Giving Credit Where Credit Is Due

In 1985, a visitor to China strolling about Beijing or Shanghai could expect to see in a day perhaps 10-20 cars struggling to make their way through a phalanx of bicycles and streaming rivers of pedestrians. Now Beijing struggles with almost perpetual traffic jams involving tens of thousands of vehicles that may be stranded on the highway for days—even weeks.

Situations like this make statisticians salivate. How intriguing, they think, to understand these jams. Are they random? Are there causal factors that can be identified and even managed? In short, what is happening? We can’t help but ask similar questions, not about cars in China, but about leverage in America.

1. Why can’t we return to the stock market growth rates of the 1980s, 1990’s, and into 2007?
While we would like to think that stock market growth during those nearly 30 years was primarily due to productivity gains, technological innovation, and good ol’ American know-how, we think that much of that stock market growth was due to the massive increase in our country’s leverage at the exact same time. Heresy? Perhaps. But if we are correct, then investors need to rethink expectations for stocks going forward.

Chart I below compares the growth of the S&P 500 (large US company stocks) to the growth of Public Debt (Federal), Consumer Credit, and Mortgage Debt from January 1976 to June 2010. Syntrinsic has added a “Smoothed S&P 500” line that mitigates the volatility of the S&P from 1994 to the present, so we can better see the general S&P 500 trend excluding extreme market noise.

Source: Treasury Direct, Federal Reserve, Bureau of Economic Analysis

The Debt is almost perfectly correlated to the Smoothed S&P 500, with correlation between them of 0.99. It could be coincidence, but we think such a strong relationship indicates something more important. While there has been a lot of noise over the past 35 years (fall of USSR, emergence of internet, rise of China, rise and stagnation of Japan, NASDAQ bubble, 9/11, Iraq, Afghanistan, housing crisis, etc.), leverage is a prime suspect in driving stock market growth during this period.

Just to emphasize how much our country was increasing its use of borrowed money, during this period leverage grew at a rate of 4.8 times the concurrent rate of inflation.

Based on the relative growth of Debt and the S&P 500 during this period, the Debt could be responsible for 50 - 60% of the stock market’s increase. If we were to factor in growth in municipal and corporate debt, the role of leverage would be dramatically higher.

2. But wasn’t our strong stock market of 1981-2007 due more to robust domestic growth than to leverage?
We wish that it were so; however, we think that domestic growth had a less significant impact than the increase in leverage. Chart II below compares the growth of the S&P 500 to the growth of America’s Gross Domestic Product (“GDP”). GDP is an imperfect measure of the economy, but it is the most comprehensive imperfect measure we have. Importantly, it includes much of the growth due to the increase in real estate values.

As with leverage, the smoothed stock market grew as GDP grew with a correlation of 0.99, (remember, perfect correlation is 1.00). However, the stock market grew 3.7 times faster than GDP grew during that period. Accepting that the correlation metric means something, then it would seem GDP is responsible for about 25% of the stock market’s growth. When we factor in the erosive effect of inflation, then the GDP growth rate falls to about 2.5% per year and GDP’s role in stock market growth drops below 10%.

The information below summarizes the annualized returns of these measures. Note that the sum of the annualized growth of Real GDP (Nominal GDP less CPI) and Public, Consumer, Mortgage Debt is quite close to the annualized growth of the S&P 500 (11.41% v. 10.66% per year); unfortunately, Debt represents over 78% of that sum.

Annualized Growth (Jan 1976 – June 2010)
S&P 500 = 10.66%
Public, Consumer, Mortgage Debt = 8.91%
Nominal GDP Growth = 6.55%
Inflation (CPI) = 4.05%

3. But aren’t we in a Great Deleveraging?
Nearly two years ago we wrote that we were in the midst of a Great Deleveraging, that it was time to rise up and spend down our lavish ways, unwind our collective exposure, and get back to basics—or something like that. Indeed, consumers have stopped increasing our leverage. Since the end of 2007, consumer credit has been stalled out at around $2.5 Trillion and Mortgage Debt has been stuck at about $14.5Trillion.

However, since December 2007 we have grown our country’s Public Debt from $9.2 to $13.2 Trillion, thus increasing the sum of our Public, Consumer and Mortgage debt from $26.3 Trillion at the end of 2007 to just shy of $30 Trillion as of June 2010. In short, we are not in a Great Deleveraging.

4. But if we are continuing to increase our leverage, then why is the stock market still about 25% below where it was in October 2007?
There are many reasons, but let’s consider investor sentiment and the how our leverage has been growing. Assume that 2008 was a shock to most investors and that people generally become more wary of the role of leverage. Certainly, there emerged for many an appreciation for the critical role that consumer credit and mortgage credit had played in America’s historically robust growth during this period.

But that is not the kind of debt we have been increasing; we have only been increasing our public debt. Increasing public debt at such massive levels has been sparking worry and fear, not consumer or investor confidence. Whether you embrace Keynes or Hayek, and whether or not you think the investing public is intelligent, investors are signaling their generalized anxiety about the potential affect of borrowing and printing more money. Thus, unless something enables consumer or mortgage borrowing to reengage, it is hard to see what would cause the market to rise materially.

