Quarterly Newsletter October 3, 2016
An Ode to Goldlocks… and TINA
Have you ever said something so many times that you just assume you’ve said it to everyone you know? Such would be the case with Goldilocks and me. If this subject seems like uncovered ground to you, you’re in luck with this newsletter. If you’re all too familiar with references to “the Goldilocks economy,” tag along anyway.
Most people born in the 20th century will recall the fairy tale of Goldilocks and The Three Bears, written (believe it or not) in 1837. While the story deserves a re-read, if only for the peculiarity of it, we’ll paraphrase, and explain the prophetic significance to today’s economy.
Goldilocks was a girl out for a walk in the forest (not to be confused with Little Red Riding Hood). She saw a house and for some inexplicable reason decided to go in. Upon entering she saw 3 bowls of porridge in the kitchen. One was too hot. One was too cold, but the other was just right. So she ate up the latter bowl.
That’s the end of the story for most people, but there’s actually much more. She decides to rest off the food coma, cast upon her by the carb-heavy porridge, by sitting in 3 living room chairs. Two chairs were too big, but the 3rd chair was just right. So she sat in it, but it broke into pieces. Finally, taking the “mi casa, su casa” adage way too far, she removed herself to the bedroom to have a nap. You guessed it—the first 2 beds were unsatisfactory, but the 3rd bed was just right. The owners of the house, a family of 3 bears, returned home and discovered the eaten porridge, broken chair, and finally the perpetrator. As the bears growled about the home invasion, Goldilocks escaped from the house back into the forest. The End!
Kids today probably would be confused by the story, but if they understood the post-financial crisis U.S. economy, it makes more sense. So let us illuminate. Goldilocks is a metaphor for the economy. If an economy is too hot, meaning that it’s growing too quickly, and the inflation rate is rising, then the Federal Reserve intervenes by raising short-term interest rates. Just as businesses are starting to worry about inflation in their costs—labor and raw materials—and consequently slow down their hiring, higher interest rates work in tandem to deter borrowers from borrowing money. Some people decide to not buy a house because mortgage payments make it too costly. Some people decide to not buy a car because of the payments. Businesses decide to not expand because it won’t be profitable. You know what follows most of the time….recession. However, a few magical times, the economy has slowed into a “soft landing” of a couple flat quarters, rather than all the way down into a recession, before recovering for more good years. The Fed chair likes to believe he/she will be able to pull off the rare soft landing every time. Nonetheless, the Fed will use interest rates as its main tool every time, and without abandon, because they have a mandate to contain inflation before it spirals out of control. Out-of-control inflation is worse than a recession, and a recession almost always takes care of the inflation anyway.
It doesn’t take a scientist to know that “too cold” is the opposite. If the economy is in a recession, that’s too cold. Then, the Fed becomes more concerned about getting the economy growing again, and not as concerned about inflation. So they lower short-term interest rates, which helps to stimulate borrowing, and thus spending, by consumers and businesses.
If it has long seemed like the Fed is always raising or lowering rates, and never keeping them the same, until this cycle, you would be correct. Looking at this chart of the Fed Funds target rate, the longest period of flat rates, before this cycle, was only 1 ½ years. Even during the Great Moderation of 1995-2000, once it became clear that the Fed had helped the economy into a soft landing following its tightening cycle of 1993-95, the Fed still raised or lowered interest rates 11 times in 5 years.
Fed Funds Target Rate, 1971 – present
What would happen if you could design an economic cycle that somehow never got too hot or too cold? You’d think this would be even better than sliced bread. Gone would be all the hassle that businesses face in deciding when to hire and spend, investors trying to decide when to own stocks, and borrowers figuring out when to borrow money. You’d think. Now look back at the chart on the previous page. The last 8 years look like a placid lake at sunrise (the alternative hypothesis, since we know some of you are thinking it: the EKG of a dead patient).
