My friend at Shareholders Unite, whom I respect greatly, has written an article advertising a new secular bull market in U.S. equities. His reasons are basically that (1) household balance sheets are being repaired, (2) China's wages have become less competitive, (3) robotics and other automation are making the U.S. more competitive, (4) less expensive natural gas and oil are giving the U.S. an energy advantage over its competitors, and (5) America's demographic forecast is better than the forecasts for Europe, China and Japan in that America's population is expected to grow rather than to shrink over the next 30-40 years.
Perhaps my friend is correct-eventually. But eventually could be a long time, and I see a number of countervailing factors that make me think that before the secular bull begins, we will have another significant downturn for U.S. stocks in the fairly near future, perhaps in the 20% range. The reason is that I believe the stock market has been running on psychological fumes rather than fundamentals for about the last two years. With a "riskless rate" of zero, the stock market looks like a reasonable alternative. At least it has a potential upside to go along with the attendant risk. And the series of QEs and Twists have made it psychologically attractive to believe that the Fed is helping the stock market-and "Don't fight the Fed."
All that has created a market that is significantly ahead of its fundamentals. And a market that has been fuelled by psychology is highly likely to suffer a significant reversal when the psychology reverses.
There also are some significant headwinds for the U.S economy, most of which are well-known but that bear enumerating anyway.
(1) Within a few years, Medicare entitlements will become a significant burden on younger generations unless costs are reduced. That is an emotional issue that could well create significant inter-generational strife as well as hold back the economy. The known solutions involve rationing medical care at the end of life-a most controversial subject.
(2) Pension funds, both public and private, are significantly underfunded, and that underfunding is becoming worse because at a zero riskless rate, these institutions are either foregoing the income on which their projections of relative solvency are based or going out on the risk curve which, unless this time is different, will result in losses that will make the apparent income illusory. Re-funding those institutions will be a drag on the economy.
(3) There is considerable debate as to whether the Luddite Fallacy is still a fallacy; that is, as to whether new technology will continue to create as many jobs as it replaces. Frankly, I have my doubts as to whether the new technologies will create as many jobs as they replace. Just as important, however, is the question of whether the new jobs will be good jobs-or will they be, instead, jobs as gardeners for the people who invent the technologies? And from the point of view of America, will the new jobs be in the U.S. or abroad where others may have a comparative advantage of some kind in producing, for example, robots?
(4) Although China's wages have climbed significantly, other Asian countries' wages have not done so yet. Therefore those other countries remain competitive in areas of production where cheap labor has an advantage. Just as important, both China and India have emphasized education, and both have growing numbers of technologically educated people that will make those countries competitive with the U.S. in fields where technical education is important. Continuing improvements in communications and software are making it possible to utilize workers from the other side of the world almost as if they were across the street.
(5) What is making the problem worse for U.S. workers is the fact that many Americans are not getting world-class educations. Many factors are to blame for this, and most of them appear to be quite intractable, at least in the short term. The most basic problem is that at the lower end of the economic scale, parents either do not know how to prepare their children for school or do not have time to do so. Then, once in school, the same problem continues to haunt the children. The well-off, mostly college-educated, by contrast, lavish time and money on their children, which tends to entrench inequality. This situation has been made worse in recent years by the prevalence of out-of-wedlock births among what once was the middle class. These children grow up in one-parent households, often with women who have foregone their own education in order to have them. The feckless men seem to be uninterested, and the women seem often to be glad to be rid of them. Even good schools have a hard time getting these kids up to global speed. Teachers unions do not help, either. They tend to entrench poor teachers, and the resulting behavioral problems make learning doubly hard. For these reasons, a large part of Americans are not-and their children are not likely to be-capable of competing globally. Will this new American demographic change? Not soon, I fear, because hardly anyone sees anything wrong with it. Liberals think single motherhood is just fine. Conservatives with money rail against it. But ordinary folk think that's just what life is in the modern world. "Don't persecute these poor single parents, please. They have a right to make their lifestyle choice." That is the prevailing (wrong, in my view) attitude.
(6) To some extent, greater Federal government involvement in education could help. But it is unlikely to be forthcoming because neither party makes a distinction between government investment and government spending. And that brings us to the fiscal cliff. I am afraid that bad things may happen. If Romney wins the presidency, the Republicans will have power and will force the country to commit economic hari kari. If President Obama wins, the Republicans will be angry, and they will commit political hari kari. In either event, there will be an economic mess that will impede solution of the various problems outlined above.
