Normal?

In some ways, the economic crisis is a crisis no longer. Business analysts still discuss it and there are still news articles about it, but in most parts of the country the crisis has simply morphed into a bad recession. In fact, as time goes by and the actual statistics get compared to other recessions, the claim that this has been the worst since the Great Depression may or may not hold up.

As in all recessions, the underlying fundamentals of the economy need to find the appropriate level to regain stability and start to grow again. The growth we had in 2005-2007 was based on unsound fundamentals, driven largely by inflated real estate prices. Correcting that has been painful, but the worst part of that correction is over and generally we should start to see some more appropriate valuations in that market.

At some point, the fact that houses get foreclosed on, businesses fail and people lose jobs, is part of every economy. What is the normal numbers we should see? Our perception on that changes over time, but the level of unemployment we have now will not destroy the country, it has been at and above these levels before.

American Economy

One thing that those of us who live in the United States should never forget is how wonderful a country this really is. Now, if you consider arable land, natural resources, educational levels, level of technological development, population density, and standard of living, there really is no comparable country in the world.

There are those who point to the current economic problems and predict Armageddon. Yes, people are suffering in some cases, unemployment is higher than we would like, but generally the country is carrying on quite nicely. Americans are making tough choices about whether to buy a new car or save more. Home prices are down and unfortunately many people have lost their homes (many of these were in homes they really couldn't afford in the first place). But the great majority of Americans are doing better than almost any citizens of any other country in the world.

Now, we are running a deficit that is higher than we would like, we are spending too much on health care, we face serious shortfalls in social security and medicare funding but does anyone really want to equate this to the horrors Europe, China and Japan faced after World War 2? In fact, if you consider the great depression, the turmoil in this country, which after all was intensified by the dust bowl drought, did not lead to fascism, or communism. In fact, while Americans became thrifty and cut back from the excesses of the 20s, the standard of living for most Americans in those years was still generally better than anywhere else in the world.

As we move into the future, we face some challenges, but really, even if China decides it won't but more Bonds from us, does anyone really think the country is going to collapse? We have contracted from what were the excesses of the early 21st century and in a few years we will have regained economic stability.

A lot is being made about bank failures. In the depression when a bank failed, the depositors lost their money. Now, the bank is renamed, depositors are safe and business continues as usual, with the losses from bad loans absorbed into our bank insurance system.

A lot of people in this country are having to make do with less right now. Lobster prices are very depressed as are many other commodity prices. In fact, while we continue to hear people worry about inflation, some sectors in this economy would love a little inflation right now. Yes, common sense tells us that prices will go up again in the future but it isn't likely to happen in the short term.

We are beginning to see renewable and national energy resources replace oil, slowly, but if you think about it, every barrel of oil replaced helps keep energy prices down, reduces carbon emissions and helps the trade deficit. You don't have to stop all oil use all at once, you simply have to work at the margins.

This country is going to have problems and issues, but we are the greatest economic power in the world. China, to use a Mao quotation, is really a paper tiger. With a population that exceed the U.S. by a multiple of 4 and a GDP that is about half. The economy is extremely dependant on exports and if they were to stop buying US bonds, Americans wouldn't be able to buy their exports. Realistically, until we start to equalize the trade deficit, bonds are the only way to equalize the currency equations.

Suppose the worst case was to happen and the United States couldn't sell treasuries any more, or the interest rates became inflationary. Well, imports and exports, while important, are still a very small part of the US economy as a whole. If foreign goods became unaffordable, especially energy, it would become disruptive, but we would adjust and really do much better than just about all our trading partners. Imagine the impact of American exports getting cheaper and cheaper? OK, we would have to replace oil with natural gas or coal or renewable, we would drink California wine instead of French, but we wouldn't collapse. In fact, we might have a boom!

There is a big difference between stock prices going down and Armageddon. Those who like to predict the worst ofter either want to sell bonds or want to make money shorting stocks. Meanwhile the average American, while a little worried about the future, is actually doing quite well.

The loss of Ted Kennedy is sad and ckoses an era for this country. We need to maintain the love of country that he represented.

Current earnings

Over and over again I hear analysts say that the recent good (relatively speaking) earnings were due to cost cutting and that there is only so much cost cutting you can do.

The implication of this is that earnings related to cost cutting are temporary and unless top line revenue grows, the earnings will disappear. Now, I can't imagine that is what the analysts are actually saying, but, over and over again I hear that comment and I'm beginning to wonder if they can really believe it.

If you have a company with sales of say $1 billion dollars and make a profit of 10% or 10 million dollars and then find that because of an economic contraction you are losing sales, you either reduce cost or lose money. Now, getting rid of excess inventory, reducing staff and closing facilities can be painful, but suppose sales have shrunk to 850 mil from the billion. If you have reduce costs enough to generate the same 10% profit, you will have earnings of $8.5 million.

Now, that constitutes reverse growth of a sort, but the savings and earnings will not go away unless sales continue to decline or costs are reintroduced. Since I believe the economic contraction has ended, the reasonable expectation is that sales will increase or at least stay stable.

Now, if you are thinking about investing in this company, the stock price should be lower than what it was when earning were higher. Mostly they are. I would argue, you need to analyse the company based on what is going to happen, not on what used to be.

Does the new company have growth potential from where it is? The fact that a company that is now only 85% of what it was is simply an interesting tidbit. Does it have good growth potential? Does it pay stable dividends?

Lots of analysts came up during a period when constant growth was the goal and they seem unable to adjust to the fact that we have reversed about 10 years of growth in the current economy. Businesses seem to have adjusted and have set themselves up to be profitable. The analysts seem to be a lagging indicator.

September Swoon?

As we approach September, we have a fair number of fear mongers worrying about September and how it is historically a bad month for the stock market and is probably when we will get "the correction".


Of course there are a number of reasons that there have been significant moves in September and October, primarily the fact that activity picks up after summer doldrums. During the summer, one of two things happen. Either the market moves in the direction that represents overall market sentiment, or it moves in a contrary direction.

Because of the low volume that we normally see during the summer, it is an opportunity for market movements that would not occur when the market is more actively traded. The old adage of sell in May and go away, has some validity. However, as technology has made it much easier to keep on top of things, even when away, not as much as it once did.

If the market has moved in accordance with general market sentiment, whatever trend it exhibits will most likely continue in September and October, barring of course other news. On the other hand, if the market has moved in a contrary fashion, especially if it has moved up, we are likely to see a significant adjustment.

So, has the market movement been part of a larger trend or has the movement during the summer been contrary to the overall trend?

If you look at projected S&P earnings for the 4th quarter of 2009 on an annualized basis, the S&P is trading at about 17 time those earnings. This is actually somewhat below what it has been doing for the last few years when it has averaged closer to 19. Now, is you consider that 10 year treasury yields are about 3.5%, the S&P yield of about 5.8% gives you a 2.3% risk premium. This is not very much out of line with what you would expect to see, although a little on the high side.

So the current level of the S&P, while much higher than it was in March, does not seem out of line with where one would expect it to be objectively. Now other things impact the market and it is possible that sentiment could drive prices down somewhat. However, there really doesn't seem to be the tremendous overvaluation that some talk about and if you want to maintain a 2% risk premium, the market still has room to go up. Now if you look at the 1st quarter of 2010 earnings, annualized, they would justify an S&P level of close to 1200. Now, earning can come in lower, but I believe most of these estimates are on the low side.

So will the market drop in September? It might, but the fundamentals don't support that the market is wildly overvalued and if it does drop I would expect it to rebound rather quickly as stocks become bargains.

Jobs

Most predictions anticipate that the unemployment rate will continue to rise slowly, eventually going slightly over 10% before it starts to decline. This is based on the fact that some lagging industries are still reducing workforce and that leading industries are reluctant to increase hiring until the recovery pattern is clear. With slow hiring and new entrants to the workforce, the prediction is that unemployment will grow a bit more.

