Everyone Is Muddling In Economic Darkness

Everyone Is Muddling In Economic Darkness
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There are actually two parts to any valuation, or at the very least two.  Most of our attention is usually drawn toward the most spectacular, which is almost always the price of whatever security or class.  We notice it because that’s where the fun is, the business of finance being made in the (hopefully) upward swing of asset markets.  But we only rationalize that euphoria wherein the second part of valuation doesn’t play along.

The dot-com bubble was one such period fitting the qualification. If you were to ask most people what made it one they would likely answer with some anecdote or reference to the crazy price movements of the time.  And they were truly crazy, no shortage whatsoever of insanity as any brief review of the late 1990’s demonstrates clear violation of sense. 

What people remember are things like theglobe.com going public on November 13, 1998, soaring more than 600% in its first day of trading.  Or a little over a month later when stock analyst Henry Blodget famously raised his annual price forecast for Amazon, then a relatively boutique name, to more than $400 though it at that time traded for less than $250.  His price target was reached in weeks, not a year.  They say nobody rings a bell at the top, but Time Warner came about as close as anyone ever has in buying out AOL for $156 billion in January 2000. 

We remember the prices, especially the IPO’s because that was where it all seemed to be. It was an almost warlike competition between the NASDAQ and the NYSE; the coming business giants in tech that heavily populated the former against the aging dinosaurs of the past clustered onto the latter.  Everyone wanted to be in on it, which explains “old” media Time Warner trying to buy their way in to “new” media AOL. 

Because of all the fuss and bother about stock prices, practically no one noticed the Asian flu apart from its brief appearance occasionally in the domestic headlines.  It had appeared to be an issue for the Russians or Thailand, but apart from some market notice in 1997 the rest of the nineties proceeded as if it just didn’t matter for anything other than an historical, overseas oddity.  Even LTCM was dismissed as quickly as the name entered consciousness, if it even did outside of the few who noticed global plumbing.

Standard and Poor’s, the keepers of the most widely followed stock index, tell us a bit of a different story about the late 1990’s.  According to their estimates, aggregate earnings for the 500 companies that were at the time included in the S&P 500 actually peaked in the third quarter of 1997.  From that point until five quarters later at the end of 1998, aggregate trailing-twelve-month earnings (ttm EPS) fell by 7.2%.  That was not a major setback by any means, as ttm EPS had dropped 27% due to the 1990-91 recession peak to trough, and would be reduced by 52% by the coming dot-com recession of 2001.

As earnings had paused their sharp middle 1990’s upward drive, the price side of the index in those same five quarters shot up by more than 30% - and it would for the rest of the decade never look back.  S&P’s figures were the most charitable, too, where other data relating to corporate profits suggested a more serious post-Asian flu effect.  The BEA as part of its GDP data, on the GDI side of things, produces estimates of corporate profits that aren’t as narrowly limited to the companies of S&P’s index.  According to this set of numbers, profits from current production, one measure of economically-derived bottom lines, peaked also in Q3 1997 at $893 billion. It wouldn’t be until Q3 2002, five years later right at the bottom of the dot-com bust, that profits would finally surpass that mark.

In other words, the late 1990’s wasn’t as perhaps robust as might be remembered overall.  The reason for that was the economic transformation that at the time was truly radical.  It was the NASDAQ versus the NYSE in more than just stock listings, as the term “new economy” became ubiquitous.  That label didn’t just apply to tech companies going public at a frenzied rate, it was so much more than that. 

In January 2001, President Bill Clinton reported to Congress for one last time on the state of the US economy.  Transmitted to both houses as required as required by the Employment Act of 1948, amended by the Full Employment and Balanced Growth Act of 1978 (colloquially Humphrey-Hawkins), via his Council of Economic Advisors, Chaired by Martin Baily, the report was practically threaded together with the words “New Economy.”

“Over the last 8 years the American economy has transformed itself so radically that many believe we have witnessed the creation of a New Economy. This Report presents evidence of fundamental and unanticipated changes in economic trends that justify this claim.”

This kind of enthusiasm was not unique in history, as any time such radical departures become so broadly experienced it often triggers the same interpretations; that in being situated on the cusp of transformation, the fruits of it would be an enormously positive boost forever thereafter.  Caution against such extrapolations, however, are in this case included by just one word in the very statement recorded above introducing it:  unanticipated. 

If you don’t anticipate something that has happened, it is wise to be careful about believing it will always happen.  At the very least, it says that maybe you don’t completely understand what did occur, and therefore prudence demands being aware that it could end rather than, quite ridiculously, continue on forever. 

The President’s report was, of course, a strictly political document where being Clinton’s final one was quite intentionally made to couch his two terms in office in the most positive fashion possible. What better way to leave office than to be able to say, somewhat plausibly, that you created a better world? It is largely the one thing Clinton is remembered for. But the “new economy” was not strictly a Washington invention; as the quote above shows, it was something that happened that only later did politicians attempt to get credit for. 

