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Sunday, May 21, 2006 1:19 PM


Ostrich of Omaha


Michael Mandel, chief economist for BusinessWeek, is writing about the 'Ostrich of Omaha'.

Buffett's bearishness on the U.S. economy ignores how Americans' hard work adds value at a steadily higher rate than trade adds debt. To be frank, I'm getting a bit tired of Warren Buffett's pessimism about the U.S. economy.

The so-called Oracle of Omaha, the second-richest man in the world, was anti-New Economy in the 1990s. Now he's downbeat on the U.S. dollar.

In his latest letter to the shareholders of Berkshire Hathaway, Buffett wrote: "The underlying factors affecting the U.S. current-account deficit continue to worsen, and no letup is in sight.... Either Americans address the problem soon in a way we select, or at some point the problem will likely address us in an unpleasant way of its own."

We don't need this "voice of prudence" from someone worth more than $40 billion.
Mandel writes "We don't need this voice of prudence from someone worth more than $40 billion." Somehow that does not seem exactly right. Here, let's try this version: What we don't need is someone who is totally clueless about factors affecting the current account deficit giving Buffett a lecture about "fundamental market values" based on the nebulous idea of "hard work".
Mandel continues with:
"Lucky for us, the Social Security Administration publishes a range of long-term forecasts going out to 2080, which take into account a variety of assumptions about demographics and productivity. Their most pessimistic forecast calls for a long-term growth rate of 1%, while their optimistic forecast projects that long-term growth will average 2.8%.

The fundamental market value of the U.S. economy also includes the output generated by future labor -- that is, all the skilled labor and hard work that Americans will put out in the years to come.

It turns out that the market value of the U.S. economy is increasing by anywhere between $4 trillion to $7 trillion per year. To put it in financial terms, this is the annual capital gains for the whole American enterprise. By comparison, our trade deficit means that the U.S. is adding roughly $1 trillion in external debt each year. That's a big number, but far less than the increase in the market value of the economy. From this perspective, we can keep this up forever."

USA! USA!
Other industrialized countries are not so fortunate. It's expected that the prime-age working populations of Japan, Germany, and France will start shrinking soon. As a result, most current forecasts call for these countries to have very slow economic growth 20 years from now. That means the fundamental market values of these countries is rising very slowly, if at all.

My advice to Buffett is to apply the same sort of fundamental analysis to countries as he does to the stocks he owns. He might find that it's the U.S. that is the better deal.
Lucky For Us

Gee, "lucky for us" the Social Security Administration publishes a range of long-term forecasts. That is indeed lucky, or do I mean useless? Since when has any long term government forecast been any good? I also have to wonder if Mandel thinks Buffett is supposed to feel "lucky" that Mandel is so generous with his advice.

"It turns out that the market value of the U.S. economy is increasing by anywhere between $4 trillion to $7 trillion per year."

This is a lot like looking at the stock market in 2000 and projecting future earnings growth as far as one can see forever into the future without considering whether or not the result is sustainable.

Other than "hard work" Mandel does not explain where this "market value" comes from. He does not look at production of goods or manufacturing and perhaps presumes we can keep borrowing forever while flipping each other houses at ever increasing prices, living happily ever after. One can work hard at digging holes then filling them up again but that work simply is not productive. Working hard at flipping homes or working hard at passing the trash (risky loans) to Fannie Mae is not exactly productive either, and certainly bombing Iraq to smithereens is not what anyone should call productive.

Just as people were offering Buffett advice on "The New Economy" in 2000 we now have economists like Mandel explaining to Buffet how the US can "can keep this up forever".

To any thinking person that is just another version of "It's Different This Time". I have no doubt this proclamation from Mandel will prove to be as foresightful as the June 2005 cover of Time Magazine "Why we're going gaga over real estate" or the 1999 Economist cover story predicting $5 Oil with a cover touting "awash in oil".

The Richebächer Letter

Actually the best rebuttal to Mandel's "It's Different This Time" argument come from the May issue of the Richebächer Letter. Let's take a look at a few highlights. Richebächer writes:

It Is Far Worse Than In 2000
THE NEW U.S. ECONOMY

The policy dilemma currently facing the United States can be simply stated. Economic growth has become completely dependent on consumer spending, and this, in turn, has become completely dependent on rising house prices providing the collateral for the most profligate consumer borrowing.

This borrowing has become a necessity because income growth has abruptly caved in. Rock-bottom short-term interest rates and utter monetary looseness were the key conditions fostering altogether four bubbles: bonds, house prices, residential building and mortgage refinancing.

What developed is an economic recovery with an unprecedented array of escalating imbalances: ever-declining personal savings; an ever-widening current deficit; exploding government and consumer debts; and, on the other hand, a protracted shortfall in business fixed investment, employment and available incomes.
We must admit that the staying power of this extremely ill-structured and debt-laden recovery and the stubborn buoyancy of the financial markets have rather surprised us.

But this only lengthens the rope with which to hang oneself. What American policymakers and most economists studiously keep overlooking is that the credit bubbles are doing tremendous structural damage to their economy. The longer the bubbles last, the greater the damage.