I think there are two factors that might prove these predictions wrong. Now, I don't see unemployment dropping dramatically, but I do think the prevalent view does not account for the increase in boomer retirements based on increase in equity values and the creation of jobs related to the entrepreneurial efforts of many of those who lost their jobs during the recession.

Many boomers have become retirement eligible but were unwilling to take the step as the value of their houses and equities collapsed last year. We have seen some significant recovery in the equity market and I believe it will continue, with minor corrections until the end of the year until the S&P reaches 1200 or so. In addition, we have seen the decline in home prices slow and start to reverse. Now, remember that prices are more deflated in some prime retirement areas than they are in the Northern States. Relatively speaking, if you have a house in the north, it is worth 20% less, but you can buy a house in Florida, Nevada or Arizona that is down almost 40%. As this fact becomes clearer to many retirement eligible boomers and they see that the monthly income they can get supports a good lifestyle, I believe the number of retirements will increase fairly dramatically.

The second factor is what I call the ingenuity factor. Many Americans are coming up with creative ideas on new business opportunities, and implementing them. As these ideas bear fruit we will see small companies start to build and hire. I believe a lot of this is already happening.

I know some of these trends will take time to develop fully, but I believe they have already started. I also think they are enough to keep the unemployment rate where it is now and will perhaps bring it down a few points.

Paying for the future

Over the next few decades we are going to see a major transitional period in America. The primary element of this transition is the aging of the Baby Boomer generation and their movement into retirement and of course eventual reduction via natural causes.

One would like demographics to look like a pyramid with each age group being slightly less than the next younger group. This would lead to a fairly stable relationship between number of people in prime earning years, retirees and students. That sort of demographic would allow for an orderly approach to the various infrastructures required to support each group.

However, the baby boomers distorted that pyramid and in fact they will in some ways continue to distort it for quite a bit longer. In addition, advances in health care and life expectancy have compounded the problem, as the boomer generation is not only getting older, but can also be expected to live longer.

The problem with this is that we have set up social systems that require current workers to pay for the retirement benefits and medical benefits of those who are retired. We never wanted to tax the boomers enough to secure either Social Security or Medicare financially in the future.

So as the ratio of workers to retiree drops the current tax structure will be insufficient to fully fund these benefits. So, we are faced with three options, increase taxes, reduce benefits or increase debt. The first two options are very difficult to accomplish politically so we see the third option being implemented.

Is this a sustainable option? Ultimately it may be, but only over a very long time period. It is certainly predictable that in the future, the demographics may return to a better ratio and that the benefits paid drop below the taxes collected. At that point we could see debt reduced. However, this is so far in the future that the problem is supporting the debt for such a long time. Also, the debt itself creates an expense related to the interest payments required.

The only real solution is to balance the expenses and the taxes. Since cutting benefits is extremely difficult, and the amount that can be saved via efficiencies is simply not enough to balance the budget, we need to consider how to increase taxes.

This of course is unrelated to any further increase in Government outlays, simply based on the deficits that will be created supporting our current systems. This tax burden can not easily be borne by the smaller percentage of the population that is of working age and needs to be shared across the demographic spectrum.

I believe the most important thing we should be doing in this country is looking at ways to increase our tax base. I believe a consumption tax that replaces business taxes would lead to two things if applied appropriately, an increase in jobs in this country and an increase in tax revenues. If jobs increase, we will either get boomers to work longer or alternately, attract immigration of younger people who will share the burden. To increase jobs we need to reduce the cost of doing business in this country and further make sure that anyone selling product in this country pays a fair share of taxes.

Recovery Start

As we see the stimulus start to kick in at a greater pace and the people who are still doing OK in the current economy start to feel that they are not in danger of falling off the cliff, we are seeing the start of economic growth.

This is just the start and as the growth continues it will start to build momentum. There is still a lot of skepticism about what happens after the stimulus runs its course, but much like a person who uses crutches to support a broken leg until he can walk again, the stimulus will start enough momentum to enable the economy to walk on its own.

As we start to see some increase in employment and housing prices, whether due to the stimulus or some other factor, it will feed upon itself much like the downward spiral fed upon itself.

If we somehow have a major disruption, this may change, but barring that it is clear that we have started the upswing and the next few months will be very interesting.

Greed and Prudence

When you consider the recent recession, the one that seems to be ending, the ultimate cause was clearly the overall greed culture.

Greed became the predominant characteristic of our society as everyone felt that they could get rich and disregarded the risk of their actions.

Now this was almost universal as bankers created very risky derivatives and other investments and consumers ran up debt based on the belief that the house they owned would somehow pay it all back.

This greed is a fundamental characteristic of human nature and it certainly still exists, and would be the fundamental reason that the economic recovery could be jeopardised.

Now, things are starting to get better, but they aren't "better" yet, and we have to be careful in how we individually and collectively approach the next few months.

The main danger would be for greed to regain momentum and lead to practices that bring our last President's middle initial into play, the great W recession.

Prudence is our weapon, we need to use it.

Public/Private

One of the issues that we need to address in this country is what are the responsibilities of Government vs the Private Sector. We have been transitioning slowly since the 1930s from a system in which the responsibility for these areas were purely handled privately to a system in which the Government plays a much larger role.

If we were going to approach this from an efficiency approach, we have to be able to determine which method costs less. Now, this argument comes down to efficiency vs profit. In order for a private institution to provide a service, it needs to make a profit. In this type of industry, the profit would have to be near 7% in order to attract investors and capital. So if private industry is at lease 7% more efficient than the Government it would make sense to provide these services privately.

Now, most proponents of private industry would argue that private industry is clearly that much more efficient than the Government. They can find plenty of examples of Government waste and Government employees who find ways to game the system. However, most instances of Government waste are caused by political involvement and yes there are employees who game the system, but these same individuals often exist in private industry. Remember, these would have to be large companies with significant infrastructure and bureaucracy whether it is private or Government.

Clearly, the Government lacking a profit motivation starts out with a significant advantage. Additionally, the Government would have no motivation to increase costs. What I mean by that, is that at time in private industry, the amount of reimbursement and profit goes up as cost goes up. In fact, the relative ease in which health care costs can be passed along under our current system is clearly one factor in the continuing increase in those costs.

There is an additional factor that has to be considered in any such comparison. The compensation and bonuses paid to the top executives is pre-profit. There is often a significant difference in the way pay is structured between private and Government organizations. At the lower levels, Government employees often do better than private counterparts especially when benefits are included. However, there is no doubt that as you move up the organization, private managers and executives normally do much better than their Government counterparts, often because of bonuses and other perks.

For a number of years, there have been private vs Government competitions under a program that was designed to increase privatizing non-essential Government services. From the outset, costs had to be added to the Government to offset costs that private industry has to pay, such as cost of capital and taxes, etc. Even with this, most of these competitions were won by the Government organizations. Now, many of these competitions were considered unfair by the losing entities and it is very hard to judge how making a change would have worked out in the long run.

So the data we have is somewhat inconclusive but I suspect it would be very hard for private health insurance to compete. Government obviously has one great advantage, the fact that they have the ability to dictate certain reimbursement levels.

I would like to see this debate focus on the overall cost and not the philosophical issue of whether big Government is good or bad. We need to find the most efficient method of delivering quality services to our population.

My scenario

There are still many people who remain skeptical about the economic recovery. There are still many issues that are in process of being resolved that they point to as indicating continuing economic distress.

The things they point out are certainly real enough, but I think it is important to consider what we mean by a recovery. Generally, the recent apparent prosperity in this country was the result of a credit bubble fueled by an unwarranted increase in real estate prices. As a result of this increase, many new houses were built in areas that had little or no economic base to support the population, except the construction jobs and the actual increase in housing that provided credit to the residents.

So these areas are still faced with tremendous problems as the excess housing will take years to be absorbed and since construction in those areas is effectively dead for quite a while, unless they attract new industry, they will remain in recession.

The primary areas impacted this time were Florida, California, Nevada and Arizona although other areas saw an increase in construction. Now, there will be some improvement in these areas as the population will stabilize and the economics will improve somewhat, but the housing bubble is over. One advantage these areas offer is potentially an opportunity for retirees to acquire housing at much more affordable prices, as the rest of the nation recovers.

