There is great division in opinion about the future of the equities markets. Pessimism seems to have the edge in Alpha-land. This pessimism appears to be based on five critical issues, but each of these can be given a more positive spin. I will address the five issues and provide a more positive spin than usual for each of them. I will also address a sixth issue, which I believe is probably more important and basic than the other five issues: dangerously increasing income inequality.
1. Euro problems will continue to be a problem for some time, is the downside argument. The argument for recession is that the sovereign debt crises and the corollary problems with European (sic America) bank Sovereign debt holdings cannot be effectively resolved by a fractured political system with no clear central authority to act, and even if there were such a central authority this facility would be overwhelmed by the debt of Italy and Spain combined.
1a. Italy and Spain both appear to be taking the political steps necessary to reduce their long-term debt.
1b. The downgrading of Spain and Italy by Fitch is like the downgrade of the USA: it adds no new information to the market.
1c. The imminent collapse of Dexia bank has been quickly, competently and completely addressed. I would suggest the recent rally is based more on the response to Dexia then to the admittedly vague assurances by Olli Rehn, European commissioner for economic affairs. Here, actions speak louder than words. When push comes to shove, Europe can respond effectively.
1d. Bailouts suggest increasing the money supply. Whether this will increase inflation in this instance is questionable, since the "new money created" is roughly equal to "old money that has gone bad." But, insofar as it does fuel inflation, this augers well for both equities and gold.
1e. We all know Greece is going to default. It's accounted for.
2. US GDP continues to falter. Yes, but GDP has been poor for ten years. It notably crashed into very negative territory at the end of the Bush Administration (2009). The positive spin is that since 2009 GDP has been on a pretty good trend, as seen in this chart. There is no reason that the GDP trend of the last two years should predict a recession, at least no more than the trends have for the last ten years. No, GDP is not as robust as anyone would like, but on the other hand it is certainly no worse than it has been for ten years. So changes in American GDP are not a precipitating event.
Other economic indicators suggest our economy is slowly moving forward. The ISM's Purchasing Manager’s Index (PMI) came in at 51.6% last Monday, again beating estimates and again indicating growth in manufacturing. This is the 28th consecutive month the index has demonstrated an expanding manufacturing base. Perhaps not a hugely growing economy, but certainly not one that is heading for recession.
Finally Mr. Buffett claims that freight on the rail lines continues to increase over the last year.
Again, none of this indicates a boom, but neither does it indicate recession. These figures all suggest a slow, steady, ongoing low-level recovery.
3. US Unemployment is still high. Yes, it is. We can all agree that a rate of 9.1% is unacceptable. But most job cuts are actually from the public sector, not the private sector. This is in large part a political issue, not an economic one. It is fueled by Tea-party resistance to Keynesian spending through a downturn. Last week, ADP, the private payroll processor, reported private sector jobs expanded by 91,000 in September. The Labor Department reported 137,000 new jobs in September. And, for what it is worth, last week's Labor report stated seasonally adjusted unemployment claims climbed by only 6,000 for the week of October 1, which was less than expected.
The fact is, unemployment has been high for a number of years now, and despite that corporate profits have been stellar. Apparently our corporations can find an excellent market with the current number of employed households. In fact, the high unemployment rate serves to cap labor expenses, which is good for the bottom line. Wage inflation is non-existent. Commodities are depressed.
Slow, incremental growth is found in the labor market.
4. Housing is down 4.4% year over year. Yes, this is a major problem in industries related to construction and banking. Housing continues to haunt, and foreclosures and downward pressure on prices continues to threaten the value of a great many homes marginally above water.
Housing will not improve until the job situation improves. Jobs will not improve until demand for corporate production improves. Demand for ramping up production will not improve until the lower and middle classes have more money to spend, which will not happen until jobs improve. We know the dismal cycle. Despite this, the bottom line is that (a) the market has already hugely discounted both banks and construction-related industries, (b) that construction and housing makes up a lower percentage of our economy than they did ten years ago, and (c) the economy is doing fine in other areas.
5. U.S. government is paralyzed, many economists predict a recession, and brokerages reduce their year-end estimates for the markets.
Well, political stalemate is a fact if you listen to the pundits. However in fact the current debate has starkly clarified choices for the electorate, and the next election is likely to resolve the 50/50 (or 33/66) gridlock. Politics are fluid.
As for the predictions of economists who look for gloom ahead and brokerage houses that predict a year-end decrease in the equity indices: the history of these two professional groups is that they are “following” indicators, not leading indicators. They revise their predictions upward following increases in economic and equity indices, and they revise downwards following decreases in economic and equity indices. They post-dict more than predict.
6. Income Inequality. I would add this as a 6th issue, and one which I believe underlays the problems of the other five issues. The significance of income inequality is not given sufficient weight in most arguments about our economic wellbeing and the future of the markets. For obvious reasons It is an issue that investors and the wealthy don't like to address, but which is ignored at their own peril.
My view is that our high unemployment results directly from a lack of broad consumer demand, not a lack of available capital. We cannot expect consumer demand to increase when income and wealth are so grotesquely concentrated in the wealthiest few percent. This concentration of wealth is higher than at any time since the start of the great depression, a fact which is not just symbolic but which has real consequences in lowering consumer demand. "The top 1% of Americans control nearly a quarter of all the country's income, the highest share controlled by the top 1% since 1928" (source: The Stanford Center for The Study of Poverty and Inequality). As of 2006, the top 20% control a 61.4% of the country's income. See the article by UCSC Professor Domhoff's for a summary. The economy of our country is developing the hallmarks of a third world economy, and this is in good part because the Reagan/Bush tax code has created structural income and wealth inequality that approaches that found in the third world. While we have had increases in GDP and productivity since Reagan, virtually all of this increased wealth has been concentrated among the upper 20%.
There is lots of capital sloshing around, but it is all sitting on the sidelines. Capital sits frozen and underemployed, sitting in highly concentrated forms in the hands of the wealthy and corporations. Cutting corporate taxes does nothing to create jobs in this situation. Corporations won't invest in new plants until there is more demand, which means more wealth in the hands of the middle and lower classes.
The wealthy might in fact be encouraged to spend more of their wealth (= re-distribute) if they knew their future income/investments would be taxed at a higher rate. There is nothing like a tax on future income to encourage living in the present.
My view is that a structural re-distribution of wealth from the wealthy to the lower and middle classes is essential for unemployment and the economy to improve in the long term. The most efficient way of doing this is the tax code, which is to say return it to the progressive code that was in force for those decades of the 20th century when the middle class blossomed.
Government stimuli in the Keynesian tradition such as the current Obama jobs proposal may be helpful stopgaps, but they are inefficient and totally insufficient for the kind of structural re-distribution of wealth that is needed for a healthy economy. Such stimuli are required with increasing frequency because our increasing structural income inequality chronically and increasingly dampens demand by limiting the spending of the lower and middle classes.
The five commonly argued positions supporting a pessimistic view of the market can all be given a positive spin, and are not as dire as often touted. Some are clearly influenced by policitics as much as underlaying economics. The sixth issue, which I raise, is more problematic. Can I put a positive or hopeful spin that the issue of our grotesque income and wealth inequality can be resolved? Well, that is difficult. We'll see where the next election cycle leads.