We would be quite happy if employment were to improve meaningfully in the U.S. We know plenty of people who have been unemployed or under-employed these last few years and it goes without saying that we share their frustration, particularly when the pundits paint our current subpar economy in such glowing terms. We always find it useful to look at the bigger picture and not respond manically to every new piece of data. Last Friday’s employment report was no exception in its ability to bring out the usual proclamations of what great successes fiscal and monetary policies have been. A longer term view shows just where we stand. While not exciting enough to provide the T.V. babblers with something to fill countless hours of time, it tells the real story. Employment may have had a slight uptick in recent months, but in the grand scheme of things the situation has been terrible for years.
Of course, the bulls want to point to improvements in the housing market, but while things may be better, actual activity is a long way from the 2005-2007 bubble. The FHA is doing its best to make the same underwriting mistakes of the last cycle and builders are bending over backwards to qualify prospective buyers for mortgages, but overall activity remains well below the last peak. Hedge funds are even entering the game by buying up houses in depressed areas hoping to make a buck. We do wonder what happens when they inevitably attempt to sell these rental properties at the same time.
Housing bullishness in the equity market has reached extreme levels. According to CNNMoney.com “struggling homeowners increasingly turned to short sales to get out from under mortgage debt last year. There were nearly three times as many short sales as there were sales of foreclosed homes in 2012, according to RealtyTrac. Foreclosures accounted for 11% of all sales, down from 13% a year before. Meanwhile, short sales rose 5% year-over-year, accounting for 32% of all home deals…. During the fourth quarter, the average discount on a foreclosure was a whopping 39%, while the average short sale sold for 23% below market, RealtyTrac found.” That would mean that foreclosures and short sales together accounted for 43% of sales in 2012 with a weighted average price effect of almost minus 12% to average total home sales prices by our math based on this data. We just have a hard time being too excited that housing has turned the corner because that still sounds just plain terrible to us.
Bear in mind that economic growth was low or nonexistent prior to the sequester cuts that began March 1, but the finger pointing will continue in earnest nonetheless. The cries for even more government spending will soon be heard because many pols believe they know best how to run an economy. We opine that even the fiscal hero of many of them, John Maynard Keynes, would likely say that these guys have taken things just a “bit” too far because we suspect that he might have the intellect to read the “tea leaves” of Europe and Japan’s fiscal woes and realize that debt-to-GDP ratios approaching 100% with no end in view tend to swallow economies whole by their very size. Basic math tells one that each 100 basis point increase in interest rates adds about $150 billion more to our deficit in the U.S. each year and in this age of financial repression rates are more than a stone’s throw from normalcy.
We share investors’ quest for returns and income and comprehend the fact that so many feel as those their hand is forced into ever riskier investments. The Fed has crushed incomes of the prudent in this economy by creating a bubble in bonds of all types, which has pushed interest rates to levels which punish savers. There is obviously so little investment income to be had in fixed-income, yet life is much more expensive for us all. The riskiest bonds are the most dangerous now because spreads are stupidly tight to treasuries that themselves trade at unnatural levels, even if one takes government inflation statistics at face value. We do not because we go to the grocery store, buy health insurance, put gas in the car and pay tuition. Sadly, we have not yet found a way to live our lives “ex. food and energy.”
With this in mind and because they face real world expenses, some investors have heard that dangerous “unlimited income” song and dance from Wall Street and responded by subjecting themselves to the risks of the equity market as if it is some magical land removed from the forces and bounds of the economy. However, equity valuations over time and across the economy are subject to the same time value of money analysis as any other investment. Profits tend to grow about 5-6% annually over time and average about 5-6% of revenues across the economy throughout history. P-E multiples tend to gravitate toward 15. Long-term returns in equities do average about 8-10% depending upon how you look at it, but recessionary losses are about 30-40% from peak and it is not unusual to see 10-15% drawdowns during any calendar year. Obviously, we have witnessed two roughly 50% disasters since the turn of the century alone, though many pundits have seemingly forgotten those.
Returns over time are “baked in the cake” so to speak just like the case with bonds-your initial purchase price determines your long-term return. Importantly, at present, profit margins run the risk of correcting at least 30-40% and taking stocks right down with them. We are not trying to ruin the party, but equities are not divorced from basic math over long periods. We do not play the “greater fool” game expecting to sell positions to a sucker before reality hits because we know how quickly speculative profits can vanish.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.