Areas that did not have the same sort of housing bubble have largely absorbed most of the excess housing that was built. Now, some areas are still suffering from job losses related to decline in manufacturing, but as demand picks up, these jobs will start to be refilled and without a glut of foreclosures, they will see growth.

However, they are growing from a reduced base. Tighter credit and even modest declines in home prices will cut in to consumer spending significantly. Banks are going to maintain higher reserves and much of the American public has a new found respect for more traditional saving since the belief that your house would make you wealthy has been discredited.

So, if the economy is down about 15%, and the recovery produces growth at something like 3%, it will take 4-5 years to return to pre-recession levels. However, the cost cutting done by manufacturers and retailers and the loss of the less efficient companies will assure significant profitability and some job creation. However, I believe the recession has caused productivity increases that will remain.

So consider the scenario I see. The reduction in consumer demand has led to an increase in unemployment of about 6% (possibly more depending of part-timers and other factors). If a 15% contraction led to this reduction, that would be a ratio of about 1% jobs lost for every 3% of contraction (very rough but bear with me). Now if productivity is up nearly 10% a 3% growth in the economy will only reduce unemployment by .9%. Now other factors are in play here mathematically, and it would be better to use raw numbers but I believe we have built in a secular increase to the unemployment rate of approximately 10%. Also because of the size of the contraction, it will take 5 years to recover the levels we had previously.

Now, the best chance we have of eliminating that new unemployment is to pursue a new growth industry, which I believe is renewable and domestic energy sources. Without that we will see growth but high unemployment and potentially a return of inflation as demand picks up. However, I think that inflation is unlikely to come back until we really absorb all the excess capacity that now exists and I think that will take 4-5 years. If the credit situation changes and banks start to create money via credit, inflation could heat up, but I also think it will take years before that happens.

In this scenario, I see the S&P which is now down from 1500 at its peak to stabilize at about 85% of that level or at in the mid 1200s and trade in a range with an upward slope from there. I also get around this level based on projected earnings. Now, thanks to the recent run up we have reached a level that is close to what I see as the bottom of that range. So we may see a minor correction but the fundamentals look pretty clear for us to get to 1200 by the end of this year with a likely pull back after the Christmas season shows sales down from prior peaks although higher than last year.

Too many people think things will simply go back to where they were. They won't, but they are getting better than they are now.

Real Estate

Starting right now, there should be an uptick in hiring due to the stimulus spending and getting ready for the Christmas season. We are also seeing some increase related to the increase in auto sales.

Will this uptick be enough to reduce the unemployment rate? We saw a very minor tick down in the July unemployment rate that may disappear upon revision. There are still jobs being lost, as there always are, and new people enter the workforce. To offset this we see a certain number of people leave the workforce due to retirement or death and we also have a certain number who partially retire, going to part time work.

We have a very large number of baby boomers who are entering the retirement age demographic. Due to recent economic events, some of them have been forced into early retirement, but more have revised plans due to loss of retirement assets and/or home value.

A lot of the increase in savings we have seen is being done by these very people as they try to recoup or replace these lost retirement savings. Will this new thrift continue? Generally speaking, the baby boomer generation has not shown tremendous ability to postpone gratification. In addition, some of this reaction was inspired by a degree of panic that has started to dissipate.

The increase in stock prices is part of the recovery equation that helps these baby boomers recoup some of their wealth. What is needed next is for their to be an upturn in real estate prices. Now most experts are predicting that prices will continue to fall for another year. Most owners, feel that prices have hit bottom and will start to increase. Why would we have this disconnect? Well their are two clear factors. In some parts of the country real estate is truly depressed. Many people have been foreclosed on and almost all sales are those of foreclosed homes. However in other parts of the country things have just not been that bad. This is related to the number of houses in play so to speak. Where there has been significant new construction and therefore new buyers at the top of the bubble, California, Nevada, Florida, Arizona, the downturn has been catastrophic.

However in more stable parts of the country, while much of the sales activity has been in foreclosed homes, most people simply postponed any plan to sell their home, waiting for prices to increase. So, for the relatively small number of homes in those areas that were in foreclosure, prices were very reduced, the number of homes actually impacted and overall sales activity was very slow. Further the reduction in price from the bubble period is not very dramatic.

One area that saw tremendous price escalation was Washington D.C. From May 2006 to now the median asking price of a home there has dropped from 489,000 to 307,000 a 37% drop. However the rate of decline has decreased tremendously recently although it is still happening. Now inventory of home for sale in the D.C area is around 30,000 (it was up to almost 40,000 at the peak). If you look at Dallas TX during the same period you see that median asking prices actually increased from 165,000 to 201,000 during the same period with inventories dropping from a little over 35,000 to a little over 30,000.

Dallas is certainly an exception, but as I look at area after area, it is clear that while most have seen some decline in prices due to worsening economic conditions, most have not seen the dramatic impacts of the states hardest hit. So while the amount of activity has been greatly skewed by the number of foreclosures in the hardest hit bubble states, most Americans don't actually live in those states.

So where national statistics are grim, many local statistics are nowhere near as bad. In fact, I see many real tors in this area trying to get me to sell be saying they have plenty of eligible buyers. I don't intend to sell, but advertisements like that, even if exaggerated would lead me to believe that if I did, I could get a decent price.

Looking at real estate from a National perspective ignores the three fundamentals of real estate, location, location, location.

Unemployment turnaround?

If you consider the supply side argument of economics, the argument is that if you make supply more abundant, it will drive down prices and create demand. The way to increase supply is to incentivize the businesses with tax breaks.

Businesses pass the cost reductions on to consumers as lower prices leading to the greater consumption, leading to additional production, more jobs, more demand, economies of scale, and so on and so on.

The only potential flaw in this approach would be if the cost reductions are not passed along, or not passed along fully. In classic supply and demand analysis, the price reductions must be significant enough to truly stimulate demand.

Now, in our recent economic contraction, we saw significant price reductions because of the fall in demand. In order to sell off inventory businesses were required to reduce prices and those that survived then reduced costs in order to return to profitability.

To some extent, some of this cost reduction was enabled by the cheap credit policy the Government has followed. The other cost reductions were primarily achieved by reducing locations and employment. Now, these type of cost reductions, lead to reduced demand and the cycle will continue until at some point demand is increased in some fashion.

We have seen one program on the demand side that may actually have the potential to reverse the cycle. This was the so called cash for clunkers program. This program increased demand by stimulating the demand side and effectively reducing the cost of product via a Government subsidy.

As the Auto manufacturers start to ramp up to cover demand, the wave of hiring will spread throughout all their suppliers including commodity suppliers. Will this be enough of a spark to reverse the cycle? By itself, maybe not, but if we start to see the stimulus create additional jobs in road construction and infrastructure repair or creation we may see a bottom.

What we need to do

It is pretty clear that there is a lot of nervousness in the stock market. While there are some pretty clear signs that the economy is going into a sort of recovery, there is a wide divergence of opinion over how strong that recovery will be.

I've talked in prior writings here about how the economy has made a semi permanent contraction of 15% or so and that the growth is not going to recover that amount anytime soon. Companies have adjusted to the reduced level of sales and have figured out how to be profitable at the lower levels. We will see some growth, but consumer spending has to start from the new base, and if anyone expects spending to jump to where it was two years ago anytime soon, they really need to look at the economics.

A lot of the credit that was available due to home equity is simply gone. A lot of that debt has also been liquidated in foreclosures and credit card defaults and this was the major adjustment that led us to where we are today. There are still more foreclosures and defaults to come, but most Americans are not going to abandon their homes. Most Americans are going to make a good faith effort to pay their debts. What has hopefully happened is that those who count on easy credit and lax standards to support an unsustainable lifestyle can no longer get credit.

