…also appears to have peaked in February 2015.)

The rest of the sectors (except interest rate-sensitive utilities), peaked in May-July 2015 and are were only down mid-single-digit percentages as of Friday August 21. It would be easy to then say that energy was the leading sector both in the market, and in the economy with the fracking boom, and that China was the secondary leader, and both are in big bear markets and the rest of the market and economy is finally catching on.

The Not-so-clear Bear Case: Consumer Discretionary is the leading sector

If you look at the numbers, however, it's hard to make the case that energy was/is the leading sector of the recent/current bull market. While energy far outpaced the S&P 500 in the bull market of 2003-2007, it actually underperformed in the bull market from 2009 to its peak in 2014 and its peak was only 14% higher than its previous peak in 2008. In my personal view, energy, commodities and emerging markets are more tied to the dollar cycle than the core market and are rarely likely to be a lead market sector in the US. The dollar cycle drives the 3 business cycle, disinflationary-reflationary-balanced model that I use to set over-weights and under-weights within my portfolio. In 2013 (in my last post…egad I've been slacking), I suggested that we were transitioning from a balanced cycle (the "Rounded Bottom" scenario of 2009-2012/3) to a disinflationary cycle (the "subdued mid-late 1990s" thesis).

As I said then:

My core base case at this time is that we are in the midst of a regime change in the market driven by a shift in the economic cycle. The timing of economic and credit cycles both in the US and abroad should be turning the market relationships of the last 10 years on their heads. I'll cut to the chase: over the next several years I expect the dollar to strengthen, I expect growth stocks to outperform value stocks, I expect real interest rates to rise and bond prices to fall (but only modestly), I expect inflation to remain subdued, I expect commodity prices to fall, I expect emerging markets to have problems, I expect Europe and Japan to recover modestly, and I expect US real estate to perform ok.

Cyclically, I would compare where we are today to a subdued version of the mid-1990s.

Not to pat myself on the back, but the thesis is actually playing out in the markets. Economically, the recent, energy, emerging market and commodities crash would be analogous to the emerging market crash of 1997-1998, which cemented the trend of a global allocation of capital to the US, which then flowed into an investment and consumer spending boom of epic proportions, led by technology and telecom.

Why do I think the economy and market will be more subdued than the 1990s? This time around, the underlying cycle has been much slower to turn than in the 1990s due to higher debt levels and lower inflation. The market cycle has turned up faster than the economy due to the corresponding low interest rates and quantitative easing. Whereas in the 1990s there was latent capacity for the global economy to lever up with more debt (a process that continued into the early 2000s), in the post-financial crisis world the trend has been de-leveraging, particularly in the private sector.

That said, there is pent-up demand for capital investment after the under-investment of the past decade and a lack of true excess in the US system that sets us up for disaster (as far as I can see). I therefore find it unlikely that we are staring at a recession in the very near term caused by a slowdown in energy and emerging markets. And it would be highly unlikely if we were heading for a generalized bear market if we weren't also headed for a recession.

If we look at the performance of the stock market, it should be noted that the broader market peaked along with the lead sector in early 2000 and 2007. The broader market fell, then rallied but failed to regain their highs at the beginning of bear market phase two. In the most recent case, the market has continued to make news highs in the year after energy stocks and emerging markets began their bear market in 2014. Don't get me wrong, overall market breadth has clearly deteriorated, with the above-mentioned breakdowns in industrials, utilities, speculative tech and transportation in early 2015, but the actual lead sectors and the market as a whole have made new highs. 

So what have actually been the lead sectors of the market? Using the sector ETFs, the clear winner is the Consumer Discretionary SPDR (XLY). At its recent peak in July, the XLY was up 392% from its trough in March 2009 (vs. 209%) and was up 100% from its previous peak in 2007. The top holdings of the XLY include Amazon, Disney, Comcast, Home Depot, McDonalds, Starbucks, Nike, Netflix, Time Warner, Priceline, Lowe's…media, internet retail, home improvement, restaurants, automakers, etc. In other words, growth stocks levered to the US consumer. The other leading sector has been the Health Care SPDR (XLV). At its recent peak in July it was 245% above its trough in March of 2009 and 100% above its peak in 2007. Both sectors are levered to the US, so are less affected by a strong dollar. The XLY, however, is cyclical and highly vulnerable to a recession and the XLV is vulnerable to big changes in the health care laws (i.e. vulnerable to a GOP electoral sweep on the right or a Bernie Sanders win on the left).

