Last week, while clearing out old office files, I came across a brilliant 2004 presentation by Northern Trust's Paul Kasriel, one of my favorite economists. He spelled out exactly why the housing bubble would inevitably burst, and he predicted the financial train wreck that would certainly ensue. His devastatingly accurate appraisal was based on the simple observation that house prices could not forever outpace household incomes. And sure enough, they didn't! But it took over three years for the mortgage frenzy to finally collapse, during which time the NASDAQ index soared 55%, proving once more the importance of timing.
When we realize that certain economic or financial conditions cannot go on forever, we must examine how long they might persist, what is likely to finally bring them to an end and how that end could affect investment risks and opportunities. With effort, we can learn how to use this awareness to strategic advantage. Soaring government spending provides a real-world example we can practice on.
In August, the stock market shrugged off as unimportant the news that the federal deficit for the next ten years was estimated to be $9 trillion, up from a $7 trillion estimate just a couple months before. This anticipated funding challenge takes into account no additional costs for the proposed health-care reform, and it assumes healthy economic growth despite rising tax rates. Nor was investor optimism diminished by the estimated current year deficit of $1.6 trillion, which is more than 11% of GDP; this figure is about four times deficit levels in recent years, levels considered by some pundits back then to be an immoral imposition on future generations.
Total federal debt is now expected to approach 100% of GDP in about four years. That's almost a five-year double. Can we keep doing this without serious consequences?
What attitude, what expectation allows investors to be so nonchalant about deficits on a previously unthinkable scale? The prevailing explanation is that this huge spending has been necessary to sidestep a credit meltdown, and that it is only temporary. The Fed and Treasury will remove the stimulus in a timely fashion, navigating between the Scylla and Charybdis of deflation and inflation. Enlightened regulation will prevent a return of the avarice that precipitated the problem in the first place. And resumed economic growth will make the debt quite manageable, thank you.
Nice concept; neatly covers the issues. Yet I am so not convinced. I personally think that most investors have not intellectually embraced this rosy scenario; they are just swept up in the short-term trading mentality that has dominated market activity during the huge rally from the March lows. I think a fear of missing the upswing (especially on the part of fund managers desperate to show they haven't lost their mojo) has overwhelmed nagging concerns about longer-term fundamentals. As if to showcase this idea, journalist Floyd Norris penned a recent article in The New York Times about the new deficit forecast. His headline read, "It's hard to worry about a deficit 10 years out."
In a recent investment meeting at Financial Advantage Inc., as we tossed around this question of whether government deficits were more ominous than markets seemed to indicate, our staff observed that we Americans "don't do future very well." Perhaps our risk perception has been numbed by the long post-World War II credit cycle that allowed us to indulge today on a promise to pay tomorrow. We live in the now, and somehow the ability to think critically about possible future problems has been deleted from our societal DNA. In this year's stock market surge, I see similarities with the run-up between 2004 and 2007 that ignored Kasriel's and many others' chilling forecasts for housing and credit.
A rally supported solely by investor insouciance is ephemeral. Perhaps, like the stock market recovery during the last stages of the mortgage bubble, our current rally offers us a golden opportunity for serious reflection on the realistic outlook for the economy and for securities. To that end, I can't think of a more poignant inquiry than this: "How long can a country live beyond its means without serious negative consequences?"
Reality Check Time
Optimism is bred into us as Americans. It is in many ways our unique strength, giving rise as it has to an indomitable, can-do spirit. But if our tendency to anticipate only favorable outcomes were to morph into a childlike naiveté, our virtue will have become our Achilles' heel. (In case you forget how that poor fellow ended, check Wikipedia. Sobering!)
During four and a half decades of jousting with Mr. Market, I've developed my professional investor's definition of "optimism": "The conviction that one can make money in any kind of market." This is profoundly different from a naive optimism which supposes that the private economy will almost always grow and prosper, governments will act in the public's best interest and citizens will behave prudently. I have learned that realism, peppered with skepticism, is the healthiest attitude if you want to prosper in spite of the market's capricious behavior.
So what are the consequences of a nation living beyond its means? I propose a series of four basic questions (realizing that each is prone to generate a flurry of subsidiary questions, insights and possibilities).