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Market Update: November 2012

November 9, 2012
David Matias

Post Election Hopes

As I sit here on the morning after, there are a number of very important points that come out of the results from last night.  Most important, the difference in this election from four years ago is a stark one.  While I am no political pundit, it appears that the Obama campaign won every swing state and Democrats won every closely contested Senate seat except one despite an economy that should have dictated otherwise.  Yet all of those wins were by a much smaller margin, Florida being a good example.  In all of these races, the difference that put Obama over the line was the changing demographic.  Minorities are growing while the white middle class is shrinking.  The Obama campaign was able to tap this trend.  Not only was the Obama campaign also able to command the women’s vote, but the number of women in Congress will now be higher than ever.  In a very positive sign, we are diversifying as a country, and the vote is starting to reflect that diversity.

So the question is: what comes next?  Regardless of your politics, we have a raft of issues that need to be addressed now.  Not just in the coming months and years, but in the immediate.  Irrespective of one’s position on the various topics, the lack of lasting resolution is more damaging than one particular tact or another.  The two issues I’m thinking of now are the fiscal cliff that enacts a raft of automatic budget cuts at year-end, and the expiring tax laws.  Both of which has a dramatic impact on individuals and the economy.

Despite significant frailty, the economy is showing signs of improvement – there would not have been an Obama victory without them.  The most important of which is the improving GDP figures and the housing market.  Real estate prices are showing signs of stability – a significant positive – and personal debt levels are down as well – a function of foreclosures.  The last quarter’s GDP growth increased to 2% from the tenuous 1.3% of the prior quarter.  Without growth, we cannot create jobs.  And without jobs, we cannot grow consumption.  Without more consumption, we cannot grow the economy.  It is a vicious circle that we have embraced – but one that we cannot break right now.

The jobs recovery to date, however, has been anemic.  As you see from the employment chart below, we have barely witnessed any change in the overall employment levels.  Long-term structural unemployment has now become pervasive, with over 1.7 million people unemployed at least 99 weeks.  That statistic, unfortunately, is grossly understated – it does not account for those who have simply given up.  We are employing the same percentage of the population as back in the 1970s, when there was a radically different expectation on quality of life, family structure was more traditional, and the debts were miniscule as compared to today.

US Employment as a Percentage of the Population (Ages 16-65): 1970 – 2012 

As the economy went through the dot-com bubble of the 1990s and the real estate bubble of the 2000s, employment was broadly boosted due to increased spending. Today, with the current recession, those jobs have been erased and we struggle to find a way to recreate the lost jobs. In fact, we are experiencing the same employment levels as the 1970s, when the standard of living was far lower.

Fixation on Debt

There has been plenty of discussion and debate around the level of federal debt.  It is not pretty, but it is not unbearable.  If there is future economic growth, and if there is an ability to stem future deficit spending, then these debt levels are manageable.  The problem we are facing today is the continued deficit spending on top of anemic economic growth.  The two combined is a recipe for disaster, a la Spain-style.  Hence the importance of the election message – we need to deal with the concurrent problems of increasing deficits and a lack of jobs.

State debt, in our view, is far more troubling.  The states don’t have the ability to inflate their was out of their obligations, and those obligations are enormous.  While the public municipal debt market is already $3 trillion, there is at least another $4 trillion in unfunded obligations across the country (and some say more like $7T).  No way to make those payments – and limited ways to borrow to cover them.  Future defaults on these debts or obligations are a strong possibility.  These are typically pension obligations, an area that will have a direct and profound impact on retirement, health care costs, and our ability to consume.  The same problems that we face now as a country could further compound as the states grapple with the realities of poor fiscal management.

The silver lining to the debt story is real estate.  Personal debt, the area that exploded in the last real estate bubble, is actually coming down.  The reason is simple – much of that debt was tied to real estate borrowing.  With so many homes in foreclosure, and much of that personal debt eliminated through bankruptcy, individual debt levels are down dramatically.  It could be a good omen – people can not put those dollars to improving quality of life and building retirements – or a bad one if there is little personal constraint and new debts are accumulated.  How it unfolds will be an important factor for the economy.

The problem with growing debt – whether it be personal or government – is that the debt service eventually tears into your ability to spend on important items.  Those important items could be a car repair, or repairs to a school district.  Either way, it can start to eat at the current quality of life and our future prospects.  In a worst case scenario, that debt is so burdensome that one defaults – such as personal bankruptcy or by devaluing the currency.  A personal bankruptcy is not as bad as it used to be – you no longer have to go to debtors prison and eventually someone will give you a new credit card.  For a country, however, the devaluing of a currency can have a devastating impact.  Other countries refuse to lend at favorable rates, quality of life for those who are paid in the currency declines across the board, and wealth in general is slashed.

The debt accumulation in the US, however, is a byproduct of the bubble economy that we’ve fostered for the past three decades.  As I’ve outlined in my article, “Turning the Economy into a Casino” (from The Intellectual Origins of the Global Financial Crisis, Berkowitz and Tuoy, eds., Fordham University Press, 2012), our economy suffered a decline of our core growth drivers that dates back to the 1960s.  To mask this erosion of economic growth, asset bubbles were fostered through government policies that allowed for a false sense of wealth.  This “wealth” led to greater consumption, the core of economic growth for the past three decades.

