The Death of US Manufacturing has been Greatly Exaggerated

I often get comments from my friends that they look to my blog to get an optomistic viewpoint on the economy given all the "doom and gloom" that pervades most economic and political discourse these days. Seeing as that I call my base case view of the current economic situation a "Rounded Bottom", I figured optimism is clearly a relative concept. That said, I generally do believe in a self-correcting system, and so therefore counsel against panic and dispair. Tough times make people gloomy, and gloomy people call for more radical action than is generally needed. Often times, it is the very government action designed to goose the economy in times of distress that sows the seeds of the next economic downturn (see housing market, the).

It is in times like these that declinist theories roam the land. While I don't deny that the United States has faced a nasty cyclical decline in the housing market that may have led to a secular downshift in consumer spending and debt accumulation, I don't necessarily view that as a long-run negative. Consumerism, while beneficial to one's near term standard of living, can be carried too far if it becomes a debt-fuelled bacchanal that diverts resources from other productivity-enhancing investments like business equipment and infrastructure.

Exhibit A to most declinists is the supposed decline in American manufacturing. This seems like a no-brainer given our huge trade deficit, the large declines in manufacturing jobs and the visible industrial ruins in former manufacturing hubs like Detroit, Cleveland, Pittsburgh, Philadelphia and Baltimore. A closer look at the numbers, however, tells a much different story.

In October 2011, after one of the nastiest recessions and slowest recoveries in modern history, the United States produced $3.3 trillion worth of manufactured goods on an annualized basis (in 2005 dollars). To put this into perspective, the entire GDP of Germany in 2010 was only $3.3 trillion (in 2010 dollars, no less). China's GDP is only $5.9 trillion. The U.S. is thus by far the largest manufacturer in the world. While production is down about 5% from the $3.5 trillion produced at the end of 2007, and it is up 5% from what was produced in 2000. It is fully 80% higher, on an inflation-adjusted basis, than the manufacturing production in 1979, when manufacturing was still the centerpiece of the U.S. economy.

Look at the chart below (click to enlarge):

For comparison purposes, it is important to compare similar points in the business cycle. In the case of manufacturing production and capacity, it is most meaningful to compare cycle peak to cycle peak. I have also included the mid cycle break points (1984 and 1995) where the currency and policy regimes changed somewhat.

The things to notice in the chart above are (1) the long term decline in the peak capacity utilizations (meaning that capacity has increased faster than production); (2) the huge increase in manufacturing production per employee; (3) the decline in manufacturing employment as a percent of total employment from 24% in 1973 to 9% in 2011; and (4) the more modest decline of manufactured final goods production as a percent of GDP from 24% in 1973 to 19% in 2011.

Given the huge gains in technology, finance, professional services, leisure and hospitality, retail, healthcare and education since 1973, the fact that manufacturing has only declined by 4 percenage points from the 1973 peak to the 2007 peak is quite surprising.

In terms of employment, we have to look at manuacturing as the new agriculture. It is a hugely efficient, highly capitalized economic sector that just doesn't employ that many people anymore. I fully believe in supporting manufacturing as a way to increase national wealth, but any politician who tells you that we can bolster the middle class with tons of new manufacturing jobs is out of touch with reality.

Nominal numbers don't provide as much context as relative numbers, however. The following chart translates the numbers above into annual growth rates by business cycle (click to enlarge):

The interesting thing about the chart of above is how the numbers vary from business cycle to business cycle, but that they are pretty stable over the long run. The first thing that jumps out is the huge increase in manufacturing employee productivity since the early 1990s, particularly relative to employees as a whole (as defined by real GDP per employee). The second thing that jumps out is the huge surge in manufacturing capacity (5.4% annualized from 1995 to 2000) in the late 1990s bubble boom. Since capacity growth was so far above trend in the late 1990s, the relatively low levels of business investment of the 2000s is not surprising. The huge surge in the capital-to-labor ratio, combined with advances in information technology, has helped create a large increase in per employee productivity…also not terribly surprising yet highly beneficial for the long run health of the economy.

If we look at the longer 16-17 year Kuznets cycle of long-lived investment (consisting of three business cycles as I define them), we see consistent results. Real GDP grew about 3% p.a. peak-to-peak in both the 1973-1989 cycle and the 1989-2007 cycle. Manufacturing production grew 2.4% in the second cycle versus 2.1% in the first, even though manufacturing was viewed to be in decline in the 1990s and 2000s. Capacity grew 2.6% per annum in both cycles. The big difference between the performance under the two cycles is in employee productivity, which grew 3.9% per annum during the second cycle and only 2.5% in the first. Manufacturing productivity growth far exceeded productivity growth in the economy as whole over both cycles.

The good news is that were are now pretty close to having worked off the excesses of the late 1990s. For that reason, I expect the front end of the current Kuznets cycle to produce a powerful resurgence in business investment, which we should see accelerate over the next 6-8 years (with perhaps one recession occuring dueing that time). We can already see it in the numbers. While everyone is focused on the travails of the housing market, the U.S. economy has gradually become a lean and mean manufacturing powerhouse.

