Supply Side Dark Side

So how surprising was it that two working days after the midsummer break, the new cue cards come out and the Market starts to rock? Sure, the first day back was a disheartening bust, the major indices late push into positive territory masking a miasma of more-of-the-same feebleness in the broader market. But as Wednesday wore on, Thursday barely hesitated and Friday firmed as it went along, it started to seem like “contagion” never happened at all. And what about creaky old Europe coming unglued and dragging the rest of the global economy along with it? Not only has that purported “crisis” turned out to be much ado about very little at all (or perhaps just a fleeting recognition of an advanced state of decay that has been hiding in plain sight for decades if not centuries, as if it it were somehow new) but the Market’s recognition of this is hardly new, either. Indices like DJ Europe hit bottom a good five weeks ago, and over the past two months have outperformed most of the rest of the world, especially the likes of the RUT and the Nikkei. Not by much, mind you, the global markets look to be a correlated as ever, it sure doesn’t look like Euro-anemia is adding up to much of threat.

Obviously, the focus is now on earnings, which will start to be released in the next few days. My sense is that expectations have been lowered over the past two months to a degree that, at least initially, “whisper guesses” will be easy to beat. With the exception of a few price sensitive sectors (I’m guessing steel, for example, though I have nothing going on there) results will be objectively favorable and the outlook will remain, on balance, quite positive. If there are “bad days”, it will often as not be where opinion-leading analysts choose to read more than is really there into what was really just a “tap on the brakes” by various managements when we were all in the thrall of “contagion”. Starting with Intel on Tuesday, we are going to see that while its not quite as white hot as it might have seemed in April (component shortages, double-ordering, etc.), the world’s clamor for digital connection is most assuredly intact. We will also see healthy demand for semi-big-ticket, highly discretionary consumer goods, which gets seriously pent-up in times like the past three years, as exemplified by the likes of Briggs & Stratton, Mohawk and The Dixie Group. I expect the earnings that are released over the next three weeks, as well as what ever outlooks accompany them, to evince a global economic recovery that might have skipped a half a beat or so but is still in solid shape.

All this makes me feel a little better about being fully invested, certainly better than I did a few weeks ago! (Note to self: If you know that you have it in you to buy at moments of maximum pessimism, be willing to err on the side of raising too much cash too quickly when it feels like stocks go up every day.) Still, it is not difficult in times like these to curb one’s perhaps preternatural optimism. Like the proverbial never-boiling watched pot. economic recovery always seems to happen at a pace akin to watching paint dry. It can’t happen quickly enough, and we drive ourselves nuts worrying about how it can ever get better. Such was the case in 2002, and even 1991 for that matter. You get the sense that printed somewhere in the mission statement of CNN or AP is some mandate to prop up that “wall of worry” that every Bull Market must climb. In this sense, count me among the relatively sanguine. Where that starts to wear thin, though, is when I start thinking about the long term fix for where we are today. Not so much how difficult it is to visualize a way out of this mess as when I think through what worked the last time we were similarly situated.

Readers of a certain age might recall that a previous recovery from a similarly debilitating episode, what historian Paul Johnson referred as America’s Suicide Attempt (the 1960s) and The Collectivist Seventies, revolved around something called Supply-Side Economics (SSE). Unfortunately, much time has passed since this simple notion stormed onto the scene, and decades later little or no consensus exists as to just what this hoary term means. It does not help that we live in an era when the arbiters of the putative Ruling Class labor unstintingly to have us believe that the meaning of words will be whatever they say it will be. Nor does it help that not even its advocates can agree on what they mean by SSE. What I do know is that it needs to be understood as something more than the popular definition that has devolved, as being all about cutting taxes. It is in thinking through how it worked a generation ago and, more to the point, why it was at once so badly needed and then efficacious, that I find myself concerned about “just down the road”. We look back and see the sunny side of the mountain, as it were, that era when lower taxes stimulated economic growth and kick-started a virtuous cycle that was so robust that by the end of the century we had budget surpluses and were worrying about a shortage of Treasuries. But what about the dark side of said mountain, even further removed from us by the mists of time? The question at this time really needs to be, “how did it get that way?” Why was it that a few simple policy tweaks had such a long lasting, far reaching impact?

