By John L. Chapman, Ph.D.           Canton, Ohio

For many months now, Alhambra Partners Founder and 20+ year investment professional Joe Calhoun has labeled the current investing climate a “secular bear market.”  That is precisely correct, alas, but what does it mean for the investor, exactly? In short, that the past is prologue to the near-term future, and that preservation of real wealth is of capital importance now.  And, given global monetary instability that is not unrelated to the market downdraft, one must add that in such a long term trend *cash* itself must be regarded as a risky asset class to be actively managed, rather than a neutral parking lot for assets avoiding risk.    

Contrary to popular understanding, the realm of economic theory does not evince propositions that lead one to favor any given policy prescription, per se.  What economics does teach us is that man’s behavior, and consequently market phenomena, are the result of his innate nature, and can be reduced to fundamental axioms that can be used to inform policy choices. For example, if a freeze in Florida harms the orange crop but the apple crop in the Midwest is unaffected, the price of apples relative to oranges will fall.  The rising orange prices induce an increase in the demand for apples, until such time as increased orange production (from whatever source) can be brought online and the relative price shift reversed, at least in direction.  The implication here of course is that policies that promote or discourage the production of one good (say, oranges) will have after-effects in other markets (say, apples), that we can predict with certainty in an a priori manner because we understand the basic underlying economic laws.

And similarly, one fundamental axiom of economics informs us that wants are insatiable.  That is to say, even the wealthiest of people such as, say, Microsoft’s Bill Gates, wake up tomorrow morning with material aims to fulfill.  Even someone like Mr. Gates can never be satiated – by, in his case, even $60 billion.  And therefore even Mr. Gates is living his life, day-to-day, in constant effort to move to a state of less satisfaction to one of greater satisfaction of wants (this is true even when one devotes oneself to full time philanthropy, because the mere existence of human action implies intended movement from a less-satisfied state to a more-satisfied one).

A corollary of this is that more is preferred to less, and hence, a growing economy and rising stock market are preferred by a “rational economic agent” – i.e., including, importantly, the investor of pure theory – to an economy wherein “progressive” concerns about equality prevail, at the expense of economic growth and rising levels of capital wealth.

To say this colloquially, prosperity is preferred to depression.  And in a formalization of the key themes of Adam Smith’s writings, neoclassical economic theory builds from the basic axiom of human action to derive fundamental welfare theorems of economics, the first of which is that a competitive market is efficient.  That is to say, it utilizes the resources of society in a way that induces maximal prosperity, or wealth creation.

This is important to remember in a time when the S&P 500 is trading at levels first reached in the spring of 1999.  Meaning, literally, that there has been no real or even nominal increase in the capital wealth invested in U.S. equity markets.  That is frustrating to investors to be sure, not least because the intervening period has come with dramatic up-and-down volatility for investors, as the following chart shows after 1999:

Chart I. Dow Jones Industrial Average, 1896-Present, Log Scale

For investors who wish to understand the present and likely future paths of graphs of equity market valuations such as above, there is no better way to understand the range of possibilities than by examining the rich past that Chart I represents, because it contains wars, recessions, banking panics, shifts in monetary regimes and core policies, multiple shifts in political power, and in turn, multiple policy mixes.  And what we learn at root is this: during periods of strong real economic growth, seen especially when government’s “footprint” in the economy is retrenching or at least not growing; tax, fiscal spending, and trade policies are stable; and the value of the dollar is stable or even growing, we see a concomitant and sustained gain in equity market valuation (e.g., 1921-29, 1946-66, 1982-99).

When however we see government’s role in the economy and control over scarce societal resources grow, usually coming at the same time as shifting tax, trade, and regulatory policies, we often see both an unstable or declining dollar and equally unstable or declining asset prices (e.g., 1966-82).  And so it should come as no surprise that we see a flat equity market for the last 13 years coming at the exact same time as economic growth in the United States has been halved from its historic 3.4% annual rate of growth in the century and a half after 1850. 