Catalyst Investors Blog: Understanding IT Outsourcing and Web Hosting

Cloud computing. Managed hosting. Managed services. Software-as-a-service.

There are lots of buzzwords that are both used and misused to describe the various types of IT outsourcing and web hosting. Back at the Catalyst Investors blog, I walk through the different layers of the IT outsourcing and web hosting landscape. I explain the difference between cloud computing and traditional computing, and compare and contrast the different layers of the technology stack, including co-location, dedicated hosting, hybrid hosting, infrastructure-as-a-service, managed hosting, platform-as-a-service, application hosting, software-as-a-service, business process outsourcing and business process-as-a-service.

To read the post, click HERE.

Q3 ’11 Market Update: The Beginning of the End

The Beginning of the End

The world's economic and political tectonic plates are starting to shift. I believe the next 12-24 months will mark a major transition period for the markets and the economy, as we will see several long term trends reverse course. We may finally be working off the investment hangover from the late 1990s in the US, and are setting up for a revival of US business investment and manufacturing. The long term US dollar bear market may be coming to an end, as may be the boom in gold, commodities and emerging markets. While I think we have several years before the bear market in stocks comes to a definitive close, and the US economy still has years to go to work off its excessive debts, the US economy may start to shine on a relative basis. In addition, a number of very long term global trends may be turning, with the worldwide collapse of the welfare state and the end of the global debt buildup. While much of the transition to whatever new worlds awaits us will occur over the course of this entire decade, many market trends will likely be turning over the next 1-2 years. It is time to prepare.

Interest Rates

Using today's interest rates, the market rates of Treasury Inflation Protected Securities ("TIPS"), Treasuries, implied inflation rates, Municipal bonds, investment grade corporates and high yield corporates versus their equilibrium yields at 2, 5, 10 and 30 year maturities looks as follows (click to enlarge):

Chart 1

  Mkt update slides Q3 2011 (alt)
Treasury rates have plunged, driven by both a decline in inflation assumptions and in real interest rates. Corporate bond yields have come down less (and high yield bond yields have risen) as the market turmoil has increased risk perception.

With the possible exception of long term municipal bonds, there is very little of value in the bond market these days, unless you are extremely bearish on the economy, in which case long treasuries could rally from these levels. High yield bonds are close to being attractive, but are vulnerable if we enter a second recession.

Overall, the bond market is telling us that the supply of savings far outstrips the demand for investment, and you see very low or negative real interest rates and below average inflation assumptions out for a very long time. I think this imbalance may turn soon in the US, in which case most of the money from the great bond bull market that began in 1980 has been made.


I've updated my numbers and methodology a bit since my last stock market update. The net effect brings the implied and equilibrium returns up, but my overall view on valuation is the same. 

As a reminder, I base my valuation off of inflation-adjusted trend earnings for the S&P 500. While Standard and Poors' analysts project $95.66 for 2012 earnings, the forward trend earnings number is only $62.64. As can be seen in the chart below, earnings in the past two cycles have been unusually high, much of which is due to a series of one-time factors like high oil prices and extraordinary bank earnings. In time, we should expect earnings to revert to trend.

Chart 2


Using trend earnings, I assess the value of the S&P500 as follows (click to enlarge):

Chart 3


If I use the long term equilibrium inflation assumption of 2.25%, the stock market is pricing in a 7.8% long term equity return. Under my updated methodology, I use 8.25% as the equilibrium return target (which uses a 4.0% equity risk premium on top of the equilibrium 20-year treasury rate of 4.25%). The equilibrium return would be earned at an S&P500 value of 1011, or 13% below today's level. If we assume the bond market's long term inflation projection of 2.1% is correct (it was assuming 2.7% just last quarter), then we arrive at a long term implied return of 7.7%.

Looking back at Chart 1, we can see that the market is actually pricing in an equity risk premium of 5.1% to the 20-year treasury rate, which would imply an above-equilibrium return. The same can be said for corporate and high yield bonds, who have above-average spreads to treasuries, but lower than equilibrium yields. The problem with the risk asset markets these days is that the base real interest rate is so low. Thus the return on equities and corporate bonds are strong relative to treasuries, but low on an absolute basis. My assumption is that all markets revert to the mean eventually, so unless you're a professional investor that can short the corresponding treasury with the proper duration relative to your investments, it is dangerous to rely on relative values rather than absolute values.

The next chart plots absolute values over time. In this case, it is the earnings yield of the inflation-adjusted S&P500 relative to inflation-adjusted trend earnings. (The earnings yield is the reverse of the price-earnings ratio.)

Chart 4

When the earnings yield gets above 6.5%, you can be pretty comfortable that you are buying stocks at a good value. It was above that level in the great bull market of the late 1940s and 1950s and during the bull market of the 1980s and early 1990s. That said, just because we get above that level doesn't mean we're out of a bear market, as we saw in the late 1970s and late 1930s and early 1940s. Also, just because the yield drops below 6.5%, doesn't mean the bull market is over, as stocks kept rallying in the early 1960s and late 1990s.