So, is this 7-year long expansion actually “just right,” with 2% average growth for real GDP since we said goodbye to the recession in 2009? This may seem just a tad off the normal growth rate of 3-4%, but it does start to add up over 7 years. Seven years at 2% compounds to 15%, while 7 years at 4% equals 32%. While the stock market seems to have performed pretty well, we all have noticed side effects of the slow recovery that indicate this has not been a “just right” expansion. Income inequality has widened, wage growth has been weak, and businesses have been reluctant to spend. The country arguably seems the most divided than since the Civil War. Racial tension is worsening, and optimism for the future is low. It definitely doesn’t feel “just right.” But as it’s not too hot, and it would be a stretch to call it too cold, so Goldilocks has attached her name to this economy and hasn’t let go for 7 years running. And so the Fed has raised rates just once, up to a whopping 0.5%.
As for the rest of the story, it could be spun more than one way. Our president and his successor might see Goldilocks as the “fat cat millionaires” who need to be taxed more because they are fat and lazy and sit on the little guys (the chair which breaks). That would be off-point because, remember, Goldilocks is the economy. Instead, the economy was well-fed by the Fed’s monetary stimulus in 2008-10 and went to the first chair, businesses, and asked to help support the economy’s nascent growth. But, the fit between the Fed’s mission and what businesses saw in the economy wasn’t good. Businesses that survived were more concerned with fixing leaky roofs and paying down debt. She went to the second chair, consumers, and pleaded for support, but consumers were mired in home foreclosures, unemployment, and trying to deleverage, so there was no point wasting time with that chair. She went to the third chair, Washington, and asked it to provide some fiscal stimulus. Washington, instead, turned against itself and splintered into pieces.
Admitting defeat in the domestic economy, she went upstairs. This is not a euphemism for heaven, nor Canada. It just means she went to another location. Trying to source an avenue for exports of American goods and services, she first tried China, but found it too hard. Next she visited Europe, just as it was about to cascade into a 2nd recession (thanks to Greece), and saw it was too soft. Finally, she found the room of Quantitative Easing. Since no one else was working to help her, she hatched a plan for the Fed to buy bonds, put it on autopilot, and Rip Van Winkled herself for 3 years. Just right!
Just so we’re clear, the porridge in this story is Quantitative Easing – the Fed’s tortuous, multi-year, never-before-tested experiment in monetary stimulus. After lowering interest rates as far as they would go (0%), they decided that wasn’t the end of their powers, so they undertook 3 rounds of “quantitative easing,” through which the Fed would expand their assets to $4.5 trillion by buying U.S. Treasury bonds and government-backed mortgages.
But wait, the porridge put her to sleep? The whole idea was to stimulate, kind of the opposite. If she wanted to pump herself up, maybe she should’ve considered eating something else, like a kale salad topped with quinoa, and a Red Bull to wash it down. Please, this was 1837. Nutritional research has come a long way since then. Whether the monetary stimulus has done anything to pump up the economy is a question that has been debated for years. Maybe it was necessary to offset all the deleveraging in the economy, as consumers, businesses, and banks reduced their borrowing. Maybe it did nothing. But a growing body of evidence suggests it actually seems to have put the economy to sleep, because low yields have hurt savers, and if there are more savers than borrowers, then it makes sense that the net effect is negative.
