Are We in A Secular Bull Market?

Are we in a short-term cyclical bull market, one that is already long in the tooth and coming to an end? Or are we in the early years of a secular bull market, one that might last a decade or more? The answer could have a significant

This Bull Market Has Room to Run

NOV 4, 2016 10:59 AM EST
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Are we in a short-term cyclical bull market, one that is already long in the tooth and coming to an end? Or are we in the early years of a secular bull market, one that might last a decade or more?

The answer could have a significant impact on how your portfolios perform during the next few years. A few examples, definitions and some data points will help provide some context for this discussion.

Markets regularly go through long phases — bullish, bearish and sideways — lasting anywhere from years to decades. The 20th century saw three secular bull markets: The first lasted from 1921 to 1929, when the Dow Jones Industrial Average gained 367 percent. After World War II, the next bull market lasted about 20 years, more or less from 1946 to 1966. It is a somewhat subjective determination. The Dow had gains of about 350 percent during that stretch. The most recent bull market began in 1982, with the Dow starting at about 1,000, and ending in 2000 at 11,750 — a whopping gain of more than 1,000 percent.

In between were secular bear markets: 1966 to 1982, when the Dow went nowhere in nominal terms, but after inflation it lost about 75 percent of its value. We had another bear market starting in about 2000 and ending in 2013.

Long secular bull markets occur for a specific reason: waves of industrial, technological and economic progress make their way into employees’ wages,  consumers’ pockets and corporate profits. Improving standards of living are reflected in the psychology of an era. Not surprisingly, markets do well, as investors become willing to pay more for a dollar of earnings as the cycle progresses. Multiple expansion, in the form of rising price-to-earnings ratios, drives returns even more than rising profits.

Let’s use 1982 to 2000 as an example. The widespread adoption of many technologies, including software, semiconductors, mobile, networking, storage and biotech, fed into each other. The economy expanded, there was record low unemployment, strong wage gains and high corporate profits. As you would imagine, U.S. stocks did very well. Now think about the many long-lasting positive elements that drove the postwar period: interstate highways, suburbanization, automobiles, electronics, commercial airlines. That 1946-1966 era was one of huge growth.

But bull markets tend to get ahead of themselves, especially as they age. They end up pulling years of future returns into the present. Hence, the subsequent bear market can be thought of as a refractory period, working off valuation excesses over time.

What does this look like in actual markets? According to an analysis by the fund company Fidelity Investments:

  • The average secular bull market lasted 21.2 years and produced a total return of 17.2 percent in nominal terms and 15.9 percent in real terms. The market’s P/E more or less doubled, from 10.1 at the start to 20.5 at the end.
  • The average secular bear market lasted 14.5 years and had a nominal total return of 1 percent and a real return of –2.3 percent. The market’s P/E compressed by an average of nine points, from 20.5 at the start to 11.3 at the end.

The psychology underlying bull and bear markets is why P/E ratios expand during bull markets and contract during bears. Declining P/Es during bear markets reflect investors’ fears. They become less willing to pay the same price for each dollar of earnings. This is why judging secular moves by price alone fails to fully capture just what is going on.

In 2003, I wrote that we were in a secular bear market and defined it this way:

Historically, this suggests an extended period of range bound trading as the highest probability long-term scenario in my view. I expect vicious rallies, and wicked sell-offs to occur — over shorter term cycles — within the larger timeline. Active management and capital preservation are going to be the key methods of outperformance.

In 2013, markets broke out, implying the start of a new bull market.  The Dow’s P/E has averaged 16 during the past three years, in the middle of the range during secular bull markets. We discussed last year the divide between the veteran market strategists, technicians and traders who were either in the secular bull or bear camps. I remain in the secular bull camp, and will share what would make me change that view in a future column.

One final thought: These things are always terribly clear in hindsight; in real time, they are more challenging to discern. It is easy to say 1982 to 2000 was a secular bull market, but read the commentary at the time. It was hardly definitive while it was happening.



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What Do US Wages Tell Us About the Business Cycle?

Yves here. For what it’s worth, George Soros disagrees, having increased his short on the US stock market as it moved higher earlier this week. Given how strained valuations are and how little prices have to do with fundamentals, the Soros bear bet may be the result of his reading of political risk and adverse market reaction to a Fed tightening at super-low rates (where the effect on bonds are amplified), as witness the market shock of early this year, which looks to have bee a delayed reaction to the December Fed rate increase.

By David Llewellyn-Smith, founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. Originally posted at MacroBusiness

From Macquarie Bank:

 Evidence continues to mount in our proprietary analysis of 131 sub-industries that headline wage growth (average hourly earnings) is on the cusp of further acceleration and new jobs are of high quality.  Our work shows wage growth has broadened significantly across sub-industries in recent months. In the past two cycles, this foreshadowed accelerating headline wage growth. As of June, nearly 50% of sub-industries had YoY wage growth greater than 3.0%, showing a dramatic broadening in 2016 (Fig 1). Similarly, our median sub-industry measure reached a cycle high of 2.9% (Fig 2).


In the last two expansions wage growth similarly broadened in Jan-96 and Feb-06. In both instances, the YoY measure moved 20% higher over the next 12-18 months (Fig 3). This suggests headline wage growth should rise above 3% before end-17. What’s more, our preferred measure (the Atlanta Fed Wage growth tracker) is suggesting this acceleration is already occurring “on the ground”. Proprietary analysis indicates wage growth has turned


Several indicators suggest the pace of gains will further accelerate. i) The ratio of job openings to the unemployed is above the 2002-07 expansion peak (Fig 4). ii) Small business owners are continuing to report a high level of job openings they cannot fill (Fig 5). iii) An increased share of respondents view jobs plentiful rather than hard to get (Fig 6). iv) A growing percentage of the unemployed are workers that have willingly left their jobs (Fig 7). v) The Beveridge curve has shifted outward indicating employers are struggling to find qualified workers (Fig 8).