What I will say, however, is that a necessary condition for a secular bear market cycle (like the one that we've been in since 2000) to end is that stocks reach a low valuation on an absolute basis, like they did back in the great bear market of 1973-74. Stocks may still bounce along the bottom for several years thereafter (like the period 1975 to 1982 or from 1937 to 1942), but these can be great periods to accumulate stocks as we set up for the next secular bull market.

If I had to guess, I would posit that the market will put in a major bottom sometime in the next 12-18 months. It could be soon, if the European crisis reaches its climax, or it could be next year, driven by something else (a crash in China?) After that, retirees and investors will leave stocks for dead and they may stay cheap for the rest of the decade as the economy continues to deleverage. In the latter part of this decade, we will then be set up for a new long term bull market. I hate making predicitions that concrete, but let's just say that's my "base case" and I accept that the actual timing and magnitude of events may vary greatly around that.


Commodities in general are expensive (click chart to enlarge):

Chart 5

In general charts that look like these don't end well. Can gold or oil or commodities in general (represented here by the CRB Futures index) keep rallying for a few more months? Sure they can. Is buying into a rally like this "investing"? No, it is not.

In the last chart I map the ratio of commodities prices relative to the consumer price index (CPI). Here you can see that the long term trend price of commodities relative to everything we spend money on has been going down. That makes sense, as mining and farming technology has gotten more efficient, more markets have opened up and global transportation networks have expanded. Also, as we get richer, we spend less of our incomes on basic commodities. During both the last decade and the 1970s, that trend was broken. In both decades, all sorts of theories sprouted up to explain why we were running out of resources relative to booming demand. In reality, both spells of commodity inflation were just that: inflation driven by currency debasement.

The Dollar

At last we come to one of the only truly cheap asset classes in the world, the US Dollar. I am on the record stating that a new long term dollar bull market is in the offing, commencing sometime in the next 12 months (if it hasn't begun already).

Charts 6 and 7


Both dollar indices (the nominal major currency index and the real broad dollar index) are near the bottom of or below their long term trend ranges. Why would the dollar go up? The dollar benefits from market turmoil, which could be a near term catalyst. Also, I think markets are going to come to the realization soon that the US's problems are manageable next to the alternatives, particularly Europe and Japan, and there is a decent chance that the bloom will come off the emerging markets rose (which becomes a self-fulfilling feedback loop when the dollar goes up and commodity prices fall). I addition, I also think the US is setting up for a major business investment cycle after a relatively weak 10 years (as we have now digested the late 1990s investment boom). Once these big currency trends get rolling, they tend to build on themselves.

OK, you ask, but how do I invest in a dollar bull market if I'm not a professional currency trader? Good question. First of all, don't be afraid to hold cash and to reduce exposure to commodity-based investments, foreign bonds and emerging markets. Second there is an exchange traded fund called the PowerShares DB Long US Dollar Fund (ticker: UUP). If you find this argument particularly persuasive, you can buy the PowerShares DB 3x Long US Dollar ETN (ticker: UUPT), which is a 3x leveraged version of the UUP. At the very least, the UUP provides a decent hedge against near term market volatility.

I am not your financial advisor. I write these posts purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations made herein.


The Dynamist’s Jobs Plan

President Obama is set to give his jobs speech tonight. In it, he will outline a series of proposals to stimulate job creation. I don't know what these are yet, but if I was appointed philosopher-king, the following would be my ideas to stimulate near-term economic activity and hiring while not exacerbating our long-term economic problems:

Employ construction workers by investing in infrastructure. The most obvious hole in economic activity is the smoking crater left by the collapse residential real estate investment. Construction employment has fallen from over 7.5 million in 2007 to about 5.5 million today. Of course with housing inventories well in excess of normal levels and with consumers overburdened by mortgage debt, re-inflating the housing bubble is not an option. The government could put construction workers to work by investing in infrastructure like roads, bridges, commuter rail, power infrastructure, broadband infrastructure, ports, etc. The focus should be on shortening commuting times, reducing trade friction and supporting export infrastructure…stuff that should be done anyway. Do not focus on controversial and dubious items like intercity high speed rail and solar power. The goal should be to employ about 1 million additional construction workers over the next couple of years. After two years or so the housing market will clear and the pace of infrastructure spending can be reduced. Yes, environmental and other types of reviews may need to be streamlined to make projects "shovel ready" this time.

Stimulate domestic investment by reforming corporate taxes. There is clearly an imbalance between the perceived return on business investment made abroad versus domestically. We need to change that. My solution would be to reform the corporate tax code by (i) leaving the rate where it is, at 35%, (ii) make worldwide earnings subject to the tax (now it is only taxed when brought back to the United States), (iii) make investment in research, development and capital expenditures made in the United States immediately tax deductible (as opposed to depreciated over several years) and (iv) make dividends tax deductible. The design here is to reward investment in the US while discouraging the hoarding of cash on corporate balance sheets (particularly in foreign banks) or squandering cash on empire-building acquisitions. Corporations should either invest their cash in the US or pay it out as dividends. If a corporation wants to make an acquisition, it should subject itself to the discipline of the financial markets and issue debt or equity. Because this reform encourages actual investment by businesses and would eliminate the double taxation of dividends, there would no longer be a need to give preferential treatment to dividends and capital gains for personal income taxes. In addition, the tax difference between corporations and "flow-through" business entities like LLCs would be dramatically reduced, ending a major distortion in the tax code.

