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The Stimulus Looks Like a Done Deal

U.S. stocks were up on Friday along with the Aussie dollar. It looks like everyone is expecting the good times to roll once Washington passes a stimulus. Blah blah blah.

Really. It’s getting hard to take the economic press seriously anymore. No one asks how you save an economy by “boosting aggregate demand” when the problem is too much debt and too little production.

If anything “boosting aggregate demand” in Australia merely stimulates profits for overseas companies. After all, much of what Australians will buy with the government handout money is made abroad. Remember that pesky trade deficit thing?

The stimulus-both here in Australia and there in America-looks like a done deal. It’s no use whinging about it. But it does show you how far we have lost our way economically. An economy grows when you produce goods and services you can sell to other people at a profit. This profit becomes the surplus savings that finance other risk taking, which creates more jobs and incomes and profits.

Productivity increases help a lot too. But the main point is that “stimulating” people to buy stuff doesn’t accomplish much in the long term. You need to make stuff. And it has to be stuff for which the demand is real and sustainable. Ripping off future generations to avoid a few quarters of negative growth is not a strategy. It’s a cop out.

But markets appear to like cop outs! Either that, or stocks in the U.S. like the one-two combo of Tim Geithner and Warren Buffett. Geithner unveils his magical mystery package of government goodies on Tuesday (pushed back a day so that President Obama can scold as “irresponsible” anyone who criticizes wasteful government spending.)

Swarm Trader Gabriel Andre does not pay much attention to the value investors or policy makers. He works in the language of numbers and charts. We shot him off a not last night asking what the charts show and got this reply back, “This week is likely to be a positive week for the Australian equity markets.”

Hmm. Really? “The last few days of the week were good, from a technical perspective,” he went on. “The indices should move further up. But only if investors and traders think a low has been put in. And maybe one has. The ASX 200 fell to 3,342.70 points twice two weeks ago. This low may be the second leg of a double bottom, while the first leg was the low of last November.”

A two-legged low? We’ll have more details, and charts, tomorrow.

What about Warren? Buffet, reports Fortune magazine this weekend, has an old rule that you should buy stocks if the market cap to GDP ratio falls below 80%. It was 75% at the end of January.

Hmm. There are a few moving parts to that metric. For more on Buffett’s original comments, check this out. But in general, you have two variables. The first is the GNP, the total value of all the goods and services produced in an economy. The second is the market cap, the total market value of publicly traded businesses.

When market cap exceeds GDP by a lot (as it did in 2000) it means investors either thing earnings will continue to grow faster than the economy, or that they are willing to pay more today for tomorrow’s earnings (because they believe earnings will keep growing faster than the economy).

Of course, shareholders should never expect to take out more in gains from a stock than the company’s after-tax earnings. In fact, long-term investors prefer to see a firm retain earnings and reinvest them in growing the business. Or, if management can’t find anything better to do with the cash, then it ought to pay it back to shareholders in the form of a dividend.

Individual investors can judge a management team by how it manages earnings and cash-flow. There are other metrics for this. But in the aggregate, what does it mean that stocks are trading below GNP? Does it mean, for example, that investors are under-pricing future earnings growth today?

Well, that’s what you’d tend to think it means if you accept the ratio. After nearly two years of bad news, investors are not willing to pay much of a premium for risky stocks. They also have a fairly bleak view of the earnings recovery potential for U.S. firms. All of which would prick your ears up as a contrarian.

Then again, in that same article linked to above, Buffett reported that rising share prices and booming GDP are not synonymous. “To break things down another way,” he wrote, “we had three huge, secular bull markets that covered about 44 years, during which the Dow gained more than 11,000 points. And we had three periods of stagnation, covering some 56 years. During those 56 years the country made major economic progress and yet the Dow actually lost 292 points. ”

From 1964 to 1981, a time of economic progress, the Dow gained one-tenth of one percent. Over the next seventeen-year period, it gained 949% (875 to 9,181). Yet during the period of near-zero stock market returns, GDP grew nearly twice as fast as the period with huge stock market returns.

Frankly, the scariest thing about all of that is that you can go seventeen years and make no money in stocks, regardless of what’s happening in the real economy. But if you take the past as a kind of prologue, perhaps we are on the verge of a period with large gains in GDP growth, accompanied by consistent investor pessimism about corporate earnings.

For that to be true, a new period of innovation-coming from an unexpected direction investors are sceptical about-would have to transform the economy in unpredictable ways. That’s a lot of unknown unknowns to count on. Then again, we live in a time when one set of institutions for the old world order is failing. Something is going to have to replace them.

We’re up on the Gold Coast for a few days last week and tuned into watch the local news. It was filled with stories about the bushfires in Victoria. It was pretty shocking. Our thoughts and prayers go out to everyone in the fire zones.

Dan Denning
for The Daily Reckoning Australia

2 Comments

  1. Anthony Teamson says:

    Dan,
    You are a great man and a forthright insightful communicator. One thing I would like you to consider is that the US government is only partially concerned about the domestic economy. Now, I admit I a am a cynic, but it seems to me that Geither is more concerned about selling $500,000,000,000 is debt, then he is in whether Guadalupe, the waitress, makes a $100 in tips. I think the whole “stimulus thing” is being designed to stimulate only one consumer. That single consumer is the Chinese government. Despite all the blah, blah about 20 million people heading back to the farm, China is the only came in town that can pony real money. If Geither can get Peter, Tyron, Moe, Juan and Amahad to buy stuff made in China then maybe he can get Hu Jintao, Wu Bangguo and Jia Qinglin to give up their savings to buy money printed in America.

  2. Paul says:

    Dan,
    I think Australia is in real trouble becasue we, like the US, are a creit driven economy. Australian household debt has reached ridiculous levels. It’s around $1.6 trillion and has doubled since 2003. That’s $4.55 of debt for every $1 of GDP. This growth rate is clearly unsustainable. However, the mainstream media continue to ignore this problem. I would love to hear your thoughts on this.

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