I have long advocated a cautious stance within the current investment universe. Stock prices did not properly reflect the existence of unsustainable practices and imbalances in the economy. But now, stocks are down sharply from their peaks, and the people who were touting stocks last year have been replaced by a new league of doomsayers. The fear is that companies and fixed assets will be useless after a systemic financial collapse, and stock prices now actually reflect this fear.
Well, I don't buy into the logic, and I am buying heavily into stocks instead. Simple economic knowledge will suffice. Economics is after all the study of labor. Every year, laborers work, build, and gather resources to create the national product.
Now every year in a closed system, it would be nearly impossible to consume more than you produce. Why? Because in order to do that, you would have to be able to liquidate capital (accumulated labor) in order to consume more today. And frankly, I can't think of many assets that can be liquidated and then turned into immediate consumption, and I don't think anyone can give an example of that happening on a large scale. You don't look at a factory from the potential to boil it down and consume its steel somewhere else. That is highly nonsensical for almost any kind of investment.
Rather, the general sense is that every year, you have a level of production. Most of that is consumed, and then some amount of labor goes to capital accumulation- building investments for the future. The general trend is that labor is accumulating in the world in the form of capital, meaning that every year people have more fixed assets to deal with and so can become more productive and consume more, as times goes on.
What could break this trend? I've identified three things.
-One I mentioned just previously- if the economy liquidated capital for present consumption. That is relatively hard to do for reasons explained.
-The second would be a temporary inefficient allocation of capital and labor. (Say for example, building a large call center and hiring a bunch of people to recklessly lend money. Or, massively over-investing in telecom and internet technology). These can not last too long because eventually reality hits and the bad investments cease to be profitable.
-Third would be imbalances between the units of the economy. For example, if the rich take too large a share of the value of production, then 1) workers won't have enough money to consume what is produced, and 2) the rich will have too much money and have nothing better to do with it then say... lend it recklessly for people to spend. Although this would be labeled investment, in reality is the finance of another's consumption. And that is a shaky investment proposition.
Both two and three have occurred, both in the global scene and the US. The rich have become to rich. And an entire infrastructure has subsequently been built around lending that money out recklessly. I find this chart to be no mere coincidence.
Yet it is important to keep these matters in perspective. There is potential for some loss of growth, but how much? I'll analyze the three risks from the standpoint of the US.
1) Consuming More than Production- unfortunately, the US is not a closed system. Every year, we import more than we export to the tune of 5% of GDP. Although it is not encouraging, it is tough to worry too much about it. After all, we are investing at the same time at over 20% of GDP. And total foreign debt amounts to 5 trillion, or maybe 250 billion in interest payments a year- That is definitely manageable in a 13 trillion annual economy.
2) Liquidating Inefficiencies- The financial sector was a bubble. An entire infrastructure was built around lending money recklessly and booking massive fake profits. At one point, financial profits made up 40% of S&P earnings. Yet still, this is also manageable. Finance as a whole employed 7 million people, or about 6% of the population. Some of that was wasteful, but many of those jobs are necessary. And most of the grossly reckless practices of the bubble days have now ceased to exist.
Meanwhile, it is hard to convince me that investments made in other sectors were bubbles as well. After all, the mere fact that people would choose to consume them given enough money is proof enough that given a little more income, these jobs and these investments would be profitable again. Rather, it points to the imbalance in the distribution of wealth, which embodies the next point.
3) System Imbalances- This touches at the heart of the problem, and it will also be the hardest to fix. There exists an imbalance between investment and consumption in the economy, with there being too much of the former. As you accumulate too much investment, the potential returns diminish; they can even be money losing propositions. Well, that appears to be exactly what is happening today, as large concentrations of wealth (what Keynes would call sink funds) have invested too much money, recklessly, in the financial sector (one of the easiest sectors to do that in). Think of economic actors such as China. Now, the correction must take effect. In a simpler world, the process would balance itself. They would invest recklessly, the returns on projects would be negative, they would lose wealth at the expense of their workers and their customers, and then things would return to a more correct level and the process would continue from there. Unfortunately, the real world is not so lucky. As this starts to happen, they panic. They throw all logic out the window and flee into anything that will protect their wealth- either cash or treasury bonds. Look at yields on short term treasuries today and they are barely half a percent annually. This has begun.
The good news is this is correctable. If the economy was producing at this level before, it can be maintained with a more equitable distribution of investment and consumption. What you need to do is let investors take losses, but also have government step in wherever it can to ensure confidence. Today, there are several things we must see. We need government to step in and invest in the financial sector, in return for equity participation in a brighter future. We need losses to be taken in stocks and bonds to correct imbalances, but we also need confidence restored for investing in the business. The government should take on debt to promote investment, taking advantage of the extremely low yields which they can now borrow at. Finally, it should tax the lower class less and tax the rich more to correct the current imbalances. Largely, this appears to me to be what the government has been doing.
So where does that leave you, the individual investor? Well today, stocks represent a huge discount to any type of scenario in which the world economy exists 5, 10 years from now. Yes, the rate of return on capital has been inflated, meaning recent profits are likely a bad representation of reality. But global growth will continue, and earnings will return one day. In the meantime, an investor today doesn't face much competition in terms of yield. For the first time in several decades, stock dividends now offer a higher yield than treasuries (whose yields have plummeted), and that is a major buying signal. Many companies are trading below any type of value based on replacement cost, or on earnings power in a normalized environment. An investor who can identify businesses which:
1) provide real value,
2) which will be around for the next 50 years,
3) have some forms of competitive advantages, and
4) are prudently financed
will find the prices on stocks today to be very attractive. Stock investors with long term time horizons will find significant bargains and returns in purchasing at today's stock levels.