Remove barriers to domestic energy production. The oil and gas industry is running at over 95% of capacity, the most of any domestic industry, so it needs more investment now. We need to remove barriers to offshore and onshore drilling and "fracking" and to encourage nuclear power and wind power, where appropriate. Within the energy complex we can encourage demand for domestic energy by putting a tariff on imported oil, which would also help fight the biggest source of our chronic trade deficit. The long term goal would be to move to a straight carbon tax. We can also raise revenue to offset other measures encouraged herein by eliminating the preferential tax treatment of oil and gas investment, which isn't needed given the tight capacity and proposed tariff. The tariff on oil prices would help encourage a transition to more fuel-efficient automobiles, whether hybrid or electric.

Encourage hiring by permanently cutting the payroll tax. We can increase the return on labor to businesses by permanently eliminating the employer side of the payroll tax (which is 6.2% of wages). It needs to be a permanent cut because businesses are otherwise rational and won't hire based solely on a temporary cut. The long term goal would be to replace the payroll tax (a regressive tax on hiring) with a carbon and/or consumption tax (a regressive tax on consumption). The cut would be partially offset by letting the temporary 2% cut in the employee-side of the payroll tax expire as scheduled.

Stand up to currency manipulators. There is no reason that an innovative, productive economy like the United States has to run a persistent trade deficit. We are being manipulated by the central banks and sovereign wealth funds of East Asian and OPEC nations, plain and simple. The inflow of these excess savings must be matched by an equal trade deficit, artificially suppressing American manufacturing. For example, there is no reason that manufacturing of high tech goods for American companies, which requires relatively little labor, should be done in Asia and not at least mostly in the United States. We are needlessly allowing excess capital formation outside of our borders. While I think the corporate tax reform mentioned above will help in this regard, we should also explore a wider array of "sticks" like currency interventions, tariffs and capital controls in addition to diplomatic "carrots" like trade deals in seeking to promote trade balance. (Our trade deficit is currently 4% of GDP.) I know that such a proposal will spark warnings of "trade wars", but in reality other countries use these types of tools all the time (Switzerland did this week) and if they are used to negotiate an end to market interference by the other country, there should be no long term repercussions.

Stop encouraging inflation. One of the biggest fallacies in all of economics is that you need positive inflation for the economy to work properly. It is absolute hogwash. Prices were basically flat for the hundred years prior to World War I and the US economy grew faster than ever. All inflation does is transfer purchasing power from ordinary people to the elites who know how to profit from inflation in the financial markets. Stopping inflation would also have the benefit of making finance boring again, which would stop the drain of talent and capital from the real economy toward non-productive endeavors like designing the latest hedge fund trading algorithm or speculating in commodities. While targeting zero inflation wouldn't create jobs per se, it would lift the real income of American workers, since prices have been rising faster than wages. I frankly don't understand what the Fed has been trying to accomplish lately. The dollar is already at the bottom of its long term trading range and gold prices are soaring. Asset prices are generally pretty expensive. It's time for a new approach.

All of these ideas are incremental steps toward what I think should also be America's new (or at least modified) long term economic strategy. I also include some revenue offsets designed pay for these programs in a way that would not harm the economy and would also serve our long term goals. I realize that some of these proposals cut strongly against the conventional "wisdom", and I don't care. The long term goals are to get more Americans working, to make sure they get paid more by their employers, to produce more domestic investment and to pay for it with more domestic savings. It can be done. We shouldn't expect miracles, however. The economy is going to be abnormally weak for some time to come. This is the time, however, that we can band together to build a long term foundation for strong growth and general prosperity.

Are stocks cheap? Not quite…but close.

Given the recent plunge in the stock market, are stocks cheap? That is the multi-trillion dollar question.

My base case is that we are part-way through a long term (or "secular") bear market that began in 2000. While inflation has masked a bit of the decline in the overall stock market, it is clear that we put in a generational valuation peak in early 2000 and have been grinding our way lower since. The bear market turned into a "Kondratiev Winter" or economic bear in 2008 with the collapse of the real estate and credit markets. Since that time we have been in a "deleveraging" phase, which would have been deflationary if not for the desperate money-pumping and fiscal stimulus that has occurred since that time. Interest rates have collapsed, yet demand for borrowing is weak as consumers and business focus on improving their balance sheets. Many lack the collateral to borrow even if they wanted to. In addition, the baby boomers are staring at retirement having under-saved. The brutal decline in their net worth and the proximity to retirement are pushing baby boomers toward safer investments like bonds, even while the Fed punishes these savers with super-low rates in a futile attempt to get people to shift back into real estate and stocks.