If we were to use this analysis as a guide to the durability of the US (and global) business cycle, recognising that in the normal run of events it is Fed tightening that ends it, we would conclude that the cycle has another 2-3 years to run and that the Fed might be able to get away another two or three hikes before it all comes tumbling down. Remembering that the Fed will be in no hurry to cut short labour income gains in this cycle owing to the need to deleverage and reboot middle class income.

I would describe that as the global best case, possible so long as European exit politics doesn’t get moving and China doesn’t crash through its glide slope. Macquarie describes it as the “long, grinding cycle”:

When looking to the financial markets for guidance, some see a record-high on the S&P 500; some see record-low bond yields. Those focussing on the record-low bond yields see a signal of an impending global slump, and regard global equities as highly vulnerable – the half-empty view. Those focussing on the record-high in the S&P 500 foresee an earnings reacceleration, global growth lift-off, and believe that low bond yields cannot persist – the half-full view. We see both. A record-high on the S&P 500 and record-low bond yields is a combination consistent with moderate global growth. It is not a combination consistent either with a global slump or with global lift-off. As Fig 11 shows, global growth has been remarkably stable since 2012. This is long enough to believe that financial markets have come to reflect this as “the new normal”. As Fig 11 also shows, our forecasts out to 2020 are for a continuation of moderate global growth, for the long, grinding cycle and associated low bond yields to continue (more below).


If it were to transpire then the current MB allocation matrix would look reasonable as:

  • equities slowly grind higher but so do bonds, especially Aussie as interests rates keep falling;
  • the US dollar remains bid but only slowly so gold remains firm as the bond curve remains flat;
  • the Aussie dollar would steadily fall with commodity prices and a closing yield gap,
  • and local house prices might hold up for a while longer before tanking into the next bust as monetary and fiscal policy is exhausted.

The Grand Strategy of Rising Superpower Management

Xi jinping Google Search

Munk School Trans-Pacific Partnership Conference: Geopolitics Panel

Revised and Extended: I could now talk about the risks of the Trans-Pacific Partnership. You have already heard a lot about the risks in the previous session here. You have heard about dispute resolution and about intellectual property. You have heard about instituting largely-untested dispute resolution procedures in such a way that they will be very difficult indeed to amend or suspend or replace or adjust in the future.

We all know very well the eurozone’s ongoing experience. We remember that the euro single currency is in its origins a geopolitical project. We remember the origins of the eurozone at Maastricht—the decision of the great and good of Europe that something needed to be done to bind Europe more closely together in the wake of the absorption into the Bundesrepublik of the German East and the collapse of the Soviet Empire. The creation of a single currency was clearly something.

But “we must do something; this is something; therefore we must do this” is a very dangerous syllogism to serve as a basis for any form of technocratic government. The inability of Europe to back itself out of and adjust away from unwise commitments made in the founding of the euro has not been a source of sunny happiness and light in Europe over the past now-eight years.

We all remember that, back in the late eighteenth century, the United States Constitution was at the very forefront of the most advanced intellectual thinking in its ultra-modern and ultra-aggressive innovation policy. The inclusion in the founding constitutional document itself of profound intellectual property protections—the power to by law reserve rights to make and use inventions and discoveries “for a term of years” in order to encourage the useful arts and sciences—was a bold step. But the bold step stopped before writing down the number of years for which rights were to be reserved. The term of intellectual property protection was left to the discretion of the legislature: either none whatsoever, or one day, or seven years, or as long as would encourage inventive and innovative activity—that was for the legislature to decide and revisit and revise as it wished.

We all remember how, back at the end of World War II, John Maynard Keynes and Harry Dexter White at Bretton Woods set about constructing their piece of the international economic institution. Keynes and White, however, did not hard-code policies and quantities into an effectively-unamendable treaty. Rather, they constructed agencies. And they then gave them discretion.

My last trip outside the United States before this trip to Toronto was a trip last December to the Rockefeller villa in Bellagio, Italy, on Lake Como—a trip to discuss Thomas Piketty’s Capital in the Twenty-First Century. Piketty writes about how it is the nature of capitalism that plutocrats and entrepreneurs invest not just in productive capital and beneficial technologies but in political influence in order to rejigger the system of property rights in order to acquire and protect economic rents. How much of what is in the TPP is part of that process rather than a good-faith technocratic effort to construct a better international trade, investment, innovation, and intellectual property-mobilization system for us frogs who live around the pond that is the Pacific Ocean?

All these considerations suggest that the TPP poses considerable risks as a leap into the untested dark. We do not know much about how these dispute and intellectual property provisions will actually work on the ground. And I have no idea how, in a decade, the negotiators of TPP anticipate backing-out of TPP'a mechanisms if on a decade they change their mind about their desirability.

Alternatively to the risks, I could now talk about the potential benefits of the TPP. We heard much less about those in the previous panel.

I could talk about how productivity depends on the division of labor, and the division of labor depends on the extent of the market, and the global trans-Pacific market is the largest we can find—or would, if it included China. I could talk about the benefits of economic integration both in enabling productivity-boosting specialization and incentivizing innovation. I could back up into political economy. I could quote James Madison on how the legislatures of Republican government are always prone to the disease of faction—rent-seeking by special interests—how one important cure for faction is extent of territory that reduces the relative power of each particular faction, and how a set of economic rules that spans an economy the size of the Pacific Ocean will be less vulnerable to rent-seeking by interests that would otherwise merely have to capture the legislature of one national government.