DEBT EXPLOSION VS. INCOME IMPLOSION

This time, we want to focus on the dramatic shortfall of employment and income growth that radically distinguishes this recovery from all its precedents in the postwar period. It must have a particular cause, but where is it? In search of its causes, we contrast, first of all, credit and debt growth with income growth.

Over the five years from 2000–2005, total debt, nonfinancial and financial, has increased $12.7 trillion in the United States. This compares with a simultaneous rise in national income by $2.1 trillion. For each dollar added to income, there were $6 added to indebtedness.

In real terms, national income increased little more than $1 trillion. Last year, U.S. private households added $374.4 billion to their disposable income and $1,204.7 billion to their outstanding debts. Inflation-adjusted disposable income grew $115.7 billion. It is a growth pattern with exploding debts and imploding income growth.

To make our point perfectly clear: The present U.S. economic recovery has never gained the traction that it needs for self-sustaining economic growth with commensurate employment and income growth. As to its main cause, all considerations lead to the conclusion that it must reside in the protracted, appalling shortfall in business fixed investment. Investment spending is, really, the essence of economic growth.

Our own considerations begin with the recognition that the U.S. economy is, in every single respect, in far worse shape today than it was in 2000, and also that there is no other bubble in sight to replace the housing bubble. Everything depends on the housing bubble to rapidly reflate once the Fed eases again.

Our strongly held assumption that the U.S. economy is in a most precarious condition basically has two reasons. One is the extravagant size of the housing bubble, involving the whole financial system to an unprecedented extent. The other is the grossly ill-structured economy, replete with imbalances inhibiting sustained economic growth.

CONCLUSIONS:

Forecasts for the world economy are generally optimistic in the expectation that the U.S. economy will continue its global pull with continuous strong growth. We think the anemic and extremely unbalanced U.S. economic recovery is in its last gasp.

Our key consideration is that the U.S. economy has become perilously addicted to asset inflation in general and the housing bubble in particular. Both rising asset prices and the rising dollar had their foundation in carry trade of astronomic scale. While interest rates may still appear rather low compared with the inflation rates, the Fed’s rate hikes have pulled the rug from under the dollar-based carry trade.
Mandel practically taunts Buffett without considering the effects of globalization and what that that has done to real wages, he ignores a credit bubble, a housing bubble and instead focuses on a cyclical recovery of stocks while making huge assumptions about "hard work".

Somehow the busting of the housing bubble is of little importance to Mandel. Then again, perhaps he does not see that trainwreck coming. Nor does Mandel look at earnings, book values or dividends.

In The Big Chair John P. Hussman of Hussman Funds addresses some of those issues.
It's interesting that the current P/E is about double its “normal” level based on the current position of earnings. If you look at the price/book ratio on the S&P 500, at 3.1, it's also about double the historical norm of about 1.5. The price/dividend ratio on the S&P 500, at 54, is about double the historical norm of about 26. The price/revenue ratio on the S&P 500, at 1.5, is nearly double the historical norm of 0.8. This market isn't cheap.

From an economic perspective, corporate profits as a share of GDP are near an all-time high. Historically, a high profit share relative to GDP has generally been followed by disappointing earnings growth over the following 5-year period.

What's worse, nearly all the growth in U.S. domestic investment since the mid-1990's has been financed by imported capital – which we observe as a current account deficit – so that the observed “productivity boom” has gone hand in hand with an expansion in imports. To the extent that we now have an intolerably deep current account deficit, the U.S. is likely to observe restricted growth in capital investment in the coming years, which will tend to be a drag on productivity even while real wages increase. The resulting squeeze on profit margins may be acute within a few years.

In short, the S&P 500 is richly valued on the basis of nearly every fundamental measure, including earnings when those figures are properly considered. The point is not to predict a near-term decline in stocks, but rather to emphasize that the long-term returns priced into stocks here are likely to be disappointing.
So what did Buffett miss if anything? Perhaps he missed predicting that the Fed would panic by slashing interest rates to 1%, or perhaps he did not foresee panic home buying where 40% of the homes bought over the last two years were for "investment purposes" or perhaps he failed to account for the effects of credit standards lowered to the point that if one could breathe one could get a mortgage.

Please consider the MarketWatch bulletin Banks' mortgage demand weakens. Published quarterly, the Fed's senior loan officer survey polls 57 domestic banks and 19 foreign banks about lending trends. Of the respondents, 11.3% said they'd eased home mortgage lending standards, while only 1.9% said they'd tightened them somewhat.

The interesting thing is that even in the face of rising foreclosures and rising bankruptcies companies are still lowering credit standards. The fact that companies are acting reckless by taking on more and more risk in the face of deteriorating fundamentals is something that anyone but an ostrich should clearly be able to see.

More than likely Buffett did not miss much if any of that and chose to be relatively bearish on a market driven by such forces.

The question now is who would you rather believe?
  1. John Hussman, Warren Buffett, Dr. Kurt Richebächer
  2. Michael Mandel
Will the "Real Ostrich" please come up for some fresh air?
Having your head in the sand clearly affects one's thinking.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

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