S&P 500 below trend

In addition, the high inflation of the last 50 years has actually made stocks look like a better investment than they really are. If we convert the value of the S&P to 2010 dollars (as measured by the CPI), we can see that its trend line has only gone up by about 2.5% per year in real terms since 1960.

Source: Standard and Poor's,, calculations by

The good news is that the market is now below its trend line. The bad news is that in bear markets like the 1930s and 1970s (or in bull markets like the early 1960s and 1990s) the market can get very far from its trend line. The good news is that the double-digit deflation of the 1930s and the double-digit inflation of the 1970s are probably special cases. The bad news is that the 1990s bull market and the 2000s credit bubble were also of unprecedented magnitude and ought to be followed by a major bear market to undo the excess. The good news is that the bear market in stocks should bottom before the credit bear market (if that can be called good news).

Valuation based on trend earnings

So what about valuation? To smooth out the business cycle and to adjust for the effect of swings in inflation, I base my market valuation on inflation-adjusted trend earnings. A graph of inflation-adjusted (as-reported) earnings and the calculation of the trend line is shown below.

Source: Standard and Poor's,, calculations by

Expected inflation-adjusted earnings for 2011 are near the peak of 2006. Trend earnings, however, are only $62.15 in mid 2011. If I take the historical dividend payout ratio of 42.8%, the 2.7% long term inflation assumption implied by today's treasury curve and the long term real earnings growth rate of 1.55% as calculated above, I calculate that someone buying the S&P 500 today can expect a long term return of 6.6%.

Of course, the implied return is highly sensitive to inflation. If the inflation assumption fell to 2.25% (near the Fed's long term target), the S&P 500 would need to fall another 100 points just to earn the same return.

The matrix below shows the different levels of the S&P 500 that would generate target returns ranging from 6.0% to 8.0%, assuming long term inflation of 2.7%. Many market prognosticators assume 8% to be the long term return on stocks (wrongly, in my view). I assume the equilibrium return is 6.8%. (I realize that is weirdly precise…there is no exact right answer). To reach an equilibrium return, we "only" need to see the S&P 500 fall another 5%.

The effect of inflation

I am on the record that I believe in the intermediate term, inflation is more likely to surprise the market on the downside than on the upside. The chart below shows the inflation assumptions for the next 5 years, for 5-10 years and for 10-30 years, according to today's nominal and inflation-protected treasury curves. (I also included the actual inflation rates for 2009 and 2010 for illustration).

Source: (for treasury prices), (for historical inflation), calculations by

If we assume that long term inflation expectations fall to 2.25% sometime in the next year or two, we would need to see the market fall to under 1,000 (20% or so lower than today) to be comfortably earning a return of 6.8% or more.

Earnings yield on trend earnings

Another way to look at stock valuations is to look at the market's "earnings yield" using trend earnings (the inverse of the price-to-earnings or "PE" ratio).

Source: Standard and Poors,, calculations by

Looking at the chart above, it appears that we can be reasonably comfortable that we will earn a strong long term return at earnings yields above 6% (a 16.7 PE or below on trend earnings). That would imply an S&P 500 of 1,036 at today's level of trend earnings.


Using the methods above, we can say that the S&P 500 is fairly valued on a long term basis somewhere between 1,075 and 1,000 or so. We are currently at 1,121, so a drop of another 4-8% would put us in a good range. That said, from a trading perspective, the market could punch through to well below those levels if we have a deflation scare (which is certainly possible in this environment). We could also have one more big rally before the big bear market bottom is put in (also highly possible).

Given the monster rally in bonds, my investment strategy will be to average out of my bonds and gold into stocks over the next two years as long as the S&P is below 1,150. (Thankfully, I have been underweight stocks and overweight bonds for a long, long time.)

Good luck out there. These are not easy markets to navigate.

I am not your investment advisor. All opinions in are solely my opinions and are written for my personal enjoyment only. Do not act on any advice given on this site without first consulting your own investment advisor.

The market does not want austerity (now)

If one looks at both nominal and inflation-adjusted treasury yields for the next five years, the market does not think near term austerity is necessary. In fact, it is pretty clear that the market wants more treasury issuance not less, with negative real yields through at least the next five years. With fiscal stimulus being reined in, the market expects the Fed to be the stimulator of last resort (and all the Fed can do is try to promote inflation through bond purchases), hence the gold price is rising as the market expects an even longer period of negative real interest rates.

Our economic problem is simple, we went from a period of over-stimulated and debt-fuelled real estate investment running at 8.5% of GDP to a collapse in real estate investment down to 4% of GDP. The collapse in real estate prices reduced the collateral value on trillions of dollars of loans and forced austerity among consumers.

To deal with the problem we needed only three steps:

  1. Recapitalize the banks to prevent an uncontrolled unwinding of leveraged positions (done);
  2. Increase temporary transfer payments to individuals to prop up consumer spending while savings levels are increased (done, but in danger of being unwound); and
  3. Increased government investment in infrastructure to put the millions of unemployed construction workers to work (not done, we focused on health care instead).