In order to reduce unemployment we need to promote new growth industries, one of which is the renewable energy area. I see more and more promising information related to that area and as we reduce our need for foreign oil we will see wealth and jobs created in this country. This is potentially an explosive growth area, once we pass a critical point. For example, if we start to convert Semi to run on Natural Gas we will need to convert or manufacture the semis and build infrastructure to support them. If we start to see a great increase in the use of home solar due to incentives, we will need to manufacture the panels in mass (probably driving down the cost) and installing them on homes.

Another thing that will lead to sustainable growth is the steps necessary to make manufacturing economical in this country. I believe a change in our tax system to a consumption tax on all products sold here instead of the current system could go a long way towards accomplishing that. Now, this would only work it that system replaced at the very least the business taxes we impose, it can't be an add on tax. We can actually keep payroll taxes, especially if we gear them to paying for services specific to our citizens, such as social security, medicare, etc.

I believe the first growth area is going to gain steam at last but could be jeopardized by a return to cheap oil. I would suggest that oil be taxed to assure that its price does not fall below a level that keeps alternate energy competitive.

We are in the midst of a transition in our economy. A lot of the pain has already been felt, but we are not complete and there may be additional pain. However, if we don't learn from our mistakes and take the actions needed to create future growth and prosperity, we have only ourselves to blame.

Earnings projections

In every industry, whether times are good or bad, some companies do better than others. The reason for this is most often better management although at times other factor play a part.

When one company in an industry reports results, and they are unfavorable, often they claim the problems are beyond their control and attribute them to a poor economy. When the companies that have done better report, they may also cite economic conditions and generally, try to be conservative in making predictions as to future results.

While human nature has a certain boastfulness to it, in business, the surest way to fail is to fail to produce the promised results. For a fair number of years I used to review bonus plans for companies. No employee likes to sign up to a performance objective that they don't feel confident about. At times management tries to impose stretch goals but these are resisted. So, when you are preparing projections, and put together estimates based upon inputs from various districts, regions, stores or whatever corporate structure you have, it is going to be understated since any manager knows that he better not promise more than he can deliver.

Clearly, there may be events that cause even fairly conservative estimates to fall short but in an economy that is reasonably stable or growing, most companies will exceed their estimates.

We saw that during the recent earnings season. Earnings generally exceeded projections despite the decrease in year over year revenue. Most companies were quite conservative in giving guidance about the rest of the year citing difficult economic conditions. However, the fact that they exceeded estimates for the most part is a tremendous indicator that conditions have achieved a reasonable level of predictability. This occurs when the economy is stable or growing, not when it is contracting.

The one lesson I believe you can take away from earning season is that the economy has clearly stabilized and is probably starting to grow slowly.

Oil demand

As you watch the fluctuating cost of oil, we are looking at a commodity which is likely never going to recover the peak demand of a few years ago. There are two reasons for this. The first is that the world economy has contracted and will take up to five years to fully recover. The other factor is oil will lose market share during that time to alternate energy sources, such as natural gas and renewable energy.

As far as the contraction in the economy, I think it is obvious and with a 15% contraction and even if we see 3% growth a year, the math speaks for itself. However, the recovery in energy usage may take even longer. There are changes going on in America where some of the habits that led to significant oil consumption are starting to change. It is hard to predict the ultimate impact of things like on-line shopping, video conferencing instead of travel and telecommuting instead of having to go into an office. However, there is an impact and there are significant savings associated with these alternatives so they should become more popular.

The second factor is the ongoing reduction in market share of oil. With the investments in alternate energy sources, the growing realization that natural gas is a viable alternative to foreign oil, and the renewed interest in other energy generation sources such as nuclear and clean coal, even as energy use climbs, oil use will grow at a slower pace.

If oil gets cheap enough, it may grab a somewhat larger share of the market, but I find it hard to imagine we will relive the 1980s and 1990s where we simply forgot the lessons of the oil crisis of the 1970s and ultimately regressed. Of course, there is always that possibility, but I like to think we are smart enough to not repeat the same mistake.

Outlook

If you think of where we are with the stock market, both of the following headlines could be printed accurately tomorrow.

1. S&P 500 down 23% over the last year, slump continues!

2. S&P 500 up 50% since March, looks overheated!

Now, most analysts like to talk about the second fact, because it is a bit more recent and certainly more dramatic. However the question that has to be answered is which one is more accurate.

If you look at various measures in the economy, it has contracted about 15%. That contraction may be reversing and there are two factors in valuation of a stock, earnings and growth.

When the economy started to contract and there were predictions of a possible new Great Depression, the earning did decline, but the very low valuations of March were based on the expectation of continued deterioration. I would argue this assumption was simply wrong and therefore those evaluations constituted a very poor valuation. Of course, it was an accurate valuation based on the sentiment at the time, and it enabled anyone who thought it was too low to make a very tidy profit.

So what about the valuation today? I still think it is a bit low, but not by as much obviously. Also, lets be realistic, there is still a lot of risk so P/E ratios need to be somewhat elevated. However, it is not too high.

I've been saying for awhile that I expect the S&P to hit 1200 this year and then trade in a range for the next few years probably between where it is now and 1200. the real easy money has probably been made and it is necessary to pick industries that will do well in a slow growth environment.

Back to School Shopping

Article in the NY Times today talks about how back to school shopping is predicted to be 3-4% less than it was last season. In the article it discusses how shoppers are buying at lower price stores and insisting on bargains.

The article paints this as another indication of the poor economy. I would be ecstatic if with almost 10% unemployment rate and the trillions of dollars of wealth lost in this country, if we were only down by 3-4% and consider such a prediction very upbeat.

In fact, the CPI numbers that just came out show CPI on a year to year basis is down 2.1% and while I realize further analysis would be required, if prices are down 2.1% and sales go down 3-4%, we are pretty close to flat.

Yes, high end stores may lose sales to lower price stores, but this type of sales season would clearly indicate a need for significant inventory replenishment.

One teen quoted in the article was quoted as saying that one shirt from Hollister was the same price as three shirts from Aeropostale. In general, while buying one shirt at Hollister is good for Hollister, buying three shirts consumes more raw materials and labor.

Of course some of these predictions are based on a sluggish start to back to school season and the article does point out that many states have delayed the tax free day sales promotion they have been running. Considering many families are likely postponing back to school shopping to make sure they can afford it, the predictions may actually be on the low side.

However, with a 2.1 percent drop in CPI and a 15% contraction in the overall economy and a 10% unemployment rate, a back to school season with a decline of 3-4% would be about a pretty strong indicator that:
a. Teens can really nag parents to spend money (know this from first hand experience)
b. Things are getting better.

Human spirit

Oscar Wilde defined a cynic as 'A man who knows the price of everything and the value of nothing"

Simply looking at statistics or numbers can tell you a lot about things, but in all honesty, they can never tell you the whole story. If they did there would be very little uncertainty in life. The better sports team would always win. The stock market would always react the same way to inputs. People who lived healthy life styles would avoid serious illness.

However, we know that the ability to predict the future based on statistics is limited. Those who like numbers always feel that had they had better data, they could have gotten it right. Maybe, but the amount of variability due to individual behavior is too hard to predict.

The value of each individual is the greatest variable of all. People don't look at statistics and decide they might as well not try because the numbers are against them. They react in many ways, and in ways that the statistics simply can't predict.

One of the major factors that impact this reaction is the degree of hope in the future people have. People tend to be optimistic generally. There has been a tremendous amount of doom and gloom in the media over the last year and yet most people are still optimistic about the future. Yes, they have seen retirement funds collapse, they have seen home prices drop, but while some have been so battered that they have given in to despair, most have not.

So, what is the value of human spirit? Cynics discount it but that is a mistake. The world as we know it is the result of the accumulated human spirit of everyone who has ever lived. The world will continue to progress because of human spirit.

Human spirit causes us to overcome challenges, find solutions, and simply succeed.

Back to School

The next big shopping season is back to school shopping and that will tell us to what extent consumer spending is going to rebound. Should be no surprise that there were a lot less people driving in July than usual, both because of the stay cation trend and the high unemployment. Add that to lower gasoline prices and July was a bit slower than predicted.