The answer lies in a fuller understanding of what the framers of SSE seemed to be trying to say. That would be that most truly important things can be understood, at least in their most important sense, in very simple terms. Terms such as Supply and Demand. A generation ago we were wracked with a seemingly intractable illness called Inflation, a sustained rise in the Price of goods and services. Extant theories had worn themselves threadbare trying to understand it from a Demand perspective. All SSE did was introduce the notion that the supply of goods & services mattered, too. If, as we learn in about week one of Economics 101, an increase in supply will exert downward pressure on prices, then perhaps that is the way to contain inflation. Here is where I think SSE is not adequately understood. Yes, if you take less in taxes from those who offer goods and services, even if it is only labor, there will be more available. (It will also cycle back into the demand side to the degree that more work, more productivity, etc. translates into higher discretionary spending.) But it is so much more than “tax cuts for the rich” who for some reason seem to correlate with “the productive” (Go figure.)

I don’t think that any of the authors of SSE would argue that such policies are not subject to the same diminishing returns that beset practically everything else in nature. That such policies might not get quite the same bang for the buck in 2002 as they did in 1984 would be consistent with the laws of nature as I understand them. But the principle still holds. I think, though, that the importance of SSE rests in an understanding that extends a bit beyond that quantifiable realm that is the professional economist’s comfort zone. I would prefer to understand SSE as about tamping down the all-in cost of showing up with something to offer. This understanding, if you will, derives from my days of following aerospace companies and what I called the “all in cost of travel”. Making money in those stocks seemed to come down to making a bet, when consensus was betting otherwise, that air travel would continue to grow. I posited that it would, as long as global disposable income continued to trend upwards (because people want to travel and will choose to do so as their more basic needs are met) and the industry kept bringing down the all in cost to fly. This cost is not just the ticket price, though that is a big piece of it. It is also the time spent door to door, the risk to life and limb and all those other factors that get weighed in “Do I really want to go?” right down to how much trouble it is to get into and out of the airport.

So what does this have to do with SSE as a tool for enhancing the health of an economy? Well, there is an all-in cost to offering one’s goods and services, including labor. The tax bite is just the most conspicuous. What I think economists of every stripe miss is that the disincentive to show up with something of value goes well beyond the measurable “after tax income”. And this is the rub today, where 2010 is at least trying to emulate 1974. Not only are we staring down the prospect of tax increases the most productive (or should I say, all but the least productive) elements of our economy, but the regime of the moment seems hellbent on doing what they can to make enterprise a lot less rewarding, in every sense of the word. By enabling not only the usual suspect bureaucrats but also the litigation leeches and union organizers, they are making it damn difficult for all but the most politically well-situated business decision makers to say Yes to More. This stultifying oppression cannot be calculated in pure dollars. Mr. Dan Henninger of the WSJ aptly described the legal element of this onslaught as an attempt to “reduce the nation’s civil life to a costly game of “Mother May I?” What entrepreneur or capital allocator wants any part of that?

In the here and now, this intrusion of statism means no more jobs, or at least as few new jobs as they can get by with. I think almost everyone understands the impediments to hiring that result from such government generated uncertainty. What I see little if any acknowledgement of is how such redistributive policies sow the seed of inflation. After decades of cursory study, the one thing I think I understand about inflation is that anyone who says they really understand the why? of it doesn’t understand it at all. Money supply plays into it, but not all the time, and certainly not when producers, especially labor, do not have pricing power. We seem to be at such a pass right now, but it will not stay that way, and therein lies the peril a few years out whose seeds are presently being sown. Inflation will no doubt perk up once growth takes some of the slack (the antidote of pricing power) out of the system, but we can’t begin to guess when or to what degree. This is because we cannot know in advance, or even truly measure concurrently, what the supply side of the equation is or will be. It’s a host of rational actors who each have to decide whether or to what degree they continue to show up and add to what’s available. Right now, redistributive policies are taking the fruits of production and using a growing portion of them to raise the all in cost of showing up with something to offer. In other words, they are making work a lot less “fun”. Not fun in the sense of a day at the park, but fun in the sense of what can give joy, meaning and purpose. Make showing up with something less “fun”, and eventually the quant driven policy makers will be flabbergasted to learn that there is less of that “something” than they had planned for. (Such is life in an economy where all but a very few live at a great remove from the margin of subsistence.) This surprise, once purchasing power has caught up with a shriveling supply of goods and services, will quite likely result in a bout of seemingly (in that same sense of anything watched on a daily basis by a surfeit of commentators competing for attention) intractable inflation. All because in 2010 no one remembers what made 1979 so dreadful and in so doing made supply side economics the tonic of that age.