Business investment, exports and consumer spending have been doing fine since we came out of the recession, but the markets are fearing that a pullback in government spending worldwide, combined with continued weakness in real estate investment will tip the scales to recession.

I personally think the odds favor us muddling through for the next year or so and avoiding recession, and that the recent market correction is probably overdone. That does not mean I am calling a bottom, because the momentum could overwhelm the facts on the ground. I do, however, feel ok nibbling at stocks at this level.

With US banks in far better shape than in 2008, I don’t see a mini-replay of that crisis as the major threat to the economy. Europe has major issues, but they are also solvable in due course as long as Germany steps up to the plate. The next crisis may come from exactly where we don’t expect it today: a crash in emerging markets leading to global deflation.


Seeking American Renewal

We are flailing economically. No question about that. Sadly, no one has any good answers for what to do about it.

Sometimes, there's just not that much to do. We just have to ride it out.

The immediate economic problem is quite simple. There is a gigantic hole in the economy where real estate investment used to be. The chart below pretty much sums it up.

Source:, calculations by

As a percent of GDP, business investment has snapped back nicely and has returned to a relatively normal level. As I mentioned in my previous post "Momentum is Building", I think we are likely on the front end of a powerful investment cycle for business investment.

Real estate investment, on the other hand, has cratered to by far the lowest level recorded since World War II.

Enter John Maynard Keynes

The Keynesian economic solution would be for the government to step in and fill the hole in demand (1) by supporting consumption with lower taxes and transfer payments and by (2) directly investing in infrastructure and other public works. The government has done plenty of number (1), which is why our deficit is so large, and not enough of number (2).

What people forget about Keynes was that he advocated withdrawing stimulus and running surpluses when the economy is strong. Instead, the "Keynesians" that have been running our economy since World War II (and that includes both political parties) have made stimulus a permanent feature of our economic policy. Overall it worked great…until 2008.

As a result, we have run up huge debts in all sectors of the economy (government, financial, consumer, business).

Source:, calculations by

And have gotten to the point that government transfer payments and health benefits are equal to about 20% of GDP.

Source:, calculations by

Even more disturbing, if we total transfer payments and investment income (dividends, interest and rental income), non-work income equals 35% of GDP, while work-related income (wages, salaries and proprietor's income) equals only 50% of GDP. This is a classic sign of potential national decline, when more and more income flows to the upper "rentier" class and the government mollifies the masses with transfer payments.

This trend can also be seen as fewer people of working age are even participating in the labor force (working or looking for work).

Source:, calculations by

Generational imbalance

It gets worse as time goes on. As the baby boomers retire, transfer payments will take up more and more of GDP, particularly health care payments, but also Social Security and unfunded pension benefits.

Source: "Where's Your Budget Mr. President?" by Paul Ryan, Wall Street Journal, 8/3/11

As can be seen above, if left unchecked government health care spending will continue to gobble up more and more of GDP. The chart above assumes that the rest of the government actually shrinks as a percent of GDP.

So while in the short term today's Keynesians are right, in the long term they are wrong. Our budget deficit is hovering around 10% of GDP, and we still can't stimulate growth. In addition, even though we supposedly have insufficient demand, we are running a trade deficit of 4% of GDP. In other words, even with 9% unemployment and only 76% industrial capacity utilization we consume 4% more than we produce.

We can no longer have a smaller and smaller portion of the population earning a smaller and smaller proportion of income and expect the country to thrive. The welfare state needs to be scaled back to make room for more productive activity.

Seeking American Renewal

While the Republicans are right to focus on scaling back the welfare state, they do not have a good plan for fostering future growth. Scaling back government spending will cut back demand, and the coincidence of super-low interest rates with deficits of 10% of GDP and strong money printing prove there is extremely weak demand for investment capital. It is therefore unlikely that private investment has been crowded out by government deficits.

In the big picture, Obama actually articulates a more credible vision than the Republicans for long term growth…less focus on consumption, imports and residential real estate, more focus on savings, exports and investment, focus on infrastructure investment, technology, education, health care and reducing our reliance on imported oil. His execution, on the other hand, has left a lot to be desired. He was elected to help rebuild the economy and instead dissipated his political capital on his health care bill. Only time will tell if that was the right call or not.

While our political culture is raucous and messy, they are slowly getting it right. Cut back the welfare state, allow private investment to grow and eventually throw the government behind a new growth plan. The focus should neither be on further increasing the returns to investment (the Republican plan) nor on increasing transfer payments (the Democratic plan). We need a plan that gets more people working and making more money. (More on that in a later post.)

In the meantime, all we can do is wait for the real estate downturn to play out before we fire on all economic cylinders again. Until that time, the "Rounded Bottom" scenario holds.

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.

Get Ready for a Dollar Bull Market

Get ready for a multi-year bull market in the U.S. dollar.

Yes, you heard that right.

