Investors Beware! The Markets May Not Behave as History Suggests
If there was an uncertainty index to measure forecasts of the United States macroeconomy, it would now register 85, assuming the norm would be 50 and a reading of 25 would reflect periods of exceptional economic stability.
Economists rely on models of past behavior to predict and foretell the future. There is a popular critique "that models work until they don't." The current housing crisis provides a telling example. Financial institutions used models to extend loans which were based on the assumption that housing prices on a national level would not fall. Why? They had not fallen in any of the recessions following the Great Depression. On an annual basis, home prices had remained steady or gone up for over 60 years. This time they fell and what followed was a severe and unpredicted blow to our financial institutions and economy.
Among the numerous reasons that the past macroeconomic models may not now provide a sound basis for predictions of future economic activity are: (1) the blow to the nation's financial institutions brought on by the housing crisis; (2) the end of a 28 year interest rate cycle that is forcing the Federal Reserve to rely on non-traditional means of implementing monetary policy; and (3) a possible shift to frugality in consumer behavior, which has driven more than two thirds of Gross Domestic Product (GDP).
The current crisis in our financial institutions is acknowledged by economists to be the most severe since the Great Depression. Before it occurred, Bill Gross - the chief executive of PIMCO, which runs the world's largest bond fund - accurately predicted that a tsunami would hit the financial industry. When a major tsunami or earthquake hits, the entire structure of the area is profoundly shaken. This was a 7.0 plus Richter financial shock. After the severe earthquakes that hit San Francisco, Lisbon and Santiago, the cities that re-emerged were substantially different than their predecessors. Bill Gross now predicts this shock will usher in years of financial deleveraging following recent decades of increasing leverage. The result will be an extended period of tighter credit.
The Treasury tells us that it has stressed tested our major financial institutions and they are good to go after certain key adjustments are made. Some critics contend that the tests were designed to be easy in order to bolster economic confidence. Even assuming the humpty-dumpty banking system will be successfully reassembled, a period of sustained deleveraging would provide a very different backdrop on which to make economic forecasts.
The Federal Funds rate has now reached the end of a 28 year megacycle. In 1981, the Funds rate peaked at 20%. After numerous mini-cycles, it is down to 0.25%, or essentially zero. Rates on 30 year fixed rate mortgages have fallen from 16% plus in 1981 and 1982 to under 5% for the first time since 1956. Monetary policy has been the primary vehicle used by the government over the past quarter century to stimulate the economy out of recessions. Lowering the Funds rate has been the principal tool used by the Federal Reserve to achieve that objective. That traditional tool is now exhausted and the Fed is turning to non-traditional alternatives such as direct purchases of long term treasuries and mortgage-backed securities. An economy operating in an environment where there is no prospect of future cuts to the Funds rates may function in materially different ways.
This also may be the dawn of "a new age of frugality," the current catch phrase for the sharp drop in consumer purchases. Consumer spending skyrocketed over the past decade, so much so that consumption rose from its historic level of about two-thirds of the U.S. economy to make up nearly 72 percent of the nation's Gross Domestic Product. At the same time, the U.S. savings rate plummeted. Historically amounting to about 10 percent of income, savings fell into the low single digits. Thanks to the spending of borrowed money, net savings actually dipped below zero in 2005. Some eminent economists predict that consumer spending will revert to its mean. A reversion to the mean generally means a dip below the mean, perhaps for some time. This suggests that consumer spending may account for around 60% or less of GDP in the next few years. A shift to thrift obviously could have a profound impact on retailers, wholesalers, distributors, and manufacturers, who would be forced to adapt to the new, more frugal marketplace. And given how important consumer spending is to the overall economy, the shift also could lengthen the time it would take the economy to recover.
Only time will tell whether we have entered a new age of frugality or have merely been on a short term diet after which we will revert to our prior consumptive patterns. If this is a new age of frugality, the models of economic behavior based on old consumption patterns will be less reliable.
Commentator John Mauldin summed up the current situation, "It has long been my contention that we are entering an extraordinary period of time in which using historical analogies to plot market behavior is going to become increasingly problematical. In short, the analogies, the past performance if you will, all break down because the underlying economic backdrop is unlike anything we have ever seen. It makes managing money and portfolio planning particularly challenging. Traditional asset management techniques just simply may not work. Buy and hope strategies may be particularly difficult to navigate."
Alert investors recognize that the stock and bond markets are constantly impacted and buffeted by the weekly output of economic reports and the overall direction of the economy. Whether the prediction is for a quick, slow or no recovery, the investor should view it with an even greater level of skepticism than would ordinarily be the case. The uncertainty level is simply too high for any other course to be prudent. Wise investing will require careful attention to the flow of economic data and the agility to move with the waves as they come ashore. It will also require constantly keeping in mind the high level of economic uncertainty in which we are now operating.