Market Update: October 2013
From Tapering to Teetering
As has been the pattern of the past six years, the summer always brings an interesting set of challenges for the financial markets. This summer was no exception, from continued uncertainty in the financial markets soothed over by unprecedented Fed stimulus to geopolitical developments that are still unfolding. Unfortunately, the political dysfunction that has riddled the nation for the past fews years has reached a stage that will only continue to harm the economy and the country.
The positives, however, are fairly obvious: the US continues to pump $85 billion of newly printed money into the system on a monthly basis, with the stock market as the primary beneficiary. While the numbers vary week to week, the S&P500 is up around 15% year-to-date. The other bits of good news are real estate prices, which are on a remarkable recovery, a nominally growing US economy, solid corporate profits, and the recent changes in our energy dependence.
Unfortunately, each of those positives are countered by negatives: the stock market went apoplectic when Ben Bernanke suggested tapering of the stimulus, growth from the emerging markets has faltered, US overall employment levels are the same as five years ago (mid-recession), and the economic growth in the US is significantly below the long-term average needed to insulate us from negative shocks.
The employment picture is perhaps the best place to find reasons for caution. Although the unemployment figure we so often read about is significantly down from the high of ten percent, the employment picture is a bifurcated situation. In the recession, we lost nearly 10 million jobs in the span of just a few quarters. And while we have created 7 million jobs since then, our labor force has grown in those five years by roughly the same number. So in short, the labor participation rate among Americans is at a 30-year low. The following chart shows this fairly well.
Chart 1: Data from the Bureau of Labor Statistics shows the percentage of people employed between the ages of 16 and 65. This chart covers 1981 to present, and shows that the labor rate has not changed since 2009. With a labor rate equivalent to the 1980s, we are creating only enough jobs to satisfy the growing population base, but not replacing those lost in the recession.

The anecdotal evidence suggests the jobs we’ve created in the past five years are of far lesser value than the jobs lost. Most are at minimum wage, there is a tremendous underemployment problem, and the divisions among social classes continues to widen. These issues only make the next conundrum even more challenging.
Market behavior continues to indicate that we are in a cycle of bubble markets driven by consumption economics. The next chart shows the movement of the S&P 500 over the past 30 years, in which the market is pushed to new highs in each cycle. The driving force behind these peaks is external stimulus leading to bubble asset valuations (dotcom in the 90s, real estate in the 00s, and Fed stimulus in the 10s). In the collapse of the two prior bubbles, the damage to the financial condition of the broader society was extensive – far greater than the benefits from those bubbles.
Chart 2: The US stock market over the past 20 years (S&P500) has shown a broad trend of asset inflation followed by steep drops as the economic growth falters. These asset bubbles have been extraordinarily damaging, with the potential that we have formed another one. Corporate profits will ultimately determine the breath and depth of the rise and fall.
For the current market rise to continue (as opposed to correcting by 20%-50%), we need corporate revenues to grow. Thus far, corporate profitability has backfilled the market as price-to-earnings ratios remain at or below historical averages (16x). This has been primarily achieved through layoffs and productivity increases with some revenue increase. With the internal measures largely exhausted, revenue growth is going to be front and center for the next several quarters.
This picture could work but demand needs to come from a mixture of domestic and global consumers. The global scene is dominated by Europe – still struggling to get out of a recession – and Emerging Markets. As we have seen in China and elsewhere, the massive boom in the emerging markets over the past decade has created disruptive air pockets that make predictable growth elusive. Hence, the need for the American consumer to find additional disposable income or a willingness to once again increase personal debt levels. With such a stagnant US employment situation, neither are likely soon.
Chart 3. As the US equity markets surged ahead (S&P 500 shown in red) in the first two quarters, Q3 saw the Emerging Markets (shown in green) stage a partial recovery while Europe & Japan (shown in blue) also posted stronger gains.
It is for these reasons that we at Vodia Capital maintain a diversified asset allocation strategy for our portfolios. Relying on just equities to drive gains would subject portfolios to far too much volatility and uncertainly. While markets have shown an ability to recover in the past, these gyrations eat away at long-term returns and ultimately underperform when compared to a diversified strategy. In response, we continue to use fixed income, commodities and derivates to both stabilize portfolios from global uncertainty and generate predictable growth.
Geopolitical
The biggest challenge to backfilling the equity asset bubble is global conflict. Domestic issues are important and bleak, but with enough time and some basic legislation, our current situation will ameliorate or the domestic economy will simply adapt. But until that happens, we do not have enough consistent economic growth to withstand a shock to the system and not enter another recession.
The global issues are less predictable, although we seem to have hit a moment of pause. Despite my wildest expectations, the situation in Syria seems to have found a multi-lateral solution with Russia participating and China consenting. While I have my doubts on the ability for the global community to truly disarm Syria’s WMD capabilities in the long-term, it is a relief to see it handled through cooperative diplomacy and through the UN.
On a separate but related front, Iran has consistently posed the greatest threat to global stability in the past few years. Compared to Syria, Iran’s pursuit of WMD’s is a real problem with real ramifications. Not to overstate the situation, but by many accounts this region was on the brink war if something was not done soon. And while I also have serious doubts as to the authenticity of Iran’s overtures, we have taken steps to open a dialogue that has been closed for decades. That is progress.
Where we do not have progress is in our own political structure. As of this writing, we have a partial shutdown of our government, with another looming prospect of defaulting on our debt in another three weeks. By some estimates, a complete shutdown of a few weeks could wipe out our economic growth for the quarter and possibly the year. And defaulting on our debt is simply a non-starter – the financial ramifications are just too vast to play with. While cooler heads will prevail, the damage to the economy through continued uncertainty has already taken a toll on lower economic growth.
Changing Energy Dynamics
The most promising development is the changing energy dynamic in the US. The past six years have seen a dramatic and unprecedented change in our energy dependence. Despite the mild economic recover, our use of oil has actually decreased by 10% from a combination of better vehicle fuel economy and alternative sources. During this same time, our oil production has doubled from technological advances. The net impact is to decrease our reliance on oil imports by half, to less than 10% of global production.
Combined with our natural gas boom, this is an incredibly positive development for the economy. Much of our economic growth over the past decades has depended on cheap energy, creating a political structure and international presence that went to extreme lengths to protect the dynamic. As net exporters or natural gas and coal, along with a far lighter dependence on the global oil market, untold resources will be freed up and could generate a new form of a “peace dividend” that we experienced post-Cold War.
The medium-term impact of our energy production and consumption is still of grave concern – from global climate change to the damage we are doing to our drinking water. The shift to alternative sources, whether they be truly green or simply move us away from oil, is of paramount importance and must continue. But the ability to shift a focus away from deeply disruptive policies to protect a bad oil dynamic is a start. Where we take it next will determine just how much of a global leader we can be in the coming decades as the forces of economics increasingly determine our actions as a country.
All the best for an enjoyable fall.
Regards,
David B. Matias, CPA
Managing Principal