I could talk about how there is $4 trillion in present value in net static economic gains to the trans-Pacific economy from the TPP. And I could point out that those gains are static gains: they do not include the effects of any of the many invention, innovation, investment, spread of ideas, or political-economy virtuous circles that such a $4 trillion productivity boost would produce. I could conclude with observations about how static estimates tend to lowball our assessments of the gains—that the differences between more and less free-trade economies are vastly greater, and the share of those differences plausibly attributable to openness to world trade substantially greater, than estimates produced by the types of calculations that underpin the $4 trillion number.

I could then conclude with reflections on on model building and the estimation of the effects of trade deals. That conclusion would start with a reminiscence of a day in 1994: I was sitting in my office in the US Treasury, just before the start of the lame-duck session that was to pass the Uruguay Round. One of then-Treasury Secretary Lloyd Bentsen's consiglieri walked into my office. He said: "Brad! Your task is to get the Economist to endorse the Uruguay round as a $1 trillion global tax cut! Then no Republican will dare oppose it!” And I found that Robert Cumby and I could indeed do it, and do it relatively straightforwardly.

But this is not a panel on the risks of TPP. This is not a panel on the benefits of TPP. This is not a panel on increasing-returns models and the assessment of trade deals. This is, indeed, not a panel on the political economy of trade policy in the U.S. in the 1990s.

This is a panel on geopolitics.

So let me talk about geopolitics.

And let me talk about the geopolitics of managing our relationship with the immense rising superpower across the great ocean to our west.

(1) Rising superpowers always believe they have the key to the riddle of history. They believe that history is about to reveal that their system is the best, and their elites are extremely unwilling to take even the best-intentioned advice from abroad on how to constitute their internal arrangements. They in fact believe that other countries should learn from them, and adopt their systems—even though, as rising superpowers, they do not or do not yet seek to impose their systems on others.

(2) Rising superpowers have a profound dislike of potentially-hostile bases near their borders, and a profound dislike of other powers’ interfering in what they think manifest destiny has decreed is their sphere of influence. They make their neighbors nervous.

(3) Rising superpowers almost always have territoria irridentia: regions that they believe ought to be under their control, and that only malign manipulations by other powers and historical accidents have left outside their current borders.

(4) Rising superpowers are overwhelmingly focused on making the world economy and society work for them and for their ruling classes.

And (5) managing your relationship with a rising superpower, doing as much as possible to align its and its elite’s core interests with yours, and then appeasing those core interests that cannot be so aligned, is your most important foreign-policy task and objective not just for one but for many generations.

I am, of course, speaking about Henry John Temple and [John Russell2, the third Viscount Palmerston and the first Earl Russell. Lord Palmerston and Lord John Russell were the British Whig mid-nineteenth century grandees who led the multi-generational pivot of the Whig, the Tory, and the subsequent Liberal administrations with respect to the British Victorian-era grand-strategic problem of how to deal with the rising superpower across the great ocean to the west that was the United States.

The mid-nineteenth century United States of America was a rising superpower, aggressively confident of its system. It was, in the words of John Quincy Adams: “the well-wisher to the freedom and independence of all… the champion and vindicator only of her own… [advancing the general cause] by the… sympathy of her example.” Great Britain had nothing to teach, the Americans thought, but rather should admire and learn.

What the rising superpower of the United States would not countenance was hostile bases, or perhaps I should say additional potentially-important hostile bases, anywhere near her borders. The Monroe Doctrine was evolved long before the United States could even begin to enforce it. And the United States certainly did not seek formal empire over Latin America. But it would react aggressively and with hostility to any European power’s intrusion into Latin America. And it would, eventually, seek, in Woodrow Wilson’s words, “to teach the South American republics to elect good men.”

And what rankled the United States in the mid-nineteenth century was the territoria irridentia of Canada—especially British Columbia: “54°40’ or fight!” was the American position on where the northern border of America’s claim to the Oregon Territory should be set. Plus there was the rest of Canada.

But the United States could be guided, and could be very comfortable in a British navy-protected free-trade political-economic order that allowed it to prosper and grow. And the interests of it and its elite could be brought into alignment, in at least major outlines, to the essential strategic interests of Imperial Britain.

In the 1840s, therefore, the Whig government of Lord Palmerston and Lord John Russell did a very unusual thing. The typical way for Victorian Britain to settle a dispute like that of the 1840s over the Oregon Territory would have been to adopt the negotiating strategy of sending a Canadian army and the British navy to burn down the negotiating counterparty’s capital, followed by a dictation of terms. Britain did not do that. It compromised: agreeing to an extension of the latitude line that had previously defined the southern border of Alberta, Saskatchewan, and Manitoba.

In the 1860s, therefore, the Whig government of the Earl Russell and Lord Palmerston did a very unusual thing. Usually Victorian Britain’s commitment to freedom of trade and the seas was lexicographically preferred to all other principles. One could argue over the rights and wrongs of addicting millions of China’s citizens to opiates through the drug trade. But interfering with commerce by seizing and destroying the property of British merchants—even property in the form of opiates—was beyond the pale, and cause for war. Fight first for free trade and protection of property, and deal with the other equities later. But that was not the line taken by the Whig government with respect to the cotton trade during the U.S. Civil War. The line was drawn not at interfering with British ships carrying cotton but at taking Confederate diplomats off of British ships.

