The Dueling Errors of Optimism and Pessimism

So it looks like our concluding remark of the previous edition, anticipating the “utter.. rout (of) those who bet against the resiliency of the US economy”, is turning out to be more on target than we could have imagined. The Euro crisis seems to have been bundled into an appropriate haz-mat container, strapped to Doc Brown’s flux capacitor and transported to some indeterminate point in the future, and the economy has once again displayed its ability to shrug off manifold toxins and keep stumbling along. Investors of the bearish persuasion, who seemed totally in control in the opening moments of Q3, have indeed been utterly routed. Unless a really plausible competing narrative develops in the next few weeks (keep an eye on the Congressional spending cuts tax force), my sense is that all those managers who got under-invested over the course of Q2 will be chasing performance into the New Year. Once again, optimism has paid off splendidly.

It is that matter of optics (how we choose to look at things), that difference between optimism and pessimism, that is perplexing us today. We find ourselves torn between the two. Our economy is at once marvelously resilient and debilitated by a host of maladies, mostly parasitic in nature. It is “early” with respect to a Bull Market in the generational sense, but perhaps getting late in the game in a more tactical, cyclical sense (i.e., 2.5 years off the bottom). I would suggest that coping with this conundrum comes down to recognizing the inherent errors in these two perspectives. Of late, the error of the pessimist has been to underestimate the resiliency of our economy and the body politic. Optimists have prevailed because the error of this pessimism has been revealed in the decent sales and earnings of large swathes of corporate America and the ability of European leaders to dance the dance of forestalling the fitful entropy that has been their lot since time immemorial. But this takes nothing away from an equally troubling error on the part of the optimist, to underestimate the impediments to economic growth that will be dealt with, to the short term detriment of economic growth, over the next decade and beyond. So while it just now paid off to discount pessimistic notions, we disregard the optimist’s error at perhaps an even greater peril (especially if our objective is absolute as opposed to relative returns).

The optimist’s error disregards the inevitable undoing of what has been called the 1950 Moment, that point in time when U.S. stood astride the rest of the world with the only industrial base that had not been bombed halfway back to the Stone Age. This allowed us to have policies that built around a compact between Big Business and Big Labor, to grow government spending faster than the economy and borrow against the future in the expectation that our wealth would continue to grow inexorably. It worked splendidly for two decades and we could almost get away with it for another, but our relative stature as it stood at mid century was, indeed, only a moment. The 1970s precipitated a recognition of global competition that rendered that industrial policy obsolete, and the 1980s were all about the undoing of Big Labor and, in the private economy, the Bismarckian notion of defined benefit pensions. It took a couple of decades, but with a very few notable exceptions (i.e., Big Three automakers, and look how that turned out) it was a remarkably successful transformation. We continued to be a big, strong country, a generous people growing steadily richer, and could still afford many indulgences, especially on the public sector side of the economy. Or so it seemed, as with the passage of time the sense of entitlement and largesse, helped along not so much by incomes as by net worths rooted in home equity and 401(k) balances, outstripped the actual wealth generating capability of the economy.

We need to be very mindful that 2008 induced a discontinuity that like the c. 1974 realization that we had to re-tool and reorient in order to compete in a global economy will require at least a decade of painful, contentious adjustment. It is not as if we, as a people, have suddenly been impoverished. We are still in the aggregate a rich and resourceful people. It’s just that just that many millions of us are not as wealthy as 2006 made it seem, and millions more will be coming to that realization as the great post-Crash adjustment rolls on. The disconnect that has become too unsustainable to ignore is between the discipline of the private sector over the past two decades versus the obfuscation and lack of accountability of the public sector spending. In terms of how this plays out over the next decade or so, I am inclined to optimism. It’s the getting there a day at a time that will wear on us as investors. There will be the political theatrics, as defenders of the status quo decry the heartlessness of those who are just looking for a little accountability and perhaps a bit of cost/benefit analysis. The larger issue, though, will be that the necessary right-sizing or even dismantling of presently bloated public sector enterprises will be a persistent drag on GDP growth (both the G in C+I+G and some of the C as head counts are reduced and pensions evolve in the direction that the private sector started down thirty years ago).

It has been said that history doesn’t repeat itself but often rhymes. To the extent that 2008 rhymed with 1974, we would do well to recognize that while profit opportunities abounded, it wasn’t until 1982 that the Bull Market became recognizable, and even that was a fleeting event. Even the election in 1980 of the sort of president many of us are wishing and praying for today did not really work its way into equity valuations (at near record lows in 1982) until his stay in office was nearly over. This was in large part because the cure (Volcker’s medicine for inflation) was painful and protracted. The cure for the massive disconnect between how we manage the wealth generating part of our economy and how we manage the wealth redistributing part of the economy will be at least as painful and probably a lot more fractious. It will involve millions of households having to re-invent themselves economically. People seem to be figuring this out, as seen in the increased savings rate. It is going to take a couple of election cycles at least to come to terms with large and in some case spectacularly corrupt institutions before the economic drag (i.e., their stakeholders coming to terms with a diminished call on the collective wealth) runs its course. It will happen throughout government, at all levels, and nowhere will it be more apparent than in what we call Education. From the dubious benefits of Head Start to the $1T scandal that is student loans, and at all points in between, this money sucker has failed us. Its reform is absolutely necessary, in terms of both fiscal solvency and renewing our economic competitiveness in a world that will only get more so. Getting there will take most of the rest of our lives, and it will hurt.

Pessimists have just paid a heavy price for not allowing for their inherent optical bias. Optimists, which would seem to include the vast preponderance of successful investors, would do well to not disregard the consequences of even the most positive developments over the next several years. History might not repeat, but it tends to echo. 2008 was a moment a lot like 1974. If history is echoing the way I suspect it is, we have years to go before this generational Bull Market feels like a Bull Market for more than a few fleeting moments at a time (moments that will prove to be good times to raise cash in anticipation of the next time the pessimists slip the leash).