I've mentioned several times recently that within Alhambra we often have vigorous debates about the economy and markets. I'm a big believer in the power of competition to improve outcomes whether we are talking about the macro economy or the micro debates about portfolio strategy in which we engage. The debates we have internally are a form of intellectual competition, a battle of ideas. But for these debates to be fruitful, the participants need to be open to ideas that challenge their worldview. We are all guilty of bias in our thinking and our debates are intended to make us think about those biases. Doug Terry is the real instigator of these debates, setting aside blocks of time each week to have wide ranging discussions with all the members of our team.
In our talk last week, Doug brought up an interesting idea. We often look to history, searching for analogs, similar periods in market history that might inform us about the present. Doug put forth the idea that while everyone is talking about the similarities of the current period to 1999 and 2007 maybe we ought to be thinking about whether today is more similar to 1994, when the US was on the verge of an epic boom, in stocks and productivity enhancing technology - the rise of the internet. I've spent the long weekend thinking about the topic and while I'm skeptical of the idea, it is far from the open and shut case it first seems.
My first inclination was to look at valuations - we are ultimately talking about the effect on the stock market - and point out that valuations in 1994 were quite a bit lower than today. It is interesting that we seem to remember things the way we want and what I found in looking at valuations is that while they were lower in 1994 the differences were not as great as one might think. The Shiller P/E was 20.55 versus today's 26.3. Other measures we find helpful in predicting future returns - Q Ratio, Price to sales ratios, etc. - were also somewhat lower then but valuations were certainly no bargain in 1994 when compared with history. In fact, I could have made a very cogent bearish argument using valuations that year.
Where I did find a significant difference is in economic growth rates. In 1994, like today, we were a few years removed from recession - one also caused by a banking crisis, the S&L crisis - but the recovery from that recession was quite a bit more robust than today. The year over year growth in real GDP by Q3 1994 was well over 4%. Growth did slow in 1995 but it only fell to roughly 2.5% or about the same as today. What we see when we look at a chart of year over year GDP growth rates is that the recovery in the mid 90s saw its valleys match today's peaks:
So we had a much more robust economic recovery from the early 90s recession than the more severe downturn in 2008. That is something Jeff Snider has been harping on for some time now, that given the depth of the downturn we should have seen a more symmetric recovery. I would argue that a major difference comes from how we handled the S&L crisis versus the more recent version. In the early 90s episode it seems we were much more tolerant of losses as the bad investments were largely liquidated through the RTC. But that is frankly a guess and certainly the productivity gains from the rise of the internet were a major factor. Whatever the reason, there is no doubt that the economic recovery from recession this time around has been much more subdued.
Another major difference between the mid 90s and today is debt. Debt had been rising for over a decade by 1994 from around 1.5 times GDP in 1981 to 2.4 times GDP by the beginning of 1994. Obviously, monetary policy played a large role in that debt accumulation as interest rates fell precipitously during that time. And though I'm sure it seemed unlikely at the time, we were about to go on one of the great debt fueled spending sprees of all time. By March of 2009 our total debt had reached 3.85 times GDP. We like to remember the late 90s as a period of innovation and great economic growth but the fact is that much like the 80s, economic growth was fueled to an unhealthy degree by debt accumulation.
And that, in a way, brings us back to the valuation debate. That debate - and the inequality debate to some degree - is about profit margins. Bulls argue that profit margins are high and have been on a secular rise - interrupted only briefly by recessions - since the mid 90s and are not about to mean revert absent a recession that they argue is a long way off. Bears argue that the rise in margins is unsustainable and will fall back to the historical mean. If the bulls are right, we are in a secular bull market and there is much more to go on the upside for stocks. High profit margins and - with low interest rates as far as the eye can see - multiple expansion could lead us to late 90s style valuations. If the bears are right, the downside risk to stock prices from mean reverting margins is extreme, on the order of 40 or 50%.