It was a confluence of a number of pathologies combining at just that right time, too many and far too complex for the scope of this review (lengthy as it may be in its own right).  For our purposes here, what is important to remember about the dot-com era was the divergence embedded in those ridiculous valuations and what that said about expectations.  Earnings were stuck while prices became totally unrestrained.  The former was economic reality especially after the Asian flu; the latter ignoring the present for a “new economy” that was surely just over the horizon evoking a new normal of permanent prosperity where nobody could lose.  Even theglobe.com would be hugely valuable in this future. 

It wasn’t, of course, as that particular stock was delisted on April 23, 2001, for a final quoted price of 16 cents per share.  The problem was that the “new normal” did happen, only it didn’t mean what most thought it would; suggesting that the reasons for it and what was actually going on weren’t well enough understood at all.  The economy has been more completely transformed, only it didn’t quite lead to such uniform and unquestioned prosperity as those dot-com prices once reflected.

In President Clinton’s January 2001 report, his Council of Economic Advisors went to great pains to try to relate the “new normal” to established evidence. They summarized it as:

“This Report defines the New Economy by the extraordinary gains in performance—including rapid productivity growth, rising incomes, low unemployment, and moderate inflation—that have resulted from this combination of mutually reinforcing advances in technologies, business practices, and economic policies.”

The irony of that statement is that from practically the moment it was written the opposite trends all started to become the dominant setting.  The US civilian employment-population ratio, for example, peaked at 64.7% in April 2000 and has been trending lower ever since. Productivity growth, once the “secret” ingredient in all of this, the very essence by which the “new normal” was believed to induce permanent prosperity, also began to decline so that sixteen years later it has become common to estimate there has been none at all.  The result is an economy where the BEA calculates total disposable personal income for April 2017 at just $14.4 trillion when had the economy done nothing more than stay on its prior track it would have been $19 trillion instead. 

For the most part, given the state of economics, we can’t even begin to answer how this happened because the mainstream remains in many ways still unaware that this is the case. Most people realize and feel that “something” is wrong, but it isn’t clear what.  They see on the news, meaning the internet downloaded to their phones unconnected to AOL, that GDP is low but positive and that most economic accounts also have a plus sign.  From that perspective, a low growth world seems to be lackluster but not so dangerous.  Social and political disruptions might therefore seem to be out of proportion.

In other words, they feel that there is only $14.4 trillion in disposable income without ever realizing the full extent of the loss of $19 trillion. It is linear growth being used to describe what is really an ongoing non-linear contraction. 

That is in many ways what happened to the dot-com era. The economy during the bust never fell apart; in fact the recession of 2001 was the mildest official contraction on record.  It was so devastating in terms of the stock market as well as the “new economy” narrative because the two had become related in conventional wisdom that the good economy of the nineties was going to be in the 2000’s permanently awesome.  Backing away from that view led to a systemic reassessment of not just expectations, even though there was never any economic collapse that we usually find with the bursting of massive bubbles. Valuations were the anticipation of a positive economic shift that wasn’t really possible. 

As was once said, history doesn’t repeat but it surely rhymes. At the so far other end of the dot-coms in 2017 we find somehow similar processes particularly as they relate to stock prices.  The market here and elsewhere around the world continues to find new record high prices, even though valuations are now in many ways comparable only to the late nineties and the dot-com era.  That should be everyone’s first clue about what is going on.

Also, corporate profits and earnings like that earlier period have also abruptly stopped.  Peaking in the middle of 2014, whether from S&P or the BEA, estimates for profitability have yet to equal those levels in whatever metric despite almost three years of distance.  The scale of the decline was significant but not momentous.  The issue is time in both cases; then was the Asian flu where now the world tries to overcome the “rising dollar.” 

Where the comparison seems to break down is the “new economy.”  Back then, it was an enormous blank slate through which to project every positive financial fantasy.  Today, the “new economy” is synonymous with stagnation at best, no such unbridled dreams of permanent prosperity; we would now give almost anything for just a brief burst of it.

But we need to see the world in non-linear terms.  Growth in the nineties was already good, so people were seeing the future as even better.  Growth in the 2010’s is atrocious, so people are seeing the future as not unbelievably good but rather merely something above horrid.  And stock markets are today, like twenty years ago, rationalizing conditions to make that leap of valuation.

Every small positive or increase in whatever economic account or indication is magnified into the most definitive piece of evidence ever contemplated; all the while ignoring the far more voluminous contrary evidence, the full context for that small positive, and a sufficient dose of common sense.  Inflation rates, for example, reached in the US as well as Europe 2% for the first time in years.  That “achievement” was heralded far and wide as the announcement proclaiming that finally the malaise had ended, QE’s were at last bearing significant fruit, and though it wouldn’t necessarily mean 5% growth it was at least an end to the persistent drag.  It was made out to be the transition point from a decade of atrocious to now a future of just plain unsatisfactory.