So are we starting a bear market or not?

Of course nobody really knows the answer to that. If past patterns hold, a bear market starting now would play out as follows: the market has a big downturn/correction through September/October, with the losses slowing soon and accelerating again near the end. The XLV and XLY lead the way down. The Fed steps up and does/says something to assuage the markets and the broader market rallies with many sectors nearing their old highs but the XLV and XLY would remain way off. The broad market fails to retake its high by next summer. The selling then resumes, with a broad selloff cascading through next fall and beyond. And a recession beginning in early-mid 2016.

I'll call this my alternate hypothesis.

I suspect we're not there yet. I think we are definitely in the late innings of this bull market, but not in the 9th. There is no over-arching reason today for the big economic trends to break. I expect another rally higher, but with far narrower breadth, as industrials, materials, energy, utilities, transports and maybe financials fail to keep pace with a rally led by consumer discretionary, health care and technology. The dollar resumes its rise, squeezing broad corporate profits, which the market ignores for a while. Eventually however the lack of global demand relative to over-optimistic US investing and deflationary forces around the world (a renewed Euro crisis, a second wave of emerging market problems, a true financial crisis in China?) will finally pull us under.

That's my base case (for now).

I am not your financial adviser. I write these articles purely for my own amusement. Please consult your own financial adviser before acting on any of the opinions expressed herein.  

Q2 2011 Market Update: The “Rounded Bottom” Scenario

Welcome to the “Rounded Bottom”.

That is how I look at the economy right now. As I outlined in my 2011 economic outlook, business investment has recovered to normalized levels. Government policies have propped up personal incomes, allowing savings to recover a normal level and maintaining consumer spending at a pre-recession level of GDP. Real estate investment has plunged from more than 8% of GDP prior to the recession to a record low of less than 4% as of Q4 2010. This has created a good deal of the nation’s output gap. Manufacturers of wood products and furniture, construction workers, real estate agents, and lenders have all seen business decline heavily as a result of the recession and not really recover. The decline in house prices has also reduced consumers’ ability (and desire) to borrow, which combined with rising prices for food, gas and health care is crimping consumers’ ability to spend on discretionary items.

Thus we have the great economic dichotomy of the Rounded Bottom. The business side of the economy is doing fine, with record profits and rising investment (funded largely from internal cash flow), a technology and energy boom, high productivity, ever-growing cash balances and rising exports. The consumer side of the economy, on the other hand, is struggling, with weak real estate investment, high debt levels, high unemployment and a tight squeeze on middle class finances.

Now the government sector is moving from a slight positive (propping up consumer incomes with the Fed buying the newly issued debt) to a slight negative (spending cuts, tax increases and an end to the Fed buying long term bonds). The same scenario is playing out in Europe as well.

All of the statements above are well-documented and understood by the market, and they are pretty well reflected in market interest rates:

Source: Treasury and muni rates from; corporate rates from Vanguard Funds; equity returns from model based on information from Standard and Poors and Equilibrium rates based on model.

Treasury rates are generally below their equilibrium levels largely because of the collapse in real interest rates, as reflected by the rates on Treasury Inflation Protected Securities (“TIPS”). Super-low real interest rates (notice that the 5 year TIPS rate is negative) reflect that the supply of capital exceeds demand. In other words, investors demand more treasuries than are available, which certainly separates our situation from that of Greece. In addition, the fact that real interest rates are expected to be negative for the next five years reflects that the markets expect the current economic situation to persist for a while.

In addition, there is not just strong demand for treasuries, but the risk spreads for corporate securities (both debt and equity) are below their long term equilibrium levels as well. The supply of investment capital for corporations exceeds the demand for capital. Only municipal bonds have consistently higher-than-normal risk spreads, as the problems of state and local governments are well documented.

The markets also believe that the Fed will succeed in maintaining positive inflation over both the short and long term, as it is a stated goal of fed policy to maintain inflation of around 2%.

So where does the market have it wrong?

If we want to produce investment alpha, however, we have to figure out where the market is wrong and bet against it. In the super-big picture, it is good to know in which general context we are operating. In my 2009 essay “These are not ‘Unprecedented’ Times,” I put forth the hypothesis that we are in the “winter” phase of the Kondratiev Cycle. The dominant financial impulse of the winter phase is that of deleveraging, which is consistent with what is going on today. With debt to GDP at record high levels, it is difficult to envision a scenario where the private sector reengages in a process of systematic financial leveraging like it had from 1982 to 2006.