The economy is near the bottom and lagging indicators are still going to look bad. We know that people who got into trouble on their mortgages six month ago are just now likely to be going into foreclosure. We know businesses are still reluctant to hire and are in fact still letting people go in order to maintain earnings on lower spending. However we do not consumer confidence has an upturn, more houses are being sold at very affordable prices and industries are starting to rebuild inventories cautiously.

Companies have cut to levels that provide earning even in our contracted economy. As back to school spending gets rolling, we may see the teenagers lead the consumer spending rebound.

BIG problems, small solutions

There is a simple theory, or maybe its best called an observation about how things change. Usually people look at a problem, say global warming, and feel that the problem is insurmountable. The problem is large, involves multiple aspects, many countries around the world and the search for a solution just seems so difficult.

Now it doesn't matter for this discussion if you believe that global warming is a real issue or not, but lets just assume that it is. It will be solved and it will be solved faster than the experts think. The reason is that there will be a tipping point.

When people look at a problem like this you see the trends and the massive amounts of CO2 being generated and start to look at the BIG solutions. BIG solutions are hard. I doubt very much we will find one. However, the problem will be solved because as people become convinced it is a real problem, or just because oil is so expensive, they will start to modify their behavior.

Each individual modification is by itself insignificant, but as they start to multiply and add up, they will reduce emissions past the point necessary to start stabilizing the environment. Of course, concerning global warming we will also have some help from Mother Nature as more CO2 consuming plants will thrive.

Now how can I be so sure of this? Mainly because while theoreticians ponder, most people act and they act in their own best interest. Energy has gotten expensive. Also, people are starting to believe that they are causing problems for their children. So for both economic reasons and family reasons they will improve their carbon footprint. Also, as more people do it, it will become the thing to do.

The same phenomena relates to Oil demand. We had an oil shock in the 1970s but the actions we took back then to reduce oil consumption were defeated by the reintroduction of cheap oil and a political environment that didn't support conservation or renewable energy. We have now had another oil shock and further the oil shock sent us into a recession that scared the hell out of a lot of people. We are seeing signs of recovery and we have elected a more environmentally friendly Government. However, people are going to reduce their need for oil. They will want fuel efficient cars, more fuel efficient houses and will start to insist that products they buy are environmentally friendly. Not not everyone will do this, but where it was just a fringe group a few years ago, the numbers are growing and I believe they will continue to grow.

Additionally, the administration will promote energy conservation and whatever you may think about certain programs, it will become more profitable for industry to reduce energy consumption. So as all this happens demand for oil in this country will stay depressed. It may grow some as we expand after the recession, but it will not return to its former levels. Further, this is a worldwide phenomena.

Most BIG problems and not solved by BIG solutions but rather are solved by a series of rather small actions taken by many different individuals and businesses acting in their own best interest. Yes, sometimes the reason certain actions are in their own best interest is because of the tax code or perhaps social pressure, but it is not a BIG solution.

Inflation?

Now that most earnings have been reported and the better than expected earnings have caused some optimism, we will most likely spending the rest of August drifting lower in the Market.

There is a good reason for this. There are still significant issues that need to be monitored and as various groups and analysts point them out they will tend to keep money on the sidelines and induce profit taking.

We still have high unemployment and many foreclosed houses as well as underutilization of our economic capacity.

The adjustment to a smaller economy is still ongoing. During the recession the economy has contracted by about 15%. Under even the most rosy scenario, the growth rate will take years to regain that amount. In fact in the non-Government sector the contraction has been even greater.

This slack in the economy will continue to force lower prices as companies compete by being more efficient and productive and trying to grab market share. The first area of growth for most companies may very well be in exports.

One area that shouldn't be a concern for this economy is inflation. It will take many years before the demand will push prices up. Now, the value of the dollar may decline in respect to other currencies and imports may get more expensive, however, it will be very hard for these price increases to be passed on to consumers, forcing companies to continue to improve efficiency.

Bottom line is that supply and demand are the fundamental rule for pricing and we have much more supply than demand and will have it for quite some time.

Job creation

Looking at 2010 and beyond, the biggest question about the economy is will there be enough jobs? I believe we are in the midst of a few significant changes in the fundamental nature of our economy. During the course of our history this country went from being a country that supplied commodities to Europe, to a Manufacturing powerhouse, to a service economy. Of course, in many cases the transition is notable because of the growth of the new sector, not the disappearance of the old one. We still supply a great number of commodities to both our domestic and foreign markets and manufacturing in this country still dwarfs most of the world. However, the percentage of people working in these industries in comparison to the total decreases as the new area grows.

Now, the service industry is still expanding relative to manufacturing and commodity related employment. However, we are starting to see technology starting to impact that growth. In the low end area, sales clerks, cashiers, and other retail jobs, we are seeing an ongoing increase in online retail (eliminating many of these positions) and increasing efficiencies in processing in-person transactions. In higher end service areas the technological impact has been somewhat less pronounced, but the on-line availability of expert advice and the growth of Artificial Intelligence applications is starting to impact that area also. These trends will limit the growth in service jobs. Now some service areas will continue to grow in areas such as health care, both because of the aging of the population and the Government's extending health care to more people.

However, if we really want to create jobs one area that can be self sustaining is in renewable energy. Consider the fact that this country exports a tremendous amount of wealth every year to import energy. The more we start to rely on domestic and renewable sources, the wealth will stay hear. The conversion to a more energy efficient and renewable energy profile will reinvigorate the economy.

It will lead to new construction or modifications to more energy efficient homes, production of energy efficient automobiles, conversion of plants and factories to more energy efficient profiles and reduce the balance of trade deficit. If this can be combined with a smarter tax system that makes sure everyone profiting in this country shares the tax burden, I believe we will see a revitalization of high technology manufacturing in this country. The number of jobs in alternate energy and related areas is I believe how we will restore jobs to this economy.

S and P valuation

I'd like to return to a theme I've addressed in prior posts and talk about the market valuation. Now, we have seen that interest rates have stayed low and for the 10 year treasuries are still below 4%. Since they are considered extremely safe investments they are a good starting point. If you are going to invest in a stock, you are taking on risk that simply doesn't exist in a treasury bond. Because of this risk, you probably want to get at least 50% more in earnings (not dividends but earnings) from a stock investment. So that would mean a return of about 6%, or a P/E of 16. Even if you use 15 instead of 16, this means that if you multiply the S&P earnings by 15 you should get an approximate valuation.

Now we have had a surprisingly good earnings season. Now as of Aug 4th, the current S&P estimate for 2009 and 2010 is 54.28 and 73.18 respectively. If you look at the current year estimate (and note the estimate shows earning increasing each quarter) you would come up with a market valuation in the low 800s. If you consider 2010 projected earnings you would get to about 1100.

Based on recent data, I believe there is sentiment that the earning may increase faster than the projections. After Friday's rally the S&P is just a little over 1000. If the market actually looks 6 months ahead, we would be about 20 points higher than the first quarter of 2010 estimate would indicate. Of course if you think the estimates are low, the market may be undervalued. However, since earning estimates are projected to go up each quarter in 2010, unless there is some specific bad news, I would expect the S&P to go up to 1061 next quarter.

A lot of commentators think the S&P has gone up to far and too fast and expect a pull back. The numbers don't support that position and in fact say the S&P is almost exactly where it should be. Now, if you don't believe the earnings or the estimates, that is a different story.

Which brings me to my next point. I hear commentator after commentator make a comment similar to the following :
"These earnings are due to cost reductions and are a one time event"

I think the people making these comments are intelligent but I simply can't figure out what they are trying to say. Cost reductions are not restructuring events, they are in fact ongoing. Once you eliminate cost and achieve earnings at a particular revenue level, you will continue to earn at that rate if the revenue level stays the same. Now if the revenue grows, you may or may not have to reintroduce cost and if we have any kind of recovery at all, I would think cost will be introduced at a lower rate than revenue will increase, leading to very good earnings growth.

