Kiplinger: A Look Ahead
09/02/2005 12:00 am EST
We conclude our DC Highlights report withKnight Kiplinger , whose speech was a "highlight" from start to finish. In the always-difficult investment arena, it's a pleasure to hear such an exceptional overview, presented in such a clear and well-thought out manner.
"The US economy is growing, as it has been for the last three years. It’s not only growing, but it is growing at a faster rate than most expected. This is no mean feat. It’s actually quite remarkable, considering the trauma that the US economy has experienced over the last five years, including terrorism, war, a brutal bear market in stocks, corporate scandals, two bitterly contested elections, and a doubling of the price of petroleum. Now any two or three of these body blows would have staggered a lesser nation. But the US is the Timex watch of the global world. It takes a licking and keeps on ticking.
"For younger investors here, I would describe the US as the Energizer bunny, beating that drum as it marches through adversity and chaos. So it’s amazing that the US economy is growing at all, let alone at 3% to 4%. So why is it still growing? What accounts for this? Well, it’s not primarily capital spending. Sure, business spending is recovering from the slump of two years ago. But it’s not exactly burning up the track. It’s not primarily job growth. While this too is recovering, total employment in America is only slightly higher than four years ago. It’s not primarily strong demand for US exports, although they too are picking up, aided by a lower dollar.
"So why is GDP still growing so robustly? The answer is simple. Massive stimulus of consumer spending, compliments of Washington DC. After 9/11, with economic stability on the line, Washington pulled out all the stops on the powerful pipe organ of economic stimulus. It wheeled out all the big guns. It hoisted all the sails. It primed the pump. Have I run out of clichés? You get the picture. Free spending by Washington, cheap credit from the Federal Reserve, lower marginal tax rates, a lower rate on capital gains and dividends, enormous spending by Washington on everything from homeland security to bridges and highways to farm subsidies to a massive military spending and the budge went from balanced to pretty sizeable deficits–although as a percentage of the size of our economy, it’s not alarmingly big.
"Finally, the Fed slashed short-term interest rates over the last five years from 6.5% to 1%, effectively an after-inflation rate of less than zero. Basically, this was free money. And America’s businesses and consumers responded appropriately. The stimulus worked. It kept the US economy and the world economy growing through the trauma and the body blows we had experienced. While most major industrial nations in Europe as well as Japan have muddled through with lower growth and higher unemployment, we’ve been the dominant engine of growth of the entire global economy. We, along with those upstarts, China and India.
"Yes, the US consumer took the bait of economic stimulus, and the buck was spent. US consumers have only been too happy to be the buyers of last resort for the excess production of the rest of the world. Right now, consumer spending is at a very high 70% of GDP. What are they spending their money on? Well, just about everything. But especially their nests–their own homes. And more broadly, all kinds of real estate, including second homes, rental properties, you name it.
"Let me state this as clearly as I can: US economic growth over the last four years has been driven primarily by massive institutional and individual investments in real estate. This accounts for the fact that this year with corporate earnings growing at a rate of 15% so far, the major stock indexes are virtually flat. Now if this was a whodunit, we would say that the suspect has motive and opportunity. Investors had the opportunity of very low interest rates to pour money into real estate and they had the motive, which was a wariness of stocks borne of the deep bear market of several years ago.
"How powerful has real estate investing been the last four years? Here are some recent statistics from a Lehman Brothers study. Very broadly defined, including construction, brokerage, mortgage finance, furniture, appliances, landscaping supplies, etc., real estate-related industries have accounted for 74% of all US job growth over the last four years. New residential investments on an annual basis is estimated to account for about 6% of GDP, a level only seen a few times since WWII. Broadly defined, real estate is probably accounting for about 40% of all the growth in the US economy over the last four years.
"Just as the wealth effecting the stock market in the late 1990s, buoyed consumer spending, rising home equity has been the driver of consumer spending in recent years. The cash out, refinancing–the gift that keeps on giving–has gone into home additions, boats, cars, vacation homes, etc. Among young adults in some areas, flipping condo contracts is today’s version of daytrading in the late 1990s. Now home prices have sprinted far ahead of personal income, especially with zero-down interest-only mortgages. The National Association of Realtors maintains an ‘affordability index’. Right now, this is at the worst level since 1991. It measures the ability of households of average incomes to afford average priced houses in their communities. And back in 1991, interest rates were a lot higher than they are today. This can’t go on and it won’t go on
"Is this a residential real estate bubble that is about to burst? Let me redefine that a bit. Bubbles are fragile membranes. They always burst. Think of soap bubbles, or bubble gum bursting on your face. I, instead, liken the residential real estate market today to that helium filled balloon at your New Year’s Eve party. The membrane is strong enough not to burst. But the next morning, as you’re nursing a hangover, you look around and those balloon are no longer on the ceiling. They’ve drifted down and are lying in the corner. They leaked air.
"This is what I see happening in residential real estate over the next two years or so. First, expect a flattening rate of increase in prices, which we are seeing already. Then, expect flat prices and in some super overheated areas, declining prices. You don’t have to look so far back to see this. In some expensive neighborhoods of Washington DC in the early 1990s, home prices declined 25% to 30% over three years. We saw the same thing in southern California.