Without re-leveraging, it is hard to produce sustained inflation. With de-leveraging the natural impulse is deflation. In addition, the absolutely essential reform of tighter bank capital standards are also disinflationary as the banks’ loan books will be forced to grow more slowly than their equity bases for at least several more years. To maintain positive inflation, the Federal Reserve will need to continue to engage in “quantitative easing” beyond its just-ended program. I’m not sure the Fed would want to engage in another such program unless absolutely necessary, given the opprobrium to which it has been subject. Thus, we should expect continued disinflation and low interest rates for the intermediate term.

When judged by their earnings yield vs. trend earnings, stocks aren’t cheap.


Stock valuations are very sensitive to long term inflation expectations, and are vulnerable if expectations were to change suddenly. Earnings are currently very high both historically and relative to the inflation-adjusted trend.

Source:, Standard and Poors earnings estimates

Two conclusions can be drawn. Either something structurally has changed and earnings will continue to stay well above trend, or earnings are vulnerable to mean reversion in the next few years. I actually think the truth lies somewhere in between. Something has changed structurally since the 1960s and 1970s, but earnings are vulnerable because of a global demand shortage and developed world deleveraging. The big swings in aggregate S&P 500 earnings in recent years have largely been due to swings in bank earnings, which could easily fall from recent levels.

Wait, it’s not all bad

Because overall corporate balance sheets are in good shape and the cost of capital is low, business investment momentum is building. Real estate investment has nowhere to go but up, as well. A return to normalcy in real estate investment (back up to about 6% of GDP) will arrive when the high inventory of unsold homes is worked off. I expect real estate investment levels to turn back up sometime in the next 12 months, with perhaps faster-than-expected growth in 2013 and 2014 as the market reverts to trend from extremely depressed levels. I do not, however, expect there to be a return to a bull market in real estate prices, as cap rates are already low and the policy environment is likely to lean against housing (higher bank capital requirements, a scaling back of Fannie and Freddie, and a potential rollback of mortgage interest deductions).

Hence I expect the Rounded Bottom scenario through at least 2012 and probably beyond:

  • Continued disinflation, de-leveraging and low interest rates
  • Weak consumer spending
  • A long term bottoming process in housing
  • Decent performance in the business sector, including strong M&A activity
  • Weakness in developed markets offset by good growth in emerging markets
  • Continued high unemployment and overall output gap

In other words, favor long term bonds and keep your money safe, but don’t panic. Diversification is still the rule.

Q1 2011 Market Review: It’s Time to Raise Interest Rates

Since the financial panic of 2008, I have generally been an interest rate and inflation dove. In my view most of the inflation damage was done from 2001 to 2007, not in the time after the financial crisis. The combination of the TARP and Fed policy halted a potentially deflationary downward spiral in prices and asset values. Now, however, the economic need for monetary support is over and business investment, which is and always has been the driver of self-sustaining economic growth, is rising again. Waiting for residential real estate investment and construction employment to recover before declaring economic growth self-sustaining would be as foolish as the mistake of the early 2000s when Alan Greenspan waited for technology investment to recover from the dot com bust even as real estate investment was roaring ahead. Today we effectively have the same situation in reverse. The market is sending its classic signals that global monetary policy is too easy. While I place more blame on the central bankers of emerging market economies like China, there are several market signals that are telling us that US monetary policy is too loose as well.

I have gradually come to the conclusion that our forty year experiment in using monetary policy to manage the economy has failed. Monetary policy has been used to drive up asset prices and support the use of financial leverage while eroding our purchasing power by encouraging inflation. Higher asset prices and supportive credit markets are great for the elites, who can use their knowledge of the financial markets and already ample capital bases to accumulate more assets. This state of affairs is harmful to the middle class, however. As inflation eats up middle class purchasing power, they have turned to borrowing to support their lifestyles. The middle class’ borrowing backfired royally with the housing bust of 2007-2011, yet the Fed’s economic remedy remains the same…encourage borrowing, support the financial sector and prop up asset values with ever-lower interest rates.

