C O M M E N TA R Y
1860 Embarcadero Road, Suite 140 Palo Alto, CA 94303 p: 650.493.1000 f: 650.493.1800 e: invest@nelsoncapital.com www.nelsoncapital.com Volume 38 Issue 3 Third Quarter 2012 (Dis)regarding Economists To take just one example, every U.S. recession since World War II has been preceded by an inverted yield curve. So that is one area where an independent investor may hope to improve on economists’ projections. But some analysts of the Peter Lynch generation misinterpreted the lesson, and concluded that economics and politics weren’t important for investment returns. The financial crisis and subsequent sovereign debt problems taught hard lessons to those who pursued cheap‐looking stocks and high‐yielding bonds without taking macro and political factors into account. Was the last generation wrong, then? Surely the experience of the past five years has reinforced the importance of considering these broad factors in formulating investment strategy. But it is also true that economists have not been good forecasters. Few predicted the financial crisis, and most were too optimistic about the prospects for rapid recovery. This was particularly true in Europe, where austerity and tight monetary policies, justified by overly optimistic forecasts, led the continent into a second (ongoing) recession.iii U.S. performance has been only marginally better. Christine Rohmer, an outstanding scholar of the Great Depression, soberly observes that “none of us has a crystal ball.”iv How is it that economists can immerse themselves in the workings of the economy, but have so little predictive power in their forecasts? Many explanations have been proposed, but we note that there are two areas where economic consensus tends to err consistently: recessions and politics. The experience of recessions is instructive – economists almost never correctly predict them. An IMF survey done in 2000 of the history of economic forecasting concluded that “the record of failure to predict recessions is virtually unblemished.”v The next decade only reinforced this conclusion. We find this surprising, because there are numerous worthwhile indicators of an impending recession. Politicians and Policy The other source of error is much less tractable, and, at the moment, of greater long‐term import for investors. Matthew Yglesias of Slate offers this provocative explanation: Economists have a hard time making accurate forecasts in part because to do it correctly you’d need to be able to forecast political outcomes: What will Mario Draghi say? Who will win the power struggle in the Japanese parliament?vi We are humble about our own political forecasting abilities, and we have much to be humble about. Nevertheless, given the fiscal cliff and long‐term U.S. budget situation, it is important to develop a view of how things might progress from a policy perspective. One does not have to look far for evidence that Americans are dissatisfied with government performance in recent years: Congressional Approval Rating 90
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A generation ago, analysts were taught to disregard the big picture. The brilliant mutual fund manager Peter Lynch told an interviewer “I don't worry about any of that stuff. I've always said if you spend 13 minutes a year on economics, you've wasted 10 minutes.”i In 1994 Warren Buffett wrote “we will continue to ignore political and economic forecasts,” calling them “an expensive distraction.”ii Both men were, we believe, reacting appropriately to the forecasting track record of economists which has been, well, dismal. Source: Gallup And yet members of Congress were re‐elected at an 85% rate in 2010, despite this negative overall view. Evidently voters believe the problems in Congress lie outside their districts. People are clearly unhappy, but so far have not been so dissatisfied as to change their vote. A relatively new tool uses market dynamics to help predict election outcomes. Through its website, the Irish firm Intrade maintains markets in election predictions. Intrade participants have a remarkable track record on U.S. presidential elections, correctly predicting the presidential choice of every state in 2004 and all but two in 2008. That is not to say they are infallible – in June they estimated a 78% probability that Obamacare would be overturned by the U.S. Supreme Court.vii At this writing ‐ with two debates and an employment report yet to come before Election