Why 6.5% Unemployment Is The Fed's Magic Number

Today Ben Bernanke and the Federal Reserve announced that they would keep the fed funds interest rate near zero as long as the unemployment rate remained above 6.5%. Why pick that number? They did not say for sure in their press release, but I can take an educated guess. Over the last 40 years, the unemployment rate has averaged exactly 6.5% in the United States. So Bernanke and Co. are going to keep rates ultra-low as long as unemployment is above-average.

I would also point out that the 6.5% level as the long-term average is important to keep in mind as we envision what a "normal" U.S. economy looks like. Some people may mistakenly think that 4-5% is typical or common just because we got down to those levels during the dot-com and housing bubbles. That is definitely not the case. A normalized economy is 3% GDP growth (vs 2.7% last quarter) and UE at 6.5% (vs 7.7% last month). So while we are not quite at a normalized level of economic growth and employment right now, we are not as far away as many (especially in the political arena) would have you believe. Perhaps that explains why corporate profits are slated to reach a record high this year, surpassing the prior record attained just last year.

Would Going Over The Fiscal Cliff Really Be That Bad?

Easily the most frustrating thing about being a long-term investor nowadays is how short-term focused Wall Street has become in recent years (or more accurately, the last two decades). Quarterly earnings reports and whether companies slightly beat or slightly miss estimates made by a bunch of number-crunchers in New York result in huge share price volatility. Owners of real businesses would be the first to tell you that small quarter-to-quarterly fluctuations in sales and profits are far less important than the long-term strength, viability, and competitive position of their companies.

Political leaders have the same problem; they are obsessed with the short term because they are up for reelection so frequently. If you listen to the media, or your elected representatives, you would think going over the fiscal cliff would be absolute catastrophe. But is that actually true? Well, it depends on whether you care about the short term or long term outlook for the finances of the United States.

The Congressional Budget Office (CBO), the non-partisan fiscal accountant for Congress, projects that the U.S. would fall into a mild recession if we went over the fiscal cliff, and that the unemployment rate would rise from 8% to 9% in 2013 as a result. In 2014, the economy would return to growth, much like we have today. That is the short-term impact. And yes, that is a bad outcome for politicians currently holding office.

But what about the long-term view? Are there any positive effects that might make it worth it to have a short, mild economic downturn in 2013? This is a question the media and politicians rarely speak about. For instance, did you know that without any actions to blunt the impact of going over the fiscal cliff, the U.S. budget deficit ($1.1 trillion in fiscal year 2012) would fall 43% from 2012 to 2013. In 2014 it would fall another 40%. In 2015 it would fall another 45% (all figures are current CBO estimates). At that point, the U.S. federal budget would essentially be balanced. The deficit problem would vanish within three years, and that is if we do absolutely nothing! Congress could actually accomplish something important by not passing a single piece of legislation!

One could easily argue that the best long-term outcome for the U.S. economy would be to have a balanced budget within three years, even if it meant taking some short-term pain in 2013 as tax rates reset to Bill Clinton-era levels. But nobody is taking a longer term view. Everyone is acting as if they are on Wall Street and care only about the immediate future. There is absolutely no chance that our country's leaders do nothing and balance the budget, even though they would all agree that $1 trillion annual deficits are unsustainable and are easily the biggest problem the U.S. faces in the intermediate term.

Instead, we should expect that politicians will opt to extend most of the Bush tax cuts and postpone or eliminate most of the planned spending cuts. Such a plan would do nothing to reduce our deficits and sets us up for much bigger problems a few years down the road. What people don't seem to understand is that the debt crisis that will arise from $1 trillion annual deficits year after year is many times worse than the relatively mild 2013 recession that inaction on the fiscal cliff would cause. Don't believe that? Just ask Greece or Spain, where unemployment rates are over 25%.

