Wednesday, February 17, 2010

The Most Important Financial News You Haven't Heard

Health care costs are 17% of our Gross Domestic Product, and growing at 12% per year.  At this rate, in 10 years, health care will be 50% of our GDP.  No health care legislation on the horizon.
The biggest contraction of GDP since the Great Depression just took place, and caused a worldwide recession.  No financial reform legislation on the horizon.
This is the story that may be bigger than either of those.
I.  National Debt in Perspective
You'd have to be a recluse not to have heard the Tea Party movement raving about government spending.  Do they have a point?
According to the latest Congressional Budget Office report, the US will spend $1.35 trillion more than its revenues this year, slightly less than the $1.4 trillion deficit in 2009.  Our accumulated deficits (plus interest), or our National Debt is $12.38 trillion. 
US debt is currently 86.7% of our Gross Domestic Production, and is projected to be 94.27% by the end of this year.  How does that compare to our historic levels of Debt/ GDP?
A.  Post-War Years
Since 1792, our average level ratio of Debt/GDP was 28.32. 
Our lowest levels were from 1835 - 1842 (less than 1%), and our highest were 1945 - 1947 (averaging 114.34%), and 1948 - 1950 (averaging just under 92%).  Note that the highest years were post World War II, when fears that military spending decreases would cause another Depression subsided, as growth in housing, cold war military spending and industrial production in automobiles, aviation and electronics increased throughout the 1950s.
B.  The 1960s and 1970s 
In the 1960s, the Kennedy Administration increased government spending and cut taxes, but the level of Debt/GDP dropped from 67.9% in the 1950s to 45.3%. 
In the 1970s, a combination of increased inflation and a stagnant economy (coined "stagflation") resulted in high unemployment, and Debt/GDP dropped to 33.7% during that decade.
C.  The 1980s 
Beginning the decade with a brutal recession, the Reagan Administration responded with tax cuts and spending increases, much like the 1960s.  The difference was government spending for social programs was slashed, and military spending increased dramatically.  During this decade, Debt/GDP rose to 42.2%.
D.  The 1990s and beyond
Economic growth brought deficits down to zero in the 1990s, but a growing debt primarily due Social Security and other social programs increased Debt/GDP to 63.7%.  Continued growth in social programs (including the Medicare Drug Program), the Afghanistan and Iraq wars, and the housing bubble (with its ensuing world-wide financial crisis) increased the Debt/ GDP ratio to 64.6% during the decade ended 2009.
II.  US Spending by Category
National Defense 19.9%
Human Resources (Including education, training, employment, social and veteran's services) 65.2%
Physical Resources (Including energy, environment, commerce, housing, transportation and community/regional development) 8%
Net interest on National Debt 3.8%
Other Functions (Including international, science, space and technology, agriculture, justice and general government) 5.6%
Undistributed Offsetting Receipts -2.3%
Clearly, the vast majority of  US spending are in Human Services (65.2%), and almost half of that spending is Medicare and Social Security.  Social Security spending alone is about equal to National Defense.
Spending on Health Care, as mentioned earlier, is 17% of GDP, and is growing at 12% per year.  Left unabated it will be half of our GDP in 10 years.
III.  The Big Untold Story
China is no longer the largest foreign holder of US debt, having recently reduced their holdings by $34.2 billion.  Japan, who now holds more of our debt than any foreign holder, also reduced their holdings by $11.5 billion.  Overall, foreign holders of our debt dropped by $53 billion, the largest drop in history.
With our debt increasing, and foreign lenders less willing to buy it, the Treasury Department will now have to attract investors with higher rates of interest.
The 3.8% of our budget we use to pay interest on our debt will increase.  While $136 billion may seem a paltry amount in today's vernacular, we derive absolutely no benefit from it, and it is now equal to the amount we spend on education. 
With foreign governments finding our debt less attractive, the amount we spend on interest will surely increase to attract other borrowers.
We haven't had the will to fix health care costs that will be 1/2 of our total output in a short 10 years if we do nothing.
We haven't the will to enact financial reforms after the biggest recession since the Great Depression.
Will we find the will to make the sacrifices necessary to cut spending? 
Warren Buffett suggested that he will pay higher taxes and forego Social Security payments, regardless of the fact that he's paid into the system all his life.  Admittedly, he's a lot weathier than we are.
Nevertheless, maybe he's on to something.