And, thereafter, successive British governments, investors, noblemen and noblewomen, merchants, and manufacturers strove mightily to bind the United States to Britain. Material common economic interests and mutual economic interdependence grew. Conflicting political ideal interests fell away. Back in 1775 a core political interest of the United States-to-be was the conquest of Quebec, and Benedict Arnold’s army was sent north. Back in 1812—and for decades thereafter—a core political interest of the United States under James Madison was the conquest of Quebec, and fleets were duly built on the Great Lakes and then duly sunk by Canadian cannon. A very powerful ideal interest back then.

But what U.S. citizen today feels a pain at the thought that Toronto lies north of the U.S. border? I know I do. I look around this room. and it is painful to me that the Rt. Hon. Chrystia Freeland is Her Canadian Majesty’s Minister of International Trade in Ottawa. I wish she were not in Ottawa but in Washington. I wish she were the eloquent and influential Senator Chrystia Freeland (D-South-Central Ontario). U.S. politics would be much healthier were that the case. But I am unusual. And I digress…

The binding of the rising superpower back in the nineteenth century had many policy and non-policy parts, not all of them conscious or deliberate. but whether it was Cecil Rhodes’s offering free acculturation at Oxford to young members of the American elite, British investors entrusting the House of Morgan with their money, the Dukes of Marlborough offering their sons to daughters of plutocrats Consuelo Vanderbilt and Jenny Jerome, it was effective—so effective that just when Nazi Germany attacked the Franco-British army in 1940 the Prime Minister of Britain was a man who, as a natural-born citizen of the United States, was also perfectly well-qualified to be the American president.

This alignment of American interests and values to British took a long time—from 1850 and 1910: economic ties, cultural ties, plus political ties of mutual deference where strategic issues were at stake. But, as a result, by 1910 Americans by and large perceived Britain as their friend, and the British Empire as by and large a force for good in the world, and its interests as closely-aligned with theirs. This is in striking contrast to how Imperial Britain was perceived in 1850: as the cruel and corrupt ex-colonial power, the heartless aristocrats who had just starved a quarter of all Irishmen to death.

This mattered a lot. And this mattered a lot not just for the wave of prosperity produced up through 1913 by the coming of the Second Industrial Revolution and the First Great Globalization.

This mattered a lot for grand-geostrategic reasons as well. This meant that when Britain got into trouble in the twentieth century—as it did, first with Wilhelm II Hohenzollern and his ministers, second with Adolf Hitler, and third with Josef Stalin and his successors—it had wired aces as its hole cards in the poker game of seven-card stud that is international relations. The willingness of the United States to send Pershing and his army Over There, to risk war with and then to fight Hitler, and to move U.S. tanks from Ft. Hood, TX, to the Fulda Gap. These were all powerfully motivated by America's affinity with Britain, its geostrategic causes, and its security. And these allowed Britain to punch far above its economic and military weight from 1917 on.

How does this apply to the TPP?

Just like Lord John Russell and Lord Palmerston in the 1840s and thereafter, we face a rising superpower across the ocean to our west. There is a good chance that China is now on the same path to world preeminence that America walked 130 years ago. Alexis de Tocqueville could project before the Civil War that the U.S. and Russia were likely to become twentieth-century superpowers. We can project today that at least one of India and China--perhaps both--will become late-twenty first century superpowers. We have an interest in building ties of affinity now.

My old Harvard professor Benjamin Friedman’s The Moral Consequences of Economic Growth argues that the wiring of human brains is such that the process of becoming richer relative to the reference point provided by our parents and their peers has a large number of beneficial moral as well as material effects. Modern societies are like bicycles: they move forward, or they fall over. Come 2047 and again in 2071 and in the years after 2075, the NATO powers are going to need China and China’s elite to believe and to have material and ideal interests broadly aligned with those of NATO. Thus there is nothing more dangerous for America's future national security and nothing more destructive to America's future prosperity than for Chinese schoolchildren to be taught in 2047 and 2071 and 2075 that America tried to keep the Chinese as poor as possible for as long as possible. There is little more dangerous to the NATO powers than a Chinese elite whose values and interests are not broadly consonant with those of America. And there is nothing more conducive to aligning the interests of China and its elite with those of the NATO powers than a China which is (a) growing richer, (b) increasingly entranced by the economic and cultural successes of North Atlantic civilization, (c) treated with respect, and (d) incentivized to strive for victory not in negative-sum military power but in positive-sum economic and technological games of international relations.

The big geostrategic danger, I think, is of a Wilhelmine China. Wilhelmine Germany was a rising economic superpower ruled by a class that had lost its social role. Faced with internal dissent, it contemplated busying giddy minds with foreign quarrels as a way to distract popular attention from internal problems and debates. Needless to say, this ended in total disaster for generations of Germans. But is China’s East China Sea Air Defense Identification Zone and its adventurism in the South China Sea an attempt to cheaply accomplish the primacy-of-internal-politics foreign-affairs strategy that Shakespeare’s Henry IV Lancaster recommended on his deathbed to his son the future Henry V? And, if so, how to lead China’s elite to the realization that, in the words of the computer in the movie “War Games”: “The way to win this game is not to play”?

This is the broadest context in which the North Atlantic—and Asian-Pacific Rim, and Australasian—discussion of the TPP ought to be set.