Typical Warren Buffett: Logical, Factual, and Fair

"A Minimum Tax for the Wealthy" - By Warren Buffett (11/26/12 - NYTimes.com) 

A Challenging Global Outlook for the Next 50 Years

The above is never something I would venture to take a stab at, but GMO's Jeremy Grantham has made a name for himself by making bold predictions about the future. His latest quarterly letter, entitled "On the Road to Zero Growth" is one of his best, in my opinion. A highly recommended read if you are interested in a 16-page article characterized by a lot of economic jargon. Granted, it makes a lot of sense and was written by someone who has been right an awful lot over his multi-decade investment career. Just thought I would share the link. Enjoy!

Consumer Debt Paydown Crimps GDP Growth

It's election season so both candidates would love for you to think that the POTUS has a lot of control over economic growth, but this week we got a report that sheds light on one of the major reasons the U. S. economy is growing at around 2%, down from its long-term average of around 3% per year. The New York Federal Reserve reported that credit card debt balances last quarter dropped a $672 billion, a level not seen since 2002. It also marks a 22.4% decline from the peak we saw in the fourth quarter of 2008.

So how exactly has this de-leveraging trend negatively impacted GDP growth? Well, consumer spending represents about 70% of GDP, so a drop in credit card balances of $200 billion over the last few years represents a lot of money that was sent off to pay bills, not spent on goods and services. Toss in another $100 billion of spending that would normally be incremental over that time period due to overall growth in the underlying economy, and you can see that about $300 billion of consumer spending has been absent from the system, compared to what would have been normal.

With annual U.S. GDP at around $15 trillion, this consumer credit card de-leveraging represents about 2% of GDP growth lost. Over 3-4 years, that comes out to about 0.5% GDP impact per year. In a world where GDP growth has dropped a full percentage point from its long-term normalized level, consumer debt repayments account for a major portion of that slowdown. You aren't likely to hear much about that on the campaign trail, but politicians rarely deal with facts and truths when it comes to hot-button issues like the economy.

Let's Face It, Given All That Has Happened Lately, A Market Correction Makes Sense

In a few short days I leave town for a two-week vacation (interesting timing I know, but it has been planned for months and therefore not market-related) but before I leave these volatile markets behind for some refreshing time away I think a few comments are in order. As I write this the Dow is down 400 points to below 11,500 and the S&P 500 index has now dropped 11% from its 2011 high. In the days of computer-driven trading stock market moves are more pronounced and happen faster than ever before, so it is important to keep things in perspective.

First, given everything that has happened in Europe this year, coupled with our own ugly debt ceiling political debate in Washington DC, it is completely reasonable to have a stock market correction. I would even go a step further and say it was a bit odd that the market held up so well prior to last week's debt ceiling dealings. Historically the U.S. stock market has corrected (by 10% or more) about once per year. The last one we had was a 17% drop in 2010 during the initial Greece debt woes. That we have another one now in 2011 is not only predictable based on history, but especially when we factor in everything going on lately financially, economically, and politically. Let's keep the market swoon of the last week or two in context.

From an economic standpoint, investors need to realize we really are in a new paradigm. The U.S. economy was goosed up by debt, both at the consumer level (credit bubble) and at the government level (tax cuts along with increased spending). As a result, we have to see both groups de-lever their balance sheets. Consumers are reducing debt and saving more, and many don't have jobs. The government is now beginning to cut back as well. Consumer spending represents 70% of U.S. GDP and government spending, at $3.6 trillion per year, makes up another 25%. Corporations are the only bright spot in today's landscape, with record earnings and stellar balance sheets, but their spending is only the remaining 5% of GDP. With both consumers and government agencies cutting back, a slowing economy and lackluster job growth are all but assured.

So are we headed back into a late 2008, early 2009 situation for both the economy and financial markets? While anything is possible, we probably should not make such an assumption. A slowing economy (say, 1-2% GDP growth) is far better than what we had at the depths of the financial crisis with 700,000 jobs being lost per month, negative GDP of several percentage points, and runs on the country's largest banks. The 2008-2009 time period did not reflect a normal recession (which would last 6-9 months and be relatively mild). It was far worse this time and those events typically only happen once per generation, not once every few years.