But when these bubbles pop, individual consumption contracts drastically and jobs are shed.  A cycle of decline ensues unless you either fix the core growth issues or insert a new bubble.  By my count, we are in the midst of the third major asset bubble in the past 30 years – the Quantitative Easing bubble.  Or free money.  More on that later.

Analysis of 2012

Despite this week, the year to date has been a remarkably calm one despite the underlying tensions.  I believe it is mostly attributed to this bubble.  We see that stock market valuations have again risen to pre-crisis levels, and many corporate earnings have improved in lock-step.  Through the end of October, the market was up by 14% year to date (S&P 500).  The core of that rise, however, is limited to two key areas: iPhones and banking.

The first is centered around Apple, their suppliers and the cell operators.  From Apple to AT&T to Verizon to the iPhone supply chain, and the knockoff iPhones supported by Android, the combined impact of the iPhone on stock market valuations is anywhere from a quarter to half of the market rise year-to-date.[1]  Apple alone, the largest component of the S&P 500 index, represents 13% of the market rise.

Here is the irony – we have seen the profits from the iPhone/smartphone market flow back to some shareholders in the US, but an entire slice of that revenue stream flows to Asia in the form of a negative trade deficit.  Remember that we import roughly a $1 trillion of goods more than we export each year.  Over the past forty years we have rushed to move our manufacturing overseas because of cheap labor.  As a result, we lost both the manufacturing capacity and know-how.  As the late Steve Jobs stated, the US doesn’t have the ability to make the iPhone (labor is 7% of the iPhone cost). A domestically manufactured iPhone and supply chain would have gone a long way in solving our current employment conundrum.  Instead, we handed those jobs over to China and their Asian supply chain vendors.

The second factor is the Fed stimulus and its impacts on the banking industry (what I’m calling the QE bubble or free money).  Low interest rates, subsidized losses and protective regulations have allowed the banks to prosper again and are some of the biggest market gainers this year.  I hear stories of folks who are refinancing at insanely low levels, but those loans are rarely available to people who have less-than-perfect credit.  In effect, the banks are offloading the risk onto the public sector – using free money to generate safe profits and playing with those profits in the markets (witness JPMorgan and my last Market Update).

I fear that these benefits are limited in their ability to repair our domestic economy.  As you can see from the chart below, while we have the largest economy on a per-person basis, we are quickly losing ground to Asia, led by China’s growth.  Combined with the recession that Europe is facing, and the serious debt issues that have fostered their problems, there is a dramatic shift under our feet.  As we move from the industrial age to the information age, I fear that we have lost the ability to capture enough innovation and growth to support our outsized expectations. Put another way, wealth and quality of life expectations for the 99% are going to change.

The Three Largest Global Economies

While the US has been eclipsed by Europe, and China is rapidly catching up given their sustained growth rate (perhaps in ten years), our per capita economy still affords us tremendous wealth as a country.


This is not a condemnation of the US economy, but rather a reality check on where growth is found as an investor.  Many US companies are doing remarkably well.  Their ability to shed employees, improve productivity and fortify their balance sheets will server them for years to come.  There is still innovation in this country, especially in the areas of early stage life science and energy technologies.  In the interim, the ability for the US consumer to push our economy forward is still hampered, and will be until base employment is solved.

Which comes back to my opening points on the election results.  The policies of the next four years need to clear uncertainty while fostering a stable employment base.  The improvements in real estate will help, but we cannot depend on our own consumption to fuel those jobs, and Europe is not going to do it for us either.  Firms such as Apple, that have a truly global revenue base, solid cash and deep penetration into Asia are the growth prospects for the public equity markets.  Domestic firms that maintain stability of cash flow and have managed their risks are good investments for predictable, yet very modest, returns on investment.

In the immediate term, the uncertainty of the next few weeks and months could reek havoc on market psychology.  Apple is a great example.  With the enormous run-up in the past two years, many folks are sitting on large long-term unrealized gains.  With the prospect of capital gains tax rates rising, folks are unloading their Apple shares to lock in the current tax rate.  If those tax prospects were already resolved – and set at a modest increase of say 15% to 20% – much of this panic selling would be averted.  But with uncertainty comes volatility.

As a reality check, Apple’s fundamentals are astounding.  They have well over $100 billion of cash/marketable investments on the balance sheet, and generate another $50 billion each year.  Their growth rate is still projected well into the double digits.  The price to earnings ratio, ex-cash, is 8x (by comparison, J&J is trading at 12x).  And the iPad mini, with gross margins over 50%, is going to explode on the global market and likely change the face of education.

But psychology will always win over reason.  And that unfortunately is the prospect that we face as a nation.  Our demographic is changing, our vote is reflecting those changes, and our economy is drifting in the currents of a dynamic world.  Change is inevitable.  How we manage this moment is paramount to the future of this society.

All the best for the start of the holiday season.


David B. Matias, CPA

Managing Principal

[1] This is a rough estimate based on the impact that those companies have on the S&P 500, and the amount that iPhone sales and related cellular service contribute to their earnings.

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