I remain operationally optimistic in part because I think share prices have only just barely started recovering from the misplaced anxiety that was catalyzed by “contagion”, let alone how early it is relative to what I think was a Generational Low on 3/9/09. It also matters that however corrupt some elements our government might be, our political system has not deteriorated to the point where it cannot produce at least some measure of remedy. (We are getting down to fingers and toes as to the number of days that Congress has left this side of the Election.) Key, high profile elements of the putative Ruling Class continues to demonstrate a remarkable capacity for auto-defenestration, something I attribute to narcissism, to a profound lack of understanding of the human condition and to a reckless disregard for what our Founders called Providence. So however capable I might be of imagining a dreary if not dreadful future, continue to count me among the warily optimistic.

A Tale of Two Crises

Independence Day 2010, the 234th anniversary of what turned out to be a fabulously successful experiment in ordered liberty, finds us refreshed by a retreat to one of our country’s great rustic treasures. That remote expanse of mountains and valleys where Colorado abuts New Mexico is, at this time of year anyway, is a soothing alternative to both Texas heat and Market-based discomfiture. It also turned out to be an excellent time to be diverted from share price fluctuations by wily salmonids, steaming hot enchiladas and one magnificent vista after another.

As noted several weeks ago, the Market was good and ready for a correction when a sufficiently efficacious catalyst in the form of “contagion” (fearing fear itself) arrived. With the S&P having declined just over 17% over the past 2+ months, this correction would seem to be in overtime. “Contagion” fears have spent their fury, but something else seems to have doused whatever Bull Market potentiality is out there. There are a couple of ostensible reasons for this lingering deficiency of enthusiasm, but I strongly suspect that the most important piece of the wet blanket currently in place is that big issue hiding there in plain sight, too big to see. It could be the consequences of persistent deficit spending has finally sunk in for a plurality of investors, but this is an issue that has been at or very near to center stage for all but a very few of my increasingly massive pile of adult years. This issue seems intractable from where we sit today, but not necessarily any more so than it seemed in say, 1982 or 1992. We also have a number of articulate, tough minded governors who have fixed similar messes, albeit on a smaller scale, who just might step up and get the fix started in 2013. I also suspect that “contagion” did in fact take a bit of zip off of the recovery, as decision makers all over the globe tapped the brakes in a manner akin to what we unconsciously do when we are driving and something happens way down the road. (Speaking of highways, my nearly 2K miles of driving across TX & NM suggest that either the recovery is intact or there are an awful lot of empty trucks and trains on the move out there!) This could manifest itself in Q2 earnings reports that are not quite as boffo as the preceding 3-4 quarters were, but in the case of the companies that I follow, such an outcome was in the price and then some a month or so ago.

My sense is that either it is later than we think, as in that which we celebrate this weekend having lost its ability to mitigate the wretchedness that has denoted so much of history, to a degree that we find ourselves on a steep and slippery slope akin to Rome c. 300 A.D.., or we are very near the end of a somewhat protracted correction in yet another Bull Market. Not much one can about the one, especially if you already live in the country that has served as THE safe haven for past 100+ years. That would be the instance in which the bet against the seeming end of the world (the one I recall making in 1987, in January 1990, in March 2003 and again six years later) turns out to be the wrong one. Kind of tough to hedge that one, so I am sticking with the bet that we’re not quite there. Not yet anyway.

Before I dig into what I think has got everyone so bummed out, that is, the situation that will eventually abate and allow for a regression towards “normal”, it would be a good idea to revisit what I understand normal to be. If, indeed, the era of Pax Americana is solidly behind us, this “normal” will not apply, but such is probably not the case. The normal I am referring to is the Market’s tendency to experience seasons of upward or downward bias, which we refer to as Bull or Bear Markets. For the past several decades, there has been a strong tendency for there to be Bull Markets of more or less four (typically more) years interspersed with Bear Markets of more or less (typically less) two years. Right now we are sixteen months in what, unless we have evolved beyond Pax Americana Normality, should be a Bull Market with at least a couple of more years to go. What’s a little abnormal is the degree to which the Market (as measured by the S&P 500) has declined. I went through all the data I could get screening for moves of 5% or more in either direction. There are plenty of > -10% declines during Bear phases, but surprisingly few during Bull phases. Indeed, the only double digit pullback during the past two Bull Markets (1991-2000 and 2003-07) I could detect was the one associated with LT Capital/Russia in H2 98, a -20%-ish speed bump that interrupted a very well developed Bull Market of a Lifetime (NAZ 5000!) Pretty much every other pullback was in the range of 5-9%. That puts the action of the past month, a 17% pullback so early in the recovery from the Market equivalent of a sixty year flood, at odds with what would seem to be normal.

