Mother's Little Helper

Many bulls believe that the economy will rebound sharply, mirroring its decline. Why do many strategists and prognosticators, believe this? Because it has happened before. Following every recession since the Paul Volcker area, the economy has experienced a healthy rebound. Economic recoveries were only a rate cuts (or cuts) away. Things are different today.

Today, Fed policy is extremely accommodative, even for a recession. Cutting short term borrowing rates to essentially zero has had some benefit, but we can't borrow our way out of this one. Since 1982, the economy had experienced a downward trend in borrowing costs. This enabled homeowners to refinance their homes time and time again. This put money back in the pockets of consumers. It also lowered monthly expenses allowing consumers to borrow to purchase big ticket items such as large trucks and SUVs. Lower borrowing rates also enabled consumers to afford larger, more expensive homes. Lower rates also opened up home ownership to more potential buyers. The real estate boom was on.

Accommodative Fed policy has been responsible for approximately 25 years of economic growth. However, this was only possible because of the poor policy decisions of the 1960s and 1970s. Equity strategists often talk about reversion to the mean. They are famous (or infamous) for describing the so-called mean. Could the economy finally reverting to the "mean"? Truth be told, there is no mean. The U.S. economy is dynamic. There is no mean, but we are entering a new era where the economy will be based more productivity and less on leverage.

If the economy will be based on productivity instead of cheap financing (after all, cheap financing has not been able to lift the economy out of the depths of the current recession), what will that mean for stock and home prices? Both asset classes will experience gradual long-term gains, but not the booming markets to which we have become accustomed. This is your grandfather's economy, without the industrial base.

This is not a bad thing, as long as the politicians can leave things alone. Politically-motivated policies to preserve jobs which have been outdated or to preserve industries which can be conducted in areas of the world which have a comparative advantage over the U.S. could result in inflation and higher rates accompanied by slow growth (see the 1970s and the Arthur Burns Fed). However, as long as the Fed is permitted to function independently of the administration, the economy should be alright. Just don't expect consistent double digit equity returns. Also, don't expect fund mangers to out perform the market by much. Many fund managers used the magic of leverage to produce above average returns. Look for leverage to be less in vogue. As the population ages, look for more emphasis to be placed on income vehicles such as bonds.


What does this mean for financial advisers? You MUST understand the capital markets. What does this mean for investors? You MUST understand the capital markets. Both advisers and investors must resist the urge to incur excessive risk in the quest for yield. Bulls make money, bears make money, but hogs get slaughtered