Tuesday, May 7, 2019

Why do we fear prosperity? Understanding the wealth effect.

From the Desk of Joe Rollins

This has been a very unusual and exciting month in the financial markets. We have received unbelievably overwhelming positive economic news, yet for some reason we seem to be ashamed of our own prosperity. There are many things I want to talk about in this posting, but recently I have been scratching my head, trying to understand why the general consensus in the media is that we should be ashamed of this country’s success. The purpose of this post is to examine that concept and try to understand where it generates from. When we went through the fourth quarter of 2018, the same financial experts were predicting a recession in the U.S. in 2019. They also assumed that a political quagmire and overly aggressive Federal Reserve would destroy the U.S. economy in 2019. And surely the bull market that has been ongoing since 2008 would collapse and burn as the final coup de grace. Well, I guess I am here to tell you that those guys were wrong.

All over the news are so called self-styled socialists who believe that income equality should be the true goal of the American economy. Poor people should be compensated like rich people. The rich should share their wealth with the poor. The people who work hard or are better educated should share their wealth with the people that do not work as hard and who are not as well prepared. When you compare those two statements, I am a little bewildered how the logic fits from an economic standpoint. There is no question that everybody would like to stamp out poverty in America, but just exactly how do you do that? Do you do that by giving them money, retraining them for jobs or by just taking money from the rich and giving it to the poor for no good reason. I would like to review those subjects as we progress along.

Partners Robby Schultz and Danielle Van Lear's children, Caroline and Reid

As always, I would first like to cover the most recent month and the performance of the financial markets. The month of April was truly an extraordinarily good month from a financial standpoint. Even though the news was full of political gyrations related to the current President, the financial markets ignored all of that and turned in a sterling performance. The year-to-date performance of all of the major market indexes have been nothing short of breathtaking.

For the month of April, the Standard and Poor’s Index of 500 stocks was up very nicely at 4%. For the year 2019, that index was up 18.2% and over the last ten years that index has averaged an increase of 15.3%. The Dow Jones Industrial Average was up 2.7% in April, 14.8% for the year 2019 and over ten years it has averaged a gain of 15.4%. Once again, the one-year return was double digits for both indexes.

The NASDAQ Composite once again led the major market indexes as it was up 4.8% in April and for 2019 is up 22.4%. Over the past ten years, that index has averaged an annual return of 18.1%. In comparison, the Barclays Aggregate Bond Index was exactly flat in April and is up 2.9% for the year 2019, while only averaging 3.6% over the past ten years. I do not need to spend a lot of time emphasizing the glaring difference between the returns in the indexes and the bond index. All three of the major market indexes have averaged an annual return over the last ten-years of greater than 15%, while the bond index has averaged 3.6%. I continue to read the advice given to seniors just entering into retirement, stating that your portfolio should have a percentage equal to your age in bonds. In my honest and now well-documented professional career, that type of blanket advice borders on negligence. Such advice has led to overly conservative portfolios which almost assuredly will underperform the indexes in the next decade.

A client called me recently, frantic that the national debt would continue to grow at this seemingly accelerated rate and undoubtedly lead to financial chaos in the future. I responded that I was not terribly concerned about the growth in national debt as long as GDP continues to grow, and that the national debt is less than one times GDP in any given year. I pointed out that Japan’s national debt is roughly two times the GDP and has been that way for close to 35 years. There is no question that this level has slowed their economy, creating a subdued GDP in the intervening period, but it has never led to the complete destruction of the Japanese economy. Slowed down? Yes. Led to destruction? No.

I indicated to him that over the last decade GDP has basically doubled, and that as long as GDP was growing I did not share his concern. The President basically said the same recently, when he exclaimed that if we could continue to accelerate the growth in GDP, a lot of positive things would occur in the economy. By the very definition, income tax dollars paid to the Treasury would have to go up. With these extra dollars, the government could complete its long-awaited capital projects such as, roads, bridges and dams. Correspondingly, the money spent by the government on these projects would further increase GDP, coming full circle as these tax dollars go back to employees. He was exactly right on this subject.

Ava at her ballet recital

After we hung up, I went back to actually look at the numbers and make sure that I did not misquote and provide this client with inaccurate information. The GDP in 2009 was $14.418 trillion. In 2008 GDP was $20.495 trillion. GDP for 2019 is expected to come in somewhere in the neighborhood of $23 trillion. Okay, so perhaps I did misquote. From 2009 to 2019, GDP only went up from $14.418 trillion to roughly $23 trillion. So that is only a 60% increase, not 100%. But there is much more positive information in that analysis than meets the eye. In 2009, the unemployment in America was 9.3%. In 2019, unemployment in America is 3.6%. In 2009, even after one of the worst recessions in recent time inflation was at or near the same level it is today.

