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Market Commentary First Quarter 2014

April 10, 2014

Following stellar gains in 2013, the stock market experienced an unusual losing January before wobbling higher during February and March. During the quarter, the S&P 500 and NASDAQ Composite stock indices recorded gains of 1.8% and 0.8%, respectively. The Dow Jones Industrials declined 0.2%. A losing January, usually a strong month, has often been a harbinger of stock market trouble during the remainder of the year. Since 1950, winning Januaries have been followed by average gains of 12.1% during the remainder of the year. In contrast, January declines have been followed by further declines 11 times out of 20, and the average price gain for years with declining Januaries has been negative.  With equity valuations high and individual investors already heavily invested in stocks, we would not be surprised by additional stock market weakness.




Following a very negative year for fixed income investors in 2013, the prices of most fixed income securities rallied during the first quarter. For bonds, one bullish development was new Fed Chairman Janet Yellen’s February testimony before Congress that she would be slow to curtail the Fed’s massive program of buying Treasury and mortgage bonds. Another bullish development occurred on February 24, when the Bureau of Economic Analysis (BEA) issued a substantial downward revision of its estimate of fourth quarter 2013 GDP growth. Economic weakness is typically bullish for fixed income prices, and the BEA’s revision resulted in 2013 annual GDP growth of only 1.9%, very anemic during the fourth year of an expansion. Since the economy is already benefiting from ultra-low interest rates and sizeable, albeit shrinking, Federal deficit spending, is this anemic growth a sign that the economy has structurally shifted to lower than historical growth for the future?




Renowned investment strategist Jeremy Grantham thinks the answer is yes. One method of calculating GDP growth is to add the annual change in hours worked and the change in annual worker productivity. (Is labor working longer and more efficiently?) Grantham relies on that equation to forecast U.S. economic (GDP) growth of only 1.5% during the next 30 years. First, he accepts the Census Bureau’s prediction that future “person-hours” worked will grow at only a 0.2% per annum rate. Then, he adds productivity growth of 1.3%, the same rate as the past 30 years, to arrive at his GDP growth forecast of 1.5%. If Grantham is correct, this tepid rate of growth would present significant challenges for the economy’s ability to sustain private sector investment and to fund federal entitlement programs.




Grantham’s prediction is consistent with an existing trend of slowing growth. He notes that between 1880 and 1980, a great industrial age, the U.S. economy produced average economic growth of 3.3% per annum, notwithstanding numerous recessions and two depressions. During that century, our economy grew 26 times larger. However, from 1980 through 2000, perhaps due partly to the shift of manufacturing offshore, economic growth decelerated to 2.8% per annum. This downshift occurred despite the benefits of steadily falling interest rates, rising consumer spending and two long expansions during the Reagan and Clinton presidencies. Since 2000, despite lax lending practices that fueled more consumption and a historic housing bubble, economic growth still slowed to an average rate of only 1.4%.


The generational implications of whether we grow at the former rate of 3.3% or the predicted 1.5% are significant. During a worker’s 40-year working span, an economy growing at 3.3% will be 265% larger at retirement, probably well able to support his or her pension and entitlement provisions. In contrast, 40 years of 1.5% growth results in an economy only 80% larger, with far less additional wealth to apply to pension and entitlement promises. This “new normal” rate of slow growth would only exacerbate already looming problems funding entitlements and pensions.




The economy grew at only a 2.1% rate during the Bush years of 2001 through 2008, and it has slowed further to 1.2% per annum during the Obama presidency. Obama’s first term was burdened by the Bush recession following the 2008 Wall Street collapse, but he also presided over trillions of dollars of deficit spending that has yet to accelerate the recovery. (Many economists believe that federal “stimulus” spending is a weak method to spur sustainable economic growth.  Meanwhile, federal debt has expanded from $10 trillion at the end of 2008 to a current estimate of $17.5 trillion.) Our recent economic growth has fallen far short of predictions made in 2009 and 2010 by both Obama’s White House economists and the non-partisan Congressional Budget Office (CBO). Our April 2010 letter was skeptical of the CBO’s economic growth predictions, which were cited by Congress to justify the passage of Obamacare. In 2010, the CBO predicted 4.5% growth during both 2012 and 2013, while actual growth was 2.8% in 2012 and 1.9% in 2013. That is a $730 billion shortfall from the CBO’s predictions just for those two years.