No statement about investing right now could feel more wrong. And this is why it's probably time to start swimming against the tide.

First, I'll make a mundane case based on timing. Consider the following chart:

Since the Bretton Woods monetary system started breaking down under the strains of the Vietnam War and Great Society spending, there have been three dollar bear markets, each lasting roughly 10 years: 1968 to 1978, 1985 to 1995 and the current dollar bear market, which started in February of 2002. Currently the dollar is right against the lower bound of its long term trading channel.

You might say that the major currency index is no longer relevant due to the rise of emerging markets. Here is the broad dollar index (which incorporates all currencies on a trade-weighted basis) in real terms (adjusting for differences in inflation):

Not much difference in the timing of the bull and bear markets. Against the broad basket, the dollar has punched below the lower bound of its long term trading range, which means it might just be ready for a snap-back.

But things are so much worse now, aren't they?

In the mid-to-late 1970s, we experienced the loss of a major war and the resignation of a president, soaring inflation and commodity prices, union militancy, provocations by tin pot despots in the Middle East, years of bear markets in both stocks and bonds, weak leadership at the Fed and a general sense of American decline. Plus you had polyester leisure suits and disco.

In the early-to-mid 1990s, we were experiencing the "hollowing out" of American manufacturing and "downsizing" of white collar jobs, years of a brutal bear market in real estate, Japan was eating our lunch, years of large fiscal deficits, the aftermath of a major banking crisis and credit crunch that had followed a boom in high yield and real estate debt, a divided government with Congress controlled by firebrand conservatives that had forced a shut down of the Federal government and a general sense of American decline. At least we had flannel shirts and grunge rock…better than the late 1970s.

Hmm…for the most part these periods of time sound pretty similar to today.

There are major differences, of course. For example the transition to the dollar bull market involved a horrible recession in the early 1980s, while in the mid-1990s the transition was relatively smooth (in the U.S. anyway).

So what happens in a dollar bull market?

  • Real interest rates rise. This might come from a rise in short term interest rates or a shift to falling prices or very low inflation (or both).
  • US technology is hot. Leading edge technology attracts a lot of investment. The great venture capital bull markets coincided with the dollar bull markets of the early 1980s and late 1990s.
  • US business investment rises. Higher real interest rates attract investment capital back into the US, which flows into software and business equipment.
  • Emerging markets crash. It is no coincidence that the great emerging markets crises occurred in the early 1980s and late 1990s. The strong dollar draws investment dollars away from emerging markets and back to the US. This occurs after 10 years of an emerging market bull market during which untold unbalances build up. Would you really be surprised to find out that much of China's growth has been built on a mirage of cheap credit and wasteful infrastructure spending?
  • Commodities and farm prices crash. A rising dollar is a net negative for commodity prices (which are priced in dollars). Plus, it usually turns out that much of a commodity bull market is built on financial speculation, which flees once it becomes clear that momentum has shifted.
  • Large cap outperforms small cap. The long-awaited rotation from small cap to large cap and from value to growth might finally occur.

I am assuming that the transition to a dollar bull market will take a year or more. My plan is to gradually start moving to underweight in commodities, emerging market stocks and foreign bonds. As the Fed transitions from accommodating to neutral or restrictive, or if there is an inflation or financial crisis in emerging markets like China, there could easily be a major bear market US equities. I will wait to see how the market handles the transition in monetary policy before moving to overweight in large cap US stocks. There is also a dollar bull ETF, the Powershares DB USD Bull ETF (ticker: UUP), for those that want to get more aggressive.

I remember people yelling at me for being an idiot when I was buying gold and silver back in 2002. People argue vehemently against me now. I must be on to something.

I am not a financial adviser and write these articles purely for my own amusement. Please consult your financial adviser before acting on any of the recommendations posted here.

GDP Outlook 2011: Momentum is Building

2010 was a year of recovery for the US economy. On a year-over-year basis, nominal GDP grew 4.1%. (I will mostly use nominal GDP because I like to look at relative values. Nominal GDP represent actual cash numbers, while the individual items that make up real GDP can get distorted by quirky inflation adjustments.) Real GDP grew 2.85%, implying an economy-wide inflation rate of only 1.25%. The components of growth are as follows:

Personal Consumption: 2.7%

Private Investment: 1.1%

Government Spending: 0.7%

Net Exports: -0.5%


Within this mix, private investment gained economic share, while the rest of the components lost share. This is not surprising, because private investment is the driver of business cycles.


The preliminary estimate for Q1 GDP growth slipped to 3.7% in nominal terms and 1.8% in real terms implying an inflation rate of 1.9%, a pickup in inflation and a slowdown in growth from the pace of 2010.


I believe that the Q1 slowdown is a blip and that economic momentum is building, driven by a strong and lasting expansion of business investment. I believe that the investment boom will more than offset what I believe will be sustained long term weakness in real estate investment.