"The Fed is quite concerned about this. In the last, the Fed has tripled the Federal Funds rate from 1% to 3.5%. It won’t stop there. It feels that today’s short rates are still too simulative, and they want to go to a neutral monetary policy. So they will keep raising short rates into 2006, well past the 4% level and most likely towards 5%–barring some global crisis. Remember, just five years ago, short rates were north of 6%. So far, long rates haven’t risen nearly as much. But they will. The yield curve is not going to go flat and it is not going to invert. Long rates will rise, especially mortgages, and this will cool off housing.
"As home prices cool, so will consumer spending–the reverse wealth effect. And consumers, seeing this happening, will do something really novel. They will save some of their current income. Right now the US consumer savings rate is just about zero. This is because the rise in home equity has been seen as a surrogate to savings. Why defer current consumption if your home, a major asset, is growing so much? As consumers pull back, don’t expect the US economy to tank. US business will continue to pick up it’s spending. Uncle Sam will maintain a high level of spending. Exports will continue to grow in a globalizing economy. The bottom line is that more growth is expected through 2006 and 2007, but at a much lower pace than we are seeing now–perhaps 2% to 2.5%.
"So what are the investment implications of all of this? When you set your asset allocation mix, hold to that discipline and rebalance your portfolio as things rise and fall in value. This will force you to do what most investors have trouble doing, which is selling high and buying low. In the 1990s, if you were trying to hold to a 60/40 allocation of stocks to bonds, your would have been forced to sell stocks when they soared and forced to buy the most shunned and scorned asset class, bonds. And of course, had you done that, you would have been sitting pretty when the bear market in stocks came. Likewise in the early part of this decade, with stocks in the tank your 40% share of bonds would have moved up to 55% to 60% of your portfolio, and you would have again been forced to rebalance.
"I am not urging you to practice market timing and plunge into particular asset classes or dump your positions according to the daily headlines. When I talk about the relative attractiveness of different asset classes, I am talking about weighting or tilting your new money while maintaining a basic asset allocation. So what weightings might be appropriate over the next coupe of years? Rising interest rates are not particularly auspicious for any asset class, except for cash savings. Rising interest rates will hurt real estate the most and the soonest. Happily, the impact will be gradual. The effect of rising rates on bonds differs between the near term and the long term. Two years from now, when interest rates are a good bit higher than today, bonds are going to be very, very attractive to investors and will attract a lot of money that is now going into stocks. But between now and then, as interest rates rise, and before they plateau, the value of your old bonds are going to take a hit. On a total return basis, bonds are pretty vulnerable over the next two years.
"Real estate gives me the willies, and bond make me cautious. As a result, I am drawn to stocks to default. Aren’t stocks hurt by rising interest rates too? Yes, they are. It will impair corporate earnings growth. But stocks in the near-term will be hurt less by rising interest rates than the other asset classes. Remember, you can’t judge any asset class in a vacuum. You can only judge them relative to something else. Stocks are not cheap right now. But they are not badly overpriced either.
"There are only two things that cause stocks to rise in price. Either earnings grow or investors are willing to pay higher prices for future earnings. Multiples are not likely to expand over the next few years. There is nothing to justify that. But earnings will continue to grow quite nicely. We’ve had 13 consecutive quarters of double-digit growth in corporate earnings in America. Now this double-digit growth won’t continue indefinitely, but earnings for the S&P 500 will probably continue to rise for while at a high single-digit rate.
"Over the long run, there is no reason for stock prices to rise any faster than earnings. If you look for earnings growth of 8% or 9% you can expect price appreciation in that range as well. And don’t forget dividends. The dividend yield on the S&P right now is a little under 2%. And there are a lot of good companies in the S&P paying substantially more than that. That gives you the historical long-term total return of 10% or so from stocks. Given the current overvaluation of bonds or real estate, I don’t think you can do consistently better than that over the next 5 or 10 years.
"In parting thoughts, America faces so tough challenges, such as meeting our financial commitments to older citizens through Social Security and Medicare. Another challenge is how to gradually reduce excessive consumption in America and boost our national savings rate. How to reduce our gross overdependence on foreign petroleum? How to meet the tough competition from China and other emerging economies? How to protect ourselves from terrorists? How to improve public education, because the skill of our workforce ultimately underlies all future success for America?
"None of these challenges is going to be easy. The solutions will require a lot of money, sacrifice, ingenuity, and personal commitment to a collective good. Now there are pessimists who say that these are intractable, insoluble crises, which will lead to America’s decline. But I remember similar prophecies of doom from the 1960s, the 1970s, and the 1980s. They turned out to be wrong because they underestimated new technology and the adaptability of the American people.
"A favorite putdown of our popular culture is that no one every lost money underestimating the taste of the American people. Whoever said this obviously never watched reality TV! I’ve devised an investment corollary that goes like this: Lots of people have lost money or missed opportunities to make money by underestimating the talent and resolve of the American people. Don’t be one of those people making that mistake. I hope you are among those who have the faith, the vigilance to look for opportunity, and the chance to prosper in these challenging but very exciting years ahead."