I have heard some analysts say something that does make sense to me. Companies have used this downturn to eliminate jobs that they perceived to be of limited value. I believe many of the jobs cut will never be replaced, no matter how fast the economy grows, because companies will use this opportunity to either outsource them or replace them with automation.

I have discussed the need for the country to get behind the renewable energy growth engine to create jobs, but that is a different post.

Health care debate

Right now in this country we are trying to decide the future of health care. I believe that everyone agrees that the current escalation in costs can't continue and I would also like to believe that everyone agrees that everyone is entitled to adequate health care. Now, if some people want to continue to see costs escalate, or feel that some people should be denied health care, I don't understand why and would be interested to hear their reasons.

What I believe is under debate is the best way to achieve these outcomes. Clearly there is a fairly clear divide between the best way to control cost and the best way to provide health care to all. Some argue that a pure free market would accomplish this. Now, I don't think it would since in free markets there are always winners and losers. In health care, losers die or at least go broke. Currently, the system provides that if you get sick enough and don't have the right health care coverage, you will become poor and the taxpayers and health insurance companies will end up paying for what you couldn't manage to pay.

I don't find this result satisfactory. Now I should say, that I have what I consider quite wonderful health coverage. I don't have any reason to think the coverage will end so my position isn't dictated by the fact that I need coverage.

Going back to the pure free market approach, the main flaw in it is that knowledge is simply not equally shared. Those who have enough information and knowledge would do quite well while many others, possibly the majority, would be persuaded by questionable sales tactics and end up with inferior, overpriced products.

One way to address this, and this would be my preferred method, is simply to set up rules related to health insurance and also to make sure that any plan sold to the general public was held accountable for the claims it made, lets call it truth in advertising. Now some may feel that we don't need this since consumers and customers have some legal rights now, but arguing or suing a company following a serious illness is not a satisfactory solution if you were denied adequate care when you needed it.

While choosing health care can be complex and deciding whether you want an HMO or a PPO or are willing to pay more for even more choices should be made easier by knowing that the promises made by the plans were in fact legitimate. It would also seem important to me that any plan covered preventive medicine and catastrophic insurance.

Will this cost more? I think it should cost less, especially if the preventive medicine part is effective. Now when I say it should cost less, I am talking about the total amount spent on health care in this country, not the way that cost is proportioned. Currently we have a significant part of the population who utilize the most expensive type of health care imaginable, trips to hospital emergency rooms. Of course many of these trips are absorbed in the costs we already pay.

Now, it is possible, that costs could go up. The increased demand for health care may result in price increases. I think this won't happen, but the simple question remains, do Americans really think some people are not entitled to care?

Certainly there should be a debate about the amount of Government involvement and whether there should be a Government plan as part of the mix. However, I would like to think we could have that debate in a rational way. Currently, we are seeing activists trying to prevent debate by using tactics intended to disrupt meetings. This tactic is designed to get press coverage and influence the public. It may or may not work, but those who advocate it are clearly not proponents of honest debate and democracy.

Consumer spending trends

We all know that there are many Americans suffering economic hardship right now because they are out of work, lost a lot of their retirement funds, or have lost value in their houses. All of these factors create a reduction is spending for two reasons, lost of immediate income and loss of credit.

Now, the opposite is true as well. When an unemployed person gets a job, they suddenly have much greater access to credit. Rightly or wrongly, a newly employed person often starts to spend future income in order to get items that were put off because of their financial situation and because they simply feel better.

This trend also exists in homeowners who refinance and of course if retirees get increased retirement income. However, the new job impact is normally the greatest. This is a much faster increase than the opposite, since when you lose your job you don't immediately lose your access to credit and usually for a few months, consumption drops slowly.

What does this mean for the economy? Well, right now we are still losing jobs on a net basis. However, we are seeing signs of a bump up in the economy from the stimulus programs as well as the fact that industry needs to restock inventories that were burned off in the first half of this year. Now in any given month, a certain number of people are hired and a different number are let go. So, even in periods with net job loss, we often see increases in consumer spending, since those getting jobs start spending faster than those losing jobs stop spending. There is therefore a tipping point where consumer spending increases enough in this economy to have demand exceed supply, requiring an increase in production.

When that happens the economy is in recovery. Recovery's feed upon themselves. More demand creates more economic activity creating more jobs. Other factors of course are related to imports and exports and whether the jobs created are in this country or elsewhere.

I believe we have passed that tipping point and are creating enough jobs to increase spending over the decreased spending from job losses. So with increased spending and inventory replenishment we may have a very good fourth quarter, better than many expect.

Economic revival

There is a quote by B.C Forbes that goes, "The victors of the battles of tomorrow will be those who can best harness thought to action."

Yesterday I watched a speech given by President Obama in Indiana where he announced a grant to the local factory to build electric vehicles or a component thereof. The actual grant was one of many from the stimulus and similar announcements were apparently being made by the Vice President and other members of the cabinet.

What I found significant was that he talked about the need for American to take leadership in the renewable energy field.

I couldn't agree with him more, and the question is can we?

The Government stimulus and the bank bailouts have been widely criticized. However, they shouldn't be in fact they serve as real investments in America. As far as the bank bailouts, if the banks generally recover, as many of them seem to be, and they repay the Tarp money with interest computed at the Treasury rate, they are simply investments that transfer money borrowed by the Government to a future period. Since they provided needed reserves and allowed the financial system to recover they are in fact not a debt being handed to the next generation. Further, our stock positions in C and AIG may end up being profitable as well as the amounts we get for the warrants the financial institutions gave us.

Similarly, while it may take a while longer, the amounts provided to the Auto industry have similar potential. When I hear analysts arguing against them, they immediately assume we will never get paid back. I don't really know, but I do see some signs of recovery in the Auto industry, helped in part by Cash for Clunkers. So maybe that money will return to the treasury and not add to the debt down the road.

I would also like to address a comment I hear about cash for clunkers that sort of is inane yet often repeated. It is arguing that it is stealing sales from the future. There is no proof of this and further, what about all those sales that didn't happen between the middle of 2008 and now? I know that I have been thinking about replacing my wife's car and when I heard about Cash for Clunkers coming, decided to wait. Turns out her car doesn't qualify but I don't think I was the only one thinking that way. Further, cars wear out. There is some normal turnover cycle for cars and it is greater than the rate that we have seen recently. The cars being sold in this program are not just cars that would have been sold anyways. They are in many cases cars that should have been sold over the last six months. Another factor is that it is stirring other economic activity. There has been an uptick in used cars recently. Ever occur to anyone that it might be well worthwhile to buy a clunker if you don't already own one? Finally, every car turned in generates jobs, sales tax and improves gas mileage reducing the need for foreign oil and improving air quality. I challenge anyone to find a more productive Government use for the $3 Billion dollars.

Considering the need to reduce foreign oil dependence and increase jobs in this country, the investment in renewable energy has the potential to do both of these things. We need to be the ones to win the battles of tomorrow by harnessing thought to action. Every person working generates taxes, every product that gets built in this country creates jobs. A lot of the analysts who pooh pooh the stimulus, are in the financial sector and they don't care if the work is performed in this country or somewhere else as long as they can profit from it. I have no problem with them betting against America, and I also think the rest of the world has some wonderful investment opportunities that don't conflict with American prosperity. But if you are betting that America is down and not getting back up, I think you are going to lose that one.

Unemployment impact

How much will a high rate of unemployment impact the overall economy? The answer to that depends on two factors. First, assuming that the unemployed will have some sort of income, whether from Government, benefits, retirement funds or perhaps "off the books" work, that will offset the loss of employment income to some degree. Of course, the amount of Government aid they get impacts taxes. The second factor is the ability of businesses to be profitable if you subtract the loss in disposable income, the first factor, from the economy.

I haven't seen very much information on the actual reduction in income suffered by an unemployed individual, and anything I come up with here is clearly speculative, but lets assume they lose 2/3rds of their income. I actually think that between retirement funds, Government aid, part time work both on and off the books, they will actually do better than this but I need to use some number. Well, if we were to have a long term unemployment rate of 10%, and nothing else was to change, we would see a 6.6% decrease in disposable income from unemployment. Now of course, you have to subtract the unemployment rate that we had prior to the downturn and lets use 4%. So instead of 6.6% we have a net decrease of 4%. Clearly, a factor and there are other factors that may very well mitigate that impact but lets use that.