3360 words


Weekend Reading: Warren Buffett: These were my biggest early mistakes

Warren Buffett (1989): These were my biggest early mistakes:

To quote Robert Benchley, “Having a dog teaches a boy fidelity, perseverance, and to turn around three times before lying down.” Such are the shortcomings of experience. Nevertheless, it’s a good idea to review past mistakes before committing new ones. So let’s take a quick look at the last 25 years.

My first mistake, of course, was in buying control of Berkshire. Though I knew its business – textile manufacturing - to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had to learn it the hard way – in fact, I had to learn it several times over. Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras – unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o – three years later I was lucky to sell the business for about what I had paid. After ending our corporate marriage to Hochschild Kohn, I had memories like those of the husband in the country song, “My Wife Ran Away With My Best Friend and I Still Miss Him a Lot.”

I could give you other personal examples of “bargain- purchase” folly but I’m sure you get the picture: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first- class managements.

That leads right into a related lesson: Good jockeys will do well on good horses, but not on broken-down nags. Both Berkshire’s textile business and Hochschild, Kohn had able and honest people running them. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand.

I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. I just wish I hadn’t been so energetic in creating examples. My behavior has matched that admitted by Mae West: “I was Snow White, but I drifted.”

A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. On occasion, tough problems must be tackled as was the case when we started our Sunday paper in Buffalo. In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO. Overall, however, we’ve done better by avoiding dragons than by slaying them.

My most surprising discovery: the overwhelming importance in business of an unseen force that we might call “the institutional imperative.” In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.

After some other mistakes, I learned to go into business only with people whom I like, trust, and admire. As I noted before, this policy of itself will not ensure success: A second- class textile or department-store company won’t prosper simply because its managers are men that you would be pleased to see your daughter marry. However, an owner – or investor – can accomplish wonders if he manages to associate himself with such people in businesses that possess decent economic characteristics. Conversely, we do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business. We’ve never succeeded in making a good deal with a bad person.

Some of my worst mistakes were not publicly visible. These were stock and business purchases whose virtues I understood and yet didn’t make. It’s no sin to miss a great opportunity outside one’s area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire’s shareholders, myself included, the cost of this thumb-sucking has been huge.

Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.

We wouldn’t have liked those 99:1 odds – and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds – though we have learned to live with those also.

Comparing Generational Lows: 1942, 1974 & 2009

Source: Monthly Chart Portfolio of Global Markets, Bank of America Merrill Lynch



It seems that every 30 years or so, markets make what can be described as a “Generational Low.” We can define this as a capitulatory bottom, one that might be caused by a variety of factors, but usually includes some combination of fear and panic in the mix.

This equity market low point is likely to be unchallenged over the next 10-20 or so years. After that point, the combination of population growth, technological gains and of course, inflation, means that we will are highly unlikely to ever see stock indices at those prices again.

Towards that end, have a look at the chart above, courtesy of the technical team at Bank of America Merrill Lynch. “History may not repeat, but it rhymes” goes a quote which is often credited to but has never been verified as written by Mark Twain.

Continues here

Get Ready for the Next Golden Age

I believe that the global economy is setting up for a new golden age reminiscent of the one the United States enjoyed during the 1950’s, and which I still remember fondly. This is not some pie in the sky prediction. It simply assumes a continuation of existing trends in demographics, technology, politics, and economics. The implications for your investment portfolio will be huge.

What I call “intergenerational arbitrage” will be the principal impetus. The main reason that we are now enduring two “lost decades” is that 80 million baby boomers are retiring to be followed by only 65 million “Gen Xer’s”. When the majority of the population is in retirement mode, it means that there are fewer buyers of real estate, home appliances, and “RISK ON” assets like equities, and more buyers of assisted living facilities, health care, and “RISK OFF” assets like bonds.

The net result of this is slower economic growth, higher budget deficits, a weak currency, and registered investment advisors who have distilled their practices down to only municipal bond sales.

Fast forward ten years when the reverse happens and the baby boomers are out of the economy, worried about whether their diapers get changed on time or if their favorite flavor of Ensure is in stock at the nursing home. That is when you have 65 million Gen Xer’s being chased by 85 million of the “millennial” generation trying to buy their assets.

By then we will not have built new homes in appreciable numbers for 20 years and a severe scarcity of housing hits. Residential real estate prices will soar. Labor shortages will force wage hikes. The middle class standard of living will reverse a then 40-year decline. Annual GDP growth will return from the current subdued 2% rate to near the torrid 4% seen during the 1990’s.

The stock market rockets in this scenario. Share prices may rise very gradually for the rest of the teens as long as tepid 2% growth persists. A 5% annual gain takes the Dow to 20,000 by 2020. After that, we could see the same fourfold return we saw during the Clinton administration, taking the Dow to 80,000 by 2030. Emerging stock markets (EEM) with much higher growth rates do far better.

This is not just a demographic story. The next 20 years should bring a fundamental restructuring of our energy infrastructure as well. The 100-year supply of natural gas (UNG) we have recently discovered through the new “fracking” technology will finally make it to end users, replacing coal (KOL) and oil (USO). Fracking applied to oilfields is also unlocking vast new supplies.

Since 1995, the US Geological Survey estimate of recoverable reserves has ballooned from 150 million barrels to 8 billion. OPEC’s share of global reserves is collapsing. This is all happening while automobile efficiencies are rapidly improving and the use of public transportation soars.  Mileage for the average US car has jumped from 23 to 24.7 miles per gallon in the last couple of years. Total gasoline consumption is now at a five year low.