The lesson here is clear:  absent a major shift in the policy mix of the U.S. government in the time ahead, U.S. equity market valuations will be capped in real terms, because real economic growth is capped.  Indeed, the prospect of a larger footprint for the government in the U.S. economy, first in higher tax rates and inclusive of more involvement in industry via regulation, coupled with an activist Federal Reserve, guarantees this.  We do not claim to know the trading “high” point of U.S. equities that are moving in a range through this secular bear market, but certainly do not agree with calls for new nominal records in the near term.  Further, cash itself, and most prominently the U.S. dollar as the global reserve currency, must be actively managed during a period such as now, with elevated levels of volatility.  This is so because cash no longer represents neutrality of purchasing power when such high volatility is emblematic of relative currency value shifts, first and foremost. 

The bottom line is this:  an era of 1.5-2% growth limits the market’s upside in the aggregate, and while stocks won’t see a sustained swoon until recession formally hits the U.S. again, declining corporate profit growth, the wall of global worries, and imminent tax increases on the U.S. economy’s most productive job creators could portend trouble in 2013, even in the event of a near-term rally we’ve anticipated due to the prospect of better policies ahead.

The news out in the last week confirms this continued sluggishness – albeit of the positive kind – to the economy.  The U.S. trade deficit shrank in May from April, to $48.7 billion, based on $183.1 billion in exports and $231.8 billion in imports.  As we’ve stated before (e.g., see post-script here), we follow the total volume of trade far more than the deficit, which is important to conventional wisdom’s assessment of Keynesian-style GDP calculation, but next to meaningless in the real world.  We also follow the growth of imports, as it is a direct leading indicator of consumer energies and demand level (and at the same time, signals foreign investor interest in the U.S.), and so it is a disappointment that import levels fell again for the second month in a row.  However we note that total trade volumes are still up 4% year-on-year, and near their all-time highs.  And, that in spite of all the doom-saying, exports to both Europe and China grew for the month and year-on-year (4% and 13.5%, respectively, in the latter case). 

Relatedly, import prices are down year-on-year (-2.6%, much of that due to energy), as are export prices  (-2.1% year-on-year after a -1.6% drop in June) – this surely shows steady if not rising demand given rising productivity and output levels.  The growth rate of both imports and exports has also been declining for the better part of two years, and this is concerning, as it is long enough to make a trend.  But again, absolute volumes continue to increase, and cannot be said to show any hint of recession in the U.S. at the moment.

Meanwhile, the Producer Price Index rose +0.1% in June, for the first time in four months. Producer prices are now up +0.7% year-on-year, albeit with huge drops in energy prices matching a +2.8% gain in food.  The core PPI, which excludes these two volatile items, was up +0.2% in June and +2.6% year-on-year (and the rate of gain for the core in the last six months is up to +2.8% while overall producer prices are down slightly in that time thanks to energy).  This is consistent with a (lagged) rising CPI in the months ahead and we therefore cannot agree with any of the rumblings from the investor community as it clamors for “more QE.”

Finally, seasonally-adjusted weekly jobless claims fell to 350,000 for the first week of July, way down from the prior week’s revised 376,000 and the prior four-week moving average of 386,500.   In the volatile market era we’re living through now, investors pounced on this news, even though this data series is itself highly volatile week-to-week.  Nonetheless, 350,000 is the upper bound level that, in the modern era, has sustained an economy growing north of 3% per year: if only it were a harbinger.               

All in all, then, we see a continued “plodding” in the U.S. economy – a track we expect to see run out for perhaps years yet to come.  In such an environment, a sustained gain in equity prices is highly unlikely in our view (again, Chart I above is very clear on this), but again, at least the absence of a downturn precludes a dramatic dropThe coming few weeks will see the release of second quarter profits, and these data will provide us with the very best macro-indicator of near term market direction and recession threat.  As we remain vigilantly alert to unique (and likely mispriced) opportunities around the globe, all eyes are also now on Bernanke testimony and the upcoming Fed meeting in the next 18 days. 

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

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