It is now time to normalize interest rates. The financial instability of wildly swinging interest rates, asset values and debt levels accrues to the benefit of the financial sector at the expense of the real business sector. If the Fed focused on policy stability, there would be far less need for hedge funds, commodities traders, bond traders, private equity funds and the seeking of profits via financial engineering. There would instead be more focus on trying to earn returns from actual investment in productivity-enhancing business investment. America has one of the most innovative and productive financial sectors in the world, but even I, a member of that financial sector, must admit that it has grown too large relative to the non-financial economy.

Interest rates

Source: Bloomberg, Vanguard Funds,

The yield curve is telling us that inflation is expected to be well higher than the Fed’s target range of just under 2% for the 10 and 30-year time horizons. 5-year Treasury Inflation Protected Securities (“TIPS”) yields are negative, and treasury yields of less than 10 years are well below their equilibrium levels, signaling that the market expects the Fed to leave rates low for too long and then lose control of inflation.

The long end of the yield curve continues to offer the most value, particularly among treasuries and munis, even with the current market view of inflation. If inflation expectations come down, we could see another rally in long bonds.

The dollar


The broad real dollar index has for the first time punched well below 85. It is also trading at the bottom of the range relative to the major currency index as well. It should be noted, however, that dollar bear markets have tended to last about 10 years (1968 to 1978, 1985 to 1995), meaning that cycle timing-wise, the dollar bear that began in 2002 may be due to end and that the dollar may be ready to enter one of its periodic 7-year bull markets (1978-1985, 1995-2002). It may be time for the Fed to tighten if only to focus on strengthening the dollar a bit.



The ratio of commodity prices (CRB futures index) to the Consumer Price Index (CPI) is at the highest level since the early 1970s. Commodity prices are a leading indicator of broader inflation.

Most are aware as well that the price of gold, widely viewed as a neutral currency, has been skyrocketing for some time now.



The housing bear market continues, but may be nearing the bottom. Expect a rounded bottom in the housing market over the next several years, regardless of Fed policy.

Source: Standard and Poor’s,,


My market valuation model (which uses inflation-adjusted trend earnings) shows stocks to be fairly valued currently.

The 6.8% return implied by today’s S&P 500 is driven by a long term inflation assumption of 2.8%. If inflation expectations drop, so will the stock market.


If interest rates get normalized on a schedule faster than the market currently expects, short and intermediate term interest rates will rise and stocks will likely fall somewhat. I don’t think the housing market would be affected, as the market is not moving higher even with the current ultra-low interest rates. So yes, tighter monetary policy would be a moderate negative for the financial markets. To this I am finally saying, “So what”? It’s time to wean ourselves off our need to surf from financial bubble to financial bubble and get back to the hard work of building the real economy.

Why the Fed Likes Inflation (And What it Means For You)

Why would the Federal Reserve Bank, who is holding interest rates at zero, be purposely trying to whittle away the purchasing power of savers in this country? Below are a few simple rules to understand how the Federal Reserve operates, why interest rates will likely remain low for a while, and why that’s good for stocks and commodities.

The remainder of this article can be found at the website Man Of The House.

You Need Skills to Pay the Bills

The economy has gone haywire and politicians and economists are in total disagreement as to what to do about it. Regardless, the key to getting ahead is to look at the world how it is, and not how it ought to be. The world is tilted toward those that are well-educated or highly skilled and jobs will continue to shift from classic middle-class occupations like manufacturing and back-office work toward technology, education, health care and leisure services. There are two choices: complain about the trend or join it.

The remainder of this article can be found at the website Man Of The House.


2008 – The Credit Crisis

The Dollar is not Weak (12/24/07)

The Fed will Act (1/3/08)

New Home Sales (1/3/08)

Who to Blame for the Housing Market Bubble (and Crash) (1/9/08)

Credit Crunch Video (2/8/08)

Deflation Avoided? (3/18/08)

Brokerages Under Fire – the End of an Era? (6/20/08)

Taxpayers: congratulations, you will soon own Fannie Mae and Freddie Mac! (7/11/08)

My advice to John Thain (not that he asked) (8/6/08)

UBS to jettison its investment bank? (8/12/08)

New York tax revenues go “poof” (8/12/08)

Am I the prophet of doom? (9/14/08)

Long Term Opportunities Abound (9/18/08)

Are we turning Japanese? (11/10/08)

The rebirth of deflation (11/11/08) 

A Call for Sound Money (11/14/08)

Save General Motors (11/18/08)

Inflation versus Deflation (12/2/08)

Merrill Lynch 2009 Forecast – Deflation Ahead (12/11/08)