So if high unemployment led to a reduction in consumer spending of 4% what does that mean for the economy? I guess it depends on you view of what a recovery is going to look like. Considering other factors in the economy, such as loss in housing and equity wealth and increase in savings it would potentially lead to a smaller economy of about 15%.

Now if the economy was about to contract by 15%, this would be quite scary. However, the economy has already contracted by more than that and is now in fact starting to recover a bit. What we are seeing is company after company reporting earnings that support a contraction to a lower need for revenue in order to maintain profitability.

A number of analysts or bloggers seem to think that cost reduction is a one time event and try to discount it. However, when a company reduces cost by laying off workers or closing plants, this is an ongoing reduction. The savings keep on helping profitability. So if a company has adjusted its operations to be profitable at a certain reduction in revenue and revenue then grows, the improved profitability actually may lead to greatly increased profits.

So, as we watch what may very well be, at least initially, a jobless recovery, how bad is it for the economy? On an ongoing basis, I think it will lead to about a 4% reduction in economic activity and consumer spending. Without ignoring the individual devastation that losing a job can cause, from a purely economic impact it becomes a fairly minor overall factor in economic recovery.

Whither the middle class?

One of the trends that is hidden when you look at employment/unemployment numbers is the fact that for many Americans, the traditional path to the middle class is disappearing. This is because of the transitioning of America from a manufacturing country to a service industry country.

Starting in the late 19th century and continuing through much of the 20th, we saw tremendous growth in American manufacturing. Industries, such as the Auto Industry, Steel, Aircraft, heavy machinery and many many others needed workers. It coincided with a migration of many rural workers to cities and suburbs. It also provided good wages and benefits and enabled American workers, often starting with few skills and maybe a high school education, to own homes, cars, send their children to college and generally have a standard of living that exceeded that of most of the world.

In the latter stages of the 20th century, the cost of labor in the United States began to become a significant drain on profitability for American industry. Foreign competition started to seriously challenge many of these industries. What we saw happen then and what is still continuing is that these jobs started to disappear, or perhaps more accurately, migrate from high cost areas to lower cost areas. Initially, a lot of this migration was from the Rust Belt to the Sun Belt, but of course ultimately, it is now going overseas to even lower cost areas.

If you consider the garment industry, once a major employer in New York, and then a major employer in some Southern States and now almost universally moved offshore. The International Ladies Garment Workers Union has lost a tremendous number of members and has merged despite that catchy jingle.

There are many examples of other industries, many of them better paying than garment workers where the jobs have left, look at Michigan, and are not coming back. So what happens? Well eventually, other jobs, mostly service industry jobs, get created.

Now there are two types of service industry jobs. One is relatively high paying and generally requires at least a college degree for entry. At the top of this pyramid you have financiers, lawyers, doctors, and other professionals who make very nice salaries when there is work. The other type of service job is best typified by the phrase "do you want fries with that?". Now of course there are only so many fast food jobs, but there are many service jobs that require few skills for entry but also don't pay very well.

So workers who used to get high paying jobs in manufacturing are now lucky if they make half as much in some service industry. Of course many of these folks work multiple jobs and both spouses are now required to work in order to maintain the lifestyle they have come to expect. The problem is that ultimately, on a permanent basis that is not sustainable. First, even many of these jobs are disappearing as we go to self service in service industry after service industry and replace brick and mortar stores with on-line retail. We need fewer and fewer tellers, grocery check out clerks, gas attendants, sales clerks at stores, etc. etc.

So if we have lost the high paying manufacturing jobs and are starting to lose the lower paying service jobs, what is next? Well, one thing you hear discussed is retraining. However, there are clearly limits to that. First, the jobs you retrain people for have to exist, and if you train too many you will create a glut.

Now one area that helped absorb this workforce had been construction. However, with the glut in housing, many, many jobs were lost in that sector and while some will come back it is unlikely they will get back to the bubble numbers. There is money in the stimulus program for public works projects, repairing and replacing infrastructure, but while that is necessary work, it is hard to see how we can absorb enough of the workforce that way on a long term basis.

So is it inevitable that the American worker is destined to see continued deterioration in their standard of living? Well, ultimately, if the trend were to continue long enough it would self correct as it became cheaper to manufacture here and employment would rise, of course at much lower rates than previously. However part of the problem there is that the cost of manufacturing here is not limited to labor costs, but also the cost of taxation and regulation. We need to reduce those burdens, or at least spread them better if we want to preserve and revive manufacturing in this country. We also need to address the cost of health care and how much of that burden is passed on to employers. It is a significant employment cost driver.

It seems unlikely that we will reform the tax system to one that will tax consumption instead of production and ingenuity. Simply if we had a national sales tax instead of the taxes we have now, everyone who sells product in this country would share in the burden of maintaining America. It would also encourage investment, local enterprise and saving, all of which ultimately would increase wealth and prosperity. Unfortunately, we seem determined to pursue policies for political purposes that lead in a different direction.

American ingenuity

There are some analysts who think the United States is going to undergo an even greater economic recession than the one we are currently experiencing. In many cases this is based on their belief that the actions taken to combat the recession actually compounded the problem by increasing the National Debt and increasing the money supply to a point that will lead to a severe additional contraction in the economy after the initial stimulus passes.

I don't really know the future, but I do know that this country and the people who live in it still have tremendous potential. There have been people who lived beyond their means and recently many of them have been paying the consequences for that, but most Americans have been much more prudent than that.

Whatever the current unemployment rate is, 9.4 or 16% if you count part-timers and those who have stopped looking, it still means 85% to 90 percent of Americans are still employed. American companies saw a lot of demand disappear so they reduced costs and capacity to the point where they are turning profits even with lower revenues. I believe we are moving out on the development of domestic energy and renewable energy sources that will further reduce our balance of payment issues. Right now there are entrepreneurs who are going to buy up "toxic assets" and turn them back into profitable assets.

In other words, Americans are reacting to the problems in the economy and taking appropriate actions. Those who look at statistics and predict doom are ignoring the most important factor, the great ingenuity and spirit of the American people.

Inflation - Deflation?

There are still many who predict the United States and its citizens are doomed to undergo a major depression because of the tremendous debt and the Government intervention in the free market system. Dire predictions like these have been made many times before but in times of severe economic contraction they get a lot more attention.


There are competing doom scenarios, one that predicts severe inflation and one that predicts severe deflation. Now both end up with quite dire forecasts and it sort of reminds me of a Robert Frost poem Fire and Ice.

We have been experiencing deflation recently, although it is not fully represented in the CPI. The June CPI shows an overall decrease of -1.4 year over year. A lot of this reduction is due to the change in oil prices and it would have been much worse if the Medical and Services areas didn't continue to have price increases. The oil prices from last year are clearly a short term phenomena and do distort the index. However, I think most of us feel that whatever the official statistics show, the actual cost paid for many things is significantly less than it was one or two years ago. Consumer spending is down significantly and with less demand, the price curve goes down.

Now in order to combat weak demand and potential deflation, the Fed has lowered interest rates and the Government has increased deficit spending. This takes us to the inflation scenario, one in which proponents of monetary theory believe the increase in money supply can take us no where else.

It does seem that considering supply and demand, an increase in the money supply without a corresponding increase in demand will lead to a lower price for the dollar and therefore inflation. Of course this assumes the real money supply has increased, which may be debatable considering the higher reserves held at banks and loss of wealth (i.e. money) due to the drop in housing and equities.

So would either deflation or inflation be disastrous? Depends on ones definition of disaster.

Concerning deflation, one can look at Japan which has been in a deflationary period since the mid 1990s. There was some belief that it was starting to emerge from it, but recent events call that into question. The main problem with deflation is that economic activity slows, borrowing becomes difficult as debt becomes more expensive over time and economies tend to stagnate. However, looking at Japan over the period of deflation, does not indicate that society as a whole collapsed, and the standard of living for most Japanese had been maintained at respectable levels.