OPEC Share of World Crude Oil Reserves 2010

Alternative energy technologies will also contribute in an important way in states like California, accounting for 30% of total electric power generation. I now have an all-electric garage, with a Nissan Leaf (NSANY) for local errands and a Tesla Model S-1 (TSLA) for longer trips, allowing me to disappear from the gasoline market completely. Millions will follow. The net result of all of this is lower energy prices for everyone.

It will also flip the US from a net importer to an exporter of energy, with hugely positive implications for America’s balance of payments. Eliminating our largest import and adding an important export is very dollar bullish for the long term. That sets up a multiyear short for the world’s big energy consuming currencies, especially the Japanese yen (FXY) and the Euro (FXE). A strong greenback further reinforces the bull case for stocks.

Accelerating technology will bring another continuing positive. Of course, it’s great to have new toys to play with on the weekends, send out Facebook photos to the family, and edit your own home videos. But at the enterprise level this is enabling speedy improvements in productivity that is filtering down to every business in the US, lower costs everywhere.

This is why corporate earnings have been outperforming the economy as a whole by a large margin. Profit margins are at an all time high. Living near booming Silicon Valley, I can tell you that there are thousands of new technologies and business models that you have never heard of under development. When the winners emerge they will have a big cross-leveraged effect on economy.

New health care breakthroughs will make serious disease a thing of the past, which are also being spearheaded in the San Francisco Bay area. This is because the Golden State thumbed its nose at the federal government ten years ago when the stem cell research ban was implemented. It raised $3 billion through a bond issue to fund its own research, even though it couldn’t afford it.

I tell my kids they will never be afflicted by my maladies. When they get cancer in 40 years they will just go down to Wal-Mart and buy a bottle of cancer pills for $5, and it will be gone by Friday. What is this worth to the global economy? Oh, about $2 trillion a year, or 4% of GDP. Who is overwhelmingly in the driver’s seat on these innovations? The USA.

There is a political element to the new Golden Age as well. Gridlock in Washington can’t last forever. Eventually, one side or another will prevail with a clear majority. Conservatives may grind their teeth, but if Hillary Clinton wins in 2016, the Democrats will control the White House until 2025. Right now, she is leading by a 60% margin with Republican women.

This will allow the government to push through needed long-term structural reforms, the solution of which everyone agrees on now, but nobody wants to be blamed for. That means raising the retirement age from 66 to 70 where it belongs, and means-testing recipients. Billionaires don’t need the $30,156 annual supplement. Nor do I.

The ending of our foreign wars and the elimination of extravagant unneeded weapons systems cuts defense spending from $800 billion a year to $400 billion, or back to the 2000, pre-9/11 level. Guess what happens when we cut defense spending? So does everyone else.

I can tell you from personal experience that staying friendly with someone is far cheaper than blowing them up. A Pax Americana would ensue. That means China will have to defend its own oil supply, instead of relying on us to do it for them. That’s why they have recently bought a second used aircraft carrier.

Medicare also needs to be reformed. How is it that the world’s most efficient economy has the least efficient health care system, with the worst outcomes? This is going to be a decade long workout and I can’t guess how it will end. Raise the growth rate and trim back the government’s participation in the credit markets, and you make the numerous miracles above more likely.

The national debt comes under control, and we don’t end up like Greece. The long awaited Treasury bond (TLT) crash never happens. Ben Bernanke has already told us as much by indicating that the Federal Reserve may never unwind its massive $3.5 trillion in bond holdings.

Sure, this is all very long-term, over the horizon stuff. You can expect the financial markets to start discounting a few years hence, even though the main drivers won’t kick in for another decade. But some individual industries and companies will start to discount this rosy scenario now. Perhaps this is what the nonstop rally in stocks since November has been trying to tell us.

Dow Average 1970-2012 Dow Average 1970-2012

US Profit Margin 1929 - Q2 2012

'57 T-Bird Another American Golden Age is Coming

Why US Stocks Are Dirt Cheap

Once again, the hedge fund industry got it wrong. To a man, traders were positioned for a “Sell in May,” a big summer rout, and a chance to hoover up stocks at distressed prices in August.

The only problem with this scenario is that it just plain didn’t happen, leaving more than a few traders with egg on their faces, and red ink on their P&L’s.

The evidence couldn’t be more undeniable. The major stock indexes have broken out to new all time highs. The more volatile Russell 2000 small cap index has left it in the big caps dust. Inflows to equity mutual funds have been the most prolific since 2008, with an eye popping $19.7 billion pouring in during a single week in July.

Some $6.5 billion piled into a single ETF, State Street’s “Spider” fund based on the (SPX), suggesting that at least a third of the new money is short term in nature. Even long despised Apple (AAPL) has gotten off the mat, rallying some 10% off its recent lows.

To see all this happening during a seasonal period of weakness for stocks is nothing less than stunning. If equities are this healthy in the traditionally weak times, what will they be like when seasonal strength returns? It all paints a picture of a run up to and (SPX) of 1,750 by year-end, which by the way, has been my own forecast all year. Perma bears be damned!

The financial press would have you believe this is all happening because Ben Bernanke changed his mind on “tapering” postponing the death sentence for his quantitative easing program until well into 2014, as if that was ever in doubt. My own theory about the extended life of the easing has held up once again.

Ben is so fearful of seeing a replay of 1937, when premature tightening tipped the US economy into the second leg of the Great Depression that he is willing to err on the side of over stimulation, by a lot. With many commodity prices and precious metals down 30% or more year to date, he certainly has a free pass on the inflation front to do so.

Corporate earnings are also helping, with Q2, 2013 coming in at 24% better than previous analyst estimates. None other than Morgan Stanley (MS) and Goldman Sachs (GS) have led the pack with further profit upgrades. Again, this was no surprise to me.

