More economic meanderings

Economic recovery is tied to increased income. Probably it is more accurate to say that it is tied to disposable income, since income that is consumed by fixed expenses doesn't have much of an impact. Now, in the years of the housing boom, a lot of "income" was related to increase in house valuation, to the extent that Americans were willing to borrow either directly or indirectly against their home valuations.

When prices stopped going up and in fact reversed course, this income disappeared and the cost of the borrowing remained. This led to a tremendous decrease in disposable income and in fact many Americans found themselves unable to pay fixed expenses let alone have disposable income.

Now, this loss of income characterized by the loss of housing wealth led to the steep recession, joblessness and the decline in the stock market. Of course, not everyone was impacted but certainly enough people were to cause a tremendous reduction in demand across the board. This reduction in demand led to deflation in many areas and may still have that impact.

One of the biggest impacts was the tremendous decline in the money supply. Now, when I say money supply, the amount of money actually created by the Federal Government is only the tip of the iceberg. The money used to make loans multiplies the amount of money in the system since the capital reserves are only a percentage of the amount loaned. If a deposit of $1 allows you to lend $10, you have effectively multiplied the money in use by a factor of 10.

As banks started to lose money and stopped making loans, we saw a tremendous decrease in the money supply and a corresponding decrease in prices. As the Government attempted to combat this by in effect creating money by borrowing and making this new money available, it also raised reserve requirements for banks. The measure of the money supply that includes all the bank lending is referred to as M3 and is no longer published by the US Government. However, it is still estimated by a number of economic sites and is not increasing. It is still tracked in Europe where it has been declining.

If M3 is stagnant or decreasing, the risk is hardly inflation, it is deflation. Of course, there is a simple argument that the banks could increase M3 very quickly by increasing credit. However, it seems unlikely in the current environment that they will do that very quickly.

It would seem that many of the jobs that existed just two years ago are very unlikely to come back in the same areas. However, if we can get domestic and renewable energy projects going, that job growth can help significantly. Further, we should be engaging in much more infrastructure repair than we are. Finally, we need to reduce the cost of doing business in this country, by changing our tax system and reforming health care.

Market Valuation

As we are seeing more earnings data, the S&P 500 is somewhat expensive based on current earnings, but right in line if you think about next year earnings. Now, obviously, next year earnings are an estimate and therefore risky, but as we see most companies beating the estimates on current earnings, the better productivity coupled with any increase in revenue based on improved economic conditions will probably meant that the 2010 estimates are too low.

While we can certainly expect to see hesitancy in the rise of the S&P to levels above 1200, barring some significant unknown economic event, it is a highly probable outcome. Some areas of the economy are still weak and will remain that way for awhile, but these are known risks and as the Government actually takes action to increase jobs, as it will with an election coming up next year, we will see increased demand, increased revenue and increased profitability.

Whether the Government will be smart enough to turn the 2010 stimulated boom into a longer term self sustaining recovery with sustainable growth depends on how fast they increase usage of domestic and renewable resources, reduce the health care cost burden and reform the tax system.

Health costs and employment

While earnings have been improving we have not yet seen a significant increase in hiring. While inevitably, hiring will resume, the simple fact is that man industries that just went through painful layoffs will use that opportunity to implement permanent productivity increases that will result in a smaller need for employees.

Further, we unfortunately have many incentives to outsource jobs to other countries. One of the biggest of these is the excessive health care costs we have in this country. Now, health care reform is partly based on reducing these costs but if we do expand coverage, this will lead to increased demand and that normally leads to increased prices.

Clearly, we need some reforms designed to control cost increases in health care delivery and drug costs in this country. These reductions should not be related to reduction in beneficial health care but should be focused on elimination of waste to include unnecessary tests and procedures. Now, in each case the doctor patient role should not be precluded but we need to eliminate some of the fear of malpractice that leads to doctor's ordering tests that are not medically necessary.

It is certainly not desired to excuse doctors who are negligent, but we do need to reform the process which drives up the cost for malpractice insurance because of a pre-disposition to equate the performance of every conceivable test to good medical practice.

Ethical behavior

If you read Plato you may recall the question he poses concerning a magic ring of invisibility. The question can be summarized as follows, if you could do whatever you wanted to do without the danger of being caught, would you have any reason to be ethical or moral?

The question gets to the root of a human dilemma, is being "good" something that we should do or is the ultimate goal to "take care of number 1"? Now remember, this is pre-christian and the ancient Greek view of the afterlife was not the same as our current views. Further, if you really want to think about the question, getting caught by God would make it irrelevant.

So, giving no real fear of retribution, would most of us behave well, meaning not taking unfair advantage of our fellows. Unfortunately, based on recent headlines and events, it would seem many of the people in the financial industry are clearly on the side that says, get away with whatever you can. Now, I don't mean to pick on the financial world, but we see more examples there where unscrupulous people took advantage of people who for had no way of discovering their wrongdoing.

Of course it is probably unfair to focus on the highly publicized cases, but in an industry that relies on making trades where generally there has to be a winner and a loser, we probably cultivate some of the most cut throat behavior possible. It is also clear that some of the players are going to have an advantage for legitimate reasons. However, how do we control the unscrupulous players?