The best case scenario short term is that the markets calm down and we meander along with 1-2% growth. Not good, but not horrific either. Could we slip back into a garden-variety recession due to government cutbacks, 9% unemployment, and a deteriorating economy in Europe? Sure, but that would likely result in a more typical 20% stock market decline over several quarters, not a 50-60% drubbing. And keep in mind we are already down 11% in a few short trading sessions.

What does this mean for the stock market longer term? Well, believe it or not, there are reasons for optimism once investors calm down and we really get a sense of what we are dealing with. With slow economic growth interest rates are going to stay near all-time lows. Buyers of government bonds today are accepting 2.5% per year in interest for a 10-year bond. Savings accounts pay 1% if you are lucky. The S&P 500 stock index pays a 2% dividend and many stocks pay 3% or more. Given the financial backdrop for U.S. corporations relative to the U.S. government, which do you think is a better investment; lending the government money for 10 years at 2.5% or buying McDonalds stock and collecting a 2.9% annual dividend? Investment capital will find its way to the best opportunities and even with slow growth along with the possibility of a double-dip recession, U.S. stocks will look attractive relative to other asset classes.

As a result, I think there are reasons to believe the current market correction is going to wind up being much more normal than the 2008-2009 period. With interest rates and government finances where they are, equity prices can easily justify a 12-14 P/E ratio. Maybe stock market players before the last week or two were just hoping we could escape all of this unscathed, despite the fact that market history shows that is rarely the case. In any event, while I am looking forward to spending some time away from the markets, I am not overly concerned about this week's market action, especially in the context of global events lately. My hope is that by the time I return markets have calmed down and we can revisit how to play the upcoming 2012 presidential election cycle, even though that thought alone makes me want to take far more than two weeks off. :) 

Why Education Was Stressed So Heavily in the State of the Union

I think these figures from the BLS tell it all:

Earnings Growth Does Not Predict Stock Market Returns

Lots of readers are writing in to question my assertion that the stock market does not track corporate profits or GDP. They seem upset to learn that if you can correctly predict GDP growth or earnings growth in the short term that you can't also predict the direction and magnitude of the market's moves. The key here is that the market prices in certain expectations about the future ahead of time and then readjusts prices based on how the future plays out relative to those expectations. We cannot simply infer that, say, over the next year GDP will grow 3%, leading to earnings growth of 8%, and therefore the market will rise 8%. Markets are more complicated than that!

Here is an illustration I came up with to back up these claims (raw data compiled by NYU from Standard and Poor's and Bloomberg). As you can see, correctly predicting S&P 500 earnings growth (grouped along the x-axis) for any given year does not help predict the market's return (plotted along the y-axis) during that same year. In fact, the market does better when earnings are declining, relative to how it fares when earnings are growing by double digits. In the near future I will try and compile data that shows which figures actually have predictive value.

For-Profit Education Stocks Worth Monitoring Even As Government Implements Reforms

Shares of Apollo Group (APOL), the leading for-profit education company (think University of Phoenix), fell a stunning 23% Thursday to $38 after the company withdrew its 2011 financial outlook in light of upcoming changes to their industry. With the unemployment rate at 9.6%, enrollment at for-profit schools has been surging in recent years as people try to boost their resumes by completing online college courses and earning an associate, bachelor, or graduate level degree. As a result, the private firms running schools such as University of Phoenix have been minting money.