Soon after news of Beijing’s traffic jam hit the international press, China’s state controlled media reported that the massive gridlock had mysteriously disappeared. Headline changed—problem (apparently) solved. Ah, that it would be so easy to solve an intractable transportation problem or to address our economic challenges. But just as the Chinese must at some point face up to a legacy of poor urban planning, corrupt officials, and a dishonest media, we in America must at some point look at our economy with more realistic eyes and not fool ourselves into believing in past economic glories or some sort of perpetual economic superiority.

It’s difficult to realize that what we had thought was a golden age economically was perhaps just a period of decent growth consistent with historic norms but juiced by leverage. But that realization should serve us better going forward than pretending otherwise.

Creating Something Better

A few weeks ago, political commentator and former Reagan speechwriter, Peggy Noonan, joined the chorus of those questioning whether the current generation leading America will leave America’s children something better. In her August 7, 2010 Wall Street Journal column, Noonan writes,

“The biggest political change in my lifetime is that Americans no longer assume that their children will have it better than they did. This is a huge break with the past, with assumptions and traditions that shaped us…The country I was born into was a country that had existed steadily, for almost two centuries, as a nation in which everyone thought—wherever they were from, whatever their circumstances—that their children would have better lives than they did. That was what kept people pulling their boots on in the morning after the first weary pause: My kids will have it better. They'll be richer or more educated, they'll have a better job or a better house, they'll take a step up in terms of rank, class or status…Parents now fear something has stopped…they look around, follow the political stories and debates, and deep down they think their children will live in a more limited country, that jobs won't be made at a great enough pace, that taxes—too many people in the cart, not enough pulling it—will dishearten them, that the effects of 30 years of a low, sad culture will leave the whole country messed up.”

But we have to ask, “Is it true? Has every American generation been confident that they were creating something better for their children? Is America a country that, as Noonan says, has existed steadily? One in which everyone thought their children would have better lives than they did?”

Consider a few major inflection points in American life and whether this intergenerational ethic was as clear and present to those who experienced them as they may appear in our historical mythology.

The American Revolution
America’s very founding revealed a country divided. Roughly one-third of the colonists were Tory supporters of England, one-third were what modern pollsters call “undecided,” and just one-third earned the title of rebel, whether given as compliment or pejorative. There was no consensus that one generation was leaving a better world for the next. That uncertainty was exacerbated—not settled—by Britain’s surrender.

The Civil War
Imagine yourself in the 1850s as the country spiraled ever closer to succession and war over the expansion of slavery. Regardless of one’s politics or geography, it is hard to imagine that either unionists or secessionists were certain they were leading their children down a path to a better country. And during the War itself, people’s confidence in America was shaken by the sheer scale of loss of life, disease and injury, destruction of whole cities, hunger, and fear that America and its ideals were disintegrating.

The Long Depression
The post Civil War Depression of the 1870’s was the worst America had seen in length and depth. Throughout the US and Europe, people were still reeling from devastating wars and economic collapse marked my deflation and bank failures. There were no formal safety nets, no pension plans, and only modest social and civil protections. By the panic of 1873, Americans had been living with a good 20 years of fear, uncertainty, war, and social turmoil. Little was certain, not least the future.

World War I
America’s “doughboys” were fighting a war that few felt would create a better world? The War was largely one of attrition marked more by new technologies of unprecedented brutality than by any sense of social or political accomplishment. The doughboys returned to a country that was not prepared to employ them, help them heal, or otherwise honor their service. Not America’s finest moment, and hardly a time of inspiring confidence in the future for the veterans or their children.

The Great Depression
The generation leading America through the 1930s faced much greater economic, social, and political turmoil than we do today and with far fewer resources for addressing those challenges. Were they confident that their children would be better off? Was America for them “steady?” If we think we are “disheartened” today, imagine how they must have felt.

World War II
Americans confronted global totalitarianism, the physical destruction of Europe, death camps, mass famine, casualties counted in the tens of millions. Our home front was divided far more than our selective and romantic memories recall. The outcome of the War was highly uncertain when America entered, our military was woefully underprepared. Parents sent their children into battle unclear whether the world would be better for it—hoping perhaps, but far from certain. They became what some call “The Greatest Generation” but no one knew that at the time.

This list is not comprehensive, nor does it come close to fully conveying the tremendous uncertainty with which Americans have lived since before this country was founded. But it serves as a good reminder, a grounding, a context for examining our current economic, political, and social challenges in a more realistic manner. We are not as bad off as the persistent social buzz might indicate.

For what has bound America over the years is not the constant assurance that one generation is creating a better world for the next generation; rather, it is the constant aspiration to create a better world. The distinction may seem subtle, but it is everything. We can never KNOW that our children will have it better, but heaven help us if we give up wanting it that way.

America has been about moving forward despite adverse conditions to raise loving families, start important businesses, build new friendships and communities, develop new technologies, build houses of worship, and expand the definition of freedom and human rights. America has never been constant or steady in the challenges it has faced. It has however, found over and over its core, its center, its commitment to persisting anyways in the desire to create a better world.