(7) Europe and China are not about to be the saviors of the American economy. Neither the European nor the Chinese economy is strong enough at this time to become the engine for American growth.
(8) The boom in consumer spending of the mid-to-late 1990s was funded substantially by home equity extraction. The annual amount in the 1990s was about $50 billion. That soared to the hundreds of billions in the mid-2000s. That kind of borrowing is not going to repeat itself until everyone has forgotten about it-more than 20 years is the usual forgetting time. Therefore only job and earnings growth will increase final demand. Where will they come from? Home building is on the rise at the moment, but without sound household formation, it is unlikely to boom in the near future. Nor is there likely to be a significant wealth effect from the next 10-15% appreciation in home prices-even assuming that occurs over the next couple of years-because so many homes have negative equity at the present time.
(9) The coming energy revolution will indeed create opportunities. And cheaper energy will be good for all economies except those that depend on oil sales. But how cheaper energy will affect the level of U.S. industry is, I think, hard to predict. For example, an industry that consumes large amounts of fossil fuel still emits a lot of pollutants. How much dirty new industry will Americans accept? As another example, the price of oil is much the same all over the world, since transportation accounts for a relatively small part of the cost. Abundant oil in the U.S. therefore is likely to lead to lower prices for all users. The U.S. balance of trade will benefit greatly from reduced imports of petroleum and increased exports of petroleum products. But to what extent will that increase job opportunities above the opportunities that fracking etc. already have provided? Cheaper energy could indeed change many things for the better, but that is likely to take quite a few years.
(10) Both American political parties are intellectually bankrupt. I would derive no encouragement from either one being in power. I do not mean to paint every politician with that brush. There are some good ones; but the party ideologies make the good ones strangers in their own lands.
Obviously, I could go on-and on and on-some readers will think I already have gone on and on-about these social and economic problems, but ten items are sufficient. The problems are soluble over a period of time such as 10 or 20 years. But I do not think they will be solved-or even substantially ameliorated-in a few years. Therefore American underemployment (unemployment plus those who have been discouraged and no longer seek work) will, I believe, continue to be a substantial drag for at least the next decade. And with continued underemployment, I do not see how a new secular bull market can build itself. Many corporations will perform well in global commerce, and their stocks will perform well as a consequence. Many of the companies that perform well will be American in origin, but they are likely to be global in fact. Other companies that do not perform well in the global marketplace are likely to languish, unless they are in niche businesses, like supplying linens to hospitals-see, e.g., the overpriced small cap star Healthcare Services Group (HCSG)-where there is little domestic competition and foreigners cannot compete.
I am not forecasting complete doom and gloom. The U.S. economy is likely to muddle through despite the follies of the political class simply because most Americans are motivated to succeed economically. But I do not see the foundation for a great bull market at this time.
Like my prediction for the U.S. economy, I am trying to muddle through. I am still an equity investor. As I told a friend at the house we rented in France a few weeks ago, I would not have had the money to be there if I had not been an equity investor. But for the present time, I have dialed it back a little and hold a fair amount of cash. I am not in index funds, such as SPY and I am in some bearish finds such as SPXU. If I am correct, there will be an investment opportunity in the next year or so. But I still expect the homebuilders to make profits, so I am still in ITB.
Earlier in the year, I recommended three European banks as possible, though risky investments for the medium term. The medium term has come. Credit Agricole (CRARY.PK) and Societe Generale (SCGLY.PK) both went down quite substantially after my recommendation. For my part, I added to the positions on the way down, since I did not think the fundamentals had changed. I now have pared both positions by about two-thirds and have made gains of 40% or so. I think this is a good time to take some profits on these stocks, since both still have great uncertainties surrounding them.
I recommended Deutsche Bank (DB) at the same time. Deutsche did not go down as much and has not come back as much. At the moment, I am sitting on a $5 loss per share, and I plan to continue to sit for a while. I am disappointed, but I do not think the fundamentals of Deutsche bank have changed.
Additional disclosure: Neither SPY nor SPXU came up under tickers.I wanted to link to Shareholders Unite article on Secular Bull but I am now on a Mac and I have not been successful Would you insert the link, please?