The non-partisan CBO also estimates our current economic output is 3.8% below its potential, with the shortfall due primarily to the underemployment of available labor. The Department of Labor calculates several national unemployment rates, with the difference between them depending on how Labor defines the pool of available workers. The unemployment rate reported by the media is called U3 within the Department of Labor and counts only unemployed workers actively seeking work. That rate is currently 6.7%. However, Labor’s “U-6” calculation, which includes unemployed workers who have given up their search, stands at a much higher 12.7% rate. Another Department of Labor calculation, the “labor participation rate”, shows that only 63% of able-bodied, working age residents are presently working, down from 66% several years ago. In an early 2014 report, the CBO stated that “in CBO’s projections, the growth of potential GDP over the next 10 years [will be] much slower than the average since 1950. That difference stems primarily from demographic trends that have significantly reduced the growth of the labor force. In addition, changes in people’s economic incentives caused by federal tax and spending policies set in current law are expected to keep hours worked and potential output during the next 10 years lower than they would be otherwise.” In a separate February 4 publication, the CBO predicted that “the aging of the population will further reduce labor force participation during the coming decade …. to 60.8% by 2024, compared to 66.0% at the end of 2007.” Economist David Rosenberg estimates that 1.5 million Baby Boomers will reach retirement age during each of the next 15 years.




In February, the CBO also commented on the roll-out of the Affordable Care Act, known as Obamacare. The CBO predicted that, by 2021, implementation of the act under present rules would result in “substantially larger” and a “considerably higher” reduction in the labor force than the 800,000 the CBO had estimated in 2010. Obamacare subsidies are expected to incent many lower-income workers to reduce working or stop working altogether, with the purpose of qualifying for Obamacare insurance premium subsidies. How many “person-hours” that might be lost for this reason is the subject of debate. University of Chicago economist Casey Mulligan, on whose work the CBO relied, estimates that the reduction of working hours will be the equivalent of 5 million jobs lost. The CBO estimates the reduction in work will be equivalent to the loss of 2.3 million jobs. In either case, annual GDP growth is predicted to be reduced by a rate between 0.5-1.0%, no small matter in an economy that produces $17 trillion annually. Thus, the implementation of Obamacare might be another headwind against increasing the amount of “person-hours” worked and returning the economy to historical growth rates.




Demographics also play an important role in an economy’s total “person-hours”. Data compiled by Ned Davis Research show that our economy has averaged growth of 4.1% per annum when the population has grown at least 14.5% over a ten-year period, but less than 2.4% per annum when population has grown less than 11.1% over a decade. Currently, our population is growing at a very slow 9% 10-year rate, and that rate continues to fall. Additionally, the skill level of the labor force is suffering from the replacement of skilled Baby Boomers with new job entrants. Economist Rosenberg notes the paradox that we have nearly 50 million residents on food stamps at the same time that we have unfilled high-skill jobs. Retraining workers and attracting highly skilled immigrants would help address this paradox.




Currently, we believe that investors face a barren set of alternatives. Both stocks and fixed income securities are overvalued compared to historical norms, and we believe they both feature above-average price risk, should the mood of the markets darken. But the low-risk investment alternative, the money market, offers a return of zero. We believe the economy is likely to strengthen later this year. However, if that strength prompts a quicker withdrawal of the Federal Reserve’s support for Treasury and mortgage bond prices, the implications would be bearish for both stocks and bonds. In short, we expect this year to be tricky and problematic for investors in all securities classes. We will do our best to navigate the markets, recognizing that volatility will likely rise during the course of this year.

We welcome your thoughts and comments.

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