So what’s got everyone so bear’d up? I suspect’s that its what’s going on, or perhaps more to the point, not going on down in the Gulf. Investors who look to the US as something of a beacon of stability and safe haven of last resort are watching the government’s response to the oil spill and finding it very queasy making. Is this the best the putative leader of the free world can do? Who imagined that we were so encrusted with bureaucratic fiefdoms and other equally debilitating factions? Well, we got a bit of hint with that other disaster a few years back. The chattering class comparisons with Katrina had their day and died down quite some time ago, but as we move toward day 80 (or whatever), a fresh “compare & contrast” would seem to be in order. There are certain strong similarities, besides them being visited on the ancestral homeland of my good Cajun friends. Both were instances where Nature furiously lashed back at the pretense that Man could control her, whether by levees or by that vastly more exquisite engineering feat that is deep sea drilling. In both instances, vast sums of money get thrown hither and yon to speed it along, but Nature will rather quickly, within her schema anyway, repair the apparent damage. (While the delays in deploying the best available skimming technologies are inexcusable, and the 15 ppm rule be damned!, it is also a fact of nature that the Gulf is very big and the sun is very hot. At the surface anyway, the molecular soup that is crude oil rather quickly falls apart, its lighter fractions meant to end up in products such as gasoline evaporating into the atmosphere, the heavier ones meant for asphalt dropping into the fathomless deep.) Finally, both episodes have vividly illustrated that the competence of government is even more constrained and ultimately delusional than any purported technological mastery of nature.

It is with the passage of time, though, that the import of these two episodes diverges. That and the bias at the root of each Administration’s error. In the case of Katrina, the federal government was a bit desultory, perhaps too deferential to what turned out to be spectacularly inept local entities. However, it was only a matter of days before they corrected this (admittedly, a seeming eternity for those caught up in it, but it was a few days nonetheless). With the spill, a seemingly similar, lackadaisical response at first, but as days turned into weeks and now months, something sinister seems to have emerged. Not only do we seem to have an Administration that would “never let a crisis go to waste” but its actions (and inactions) seem cynically calculated to extend rather than end the crisis. It could well be that this is just what you get when you put someone with zero executive experience into a chief executive position and then something unscripted happens. But maybe they think they are smarter than that. The clean-up has thus far been executed almost as inefficiently as is humanly possible, as if it had been deemed the substitute for all those “green” jobs that were supposed to happen before Planet Gore imploded (better to have all those marginally employable clients of the state out on the beach than poking into people’s homes to check the insulation, though! But am I the only one who notices that when the news clips go to the clean up sites that there is very little actual work going on, that the ratio of those actually working to those just standing around is probably worse than what we see on road repair sites?) We also get to hear, ad nauseum, from the likes of Mr. Joe Biden, how “the government is going to make things right.”, 24/7 political theater. All this leaves me, and many others I am sure, a little scared of the prospect that in the event of some truly dire threat (the spill is tragic, but given the compensation schemes in place, dire only to the creatures living in the water) we would be utterly incapable of any sort of effective response. The responses to Katrina were inept in ways we kind of expect of government, like the first few battles in 1861 or 1941. The response thus far to the spill betrays hubris an order of magnitude greater. It is emblematic of, at best, shameless and cynical political opportunism, and, at worst, of a civilization poised for collapse. As such, it is disconcerting enough to sate the risk appetite of investors at the margin and send them scurrying into the safest possible havens. And that is what happened in June 2010.

However troubling all this is, I still see a silver lining. The people are not fooled by this cynical chicanery. Remembering that the best thing about the putatively erudite Jimmy Carter was that his ineptitude and aloofness made President Reagan possible, I think that the handling of the spill is one more reason that “inmates running the asylum” will be greatly curtailed in about 120 days, will end in two years and, God willing, will not recur for another thirty or so years. I have lived long enough to experience the truth in the assertion that things are almost never as bad as they seem nor as good as they seem. Right this moment, it feels bad. It might even be bad. But unless 234 makes us very long in the tooth, “normal” is a damn sight better than it all feels right now, and the Market will reflect that in the months just ahead.