Business investment

Source:, author's calculations

Two things stand out in the above chart of private investment as a percent of nominal GDP. First, the recessions of 2008-09, 2001, 1990, 1980-82, 1974, 1970, etc. are all clearly visible. Second, it can be seen just how severe the Great Recession was, with private investment plunging to as low as 10.9% of GDP in Q2 2009, well below its long term average of 15.9%.

Private Investment can be broken down into business investment and real estate investment. The chart below shows the relative share of GDP of both long term business investment (excluding changes in inventories) and real estate. These are the forces that drive the intermediate term (5-10 year) business cycle.

Business investment is starting to recover, while real estate investment (residential and commercial) is not.

Source:, author's calculations

Notice the general 16-18 year infrastructure investment cycle (called a Kuznets cycle for you business cycle buffs). The front side of the cycle generally benefits from a powerful business investment boom, which also coincides with strong job growth. The back side of the cycle has a larger share of real estate investment and is generally associated with weaker job growth. The good news is, we are entering the powerful phase of the investment cycle, meaning the next decade should actually produce strong economic and employment growth.

Business investment reached a low of 7.0% of GDP, below the average of 8.2% since the end of the 1970 recession. This level roughly matches the lows of 7.4% hit during the 1974 and 1990 recessions. In Q1 2011, business investment was 8.2% of GDP, in line with the historical average. It is interesting that business investment is at mid-cycle levels so early in a recovery. Perhaps we really are moving to a new paradigm of more consumer saving and higher business investment, and less focus on consumer spending and real estate investment.

Real estate investment, on the other hand, has been experiencing a series of "lower highs" and "lower lows", hitting 7.2% in the 1974 recession, 6.3% in the 1990 recession and 4.0% in Q4 2010, well after the end of the 2008-09 recession. In normal circumstances, I would expect a snap-back from such a severe drop. Demographic trends are working against the real estate market, however, as Baby Boomers are moving past their peak home buying years and toward retirement while being followed by the much smaller Generation X. I expect only a very gradual recovery in real estate investment, although it's hard for it to go much lower.

Another component of business investment is the change in inventories, which tends to lead the short-term business cycle. In 2010, inventory additions added a full 1.9 percentage points of the 4.1% nominal GDP growth.

Inventory changes are clearly volatile, and have been losing share as a percent of GDP due to the decline in the relative importance of manufacturing and to the improvement in inventory management. There was some alarm with the drop in inventory additions in Q4 2010. Inventory cycles usually last at least 3-5 years, however (as can be seen in the chart above, these cycles are known as Kitchin Cycles). We should therefore expect for inventories to continue their positive trend for at least the next year.

Consumer spending

As I have noted previously, personal savings has risen to a normalized level relative to GDP, so personal consumption should now keep pace with GDP growth, as it has most of this decade.

Even as employment starts to improve, however, we shouldn't expect much of a boost from additional spending as long as savings holds at its current percent of GDP. The reason of this is that aggregate personal income hasn't really declined during the recession.

Source:, author's calculations

Wage and salary income has declined substantially relative to GDP over the past decade, but increases in government transfers and health care benefits have held total income roughly constant at about 85% of GDP. Given the imminent retirement of the baby boomers and the planned increases in government health care spending, there is no reason not to expect a continuation of the trend of a smaller wage base relative to GDP.

One threat to consumer spending is that there is a good chance that taxes will increase.

Income taxes paid as a percent of GDP is at its lowest level since the early 1960s. In addition, consumer spending (and potentially personal savings) is being temporarily goosed in 2011 by a cut in the payroll tax.


Given the budget tussles in Washington and state capitals, and the likely winding down of the wars in Iraq and Afghanistan, we can expect direct federal, state and local government spending to start declining as a percentage of GDP. We should expect the federal transfer payments that support consumption (social security, Medicare/Medicaid, unemployment benefits) to continue at relatively high levels unless some major budget revolution takes over the Federal government.


The economy is underperforming the public's expectations primarily because of the collapse in real estate investment and home values. As a result of the large drop in household net worth (from 470% of GDP in early 2006 to 347% of GDP in early 2009), household savings rapidly rose while real estate and business investment rapidly sank. The government stepped in and offered tax rebates, transfer payments and spending stimulus to prop up demand, while the Fed and the treasury propped up the banks to prevent a deflationary spiral. By mid-2009 the markets started to recover, stabilizing consumer net worth, personal saving and personal consumption. Once businesses saw the economy stabilizing and economies resuming growth abroad, business investment started to recover, first with inventory restocking and now investment in software and equipment.

Real estate investment has not recovered for obvious reasons, and this leaves a big hole in the nation's productive capacity, which is also holding back employment. The Fed continues to ease and the economy makes a gradual transition away from the real estate fuelled economy of the 2000s and employment is slow to recover. The weak dollar is helping US exporters but is causing a rise in the nominal value of imports, particularly in petroleum products, which now account for nearly our entire trade deficit. I am not quite sure what the Fed now expects to accomplish with its current course of action.

All that said, momentum is building. The American economy is very resilient and is merely in a transitional phase where the tired consumption and real estate driven economy is handing the baton to one focused on productivity and business investment. Which is a good thing.