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Investment letter – October 18, 2009
LONG TERM STABILITY OR INSTABILITY?
The twenty-five year period between 1982 and 2007 may be the best period in economic terms in our nation’s history. There were only two shallow recessions, each lasting just 8 months. This extended period of economic growth and stability provided a wonderful investment climate that lifted the DJIA from under 1,000 in 1982 to over 14,000 in 2007. In order to gain a better perspective and appreciation of this period of prosperity, one should stand back and view a long term chart of the DJIA from 1946, just after the end of World War II. What quickly becomes apparent is the extended rally in the DJIA from near 150 in 1949 to 1,000 in 1966 that was also accompanied by strong economic growth, stability, and very little social unrest. Sandwiched between these two wonderful windows of growth and stability is the period of 1966 and 1982. These 16 years were marked by instability that not only engulfed the economy, but also resulted in enormous social stress. As assassinations gave way to race riots, war demonstrations, runaway inflation, and mile long gas lines, it felt as if the foundations underpinning our society were shifting.
From a historical perspective, visualize a pendulum that oscillates between stability and instability, with each period reaching an extreme after 15 to 20 years. The period of stability that ended in 1966 was heralded with the political phrase “The Great Society”. The ensuing 16 years were many things, but few would describe it reflective of a Great Society. On July 15, 1979, near the end of this 16 year period of turmoil, President Carter gave a speech in which he said, “It is a crisis of confidence. It is a crisis that strikes at the very heart and soul and spirit of our national will. We can see this crisis in the growing doubt about the meaning of our own lives and in the loss of a unity of purpose for our nation.” Quite a change from the optimism and confidence in the proclamation of a Great Society at the peak of the prior period of stability. The period of stability, which began in 1981-1982, probably reached its extreme as investors embraced the ‘New Paradigm’ in 1999, and bid technology stocks to absurd valuations. In response to the bursting of the tech bubble, the Federal Reserve aggressively lowered interest rates to keep the economy from deflating. Ironically, the extended period of economic stability between 1982 and 2000 encouraged market participants to take on highly leveraged risks, even as the pendulum was already swinging away from stability toward instability. This new 15 to 20 year period of instability began in 2001 or 2007, but it did not end in March 2009.
As I discussed in last month’s letter, there are numerous cyclical and secular headwinds that could easily take another 5 to 7 years to work through. (The September letter is available at welshmoneymangement.com, click on Publications and this month’s letter.) The fundamental challenges facing our financial system and all levels of government are structural in nature, and the result of excesses that have built up since 1982. There are no easy solutions. During the 1966-1982 period of instability, the DJIA made its price low in December 1974. (Chart below.) Even though the period of instability had another 7 years to run, the DJIA never fell below 730. My hope (and prayer) is that the March 2009 low marks the price low in the stock market, even as the economy struggles and social unrest increases in coming years. If the March 9 low is broken, it would suggest that all the efforts and money spent to prevent a deeper economic contraction had failed.
History suggests that these extended periods of instability (1929-1949, 1966-1982), do not reward investors who buy and hold, or the institutions that disdain cash. As a kid growing up in the Midwest, during July and August, I always wore a t-shirt and shorts and wore a crew cut. In January and February, my hair was longer and I never went outside in shorts and a t-shirt. (Well maybe once on a dare.) If my parents had known, they would have rhetorically asked me if I was stupid. So here’s a worthwhile question. Why do investment professionals advise their clients to simply buy and hold, whether we are in a period of stability or instability?
Over the last two years, the Federal Reserve has responded with unprecedented programs to initially prevent a complete collapse of the financial system and subsequently to restore some measure of functionality to the credit markets. The Treasury Department launched a large bailout of banks deemed too big to fail, and Congress passed a huge stimulus package. Despite these extraordinary efforts, overall credit is still contracting, residential and commercial real estate prices are still deflating, and consumer incomes are shrinking. On the plus side, the stock market rally has recovered half of the bear market losses, and corporate bond prices have also rebounded significantly. The economy has stabilized and is rebounding, but at a price. Government income transfers amounted to 17% of total personal income in the first half of 2009. Federal fiscal stimulus dollars helped plug the gaping hole in state budget deficits, which enabled them to avoid deeper cuts in services. But the safety net provided by the federal government will produce trillion dollar deficits for years to come. At some point, the Federal Reserve will shrink monetary stimulus and end their market support programs. The Federal government will need to raise taxes and lower spending to rein in the Federal budget deficit in coming years. The removal of these economic life support measures must be timed and balanced against the numerous secular and cyclical headwinds that will suppress economic growth and tax revenue in coming years. This sounds like a prescription for years of instability. Unless you believe the Federal Reserve and Congress are capable of perfect execution.
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