Economy, stock markets to rebound for near-term growth

In order to give a sound economic analysis, you have to ask yourself one question: “What’s really going on in the world today?”

But, before I get to that, I’d like to deliver the punch line in the beginning. I don’t think anything so succinctly describes my personal feeling toward the economic environment as this: As an investor, I am 100 percent all in.

Recovery

Last year, we had a horrible hangover and were trying to work our way out of a crisis. We went from “how bad is it going to get,” to “when will the recovery begin,” to “we’re in recovery.” At the low point, the U.S. had negative 3 percent economic growth, and we’re currently running a positive 5.8 percent growth. The horrible mess of the housing sector has bottomed and stabilized. Banks are making money, and more importantly, they’re raising new money to the tune of $500 billion. And $240 billion of the much-maligned TARP package, which totaled $350 billion, has been paid back with a $19 billion profit. 

So, what has changed and what have we learned? I think we learned that the financial center of the U.S. moved from New York City to Washington, D.C. I think we learned that economic power has shifted from the developed countries to the developing countries—developed countries are now net borrowers, and developing countries are net lenders. I think we learned that classic revolution theory is alive and well—it goes something like this: the upper class goes to excess, alienates the middle class, who then ally with the lower class, who unite to create significant change. It’s safe to say that’s what happened with the last set of elections. I think we learned that it’s not necessary to take over an industry if the government can pass several thousand new rules and regulations to control an industry. I think we learned that if you borrow too much money, it can cause big problems.

The Cause

It wasn’t long ago that the basic formula for buying a home was that you can’t get a loan above three times your salary. In some markets a few years ago, banks were giving loans at up to nine times annual income. It went like this—Fred wants to buy a home, and is convinced that he can afford a home that is realistically beyond his means. The bank gives Fred a special 2-percent interest-only loan, which the banker sells to a larger bank. The larger bank is happy to buy the loan because in 3 years, it’s no longer a 2-percent interest-only loan, it’s a 7-percent 30-year amortization mortgage. The bank re-sells Fred’s and similar mortgages groups to hedge funds. The hedge funds are able to borrow enough to buy $40 billion in mortgages on $1 billion in capital. The fund looks for someone to guarantee, and AIG obliges. Investment bankers then re-sell these 7-percent interest yield bearing AAA rated American mortgages to international banks, who then put them in their money market fund. Business is great for everyone.

 Three years go by, and Fred’s payment adjusts from $1,500 to $3,000 a month. He can’t refinance the house, can’t sell it, and so he’s forced to give up the house. The dead mortgage bounces from the mortgager, to the guarantor, and then other similar mortgages start to devalue, and a vicious circle begins. There are thousands of Freds and AIG takes a $160 billion hit on mortgages. The money market funds take a hit, and the whole system unravels. 

 Today, the real estate market has bottomed, but 22 percent of all homes in America are still worth less than their loans. Home loans are back to around 3.4 times annual income. Hedge funds will be regulated more. And we wake up to find that some remarkable things have occurred with the tax system. The top 1 percent of earners pay 40 percent of taxes. The top 10 percent of earners pay 60 percent of taxes. The top 50 percent of earners pay 100 percent of taxes. The other 50 percent pay nothing, and of those 50 percent almost three-quarters get cash back.

Asia and Debt

 The U.S. is no longer the world’s primary engine of economic growth. This year, China’s economy will grow by 8.2 percent; India by 8 percent; Indonesia by 6 percent, and Brazil by 5 percent. The U.S. will be up 2.9 percent next year; the Euro-zone will be 1.4 percent; and Japan 1.5 percent.

China is aware of its economic power. They’re sitting on $2 trillion of our debt—the U.S. has $6 trillion in debt overseas. China’s new car sales are up 53 percent, corporate profits are up 70 percent, three of the four largest banks in the world are based in China, as are the top two largest insurance companies. China, who once sought all comers, are now more difficult to work with. There are policies in place to restrict foreign company growth in China. 

But China has its problems, such as the world’s most rapidly aging workforce, a fallout from the “one child” policy. They realize this will be a drain on government resources. Political repression is also reportedly on the rise in China, and that’s a sign of weakness. They also have a real-estate bubble—the 200 million-strong middle class makes $12,000 a year and is buying $150,000 apartments, which have been overbuilt.

Back in the U.S., we have serious issues with the federal budget deficit. Over the next 10 years, the government will spend about $47 trillion, of which $9 trillion is borrowed. The deficit by 2020 will be $21 trillion. The Congressional Budget Office says we can get out of this mess if we grow 4 percent GDP each year, but the historical average of the past 25 years is 2.5 percent. We can tax our way out, but we’d have to raise taxes by about 60 percent. We can inflate our way out if we go 10 percent each year. The real answer is they will tax some, borrow some, and inflate some.

The Future

As I said, as far as the economy and the stock market, I’m fully invested. Here’s my theory: From 1950 to 1966 the economy goes straight up. From 1966 to 1982 it moves sideways and goes from 700 to 1,000 five times. From 1982 to 2000, it’s straight up again. And from 2000 it goes from 14,000 to 7,000, rallies back to 14,000 and back to 7,000. I think we’re beginning to emerge from a lateral-moving economy. In the near term, I’m a raging bull and have invested everything. The Dow Jones will get back to 12,000 and back off a little before elections. Eventually, we’ll work our way up to 14,000, and then all the bad things come to roost and we come back down.

My view on energy is simplistic. We use 25 barrels per person, India uses 2, and China uses 0.8 barrels. As their demand goes up, so do prices. So for the long term, I’m all in.

Editor’s note: This essay was compiled from Don Reynolds’ keynote speech at the 2010 PESA Annual Meeting.