The interesting part of the story is that for-profit colleges typically get more than 80% of their revenue from Title IV student loan programs subsidized by the U.S. government. With taxpayers footing the bill for all loan defaults, the colleges themselves have absolutely no direct financial exposure whatsoever if students rack up thousands in debt and cannot repay the loans. As loan defaults rise, the U.S. Department of Education is finally taking notice and is set to release new guidelines for Title IV funding. As you may imagine, if lending guidelines are tightened, new enrollment at these colleges could drop off considerably. The new rules, set to be issued in coming months, are likely to set maximum default rates for schools who want to accept Title IV loans, as well as gainful employment guidelines to help ensure that students will actually have the ability to repay these loans based on the jobs they secure with their new degrees (a communications degree online, for instance).

The market's violent reaction to the sector on Thursday was triggered when Apollo Group withdrew its 2011 financial guidance in anticipation of these new rules. For the first time ever, for-profit schools are going to have to scale back growth plans and actually become more than simply fierce marketing machines. Maximizing enrollment at all costs is no longer going to work. In fact, Apollo is now requiring all new students to attend an orientation program which spells out in more detail exactly what kind of financial commitment these degrees require. The company says that about 20% of prospective students voluntarily withdraw from the program after attending the orientation. In addition, the company's admissions staff will no longer be compensated based on enrollment rates, as the company seeks to increase the quality of their students, thereby reducing loan default rates and boosting retention rates.

While there is no doubt that enrollment growth rates will tumble at for-profit colleges, it is far too early to pin down exactly how their businesses will be impacted by these changes. I think it is worth it for investors to monitor the situation carefully, as some values may ultimately be worthy of investment consideration at some point in the future (the stocks are already down a lot from their highs). In the case of Apollo, the company's enterprise value of about $4.2 billion compares with fiscal 2010 EBITDA of $1.4 billion and free cash flow of nearly $900 million. At 3 times trailing cash flow, these stocks are already in deep value territory.

It will be important to see if scaled down marketing and increased financial awareness for students serves to merely slow down enrollment growth or also seriously cuts revenue and earnings for these companies. Exactly how much revenue is reduced and expenses rise will determine if and when these stocks reach a point where the risk-reward is worth an investment. At current prices it appears that the market is pricing in cash flow declines of 33-50% over the next 1-2 years. While possible, we surely do not know that kind of hit is a given at this point in time. If it proves overly pessimistic, shares of Apollo could become quite attractive, as the schools remain strong cash flow generators.

Full Disclosure: No position in APOL at the time of writing, but positions may change at any time.

Statistical Shocker: S&P 500 Performs Best When Economy is Shrinking

Impossible, right? As a money manager I spend a decent amount of time explaining to clients, readers, family, and friends that the stock market does not mirror the economy in real time. Just because the unemployment rate is 9.5% and GDP growth is decelerating does not mean that the stock market is a poor investment option. Stock market returns and GDP growth simply do not track each other, and as a result, reading economic reports will not help you figure out where stock prices are headed.

As always, I try to present numbers to people so they do not simply have to take my word for it. In today's world of media sound bytes and political maneuvering Americans all too often repeat something they heard from one of their favorite media or political pundits as if it was fact, even when a tiny bit of research can disprove the claim.

In order to show that stock market movements do not mimic the economy, I decided to compile data from 1958 (the first full year the S&P 500 index was published) through 2009. While I had no idea what the actual numbers would be, I was confident they would show that stocks and the economy shared a very low correlation. Sure enough, the results were even surprising to me. It turns out that the S&P 500 has performed best when GDP growth is actually negative (i.e. when the economy is in a recession). Since 1958 there have been 7 years when U.S. GDP shrank and the S&P 500 gained an average of 24% per year during those periods. Pretty interesting, right?

Here is the full data set. I divided economic growth into 4 subsets (negative, zero to 3%, 3 to 5%, and above 5%).

As you can see, there is very little correlation between the economy and the stock market. Not only that, investors choosing to own stocks only in years with negative GDP growth would have earned nearly 4 times as much than investors choosing to invest only when GDP was growing at 5% or better. So the next time someone tells you the market is going to drop because the economy is bad or unemployment is high, send them a link to this blog post.