Hussman - Eating Our Seed Corn: The causes of U.S. economic stagnation, and the way forward

Weekly Market Comments
March 23, 2015
by John P. Hussman, Ph.D.

Excerpts:

Executive Summary

    The U.S. has become a nation preoccupied with consumption over investment; outsourcing its jobs, hollowing out its middle class, and accumulating increasing debt burdens to do so.
    U.S. wages and salaries have plunged to the lowest share of GDP in history, while the civilian labor force participation rate has dropped to levels not seen since the 1970’s. Yet consumption as a share of GDP is near a record high. This gap between income and expenses has been financed by debt accumulation, encouraged by the Federal Reserve’s policy of zero interest rates, and enabled by fiscal policies that prioritize income replacement rather than targeted spending and investment.
    Since December 1999, total civilian employment among individuals 55 years of age and older has increased by 15.3 million jobs. Yet total civilian employment – including those over 55 – has grown by only 13.8 million jobs. This means exactly what you think: outside of workers 55 years of age and older, Americans of working age have 1.5 million fewer jobs today than 15 years ago.
    There are now more than 46 million Americans on food stamps, with SNAP (Supplemental Nutrition Assistance Program) expenditures increasing five-fold since 2000.
    While transfer payments and entitlements have increased, government consumption and investment as a share of GDP have declined to near the lowest levels in history. In effect, fiscal policy has been heavily biased toward income replacement, but has otherwise been a deer in the headlights in the face of repeated economic crisis. While the contribution of private investment has slowed to a crawl, fiscal policy – except for transfer payments – has actually been in retreat.
    In the investment sector, real gross private domestic investment has grown at a rate of just 1.5% annually since 1999 (versus a 4.7% real annual rate in prior decades), with growth of just 1% annually over the past decade. Yet while real capital accumulation in the U.S. has weakened, corporate profit margins have never been higher.
    In an economy where wages and salaries are depressed, but government transfer payments and increasing household debt allow households to bridge the gap and consume beyond their incomes, companies can sell their output without being constrained by the fact that households can’t actually afford it out of the labor income they earn. Meanwhile, our trading partners are more than happy to pursue mercantilist-like policies; exporting cheap foreign goods to U.S. consumers, and recycling the income by lending it back to the U.S. in order to finance that consumption.
    Debt-financed consumption, while it proceeds unhindered, is a central driver of elevated corporate profits. Unusually elevated corporate profits (a surplus) are largely a mirror image of unusually large deficits in the household and government sectors.
    The most reliable stock market valuation measures (i.e. the measures that have a nearly 90% correlation with actual subsequent stock market returns) are those that explicitly take account of the level of profit margins and mute the impact of that variability. These measures suggest that the S&P 500 Index is likely to be lower a decade from now than it is today (though dividend income should bring the total return to about 1.5% annually).
    Even if the Federal Reserve was to immediately reduce the monetary base by one-third (from nearly 24 cents of monetary base per dollar of GDP to a smaller 16 cents of monetary base per dollar of GDP), short term interest rates would still be zero.
    Once we account for movements in the Federal funds rate that can be captured by a fairly simple linear policy rule such as the Taylor Rule, additional activist monetary policy (deviations from that rule) have effectively no ability to explain subsequent changes in GDP or employment. There is a strong economic justification for proposals that would require the Fed to outline Taylor-type policy guidelines, and to explain deviations from those guidelines. These proposals should be advocated by Republicans and Democrats alike.
    Yield-seeking speculation promoted by the Federal Reserve caused the housing bubble and the resulting global financial crisis. A change in accounting rules by the Financial Accounting Standards Board in March 2009, not extraordinary monetary policy, is what ended that crisis.
    The true Phillips Curve is a relationship between unemployment and real wage inflation, it cannot be usefully exploited by monetary policy, and it is the only version of the Phillips Curve that actually exists in empirical data. Pursuing general price inflation does not somehow “buy” more jobs. It also does not raise real wages. It lowers them.

What raises both real wages and employment simultaneously is economic policy that focuses on productive investment – both public and private; on education; on incentivizing local investment and employment and discouraging outsourcing that hollows out middle class jobs in preference for cheap foreign labor; on international economic accords that harmonize corporate taxes, discourage corporate tax dodging and beggar-thy-neighbor monetary policies, and provide for offsetting penalties, import tariffs and export subsidies when those accords are violated. What our nation needs most is to adopt fiscal policies that direct our seed corn to productive soil, and to reject increasingly arbitrary monetary policies that encourage the nation to focus on what is paper instead of what is real.

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A warning on stock market valuations

A central problem for the financial markets is that they have priced in record profit margins as if they are permanent, rather than mean reverting. As I detailed in Margins, Multiples and the Iron Law of Valuation, the most reliable stock market valuation measures (i.e. the measures that have a nearly 90% correlation with actual subsequent stock market returns) are those that explicitly take account of the level of profit margins and mute the impact of that variability. For investors who understand this, the past few years have been a horrifying form of deja-vu, as overly loose Federal Reserve policies have provoked yield-seeking speculation  by investors who take these elevated profits at face value; assigning elevated price/earnings multiples to already elevated per-share earnings. Worse, companies eager to offset the gradual deterioration in profit margins have issued enormous amounts of new debt, and have used the proceeds of that debt to buy back their (overvalued) stock in order to reduce share-count and artificially boost earnings per share.

The Federal Reserve has not only encouraged the debt-financed purchase of stock by ordinary speculators (at $445 billion, margin debt on the NYSE alone is 25% the volume of all commercial and industrial loans in the U.S. banking system combined), but also by corporations. As a result, the only valuation measures that look anything less than obscene are those that embed the assumption of permanently elevated profit margins. And while investors seem eager to assume that elevated valuations are “justified” by low interest rates, any straightforward discounting method can be used to show that each year of zero interest rates only justifies a roughly 4% increase in prices over otherwise historically normal valuations (see The Delusion of Perpetual Motion). With reliable equity valuations about 116% above reliable historical norms, on average, one would need to anticipate decades of zero short-term interest rates in order to “justify” current stock prices. Even if one does make that assumption, one would still expect a 20-year nominal total return for the S&P 500 of no more than about 5.6% annually. The chart below shows the ratio of market capitalization to final sales (gross value added) for non-financial companies. See Do the Lessons of History No Longer Apply? for a broader range of historically reliable and similarly overextended measures.

It’s tempting to assume that the “normal” level of valuations has simply increased over time, and that presently rich valuations have no implications for expected stock market returns. But even a cursory examination of market returns argues otherwise. While annual market returns always vary considerably over the market cycle, stock market returns in the pre-bubble period averaged 10-12% annually as a result of the lower average level of valuations. In contrast, the S&P 500 has enjoyed average annual nominal total returns of less than 4% since the 2000 peak, and even then, has only achieved those returns thanks to a bubble advance that has taken valuations back to similar extremes.

Put simply, the most historically reliable measures we identify suggest that the S&P 500 Index is likely to be lower a decade from now than it is today (though dividend income should bring the total return to about 1.5% annually). These measures historically have been about 90% correlated with actual subsequent total returns in the S&P 500, and have retained that correlation in recent market cycles (see Extremes in Every Pendulum).