As far as inflation goes, there are a number of examples of ruinous inflation, perhaps most notably the Wiemar republic. Inflation there completely devalued the Mark, led to the fall of democracy, the rise of Nazism and ultimately World War 2. Now, other countries have also had sever inflation without having a World War as a result. Inflation makes everything seem more expensive and is particularly hard on those who live on fixed incomes. It certainly makes foreign imports more expensive but makes domestic exports cheaper leading to improvements in the balance of trade. Clearly, the rate of inflation has a lot to do with the ultimate impact. If prices grow at a slow to moderate pace it is not particularly problematic. It would be sudden and rampant inflation that would cause the most disruption. The other factor, is if inflation is expected, people demand higher returns to offset the expected devaluation of the dollar, causing borrowing to get more expensive and driving down the market p/e ratios.

Now, in our current scenario, we have seen the economy contract by about 15% over the last 4 quarters. This drop in demand is what has caused the recent deflation. It seems that the stimulus and cheap money policies may be bearing fruit and demand is starting to increase. However, we know that there is significant slack in the economy related to labor and commodities that would offset any significant inflationary trends.

Now, if the dollar continues to fall internationally, it makes American products cheaper and foreign products more expensive. It is possible that increased exports can reduce the slack in domestic consumption and lead to an increase in production, potentially fueling the inflationary fires.

So what will it be? It seems that we are at the bottom of the price reductions and that as demand starts to increase we may see modest price rises. Of course, it will take awhile for these prices to return to pre-recession levels and if we make significant progress in areas such as renewable, domestic energy sources, we may find the amount of dollars going outside the country significantly reduced. We also know that Americans are saving more, and those savings are reducing the amount of money in actual circulation, just as the increased bank reserves are.

So inflation is not guaranteed. I would like to think that as the economy picks up we take an intelligent approach to deficit reduction and debt retirement. The biggest challenges there include the cost of foreign energy and health care. I am pretty optimistic about both of these and think its time we fixed them.

Thoughts on the economy

Whether you are a student of economics or not, it can be important to know something about wealth. Wealth is accumulated value and all wealth is subjective. You may say feel some things are not subjective (i.e. gold) but the value of gold is dictated by what people are will to pay for it, and we have seen gold go from very high levels to very low levels. Money of course is subject to changes in its valuation and if you are familiar with history, there are many examples, such as the German Wiemar Republic, where money became essentially worthless in a very short time.

The world creates a certain amount of real goods each year (crops, ores, oil, lumber etc.) that can be said to increase the amount of wealth. These basic products are then turned into manufactured goods and value is added to them creating more wealth. Of course the third stage are the services provided to deliver these goods to the market as well as other services.

As nations develop, they usually start as producers of real goods, commodities, which they sell to more developed nations that turn these items into manufactured goods of some sort and provide services. Of course, some commodities require very little intervention to be marketed while others require quite a bit.

The reason all wealth is subjective is because ultimately the value of anything is dictated by demand. It wasn't very long ago that housing in some parts of this country demanded prices that were double what they can be sold for today. In a dollar denominated system, they have lost 50% of their wealth. Of course, if you own one of those houses, you own exactly the same thing you owned previously, and if you don't have a mortgage, you may actually be better off since it is likely your property taxes may be adjusted, but you would feel poorer.

By the same token, the prices we pay for many other items have also decreased as demand has withered and producers are forced to discount items in order to move them. The big danger here is potential deflation. Now the problem with deflation in a credit driven economy is that it leads to debt exceeding perceived value. If I have a $500,000 mortgage on a $750,000 I perceive that I'm doing OK. If the value of that house drops to $400,000, I am now paying the bank more than I believe I should. It makes better economic sense (depending on how you feel about your credit score) to simply walk away and let the bank have the house. Of course doing that makes the loss real, and you may very well feel that over time the value of your house will recover, but that is a gamble of sorts and requires a certain faith in the economy, or at least a belief that inflation will return.

So what is the natural outcome of an economic downturn, where wealth is lost? With or without Government intervention, prices will drop to a point at which demand is restored. Once demand is restored, the economy will stop contracting, and having eliminated the excesses that led to the downturn, it will start to grow once again. How fast it grows depends on many things, but clearly, as demand grows, employment will grow, helping to increase demand further at some rate.

In the bubble years, we had tremendous demand that was based on credit secured by housing wealth and to some extent loose credit policies that encouraged consumer spending. In fact our economy became dependant on consumer spending, and to a large extent the rest of the world is dependant upon our economy being successful. When we saw the housing wealth decline, that spending declined with it.

Now it would seem that in many parts of this country, housing has neared a bottom. However, because of the reduction in demand, we have greatly increased the number of unemployed individuals and reduced their income. Further, even if housing has stabilized (and it may still decline some more) it is not going to suddenly jump in value (at least not everywhere) so that wealth and associated credit needs to be discounted from the market for some time.

An additional factor is that many Americans have now been scared into saving. They have also been scared into safe investments. These investments simply do not create monetary wealth very quickly.

What does this mean? In a very simplistic way it means that the new American economy is going to be smaller than it was. This can be computed simply enough if you make some basic assumptions. For argument's sake, lets assume the amount of disposable income overall remains stable. This plus credit becomes the amount available to spend. Now credit spending unrelated to housing is down from 2008 levels but very close to 2007 levels. However, housing values in this country are down significantly. Ignoring primary mortgages for now, in the 2004 to 2007 period, there was a tremendous amount of refinancing done in order to tap equity. For a while the number of refinancing averaged over 800,000 a month. Currently more refinancing are done to lower interest rates and the numbers were below 200,000 a month. The implications of this should be apparent, consumer spending will increase/decrease year over year based on the following formula, d-s+c+m to d1-s1+c1+m1 where d and d1 equal discretionary income 12 months apart, s and s1 equal savings for those same two points in time c and c1 represent consumer credit and m and m1 equal cash out refinancing. In the best case scenario, m1 current is much lower than m of 2008. Now as time goes on, m1 will become m and the new m1 may actually be higher than current levels. This will create growth in consumer spending but I can't imagine anyone believes that a year from now cash out refinancing will be anything near where they were a year or two ago.

The formulas can be revised to be more precise, but with savings up and cash out refinancing down, the amount of consumer spending will be significantly less than it was, probably around 20%. If nothing else was to change, and consumer spending equals 70 of the economy, we can expect a fairly permanent contraction of 14-15%. That is about the contraction we have experienced which is why we are likely at the bottom of the downturn and starting to recover.

Now, discretionary income is simply not going to increase dramatically and I don't expect home prices to skyrocket either. Consumer credit is likely to increase somewhat as employment increases but realistically it is very hard to see growth in consumer spending going up fast.

Other sources of demand for the economy include exports and this can be an area of significant growth in the future.

One argument against a rapid improvement in the economy is the amount of foreign debt the nation is issuing. Interest payments on foreign debt will require money being removed from the economy and sent to the foreign holders of this debt. Now, this impact can clearly be mitigated to some extent if we improve our balance of payments and get those countries to use that money to buy US goods. Of course, this does not need to be a direct transaction, if China for example buy a lot of commodities from Russia and Russian spend that money on American products, the money does return to us ultimately. A lot of commentators like to discuss the likelihood of Chinese consumerism, and of course if we can sell items directly that will work, but it doesn't really matter if it is direct or indirect if exports can increase enough.

Can the US handle its debt? The answer is that in one way or another we will, the question is how disruptive will managing the debt be. What needs to be remembered is that every year the US produces tremendous wealth in commodities, manufactured goods and services, and this wealth will increase in value as the economy recovers. After WW2 the US had tremendous debt that the country was able to manage and prosper at the same time. To a significant extent that period was fueled by the redevelopment of Europe and Japan. I believe in a few years we will look back and see that the new prosperity was fueled by the development of China and India and the opportunities they will create for this country.