Monday, February 8, 2010

The Economics of What Happened Last Year in Plain English

Most economic news is reported by someone with a vested interest in what you think.  I don't care what you think, but I do care that you get all the information you need to draw your own conclusions.
I.  2009 US Economy
Industrial output fell by 10%, after having fallen 3% in 2008.  Less demand for goods.  No surprise here.
Unemployment grew  from 7.2% in 2008 to 10% in 2009.  To get some historical perspective, in the last comparable recession, July, 1981 - November, 1982 (16 months), the average unemployment rate was 9.09%.  When President Reagan took office in January, 1981, the unemployment rate was 7.5%.  When the recession began in July of that year, it had fallen to 7.2%.  At the end of the recession in November, 1982, it was at 10.8%, and stayed over 10% for the next seven months.
Consumer Confidence fell nearly 30%, after having fallen 45% in the prior year.  Again, no surprise. 
Inflation averaged under 1/4 of 1% last year.  With less demand, both the price of commodities (like oil, lumber, etc.) and consumer goods fall.  Current inflation is virtually non-existent.
Inventories fell by 6.75%.  This contributed to our Gross Domestic Product, and many think this growth is artificial.  I do not share this point of view because the opposite (growth in inventories) is subtracted from GDP.  When you think of inventory building as wholesalers buying goods that sit on shelves (which does not contribute to growth), then depleting those inventories by selling them makes more sense as contributing to growth.
Orders for "big ticket" items fell by 20% from the previous year, but increased from  $160.1 billion in January to $167.9 billion in December.
Leading economic indicators, which include measurements that generally predict either growth or contraction in the future, fell 8% from the previous year, but increased from 98.9 in January to 106.4 in December.
You can see, with the exception of employment, that these important economic indicators all fell from the previous year, but are improving.  These are the data that economists generally consider when they say things like, "We're stabilizing, but are far from healthy."  As you can see, history shows that unemployment lags most other economic measurements after a recession, likely due to the reticence of employers to hire until they're sure than the economy is really on solid footing.
II.  Monetary Policy
You know that the Federal Reserve Bank has cut interest rates nearly to zero - .25% to be exact - in order to lower the cost of borrowing money for businesses.  Any who save money know that a six month Treasury Bill returns about the same, .25%. 
Many investors gauge whether the stock market is expensive by comparing the return on the 10 year Treasury Note with the expected earnings for the Standard and Poor 500 Index.  Right now, the yield on the T-Note is 3.66% and expected earnings for the S&P 500 are 4.5% of its current price - about a 20% premium. 
30 year Treasury bonds are paying 4.42%, good news for anyone who is buying a home because this is the rate mortgages are based upon.  Now, all you have to do is find a bank that's not too scared to make a loan.
III.  Sentiment
Investor sentiment is my favorite indicator because it is simple and more reliable than any other I review.  As Warren Buffet often says, "Be greedy when others are fearful, and fearful when others are greedy."
That's exactly how this measurement works.  When it's high, everybody wants to buy stock.  Bad sign.
When it's low, everybody is scared to death to buy stock.  It's cheap.  Good sign.
In 2007, the reading averaged 63.  In 2008, it was 28.  As you know, if you bought stock in 2009, you show quite a profit.  In 2009, it averaged 41, with a current reading of 58. 
The market is not the bargain it was in 2008, as we'll see below.
IV.  Valuation
This is a measurement of how much stocks cost.  To get some historical perspective, since 1926, the stock market as measured by the S&P 500 had an average cost of  $15.82 for every dollar it earned. 
Right now, it's at $18.29, up from $17.97 last year. 
Not cheap, but not expensive.  It depends on whether you think businesses will earn more money next year.  Standard & Poor's projects earnings of $58.71 for the S&P 500 in 2010, up from $50.70 (a 16% increase). 
So there you are.  Based on that information, your opinion is as good as anyone's.