While I agree with the bulls that profit margins have been rising over time - that is merely a matter of observation and not subject to much interpretation - I agree with the bears that the reasons for it are not sustainable. Rising profit margins over the last 15 years or so should not, in my opinion, be taken as good news. The decades since the 80s have seen a rise in financial engineering, mergers and stock buybacks concentrating industries among a few large companies and fewer shareholders. In a highly competitive, capitalist system, high profit margins do not persist; they are competed away. That is what rising profit margins represent more than anything - a reduction in dynamism in our economy, a suppression of competition. Crony capitalism, as it has come to be called, is great for incumbent firms - and therefore the stocks which represent those incumbents - but it has a limit that I believe we are rapidly approaching. The recent push for higher minimum wages is a natural reaction to those higher margins and I suspect only the opening salvo in a backlash against a system that is no longer viewed as fair.
How those profit margins will mean revert - and especially when - is a matter for debate but that they will ultimately revert is not only something that will happen but for the health of our society must. High and rising profit margins are evidence of dysfunction but they are also merely symptoms of a much larger problem. The cause of rising margins is complicated but I would argue that the major factor has been the increasingly hyperactive monetary policy that started with the Greenspan era. There are certainly other causes - changes in laws about stock buybacks, changes in executive compensation, etc. - but monetary policy has systematically and artificially reduced the cost of capital for decades and it shouldn't be surprising that the margins generated have been higher and at the cost - to some degree - of labor. It is disappointing that the backlash against those higher margins has concentrated on the symptoms rather than the causes but over time margins will be pushed down by hook or crook. Populist politics are a natural outcome of our poor economic policies.
From a long-term perspective the problem with our high and rising margins is that they have been produced at the cost of future productivity. The rise of financial engineering has coincided with a reduction in investment and over time that has eroded productivity growth. Innovation is the true engine of future economic growth and we have spent the last three decades eating our seed corn, rearranging and redistributing the fruits of past investments. The US is still the most innovative country on the planet but we have saved and invested too little to return to or sustain the growth rates we enjoyed in past decades.
That isn't to say that we aren't innovating. Innovation is something that happens regardless of economic policy, a result of human curiosity and the desire for improvement. Even during the Great Depression, the US saw a wave of innovation. The electric razor, supermarkets, photocopying (xerography), fluorescent lights, nylon and neoprene, television, cellophane tape, chocolate chip cookies and a host of other innovations all came to market in the 1930s. Today we see innovations in biotechnology, communications, materials sciences, energy and many other areas that will benefit us for decades to come. But where would we be if we were still investing on the scale we have in the past, if productivity enhancing innovation was more important than financial innovation?
I don't reject the idea that today may be similar to 1994 completely. It is certainly possible that we will once again see stock market valuations on par with what we observed in the late 1990s. One sign pointing in that direction is the rising value of the dollar (thanks JET) just as it did in the late 90s. A rising dollar is a positive sign that should not be minimized and certainly not ignored. A rising currency is generally a vote of confidence in the future and tends to shift investment from real assets (investments in the past such as oil production) to more intangibles (investments in the future; R&D, stocks). The reason for the rise is important as we found out in 2008 - when a rapidly rising dollar was about risk aversion - but generally a rising dollar is a good sign for future growth. I'm just a bit wary of whether it is sustainable since it is really a function of how bad the rest of the world is doing rather than that the US is so very desirable.
All in all, I reject both the secular stagnation and the impending boom theses. The recent rise in the savings rate, while small, is a good sign for the future if not for present GDP growth. Increased savings - delayed consumption - are the seeds of future investment and innovation. I am also encouraged by the rising dollar which will ultimately favor innovative investments over ones that seek to maintain purchasing power. I am less encouraged by regulatory and fiscal policy which seems to concentrate more than anything on resisting the changes that are necessary to our future prosperity. Regulatory capture is real, impeding progress and reducing competition. Fiscal policies that erode the work ethic seem compassionate in the short term but have real long-term consequences. The US economy has an amazing ability to adapt to its circumstances and I have no doubt we will overcome the current obstacles to growth. The only real question is when and how.