As for her final act, Goldilocks surely foresaw that the owners of the house would return at some point, and probably there were some hints that they were bears. But just as the bears were ready to take her down, she evaded them. Doesn’t it feel like the bears have been lurking in the bushes throughout this entire cycle, ready to maul us all? Like:
- The real estate bust that was supposed to deal a permanent blow to our housing market
- Bankruptcies and nationalizations in the financial system (banks, Fannie Mae, Freddie Mac, Wall Street) and corporate sector (GM, thousands of other companies)
- The 6+ year Greek bailout-cum-Eurozone crisis
- Paralysis in Washington, the rise of the Tea Party, socialism, nationalism, populism
- Skyrocketing commodity prices
- Plummeting commodity prices
- Al Qaeda, ISIS, homegrown terrorists, the Syrian/Iraqi refugee crisis, China’s never-ending efforts to try to control and stimulate its economy
- Bird flu, swine flu, ebola, zika, opioids
- Cyber terrorism, and
- The Kardashians
Frankly, given her success in outrunning all these bears, Goldilocks deserves a shot in the Olympic trials as a sprinter. How has she been able to keep running 7 years and not get caught? Wait, this story isn’t morphing into Forrest Gump, is it? No, rest assured, the economy cannot run forever. Or can it? No it cannot—back to Goldilocks.
No matter how pessimistic you are, or how much you disapprove of the current Administration’s handling of the economy, or how jaded you are by the persistent meddling by the Fed, you must give this economy credit for resilience. Or at least give America credit. We got knocked down hard by our own greed and mismanagement during the real estate boom and bust, but after taking some medicine, we got up off the floor and got to work again. All those worries (above) have served to darken our collective outlook on the future, but they have not eliminated our ability to not only bounce back, but to grow.
New subject: TINA
Now that we’ve beaten Goldilocks to death, let us introduce our other heroine – TINA. Why is TINA in all-caps? Because she is an acronym. Coined in the 1980s by Margaret Thatcher, it stands for “There Is No Alternative,” and was her catch-phrase to convince people that democracy and capitalism are the only systems that work in the long-term. Communism would eventually be proven a failure, and she was dead right.
Our friends at Strategas have named the stock market of this cycle TINA. In order to get any return, investors need to be invested in stocks, because cash yields 0% and bonds not much more than that. Obviously this oversimplifies the financial planning process. Just because the expected return of stocks is higher, you can’t ignore that their risk is also higher than that of bonds. But it does make a plea to all those individual investors who had sold stocks in the financial crisis and failed to buy them back later, or all those pension funds and university endowments that sold stocks and loaded up on hedge funds and other alternatives, that they need to own stocks too. After years of miserable returns in hedge funds and foreign stocks, and scary low yields in bonds, TINA is alive and well.
In fact, the stocks that have performed the best since last fall, when the market fell into the first of 2 corrections in a 5-month period, have been high-quality, good-yielding, large U.S. stocks. These stocks generally outperform other kinds of stocks during shaky stock markets. But they outperformed by so much, and the biggest reason is that they earned the designation of “bond substitutes.” To be a substitute for a bond, it must yield as much as (or more than) a bond, and be considered not much riskier than a bond. While we are genuinely concerned about risk in long-maturity bonds (more on that in a bit), we’ve lived through too many bear markets to try to claim that stocks are no riskier than bonds.
It made me wonder whether our stock market was now like TINA on steroids. Which made me wonder what TINA actually looked like in the first place. Not having a face to put to the name, there’s really no wrong answer. Maybe she’s this guy (>), the face (and body, if actually from the same person) of Cenegenics, the company which claims they can turn you into this guy with their proprietary products. I hope she’s not; it seems a little unnatural.
We acknowledge that this bull market in stocks is now more than 7 ½ years old, and there’s only 1 bull market that’s lasted longer, which was the Roaring “dot.com” 1990s. This cycle shares a lot of the same elements as that era. But these similarities would put us in the middle of the 1990s, not the end, so we’d have many years to go. What hasn’t even begun to happen yet is for investors to actually buy stocks. Yes, more money has left U.S. equity mutual funds and ETFs than has gone into them since the bull market started. And not by a little, but $200 billion! Sometime in 2014, briefly, the cumulative net flows into U.S. equity mutual funds since 2009 climbed above $0, but in 2015 and 2016, more than $230 billion has been redeemed from stock funds.
