The Bland Science

January 15, 2004

One media trend we’ve noticed in the last few years has been the spread of economics as mass market news. Terms and ideas that had barely been heard outside of federal reserve meetings started appearing on the front pages of the nations newspapers and on television news channels on a regular basis.

The reason for the appearance of the technical talk is the recent recession and bear market. Economics is the science nobody cares about until the economy stumbles. When it does, everyone wants to know why unemployment is rising and why their stocks are falling. Humans like to hear answers to unanswerable questions. It’s why some cultures had a god of rain they would pray to during the dry seasons. 

In the boom times of the late 90s investors were more interested in stories about new era change and individual stocks. What industry was going to get wiped out by new technology? How fast is market share growing at company Y? What kind of cars will consumers be buying in the future? Back then most investors couldn’t care less about the price of oil, much less gold, and the fed funds rate. 

How important is it to pay attention to economic data? Economic information is somewhat relevant for investor’s broad asset allocation decisions, less so for their individual stock selections. 

In some ways all investors play economic weatherman, even if we don’t realize it. Sometimes our forecasts are aggressive: I think the economy will improve and more companies will be able to make bond payments and avoid bankruptcy so I want to own junk bonds. Sometimes our forecasts are defensive: I don’t want to lose money on the off chance that interest rates rise so I’m going to stay in cash and short term bonds. Sometimes we acknowledge that we have no idea what will happen (the economy and interest rates are notoriously difficult to predict ) and we simply build a more permanent, well diversified portfolio. 

With MAXadvisor we tend to follow a modified diversification, meaning we have outlooks for the economy, the market, and different sectors, but we stay diversified around our predictions in our model portfolios, acknowledging the intrinsic difficulty of the analysis. 

The economy and the myriad of esoteric statistics used to define it will likely continue to take center stage for the time being. Although we have left the recession in the dust, the upcoming elections will certainly draw the economist out in all of us, especially those running for president. This too shall pass, and Alan Greenspan will stop seeming like the center of the universe, in charge of saving the economy from certain ruin. People will go back to thinking the economy largely takes care of itself, and conclusion that is, in our opinion, more valid than the notion that the President or the fed have much control over the nation’s financial system.

Meanwhile, there are a few areas of the economy equity investors should keep an eye on going forward into 2004. Economics is a dull science, and one that doesn’t offer yes and no answers to many problems so much as philosophies, theories, and opinions. We’ll try to keep it as interesting and relevant as possible, but be been warned: this can be pretty dry stuff. We apologize in advance if you fall asleep reading this month’s commentary.

GDP – or Gross Domestic Product – the value of goods and services produced each year by the United States. The GDP is the broadest and most well know measure of economic activity. 

The economy is much stronger now than we would have guess a year ago. Some of this strength is the result of a massive economic stimulus package, and some is just the natural swings in the business cycle. As earnings growth ultimately comes from economic growth, the trend needs to continue to make stocks a good investment going forward from these relatively high prices. In the long run, stock prices are driven by earnings, and earnings growth, broadly speaking, come from economic growth.

While some think this is the beginning of a new great economic expansion period (like the end of the recession in the early 1990s), some are worried the economic growth we’ve seen in late 2003 was a temporary phenomenon resulting from the tax cuts and spending initiatives and will dissipate shortly after the next election. Somewhere between both extremes is the right answer.

Economic Stimulus – Closely related to the economy is the Bush stimulus plan. In the last few years taxes were cut significantly, while spending (particularly homeland defense and war related expenditures), has increased. While this has caused mounting deficits, it has also led to strong economic growth. How much of this is fiscal stimulus, meaning government spending and tax cuts, traditionally the areas of Keynesian economists, and how much is monetary policy and low interest rates (the stomping ground of so-called monetarists), is unknown.

Was the cut-and-spend strategy wise or unwise? We’ll never know what would have happened without the governmental action, but the answer may largely be answered by future economic growth. If we have great growth, the deficit will turn to a surplus, and the economic jump start will prove successful. On the other hand, If the economic battery was actually on its last legs, the jump start will only get us a few miles before the charge runs out and we are left stranded once again (only with more debt and less tools available for more stimulus). 

