When I got into the investment business 23 years ago, a very wise man told me that my job as an advisor was to find clouds when everyone else saw nothing but sunshine and to find the rays of hope when everyone else was hunkered under an umbrella. Markets and economies move in cycles, and while it is impossible to predict the exact turning points, they always come and it is the advisor's job to remind everyone of that simple fact of our economic life. So, when I write these weekly commentaries I always have in the back of my mind whether I should be looking for sunshine or clouds.
Over the last year, I've been looking for clouds in what turned out to be a very sunny period for the market. Despite turning in some pretty good performance for our clients, Alhambra and I are starting to be accused of being permabears. I suppose for some people a year is a long time, but in the investment arena a year is a mere blip when we are investing for goals that might be decades in the future.
So today I want to talk about the long term problems I see facing our economy - and therefore our markets - and why I think you need to be preparing your portfolios for the inevitable reversal, rather than trying to capture every last basis point of return in an aging bull market. I want to emphasize that my concerns do not mean that we are sitting in cash doing nothing, fretting about the end of the world as we know it. We continue to find interesting investment opportunities around the world and when we find them, we make them. But it is increasingly hard to find those opportunities and we do not reduce our standards just because the market has gone up and may continue to do so.
Over the long term, economic growth of a country is a function of population growth - or more specifically workforce growth - and productivity growth. More people working and producing more per person is the only way to produce real growth that benefits a wide swath of the country's population. It is the interaction of these two forces that improves living standards over the long term. In the U.S., we long benefited from positive trends in both. The workforce started expanding in the 1970s as more women joined the paid sectors of the economy, and starting in the 1980s we saw a steady increase in productivity. During the 1990s, the emergence of the internet and other new technologies produced a large productivity gain that was nothing short of a revolution. We faced a lot of problems through the 80s and 90s, but the strength of the trends in the workforce and productivity overwhelmed them to produce a steady gain in living standards that benefited most everyone. (I do not want to get into a debate about inequality here. I am aware that the gains were not evenly spread but in general the rising tide lifted all-- or at least most-- boats.)
The biggest problem I see facing the U.S. economy is that both of these long term trends are in danger. We can and do discuss the reasons for this, but the fact is that no one has all the answers or even all the facts and there are no magic policy bullets that will return us to the rising trends that prevailed in the past. All we can really do is observe the trends and incorporate them into our investment process.
What we observe today is that population growth has slowed to rates last seen in the Great Depression and that the workforce has, at a minimum, stopped growing. We saw this in the latest employment report released last Friday. The unemployment rate dropped to 6.7% but that was mostly due to a drop in the labor force of 347,000 while employment rose only 143,000 (those figures are from the household survey). It is easy to dismiss this as one report and I noted a large number of articles in the financial press this weekend urging you to do just that, but these are not new trends. The workforce dropped over the last year and the participation rate has been falling since before the Great Recession.
There are any number of reasons why the workforce may have stopped expanding and the participation rate has fallen but for an investor, the reasons are really irrelevant. The fact is that what was a tailwind for growth in the 80s and 90s has now turned into a headwind. A stagnant - at best - workforce means that the only means of growth is through rising productivity. If the workforce is shrinking - as it has over the last year - productivity must rise enough to offset the loss before it can even begin to contribute to growth. In the short term, the GDP growth rate may not reflect this exactly but in the long term it must-- and as an investor it is the long term that concerns me the most.
Productivity growth, unfortunately, is also on the wane. In the third quarter of 2013 productivity grew at a 0.3% year over year rate. The quarter to quarter rate did rise to 3% and if that were maintained, it would return us to the rates we saw in the late 90s, but there are plenty of reasons to doubt the durability of that one quarter spurt. Much of the gain in GDP for that quarter was due to a rise in inventories and the most recent wholesale inventory report is not encouraging. The headline numbers showed a rise of 0.5% in inventories and a 1% gain in sales, but the details were more disturbing. Inventories of durable goods rose relative to sales and the non durables were skewed by a large draw in petroleum inventory. If, as we saw last year, inventories are drawn down in the first half of the year, the rise in productivity will disappear.
And like the workforce problems, the trend in productivity is not a new one. In the past three years, productivity growth has averaged just 0.7% per year versus the near 3% rates achieved in the late 90s. Like the workforce stagnation, a lot of reasons have been offered for the slow down in productivity growth but, again, the reasons are irrelevant from an investor's perspective. Productivity rises because of innovation and investment and while true innovation is almost impossible to measure, investment is not and the rate of investment has fallen from 4.8% from 1980 to 2000 to just 2.8% over the last 10 years. I believe a large part of that is due to the policies of the Federal Reserve and a weak dollar policy at the Treasury, but whatever the reason, observing the existing trend is enough to concern me as an investor.
In the relative short term - say a few years - these long term trends may not matter that much. With Federal Reserve interventions and distortions along with a government that continues to spend more than it takes in, stock prices have risen from levels that were overly depressed in 2009 to levels today that are likely too optimistic given the longer term trends. In 2009 we believed that stocks were priced based on a view of the future that was too pessimistic and we were bullish. We stayed that way through most of 2012 but decided last year that stocks were becoming priced based on a view that was too optimistic given the current trends. We started looking for clouds on that blue horizon everyone else was seeing, and of course we've found them. In short, we are bears but we are far from permabears. When the pendulum swings again - and it always does - and the consensus becomes too pessimistic, we'll be looking for the silver linings.
I want to end this by saying that I don't think these trends are permanent. I believe the trends in workforce participation and productivity growth will eventually reverse and that creating the necessary environment for that to happen is not mysterious, or even that difficult to implement. It will take some political courage, something that has been lacking in our "leaders" for quite a long time, but Americans always find a way to overcome.
I don't buy the currently fashionable opinion that American innovation has hit some kind of long term wall. There are, even today, innovations happening in American labs and research departments that will amaze us in the future, just as they have in the past. And I don't think we've become a nation of slackers who don't want to work. We may need to change some incentives and we may need to squash some bad economic ideas - again - but most of what I see from the younger generations gives me a lot of hope for the future. But for now, with everyone jumping on the economic optimism bandwagon and bulls running rampant, it is my job to look for the clouds that could rain on the parade. I don't want to be caught without an umbrella - or a cash reserve.