So basically, the country has increased its GDP by 60%, while its unemployment has dropped dramatically and the inflation rate continues to be at virtually the same level. I guess you would have to say that with that strong backing of economic performance over the last decade you certainly would have to be encouraged about the future, and you certainly should not be concerned that the growing national debt will endanger the economy.

I often mention in these postings that the most important component of a strong economy is the number of people working. It is believed that 70% of the current GDP is controlled by consumer spending. It should be self-evident, even to the uninformed, that if you have more people working, you have more people consuming. For every person that has a job, there is a downflow of money that creates GDP. They buy food at the local market, feed and clothe their children and spend money on consumer goods. The more people that are working, the better it is for the economy.

Last Friday we received the news that the unemployment for the month of April was 3.6%. It is hard to believe, but that is the lowest unemployment for our economy in almost 50 years. Clearly, more people are working now than ever over the last half of a century. How could you not be encouraged by this strong economic information?

So, you might assume that with the economy growing 3.2% in the first quarter and unemployment being 3.6%, that there would be, almost by definition, a shortage of labor to fill jobs. As a general consensus, it is always assumed when there is a shortage of labor employers bid up the cost of labor creating inflation, which would correspondingly mean a higher interest rate by the Federal Reserve, and almost assuredly a slowdown in the future. Once again, the people who wrote the textbook do not understand the economy in 2019.

For the first quarter of 2019, productivity actually increased at a rate of 3.6%; the highest increase in productivity since 2010. If you look at the time period from World War II to 2018, which included both expansions and recessions, productivity rose at an annual rate of 2.1%. Even in the previous economic cycle for 2000-2007, productivity rose at an annual rate of 2.7%. While we are seeing the computerization of many jobs in America, these computers are not replacing people. With computers, manufacturers are now able to increase productivity and therefore get more work out of the same number of employees.

The fact that productivity went up in the first quarter is particularly surprising given that first quarters are historically slow. Weather and other conditions typically slow down productivity, but this was basically a gangbuster quarter. This is a very important trend in the future of U.S. GDP. In order for GDP to grow, you must have productivity gains. The same people must produce more or the GDP will falter. This increase in productivity in the first quarter of 2019 should be very reassuring for those skeptics that believe the economy must fail just because it has had a 10-year positive run.

As we finished 2018, the forecasters were assuming that the economy would clearly be in a recession in 2019 and GDP would falter. I guess those forecasters were also wrong when the Federal Reserve reported an extremely robust 3.2% increase in first quarter GDP, which was up sharply from the 2.2% in the fourth quarter of 2018. How could so-called “expert” economists be so very wrong about the economy? Certainly, if you look at all of the geo-political events, you could see trouble for the economy ahead. However, the one statistic that you really need to evaluate is how many people are actually working, since that is where the GDP benefits the most. With the highest level of employees working during the last 50 years, it is unlikely that the GDP could fall into recession without a major reduction in those working Americans.

For reasons unclear to me, people seem to be ashamed of the prosperity that Americans have enjoyed over the last decade. In 2008, the average GDP per American was $48,302. By the end of 2018, that number had risen to $62,606 - a fairly substantial positive move given the number of people. I always question when the general public is addressed by the media with the misplaced notion that we should be ashamed of this prosperity. I guess I cannot clearly understand their skepticism. If you have worked hard and you do a good job, why should you not be well compensated? That is what is happening in America today. Due to the hard work, better education or just luck of the draw, employees are earning more than ever and are benefitting from their success.

There is this ongoing discussion that the wealthy should subsidize the poor for the betterment of America in general. I do not concur with those assessments. I could not help but be mindful of the quotes yesterday at Berkshire Hathaway’s annual meeting. When Warrant Buffett was asked if he was concerned that socialism would overtake America, he replied, “I don’t think the country will go into Socialism in 2020, or 2040, or 2060.” His vice chairman, Charlie Munger, added “I think we’re all in favor of some kind of government social safety net in a country as prosperous as ours. What a lot of us don’t like is the vast stupidity with which parts of that social safety net are managed by the government.” Truer words have rarely been spoken.