We think some of the recent stimulus has qualities of trying to reinflate a leaky tire, and it may ultimately prove costly to grow our way out of this one easily. Look for slower economic growth (and therefore earnings growth) over the next 5-7 years then we had in the 90s as we pay for the cash advance at a latter date. This view is shared by Bill Gross, America’s foremost bond manager, although he takes a decidedly more pessimistic view.

Commodities – Commodities are the building blocks of an economy. We tend to take them for granted as just being there whenever, and in whatever quantities, we want them: food, oil, natural gas, timber, copper, etc. Commodity prices have been moving up for quite some time. Some of this reflects the falling dollar, some reflects an improving economy creating higher demand.

We are not sure whether the current rise in commodities prices forecasts anything substantial or simply reflects speculation, fears, and a falling dollar. We know that investing directly in commodities is a suckers game, more a bet then an investment. Owning some natural resource companies, including oil, metals, and others offers good diversification, and some upside if trends continue. 

Investors generally get a lot of commodity exposure when they invest in some emerging markets, as their economies benefit from rising prices (oil prices alone are greatly helping Russia). We would continue to avoid precious metals funds investing as those funds and stocks, in our onion, are overdue for a mini crash. Gold is not an investment; it is a speculation and a collectible. There is a time and a place for a small gold fund investment that invests in mining shares, but we are way beyond it today.

Inflation – Inflation is one of the most confusing and complex aspects of the economy. It is relevant to all investors, particularly those with bond investments. Inflation is generally caused by the supply of money going up, but other more bizarre psychological issues can effect inflation, like perceptions of future inflation. In fact one of the federal reserves jobs is to keep us calm about inflation. The only thing to fear about inflation is fear itself.

Experts disagree on the future for inflation, with predictions ranging from raging inflation caused by loose monetary and fiscal policy, to no inflation, to even deflation, like that experienced in Japan decade long troubles. We think there will be inflation, but not runaway inflation. 

U.S. Dollar – Until recently most people were unaware of the concept of the U.S. dollar and its value fluctuating against other currencies with ramifications for investors. Now that the dollar has fallen over 40% from levels of just a few years ago, everyone is talking about it (and forecasting more trouble ahead). We’ll never understand why some people who see no problem with something priced at X, suddenly point to problems when the price falls to ½ X and then extend the trend and predict the price going to ¼ X. More often then not the price goes back to X, making them wrong twice. 

Four factors are at play in the U.S. dollar’s long fall this past year: 1) raw speculation, the unpredictable short term craziness in all markets 2) continuing trade and budget deficits despite the weakening dollar 3) policies that may weaken our country’s fiscal strength – or at least create the perception of weakness to the rest of the world 4) more accurate pricing slowly taking over a previously overvalued currency.

We’ve always been focused on building a global portfolio for investors, and have long predicted a falling greenback, dating back to our “Go Go euro” articles on the MAXfunds site years ago. We’ve profited from large allocations to foreign bonds and stocks in most of our model portfolios.

In our opinion, the recent fall in the dollar has largely been a correction of the overvaluation in the dollar relative to foreign currencies. The behavior is sort of like large cap growth stocks in the 2000-2002 period – they fell, but the fall was from extremely overvalued to only slightly overvalued. 

At this point (this point being a euro worth about $1.30 - up from being worth closer to $.80 a few years ago.) the U.S. dollar has done about as much falling as its going to do, in our opinion. Other countries have their own economic and fiscal problems such that our country’s currency can’t fall much more against theirs. Moreover, currencies self correct. Ultimately if our dollar falls much more U.S. consumers won’t be able to buy as much foreign goods. Lowered import levels mean consumers are effectively selling less dollars to buy foreign goods. Additionally, foreigners will find our products much cheaper and will need to buy dollars to get our goods. Bye-bye trade gap, hello stabilizing greenback.