Day, Intrade is saying there is a 62% chance the President will be re‐elected. But the winner is unlikely to have a free hand. Intrade predicts just a 30% chance of a single party sweep (control of the Presidency, Senate, and House of Representatives): 6% for the Democrats and 24% for the Republicans. According to Intrade the most likely outcome, with a 51% probability, is a continuation of what we have had for the past two years: a Democratic Presidency, a Democratic Senate, and a Republican House of Representatives.viii That means American politicians will need to do something they have been reluctant to do over the past two years: compromise. A successful deleveraging of the U.S. economy would likely be a great boon to investors. The two other eras of deleveraging – the 1950s and the 1990s – were good times to be an equity investor. In both cases the key was growth – sound fiscal policies supported solid growth that led to better‐than‐expected long‐term earnings growth. But that will not happen without good policy. We know there are no short‐term solutions. What is needed is a credible long‐term plan for returning the government to a more balanced fiscal position. If that can be accomplished, we believe investors can look forward to continued upward progression in earnings. Given today’s reasonable valuations ‐ about in‐line with historical averages by our reckoning – they can potentially benefit from price appreciation in line with dividend and earnings growth. That would be a big improvement over the experience of the last ten years. S&P 500 Earnings per Share 120
100
Let’s Make a Deal 80
The U.S. fiscal situation is serious but not yet dire. The Great Recession led to a sharp decline in U.S. government receipts. At the same time, stimulus measures and automatic stabilizers of various kinds led to strong growth in Federal spending. The result is a budget gap larger than any seen since World War II: 60
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Source: St. Louis Fed The deficits have led to a rapid run‐up in U.S. government debt. So far, however, the debt looks manageable, assuming the growth rate can be brought under control. Debt held by the public currently totals $11.2 trillion, approximately 70% of GDP. Debt service is not a burden at this time ‐ thanks to remarkably low rates, the interest bill over the past 12 months was lower than it was in 1998.ix But we know that interest rates will not stay low forever, and if we continue to accumulate debt there will be, sooner or later, an unpleasant reckoning. “Betting on the Market,” 1996 interview with PBS Frontline. Accessed at: http://www.pbs.org/wgbh/pages/frontline/shows/betting/pros/lynch.html ii
Chairman’s Letter, Berkshire Hathaway Corporation, 1994. Accessed at: http://www.berkshirehathaway.com/letters/1994.html iii
Jeffrey A. Frankel and Jesse Schreger. “Over‐optimistic Official Forecasts in the Eurozone and Fiscal Rules.” NBER Working Paper No. 18283, August 2012. Accessed at: http://www.nber.org/papers/w18283 iv
See, for example, “Why Are Economists So Bad At Forecasting?” Time, July 17, 2009. Accessed at: http://www.time.com/time/business/article/0,8599,1911011,00.html v
Prakash Loungani. “The Arcane Art of Forecasting Recessions.” Financial Times, December 18, 2000. Accessed at: http://www.imf.org/external/np/vc/2000/121800.htm vi
th
Matthew Yglesias. “The Silver Fox.” Slate, October 5 , 2012. Accessed at: http://www.slate.com/articles/business/books/2012/10/nate_silver_s_book_th
e_signal_and_the_noise_reviewed_.html vii
Amy Bingham. “Health Care Games: The Odds Are Not In Obamacare’s Favor.” ABC News, June 26, 2012. Accessed at: http://abcnews.go.com/Politics/OTUS/health‐care‐games‐odds‐obamacares‐
favor/story?id=16652833#.UHIVdY7_R6E viii
Source: Intrade.com, October 7, 2012. ix
U.S. Department of the Treasury. “Interest Expense on the Debt Outstanding” for the Fiscal Year ended September 2012. Accessed at: https://www.treasurydirect.gov/govt/reports/ir/ir_expense.htm C O M M E N TA R Y
1860 Embarcadero Road, Suite 140 Palo Alto, CA 94303 p: 650.493.1000 f: 650.493.1800 e: invest@nelsoncapital.com www.nelsoncapital.com Disclosures
Nelson Capital Management, LLC (NCM) is a registered investment adviser and a nonbank affiliate of Wells Fargo & Company. Information and opinions presented have been
obtained or derived from sources we believe reliable, but we cannot guarantee their
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