Said differently, investors are still worried about stocks. In a normal bull market, that worry persists for the first year, then fades as people get back into stocks because “the smoke has cleared.” In this cycle, the first 5 years saw outflows from stocks, and not until 2013 did that reverse to inflows, and then for only 2 years. This persistent worry can be traced to scars that apparently still run deep from 2 nasty bear markets in the 2000s and a belief that the system is rigged against them. What do you do with this information? You do the opposite, and proudly call yourself a contrarian.
Will individual investors, pension funds, and university endowments return to stocks in this cycle? If not, it would be the first time ever. The pressure on them is growing, given persistently low bond yields and worsening returns on alternative investments. University endowments led the charge out of stocks in the 2000-02 bear market, and into anything that wasn’t U.S. stocks, namely foreign stocks, hedge funds, private equity funds, real estate, and commodities. If they could get their hands on assets that were 2 or more of these, like farmland and timberland, so much the better! All in the name of diversification. This worked for a while, actually better than U.S. stocks.
A new era has dawned since the financial crisis, as hedge funds have produced miserable returns, although robust private equity and real estate gains made up for that shortfall. However, returns in each of these have disappeared lately. Now the gap between the actual profits earned by endowments and pensions and what they could’ve earned in simpler, safer investments has completely blown out. Most university endowments, all of which seem to have June fiscal year-ends, are reporting returns in the 2015-16 fiscal year below 0%. The biggest of them all, Harvard’s, reported a 2% loss. A simple 60/40 allocation of U.S. stocks and bonds would have returned +6.9%. With only 10.5% of Harvard’s assets in U.S. stocks, this might seem ripe for a bump, maybe not to 60%, but is 20% asking too much? Then again, Harvard’s stock-picking was even worse than their asset allocation, as they lost 4.9% on their U.S. stocks. So maybe they should stick with stuff that only loses 2%.
Investing right now isn’t for the faint of heart. Stocks are near all-time highs, and while other asset classes haven’t kept up, their prospective returns don’t look much better. With the 10-year U.S. Treasury bond yielding 1.56%, we believe you’d be lucky to get that annual return over the next 5 years, because interest rates seem poised to eventually go higher. But count yourself lucky that the Fed hasn’t gone the way of the European Central Bank, the Bank of Japan, and the Swiss National Bank, among other central banks, which have taken short-term interest rates below 0%. And since this “stimulus” hasn’t yet worked to stimulate their moribund economies, they’ve doubled down by lowering them even further below 0%, and initiated bond buying programs like the Fed, which has brought long-term bond yields below 0%. To wit, the 10-year German government bond yields -0.12%. If you buy and hold to maturity, you are guaranteed to lose money. What a deal!
Clearly, there is a fair bit of speculation going on, as investors buy so they can sell at an even higher price. The “50-year” (maturing in 2064) Swiss bond currently trades for $194 per bond. When it matures, you’d get $100. If you buy it, you’ll lose 48% of your original investment, but at least you’ll make up for it with coupon payments of….2% annually! But remember, that 2% is on the $100 face value. Your $2 coupon payment amounts to an annual payment of only 1.03% of your original investment. It all adds up to a yield to maturity of 0%. But if you were lucky enough to buy the bond in 2014 when it was issued at $100, you made a killing, +94%!
For us, TINA lives on. Bonds are necessary in many situations, but it’s hard to beat what good stocks give you: modest future growth in earnings (to offset inflation), 2.5% dividend yields, clean balance sheets, and rampant skepticism and pessimism capping equity valuations. We’re keeping an eye on factors that are likely to eventually tip us into recession, namely wage inflation, but it isn’t yet into concerning territory. Way too many people are transferring their concern over the presidential candidates to the stock market. While neither candidate appear to be helpful to corporate America, there’s only so much damage they can do. Just remember that our current President, who has presided over the entire bull market, doesn’t have a capitalist bone in him, and has never lifted a finger to help corporate America do the heavy lifting of bringing life to our economy.
– Written by John Meyer