So basically, in an “income equality” society you would take the money from the rich in the form of higher taxes and turn it over to the government to reallocate based on their assessment of who should benefit. However, we have already seen, as mentioned by Munger, the vast stupidity of which the government allocates resources. Why anyone would actually propose or assert that the government will do a better job in the future than they do now is certainly na├»ve by any definition.

Caroline and Reid enjoying another beach day

A much better way to stimulate the economy is to do so without government intervention. The government has proven repeatedly its inability to administer social programs with any level of efficiency. However, a reallocation of wealth is actually occurring in the U.S. today. I have written on the subject of the wealth effect many times in these pages, but we see it virtually every day. We see clients that have enjoyed a run-up of 328% in the equity markets since the S&P 500 bottom in 2009. Every day, we see clients that are taking money out of their investments and using it to stimulate the economy. Maybe they buy a new car, fix their house, or educate their children…If the markets had not run-up so dramatically, then it is very likely that they would not have taken their money out of the markets and spent it in the economy.

You need to understand exactly what happens when the wealth effect is in operation. First, it is very likely that the investor creates income taxes by virtue of selling investments. These income taxes go into the government and help to fund future operations. The investor spends that money at the local car dealership creating sales for that dealership and correspondingly more employees are paid and those wages typically go up. So once again the wealth effect creates a tremendous positive attribute for the American economy. An investor takes a little profit off the table, creates income taxes and creates jobs. Does anyone really think that we could have realistically gotten the unemployment in the U.S. down to 3.6% if the wealth effect had not positively impacted the economy over the last decade?

And here we are now, being assaulted daily by the assumption that the bull market that started in 2009 must end for no particularly good reason other than “it always has.” As explained here before, bull markets do not just die of old age, there is always a reason. The reason more often than not is that the economy slips into a recession, and the stock market correspondingly goes down in sympathy to the recession. But also, the basis for which those forecasts are made should also be called into question. Forecasters were predicting a recession in 2019, which clearly looks like they were in error.

They also asserted that corporate earnings would be down in the first quarter at least 4%. As the vast majority of the companies making up the 500 indexes have now reported, those earnings appear to be fractionally higher than even last quarter’s robust earnings. I reflect back on the forecasters who said the S&P was very expensive at the end of 2016. The market could not go up in the intervening years because the indexes were overvalued. Just for the record, the S&P 500 index is up 36% since the end of 2016. So once again, do not believe everything that you read, unless it is contained herein.

One of the most respected corporate executives in all of America is Chairman and CEO of JPMorgan Chase, Jamie Dimon. He echoed my sentiments when he stated that just because things are good, doesn’t mean they have to go bad. Just recently while discussing if there has to be a recession , he said, “If you look at the American economy, the consumer is in good shape, the balance sheets are in good shape, people are going back to the workforce, companies have plenty of capital…business confidence and consumer confidence are both high… So it could easily go on for years. There’s no law that says it has to stop.”

I sure wish he would quit quoting me without due reference. He is so accurately correct though. There is absolutely no reason why economic expansion could not occur and there is clearly no reason why it must go down. As I pointed out in my last posting, I went through the volatile years of the Greenspan years at the Federal Reserve. By his own admission he would take the economy from boom to bust and vice versa for no good reason. Since 2006, the Federal Reserve has been controlled by much more educated and well-respected leadership. The best solution for everyone would be an economy that is not too strong and not too low, just right. The so-called “goldilocks” economy that we have today. If the Federal Reserve does its job, and it adheres to this double mandate of controlled inflation and full employment, this economy could continue to expand for many years to come. Today, it is hard to fathom that any type of recession could enter into the United States prior to the election in 2020.

Ava and her nameless bunny

I am often approached by potential investors for my opinion on Washington. Yes, I understand it is troublesome and that the nightly news is full of horror stories of political misdeeds, but you are missing the most important point to be learned from these political shenanigans. When Congress is completely concentrated on the irrelevant, as they are today, they are not passing laws that would be destructive to the economy. Since 2016, the current administration has rolled back regulations that were no longer needed in the economy. This has loosened up business expansion and improved the economy for everyone. If Congress remains as dysfunctional as it is today, they can never pass new laws that would add this form of legislative burden to society. I cheer them on in their incompetence.

Let them debate the irrelevant and totally worthless subjects that they appear to be focused on today until the cows come home. They can have all the hearings, meetings, subpoenas, and cross accusations they want, as long as they do not do what they are paid to do, which is to legislate. Some of the greatest stock markets of all time have been during a time of congressional incompetence. I think what we are seeing today is the government at its worst, but markets at their best.

As always, we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins

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