What is more compelling still is that this is a repetitive process.  We are witnessing nothing but the repeat of 2014.  At that time at least in the US stocks reached record highs for what QE3 (and 4) was going to do.  The economy was believed at that point poised to burst off the atrocious baseline and to then what was thought an actually decent recovery.  Stocks zoomed forward though earnings and profits did not. 

In other words, the rationalizations about valuations are becoming more unhinged each time.  In 2017, there isn’t even a QE3 with which to attach future expectations, nor is there anymore even a recovery.  The Federal Reserve, for the longest time the primary source of positive modeled and stated expectations, today sees no actual improvement in the economy at all even as they “raise rates.” The FOMC actually does so because they have finally judged this decade-long condition a permanent one and therefore nothing left for monetary policy to do (even if you believe it could ever do something). And as inflation rates have shown, there never was any momentum with which to suggest the atrocious baseline is being left behind to achieve something relatively more positive. Yet, stocks persist at and near records to the point now of 1990’s valuations.

Rationalizations are extremely difficult to break, especially when they become systemic.  There is at root a psychological disbelief that pertains to much more than stock prices.  It is true dissonance, that there just is no way the economy could remain so horrible for so long. Surveys of consumer sentiment uniformly show very high levels of optimism right now (starting to become that way importantly around 2014), levels that these statistics haven’t seen since the housing bubble days.  And yet, consumer spending continues to lag and be depressed, more like 2012 than 2005.  On the surface, it doesn’t seem to add up, especially since everyone says the economy is at least growing.

To oversimplify and generalize, a great many people are anticipating the end of what is truly a global economic depression, believing through all this time that there just has to be one even if by nothing more than random chance.  The longer it goes on, the closer that end has to be, right?  And the closer we are to the end, the more you better get in while you still can.  It seems, after all, to be violation of everything we know, that there just cannot be a permanent valley of stagnation, a never-ending non-linear contraction that in the real world is in repetition more significant than any negative GDP estimate. 

The basis for this belief in positive transformation of the baseline is as spurious as it was in 1997-00. The one radical transformation of the nineties no one ever talks about, or realizes ever occurred, has been behind all of it.  In truth, without it there is no way to even explain the dot-com bubble, or the concurrent housing market deformity. Certain policymakers, however, detected something about it and chose to believe it didn’t matter. As noted a few weeks back, in the early 2000’s the period was renamed the Great “Moderation” as if that was ever possible given these drastic imbalances.  And that so-called moderation was attributed to as much “good luck”, the unexplained (or “unanticipated”) lack of monetary disasters that had all throughout history punctuated shorter bursts of economic sufficiency.

Two decades later the conditions have all changed but the imperceptions have not.  The world still has largely no idea there is this thing called eurodollar, and so being unaware it might make sense to figure an end to its economic drag because without knowing why there is this economic drag it instead seems logical and historically valid to expect the drag to just stop at some point. We are told from childhood the economy only grows. It is the equivalent of some futuristic spacecraft flying by a black hole that its inhabitants didn’t know was there; after being pulled toward it for a long period of time, if you didn’t realize it was a black hole you might expect to stop being deviated from the prior course at some point – and look forward positively to that moment you believe is certain to come. 

Stocks are at record highs even as the economy remains trapped in depression. It seems like the impossible, but we need only visit past periods of similar digression to observe the manner in which it is not. As much as we perceive a linear world, it all really works in non-linear fashion.  There are no “unanticipated” bursts of prosperity just as there is no randomness to the world.  If the world economy seems to be pushed upward by some unknown force, only to be dragged downward at a later time by again some unknown force, it would be only practical to investigate and understand in fine detail the unknown force.  Every official was only too happy to take credit back then for reasons they couldn’t really specify or prove, and too afraid now lest it point the finger of blame in their direction. 

It leaves pretty much everyone to muddle in darkness trying to make sense as best as they might with so much of the picture missing and obscured.  People, again, know there is something, but what is it?  Where once there was a dot-com bubble, there is now a Depression Bubble Paradox.  Two decades ago, stock investors bet on even better economic conditions without ever understanding the real nature of their contemporary economic conditions.  Today, they see ahead the end of the stagnation though similarly they have no idea why there was stagnation in the first place. In both cases, valuations become so stretched wagering on a future positive (non-linear) shift that will make the present, and those valuations, nothing but minor inconveniences.  We know how the first one ended, and by examining the eurodollar we have at least a rational basis to detect reasonable possibilities for the second.  And in all likelihood it will be “unanticipated.”

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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