If you consider the financial world, there have been many safeguards designed in by the markets themselves. However, many of these self-regulating rules are not as effective as they once were as the old methods have changed due to changes in technology. In fact, one big issue that needs to be restored is trust. There are many, many people who simply don't trust the financial industry.

Government has to be part of the answer, but it can't be the complete answer. Government will never be big enough or capable enough to prevent abuse, it is more appropriate for it to punish abusers who get caught.

The financial industry needs to do what it needs to do to reform itself. This has to take into consideration that public trust is important, not just because of the amount of money that retail investors invest, but because public perception will lead to onerous Government intervention, and we know that can't come out well.

Risk taking

Success in any endeavor has many components, including hard work, intelligence, initiative and what may be best characterized as luck. Sometimes you can be successful and only employ one or two of these and if for example you simply stumble into a situation that leads to success. If for example you invested in Micro Soft because you happened to know someone associated with the founders in the early days, you may have made a fortune simply because you knew someone and maybe invested some money as a favor, even if you had no real conviction. This would be similar to someone winning a lottery. However, that sort of thing simply can not be counted on and if it happens, god bless, but a more reliable method is to employ hard work and intelligence.

Now intelligence is to some extent the result of hard work and it can be innate or purchased. By this I mean, you can certainly pay for advisers or sift through various sources of information to acquire intelligence in a particular area. Similarly, you can learn a skill that may enable you to be successful. Obviously, I am not using intelligence here to refer to potential knowledge but to actual knowledge gained.

So ultimately, you can use hard work to garner intelligence. You also have to act on your intelligence. This is initiative. If someone has acquired knowledge that indicates a potential trend or movement but fails to act, it is the same as not having the knowledge at all. This is initiative that may also be characterized as risk taking. The amount of risk that you are willing to tolerate often predicts the potential success you may enjoy.

Now this is where some of the most confusion arises. You often hear that you need to take some risk in order to enjoy significant success. However, just taking risk is not enough. For example, if you note that a particular stock for a well know company has dropped tremendously and buy it thinking it will recover, you have taken risk. If you have not acquired enough knowledge to support that conclusion you are likely to be wrong and lose the money you have invested. Now, not always, but this type of uniformed risk taking is, well very very risky.

However risk coupled with intelligence acquired via hard work can be a tremendously successful combination.

Price pressure

One of the things that seems to have changed is the sensitivity of the consumer for goods and services to changes in price. While obviously, price was always a factor in making decisions about whether to buy something or not, when demand was higher, it wasn't the main factor since many consumers felt the desired product or service might get more expensive or become unavailable if they didn't make a quick decision.

As demand fell off a cliff last year and prices plummeted, consumer's have taken a different attitude, feeling that the product or service will be available and that there is stronger likelihood that it will be cheaper if they wait. This change in sentiment is clearly going to put pressure on businesses and you see things like Coach coming out with a more affordable line of product to cater to the new consumer.

This attitude is also impacting the length of time products remain in use. Where many people felt that they needed to get a new car every few years, many are now postponing that decision and driving slightly older cars. This had led to a shortage in the used car markets. Now, I sometimes see this change characterized as a switch to cheaper products, such as store brands. However, while some of that has happened, it is more accurate that consumers want the products they have been used to buying at a lower price point.

Brands that in the past tried to maintain certain price levels are being put under a lot of pressure to provide consumers with deal. Of course, we have seen how business has been able to restore profitability by cutting costs. I believe it will be quite a while before prices will go back to what they were, since consumers have learned they can demand better value for their dollar.

This is flowing down the supply chain. I hear analysts talking about the risk of inflation as the dollar declines and things like foreign oil go up in price. However, companies that try to pass increased costs through to the consumer are going to have a hard time of it. I believe they will be spurred to find cheaper alternatives or ways to reduce costs in other areas to maintain low prices.

With all the extra capacity we have, inflation is a very unlikely event for at least two years, if not longer. In fact, deflation is still a more likely scenario.

Future economy

It is getting harder and harder for those who think the economy is not actually getting better to find evidence to support that opinion. While there are still issues in the economy related to home mortgages, commercial real estate, and unemployment, business has now factored in those things and adjusted their overall business models to handle a lower level of overall activity.

The companies that did this the best are making profits that exceed the estimates and indicate that they can be successful in the current and future economy. Consumer spending will probably not return to levels that existed during the bubble, but it doesn't need to. In fact, the fact that we have excess capacity and room to grow withing prior limits will limit inflation and put the overall economy on a better footing.

If consumer spending drops 15% and represented 70% of the economy, it would reduce GDP by 10.5%. Now we have seen this reduction and if consumer spending goes from 70% to about 66% of the economy, that difference can easily be made up over time by development of alternative energy and exports.

If you really look at the numbers, we are moving into a healthier economy than we just left and with the change will be able to reduce our balance of payment issues and start to absorb more of our own debt.

There are very healthy long term trends emerging and while we can expect some bumps in the road, the country is far from Armageddon.