However, I think the market is trying to tell us infinitely more than what appeared in yesterday’s headlines. There is something deeper going on here beyond the noise of the daily data releases. Asset prices are acting like there is a major structural change underway in the world economy, which so far has remained invisible to all except the market.

Yes, there are a few professionals out there who can see imminent momentous change within their own narrow industries. But no one has yet aggregated all these changes together, so I’ll take a whack at it. Here are ten theories for you to contemplate.

1) There is more Peace Dividend to Pay- Is it possible that the markets have not fully discounted America’s victory in the cold war? Yes, we priced in a chunk with the run up in the Dow average from 2,500 to 11,000 during the 1990’s. But could there be more to go? After all, 21 years since the fall of the Soviet Union and the US still faces no industrial strength enemy. At the very least, this reality should be enough to chop our current defense spending by half, and eliminate most of our budget deficit.

2) Obama Care Works – With the House of Representatives voting to repeal the president’s health care plan for the 38th time, conservative antipathy towards Obamacare couldn’t be more clear. But what if, instead of doubling health care costs as the right has claimed, it drops them by half? What if the plan does add 0.5% to annual GDP and creates 2 million jobs?

This, after all, was the original plan. In fact, the early evidence shows that the competitive health insurance exchanges the plan sets up are delivering price reductions of 30% to 50% in New York and California. If this, in turn, solves the health care and Social Security crisis it will do a lot to wipe out that “uncertainty” you hear so much about.

3) Another Technology Revolution – Are we on the verge of another great technology breakthrough like the one we saw during the Dotcom boom, when PC’s, the Internet, and the World Wide Web simultaneously came together to supercharge corporate earnings for a decade? What if the cost of treating cancer drops from $100,000 to $200, as my friend, Dr. Michio Kaku, believes. What if new Apples and Googles (GOOG) continue to appear out of nowhere?

If you lived in San Francisco and were barraged by venture capital pitches on a daily basis, as I am, you would think this new Golden Age is going to start any minute. The only question is whether the lead industry will be communications, health care, energy, or all three. Ride your bike south of Market Street someday and see how much research capacity is being built now, the size of a small city. It is awe-inspiring.

4) The Real Cost of Energy Collapses – We all know about the new 100-year supply of natural gas discovered under our feet that will turn us into Saudi America. But there are 100 additional ways that energy supply is improving and demand is falling.

Conservation will be huge, as will grid and utility modernization. What if Tesla’s (TSLA) Elon Musk is able to deliver a $40,000 electric car with a 300-mile range in five years, as he has promised? This will be a game changer. His track record so far is pretty good. Falling energy costs mean that the profitability of virtually every listed company goes through the roof.

It is likely that if Iran ever does make good on its threat to close the Straights of Hormuz that no one will care. Some 80% of that oil, and soon to be 100%, goes to China, and that will be their problem, not ours.

5) Productivity Accelerates – By relentlessly introducing new technologies and cutting costs, corporate profitability has soared for the past 30 years. Pessimists now say things can’t get any better. But what if they do?

As I tell guests at my strategy luncheons, this is not a mean reverting data series. Having invested in the machine that took your labor force from 1,000 to 100, what if the next one brings it to 10? Guess which country is about to lose millions of jobs from offshoring and new technology? China. Just talk to any European CEO about their new “American Strategy.”

6) Interest Rates Stay Low for Another Decade – If wages stay in check, oil prices fall, and commodity places stay low, then the Fed has absolutely no reason to raise interest rates for another ten years, no matter what the economy does. The next demographic push that creates a worker shortage and higher wages doesn’t start until the early 2020’s.

Sure, the Fed will probably normalize overnight rates back to 2% by next year, as the safety net for the economy is no longer needed. But rates could remain historically very low for quite a long time. This savings immediately drops to the bottom line of any borrower, be they individual, corporate, or government. In fact, looking at the main causes of the recessions for the last 50 years—a spike in interest rates or a sudden cut off in oil supplies, and absolutely none are visible on the horizon, for now.

7) Shinzo Abe Saves Japan – The conventional wisdom is that the new government in Japan is resorting to a last desperate act to save their economy that will fail, and that a complete collapse of their over leveraged financial system will result. But what if Abe gets his necessary reforms through and the country regains its powerhouse status. If Japan’s $6 trillion economy, the world’s third largest, bounces back from a 1% to a 4% GDP growth rate, there will be positive implications for all of us.

8) Europe Gets Its Act Together – It seems that all we ever hear about from the continent is debt crisis and stagnation and a political system so fragmented that no one can do anything about it. But what if new leadership emerges and takes the initiative to coalesce and solidify Europe?

That would involve creating a single Ministry of Finance, issuing pan Euro bonds, and a European Central Bank with teeth and courage. Their economic problems would disappear and growth would double. As part of my consulting arrangements with governments there, I have been recommending these measures for years, and everyone agrees. All that is missing is the political will to carry them out.

9) The Dollar Stays Strong – With America’s debt to GDP now over 100% and rising, many analysts believe it is just a matter of time before we see a major crash in the dollar. This is only the continuation of a 220-year-old trend.

What if it goes up instead? Energy independence means we will no longer ship $400 billion a year to the Middle East to pay for oil imports. CEO’s in Europe and Asia are stumbling over each other to find ways to get capital into the US to take advantage of a stronger economy. Higher growth rates mean the feared American deficits start shrinking on their own, with no action from congress whatsoever. This is all long-term dollar positive.