As always, the elements that have made America great are under tremendous pressure. When things are difficult as they so often are, it is natural that some would cry for more government regulation and control, and some for closed borders. At times like this, people look for scapegoats in immigrants, political opponents, and those from other cultures and religions. It is to be expected that some will lose hope and think that we as a country are lost—such despair is also a constant in American life.

However, we have more tools at our disposal than previous generations, far greater resources, better social support networks, more innovative technology, more accurate information, and most importantly, the wisdom gained from the experience of previous generations. America has not lost or forgotten something; we are simply struggling to recall what we already know and put it to action.

On this anniversary of the founding of our company, we move forward with great anticipation. Our lives have been greatly blessed by the generations before us who sacrificed, worked, thought, risked, persisted, and created. We expect our children—and theirs—to be able to say the same.

Our Modern Age of Exploration

In 1914, toward the end of the Age of Exploration, former US President, Colonel Theodore Roosevelt and famed Brazilian scientist and explorer, Colonel Candido Rondon, led a team of naturalists and camaradas (workers) on an expedition to be the first to map and explore the Rio da Duvida, the Amazon’s River of Doubt.

Their team had no idea of what they might encounter on their adventure. Almost all were capable and almost all had investigated other parts of the Amazon; none had explored this particular river. They had no way to know its course, speed or the nature of the hazards that they might encounter. It may be hard to imagine in our world of GPS that in 1914 (just 96 years ago!) a thousand-mile long river did not exist on any map and was essentially unknown to all except the small number of native clans that lived along its shore, people who had had no contact with the outside world.

Consider some uncertainties they faced:

· What type of boat(s) does one take down an unexplored river? Shallow draft or deep? Heavy or light? Wood, canvas, or metal? What is the ideal length? How should they be powered? How many such boats should be brought?

· What food does one bring and how much on a journey that could last two months, six months or more? Can one rely on hunting or fishing along the way? Since any food must be carried and stored and potentially cooked, and knowing that starvation had claimed the lives of many explorers, how does one prepare accordingly?

· What kinds of people should be included in the team? What traits and skills are needed? What if your one doctor falls ill? Your one naturalist? When do you decide that team member is unfit for the journey? Who decides and what is done about it?

The Commission consisted of a band of smart, courageous adventurers who already had proven their mettle in difficult circumstances around the globe. They knew that they were embarking on a journey of great uncertainty and were hoping that their experience, skill, and will power would enable them to make it through safely and successfully.

But the most powerful character in the adventure and the greatest variable of all was the course and behavior of the river itself. It was completely unknown. Every bend meant a new possibility, each whirlpool or eddy could mean intense danger or nothing at all. Each rapid had the ability to shoot the explorers forward or dash their boats and hopes to pieces. The river—inspiration for such a grand undertaking—could easily have brought about the death of those so inspired.

In Candice Millard’s book, Theodore Roosevelt’s Darkest Journey: The River of Doubt, the author describes various characters gradually accepting or at least being challenged to consider that their past experiences, common sense, and abilities were not necessarily enough to see them through, that they might not complete this journey, that for all their planning and thoughtfulness, they may not succeed and may in fact die on what had started as a rather straight-forward adventure.

The river represented the great unknown. One could wonder whether we more modern Westerners are comfortable with the notion that there are places as yet unmapped. With our quick and easy access to information of both superficial and in-depth nature, and with a rather glib confidence in and reliance upon our technology and analytic skills, perhaps we have grown accustomed to imagining that we can place ourselves at any point in time and place and understand what to do next.

Maybe that is why the political airwaves in this decisive year are filled with soaring—and often patronizing—rhetoric about the economy and other matters. Politicians, analysts, economists, and other commentators have been impassioned in their claims that they know exactly what to do about just about everything, from health care and financial reform to containing Iran and North Korea (not to mention China and Russia), from energy policy to immigration policy to stimulating economic growth.

Col. Rondon knew and demonstrated as he led the Commission down the River of Doubt that a lack of humility about our knowledge is frightening, that blind certainty represents a person’s or a society’s greatest potential weakness. He was as confident and brave as anyone in his position could be in part because he was willing to admit that there were risks he did not understand and was thus not willing to take or ask others to take.

Productive doubt is good. It causes us to give pause, to think more deeply, more carefully, to see things with less ego clouding our judgment so that we can better perceive the variables on the periphery that might be terribly important and yet easily overlooked by decision-makers who think they already know all that there is to be known. Doubt that leads to paralysis is not helpful, but doubt that leads to more deliberate planning can be a welcome friend.

In some respects the Age of Exploration is over. And yet in other ways it is never over, for the world has never been here before, never before experienced this convergence of political, social, technological, economic and environmental conditions. Our path forward is just as uncertain and unknown as the River of Doubt was to Roosevelt, Rondon and their men; thus, our path forward requires that we ask questions they faced as well. How will we move down our river? What supplies do we need along the way? And what types of people are required to make the journey successful? Whether we like it or not, we are on a grand adventure together, one fraught with danger and with great potential to learn about our world and make better sense of it. With good care, it could be quite a journey.