Tuesday, December 13, 2016

Is the Stock Market Wrong?

Since Donald Trump won the election the stock market has shot up.  Is the market making a big mistake?  I no longer think so.  I think earnings and profits at large American corporations will go up at least for a while.  Here's why.

The biggest component of the economy is consumer spending.  It represents something like 70%.  If consumer spending goes up then overall economic activity goes up.  We have seen this play out in the crash of '08.  When the economy cratered consumers pulled their horns in and stopped spending.  This made a major contribution to the downward spiral that followed the crash.  Since then things have recovered but consumer spending has not been robust so the economic recovery has been anemic.  Let me dive a little more deeply into this.

It has been widely and correctly reported that the incomes of those below the top 10% have stagnated or dropped.  People can't spend money they don't have, right?  Wrong!  They can spend borrowed money.  And they borrowed and spent at high levels before the crash.  The belief was widely held that consumers had racked up way too much debt and that this was bad.

This was true to the extent that when the economy contracted consumers had a very difficult time keeping up with debt service.  But a key component is the whole economic contraction part.  If consumer income had been rising steadily, which it was not, and had stayed at a high level, which it definitely did not, then consumers would have had enough money to keep up and there would not have been a problem.  But those ifs were not true and we had a big problem.

And that leads to a key fact that seems to never be newsworthy.  Debt is good for the economy as long as there is sufficient capacity to service the debt.  Debt only becomes a problem when there is insufficient capacity to service the debt.  We lost a lot of debt service capacity in the crash of  '08 and debt immediately became a big problem.

We currently see consumer income rising slowly.  If consumers continue to maintain the same level of debt they have post-crash then the consumer component of the economy will grow slowly and the stock market will have gotten it wrong.  But what if consumers increase their spending by increasing their debt?  Then the rate of economic growth goes up and the stock market looks smart.  And the willingness to incur more debt depends on psychology.  If consumers think things will get better then they will start the virtuous cycle of more spending producing a better economy producing more consumer income, etc.

These psychology induced increases in consumer spending can only go on for a short time without the need for actual economic growth happening to support it.  One of the thing s that has happened during the recovery is that small bursts of increased consumer spending were not matched by substantial economic growth so they petered out.  But I see a real possibility of an increase in the rate of economic growth.  It can't all be consumer driven, however, so let me move on to the second component.

Most of consumer income comes from wages.  If wages go up or more people become employed, or even better, both go up then consumer income goes up.  But corporate management has a lot to say about this.  If they increase salaries or hiring then they generate more income for consumers who, in turn, can buy more of their goods and services.  This grows the economy and the markets the business serves.  It's all good.

But businesses have adopted the Walmart model.  They operate on the theory that some other company should hire more people and/or raise wages.  If most companies don't follow the Walmart model then those companies that do will fare very well.  And Walmart did very well for a long time.  But if every company keeps costs down by suppressing investment and wage increases then no company's market grows and we all do badly.  And that's what we have seen during the recovery.  Companies have used aggressive cost cutting, layoffs, and financial tricks to keep their profits high while their fundamental business grows slowly or not at all.

As the economy has recovered we have had a slow but steady growth in jobs.  The unemployment rate is way down.  But the new jobs pay poorly compared to the old jobs so overall consumer income growth has been anemic at best.  We have finally seen the job market tighten enough to force wage increases in the last few months.  We seem to be at the point where this trend of wage increases is likely to continue.

And corporations have psychology just the same as consumers.  Corporations have believed that markets will grow slowly at best.  This has justified a layoff and cost cutting strategy that has created a self fulfilling prophecy.  But what if corporations change their psychology and decide that there are market opportunities out there?  That will cause them to increase their rate of investment and to be less aggressive at holding salaries down.  If they do that then consumer income will go up.  And that means that an increase in consumer debt makes perfect sense.  And that will contribute to an increase in the rate of economic growth.  And we will have a virtuous circle going.  Moving on . . .

The next most important component is government spending, particularly Federal government spending.  If neither the consumer nor business is spending the government can step in and fill the void.  This was done early in the Obama Administration with the "stim", a little over 800 billion dollars in Federal spending that was designed to stimulate the economy.  And contrary to Republican talking points, it worked.  But the effect was modest.  In part this was due to the fact that it was poorly constructed.  But the components that were a bad idea were explicitly put in to attract Republican support.  That failed.  And most economists felt that it was too small.  Finally, mostly what it did was halt the hemorrhaging.  It did not grow the economy.  It merely halted the decline.

And Republicans ramped up their "debt and deficits are bad" meme.  Somehow debt and deficits are not a problem when a Republican is in the White House.  Reagan and both Bushes ran up huge deficits which pushed our national debt to astronomical levels.  Carter kept deficits under control.  Clinton took us from a deficit situation to a surplus situation.  Obama halved the deficit between the early years when the economy was severely damaged and large deficits were inevitable to the last few years when the economy was reasonably healthy.  I expect the debt to balloon under Trump.

So, ignoring their inconsistency, are Republicans right?  Again the issue is not how much deficit and debt there are.  It's whether the capacity exists to service that debt.  And let me freely concede it's a Ponzi scheme.  The Federal government issues new debt to repay old debt.  Supposedly all Ponzi schemes are bad.  But this assumes that the debt needs to be repaid eventually.  And that is incorrect when it comes to immortal entities like governments.  And the Federal government is in a unique situation.  It could literally print enough money tomorrow to pay off the entire national debt.  So ultimately it can repay the debt.