10) Multiples Keep Expanding – Most strategists believe that the S&P 500 is fairly valued at 1,690 with a price earnings multiple of 15 times, dead in the middle of its historic 9-22 range. But if any of my theories above unfold, then higher multiples are justified. If they all unfold, then investors wouldn’t hesitate to pay a 25 multiple for American stocks, as their future outlook is so unremittingly positive.

You may say this sounds crazy, and you’d be right. But remember, twice in the last 25 years we have seen market multiples skyrocket to 100. Japanese share valuations reached that nosebleed summit in 1989, and American Dotcom stocks did so in 2000. And they reached those numbers with fundamentals far less substantial than we are facing now.

Sure, all of the above represents a pie in the sky best-case scenario. Some, or none of them may actually play out in the real world. But the ones that do occur will have a super-leveraged effect on each other. The net impact will be US GDP growth easily leaps back from today’s feeble 2% to the virile 4% or more that we grew comfortable with during the fifties, sixties, and eighties. That growth rate will solve America’s Social Security, Medicare, and deficit problems in fairly short order.

Needless to say, all of the above is hugely positive for the stock market. It brings forecasts for a Dow 30,000 and an S&P 500 out of the realm of fantasy. It kind of makes today’s stock prices look dirt-cheap. Maybe that’s what the market is trying to tell us, if we only had the patience and the foresight to listen.

This doesn’t mean that you need to rush out and buy more stocks today. Some of these trends will take a decade or more to play out. Better entry points will no doubt present themselves this year. But the writing is on the wall for higher equity prices, not just in the US, but globally.

I can tell you from the vast expanse of my own 45 years in the prediction business, I have learned one thing. All that is forecast never happens, and all that happens was never forecast. I’m still waiting for my flying car, although the Tesla S-1 comes close.

SPX 8-2-13

JT with Tesla My Tesla S-1

What Will the World Look Like in 100 Years?

George Friedman, geopolitical forecaster and founder of the Austin, Texas based private intelligence firm, STRATFOR Global Intelligence (click here for website), delivers a fascinating list of future political, military, and economic scenarios in his new book, The Next 100 years: A Forecast for the 21st Century.

Friedman claims the current Islamic assault on the West is failing, and will cease to be a factor on the international scene within the decade. Russia will take another run at becoming a superpower, which will fail by 2020, and leave the country even more diminished than it is today. When standards of living in China level off or reverse in the 2020’s, chronic resource shortages could cause the Middle Kingdom to implode and break up. China is far more fragile than we realize.

Japan may deal with stagnant economic and population growth the same way it did during the 1930’s by invading China as early as 2030. Japan may also take a bite out of indefensible Siberia when it remilitarizes. Poland, a unified Korea, and Turkey will develop into regional military and economic powers in their own right.

Friedman then describes a theoretical war by a coalition of Turkey and Japan against the US in 2050, resulting in an American victory, which leads to a new US golden age in the second half of the century. Scramjet engines make possible the development of unmanned hypersonic aircraft, which can launch a precision attack any place on the planet in 30 minutes. Warfare will move into space and be fought from “battle stars,” which will also become major energy sources for earth. Friedman kind of lost me when he predicted that the next Pearl Harbor could come from Japan, but not via the sea going aircraft carriers of old, but from caves on the moon.

The big challenge towards the end of the 21st century will be the emergence of a Hispanic nation in the Southwest, which is culturally isolating itself by not integrating with the rest of the country. This could lead to the secession of several states, or a new war with Mexico, which by then, will develop into a major power in its own right. I think to avoid a second Civil War and offload some huge state deficits, Washington just might say “¡Adios!

You can argue that someone making many of these predictions is loony. But if you had anticipated in 1970 that China would become America’s largest trading partner, the Soviet Union would collapse, Eastern Europe would join NATO, the US would enter a second Vietnam War in Afghanistan, and oil would hit $150 a barrel, you would have been considered equally nutty. I know because I was one of those people. It does seem that long-term forecasters have terrible track records.

All in all, the book is a great armchair exercise in global real politics, and an entertaining contemplation of the impossible. More than once, I heard myself thinking “He’s got to be kidding.” To get preferential pricing from Amazon on this thought provoking tome, please click here.

George Friedman

The Next 100 Years

The One Safe Place in Real Estate

I feel obliged to reveal one corner of this beleaguered market that might actually make sense.

By 2050 the population of California will soar from 37 million to 50 million, and that of the US from 300 million to 400 million, according to data released by the US Census Bureau and the CIA fact Book (check out the population pyramid below).

That means enormous demand for the low end of the housing market–apartments in multi-family dwellings. Many of our new citizens will be cash short immigrants. They will be joined by generational demand for limited rental housing by 65 million Gen Xer’s and 85 million Millennials enduring a lower standard of living than their parents and grandparents.

These people aren’t going to be living in cardboard boxes under freeway overpasses. The trend towards apartments also fits neatly with the downsizing needs of 80 million retiring Baby Boomers. So you have three different generations converging on a single sector of the real estate market. Prices here will hold up, and may even rise.

Rents are now rising at more than 5% a year in some of the more popular markets, and vacancies are dropping like a stone. Good luck finding an apartment in Silicon Valley. Fannie and Freddie financing is still abundantly available at the lowest interest rates on record.

Institutions combing the landscape for low volatility cash flows and limited risk are now accounting for up to 30% of the low-end market. In some markets it is now cheaper to buy than to rent, a 50-year reversal, if you can get the credit.

US Population 2010

 More a Rectangle Than a Pyramid

Cartoon - Financial

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