"It is the common fate of the indolent to see their rights become a prey to the active. The condition upon which God hath given liberty to man is eternal vigilance; which condition if he break, servitude is at once the consequence of his crime and the punishment of his guilt." -- JP Curran, 1790

Tuesday, January 6, 2009

This recession was inevitable and overdue!

In a Utopian world, we would never have recessions, depressions, or restraints. We could grow and spend and over-extend ourselves without consequence. We do not live in this fairy tale world. We are fortunate enough to live in a free market society that provides the opportunity to prosper but also the painful recourse when an opportunity is mismanaged. And rightfully so, we are now entering a time of punishment for over-extension of credit, surplus goods, and false demand-boosting incentives in the 1990's and 2000's.

Like many things in life, prosperous times come and go. Riding the flows upward are fun and the ebbs down are not. But its not with a messianic clairvoyance that one could foresee this coming. With a simple understanding of Economic principles (supply & demand, market pendulum, velocity of money, etc.) it is more of a question of "why did it take this long for the proverbial "bubble" to pop?"

Pick your bubble (housing, energy, tech, .com, etc.) and it has contributed to this downturn in our economy. When you over supply a market with a product (houses) without reducing prices, you create a surplus gap between the supply and the demand. Mortgage companies sought to remedy this gap by reducing the immediate impact of purchasing a home at the same price by deferring payments. This helped raise demand which fueled additional building. However, as the deferred payments and interest caught up with over-extended buyers, demand plummeted.

Here are some interactive S&D curves to play along:
Supply: http://www.bized.co.uk/learn/economics/markets/mechanism/interactive/contain.swf?path=demand_and_supply4.swf


This is an over-simplified micro-economic view of why growth has slowed. But, apply this misalignment in the supply & demand of products to a handful of industries and you have momentum. Free markets contain tightly interwoven dependencies throughout the various supply chains. The benefit is cost efficiencies and competitiveness. If there is true competitiveness, when one entity falls or fails another can rise in its place. This does not happen instantaneously and in the time it takes for the successor to rise or enter that market there can be further decline among other associated entities. So as one grows/declines so does its dependencies, which creates an inertia. If the inertia is not controlled we get the large boom and busts. The problem is that the larger/longer the boom the larger/longer the bust and vice versa.

Looking at a macro-economic view let's go back to the Utopian idea of no recessions. Well in theory it is possible. Based on the idea that markets act like a pendulum, if you don't have a flow you won't ebb. Economists vary in there belief of the ideal growth % to avoid the rollercoaster. I've come to adopt 5% based on Ibbotson's analysis of Risk Premium in the Cost of Capital equation of the Capital Asset Pricing Model (CAPM). CAPM helps determine the rate of return for an asset and is a quantifiable measure of the value of an investment. The Risk Premium takes into account the opportunity cost of not investing the potential investment capital. Ibbotson determined that in developed countries the risk premium averaged 5% throughout history. In other words, if you invest in the market expect 5%. If your investment opportunity presents a higher percentage, seek the opportunity.

Lets look at a 5% annual growth versus the Adjusted Closings for Dow Jones Industrial Average, NASDAQ, and S&P 500 throughout each indices history.

The Dow, Jones & Company has existed since 1882 and has been tracking an annually chosen group of 50 predominant companies from leading industries. The companies have changed over time with General Electric being the only original company still included (except from 1902-1908). As the graph shows, the post WWII era of growth was inline with the 5% annual growth up until 1964. From 1964 the DJIA stagnated with some large swings until 1980. From 1980 to 1994 you can see a steady growth back towards the 5% line, with a few down years (1989-1990). From 1994 to 1999 the DJIA almost tripled from going 3800 to 11500!!! This unprecedented growth was the ride of rides. However, reality came back as the market started to correct itself from the overheating with the declines through 2002. President Bush and others realizing the potential magnitude of the decline following the boom used steps to change the decline (pre-9/11). Unfortunately for us today, those steps were too aggressive in my opinion and created another boom rather than a soft landing back at consistent growth. Instead the false confidence grew the DJIA to an all-time high of 14,164.53 in Oct. of 2007 and we have been sliding ever since as the market continues to correct itself.

The NASDAQ (National Association of Securities Dealers Automated Quotations) was founded in 1971 and is currently comprised of approximately 3,200 companies. It has the highest trading volume per day of any stock exchange in the world and gained its place along side the DJIA in the 1990s by focusing on technology and growth companies. The graph shows a similar trend as the DJIA against a 5% annual growth. The 1970s were a stagnant period with steady growth through the 1980s and early 1990s. Like the DJIA, the NASDAQ composite boomed in the 1990s as it gained 6 times it value from 1994 through 1999 going from 750 to +4000!!! Hurt by the .com and technology bubbles of the late 1990s, there was a resurgence from 2002 to 2007 and decline ever since.

S&P 500:
Published since 1950, the Standard & Poors (S&P) 500 index is comprised of 500 stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ. The 500 companies are typically the 500 largest American stocks according to market capitalization. Similar to the DJIA and NASDAQ the S&P500 saw growth inline with 5% through the 1950s until 1964. It then stagnated until 1980 and then steadily grew until 1994. From 1994 to 1999 the S&P500 tripled its value from 450 to +1500!!! It too declined into 2002 and re-boomed until 2007 and has been down ever since.

What the 3 charts illustrate is that we are now paying the price for the boom of the 1990s. The market appeared as though it would correct itself in 1999-2002 but then falsely manipulated growth sustained until 2007. It was appropriate to attempt to control the downturn in 2002, but the errant attempts to cling to the 1990s may have caused us even more pain now. This economy was due to slow down after the 1994-1997 joy ride. 2002-2007 only deferred the slow down and may cause a deeper and longer recession because of it.
So, let's apply this lesson towards a more cautious attitude and sense or reality as we combat this recession. President-elect Obama and his team have floated the idea of large stimulus and quick return to the double-digit growth slopes of recent yore. Largely based on public demand for a return to those haydays, I argue that it is not what we need. We need to return to steady consistent growth in the single-digit percentage range. Its fun to go fast but not on the way down. Let's slow the economy for a sustainable long-term growth rather than a short-lived burst. The problem is that political figures have a shelf-life and long-term steady growth is not beneficial to them during their career. However, their legacy will be judged by the history of tomorrow's tomorrow. A strategic vision of economic growth is why we can look back and say that Presidents like Truman-Eisenhower-Kennedy and Reagan-Bush did more to advance the prosperity in American than the short-term benefits of economic times under Presidents Ford-Clinton-Bush.
Signing off...JCB
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