The problem is that printing enough money to repay the debt would render US money worthless.  And that's bad for everybody.  So printing that amount of money is not a practical approach.  We end up yet again with psychology.  Investors believe that the Federal government is a sound institution from an economic perspective.  So they buy new debt even though they know its a Ponzi scheme because they believe that they will ultimately be able to get their money back because someone else will buy government debt in the future.  And that will allow the Federal government to make good on the current debt it is issuing.  So the real question is "what would critically damage that trust?"

Republicans have claimed whenever there is a Democrat in the White House that the trust is on the verge of being lost.  This justifies drastic measures like cutting the deficit.  (Somehow the other option, raising taxes, is a bad idea for [insert reason here].)  Whenever a Republican is in the White House the bad thing that was about to happen magically goes away.  And this is in spite of the fact that Democrats have a long record of fiscal responsibility and Republicans have a long record of fiscal irresponsibility.  Go figure.

Anyhow, Republican have succeeded in keeping Federal spending depressed during the entire period of the Obama Administration.  So there has been no pressure on the economy to grow at a fast rate from the Federal government.  This leaves the final component, the banking system in the form of the Federal Reserve.

The Fed is the only one that has been actively trying to get the economy growing and growing at a good rate.  But this is not something the Fed has the appropriate tools for.  They have been forced to resort to extraordinary measures.  These measures are often lumped into something called "Quantitative Easing".  But these tools are indirect and don't work very well.  So the best the Fed has been able to manage given that they have received no help from consumer spending, corporate spending, and Federal spending, is modest growth.

But if consumer spending goes up because consumers feel good and corporate spending goes up because corporations are feeling optimistic and the Federal deficit goes up because that's what Republicans do when there is a Republican in the White House then the Fed can get out of the business of using extraordinary measures.  A modest tilt toward the good by the other three components would be way more effective than what the Fed has been able to do.  In this scenario economic growth can easily perk up at the same time the Fed is shutting down its extraordinary measures.

Notice that Trump's only contribution so far is engineering a change in psychology.  He doesn't have to actually do or not do much of anything.  In fact, he can't actually do or not do anything until inauguration day.  Trump has promised massive tax cuts.  Since Republicans like that idea and they control both houses of congress he is likely to get his wish.  He has also promised lots of spending.  That may or may not happen.  Congressional Republicans seem to be of two minds on this.  They may sort it out and go along with massive spending.  That's what history predicts.

Or Trump may find himself uninterested.  Who knows.  But a big increase in the deficit leading to big increases in the debt seem baked in.  And as long as investors retain confidence in the Federal government's ability to pay the Ponzi scheme will continue humming along.  I think it is unlikely that investors will lose enough faith to change their behavior in the short run.  Who knows what will happen in the long run.

So I see smooth sailing for the stock market in the near term.  I see corporate profits growing.  I also see compensation packages for senior executives growing.  And that's all that is necessary to justify the stock market's current optimism.

But I don't see the situation for the rust belt blue collar workers who put Trump into office improving.  There is another group of people who are likely to be hurt.  That's the people who rely on the social safety net of Social Security, Medicare, and Medicaid.  Republicans seem bound and determined to scale all three programs back.  And that's if they can't figure out a way to privatize them or eliminate them.  Many of these people voted for Trump because he promised to protect or enhance these programs.  It seems unlikely that he will do so.

Besides the 1% I do see some people doing well.  I think the trend toward knowledge work will continue.  STEM (Science, Technology, Engineering, and Math) people obviously fall into this category.  But I also see creative people doing well.  There is a lot of art involved in a good web design and I think artists in general are going to do surprisingly well.  We'll see.

Another group that will do well are older people with some money of their own.  Back in the day a little old lady could buy a few shares of AT&T or a utility company.  The investment was safe and paid a good return.  And this investment was available to people of middling means.  The modern equivalent is government bonds or bank CDs.  But as of a few months ago these investments, while safe, paid essentially no return.  Several months ago a 30 year Federal bond paid just over 2%.  The more popular 10 year bond paid around 1%.  And government guaranteed bank CDs paid even less.  You could keep your money safe but you couldn't get any income from it.

Since Trump's election interest rates on government bonds have shot up.  The income is still well below historic levels but it is much better than it was only a few months ago.  The Fed is likely to increase interest rates this month (December, 2016).  If economic growth kicks substantially up then interest rates are likely to continue to climb.  This will cause the rates on government insured bank CDs to also go up.  Whether and how long it will take to get back to historic rates is a question I am not qualified to answer.  But things are definitely looking up for people who have some money of their own.  And these people tend to be older.

If the economy perks up then I have absolute confidence Trump will find a way to take credit for it.  And if people credit Trump for getting the economy growing more quickly, whether he deserves it or not, they will be willing to forgive him for many sins.  Of course, he has it within himself to do something so catastrophic that it actually derails economic growth.  And even if I am right I think it likely that many Trump supporters will be left behind.  Before the election I would have believed that they would figure out they had been conned and turn on him.  But he ran as such an obvious fraud then and people put their faith in him anyhow, I really don't know what it would take at this point to change their minds.