Investors can no longer easily “peel back the onion” to uncover fundamental risks and opportunities and act upon them. There are just too many onions and they are appearing at faster rates, compressing the available time to uncover, solve, and act upon opportunities. And even as the onions are peeled, sometimes they turn into completely different vegetables.
No wonder investors are hiding under their desks right now. They are being pummeled by data, commentary, opinion, and opinion disguised as data from everywhere and continuously. Not all of the data is valuable, valid, or unbiased, which makes it difficult to make objective decisions. Hence, we see low volume and high volatility in equity markets.
In an effort to decipher secular and objective trends and events which could impact the performance of companies that I cover for my clients, I have been scouring for objective research and data that can provide some backdrop to the recommendations that I make.
For the most part, I cover small cap technology stocks. At no time in recent history have technology companies had as much money on their balance sheets, and at no time have these companies traded at a discount to the main index, despite showing 15% growth in earnings year-over-year. Among technology bellwethers, nine out of ten reported earnings growth last quarter, six out of ten beat estimates and 7 guided higher. Prior to 2008, this would have represented a fairly significant move up for the NASDAQ and a perceived buying opportunity. For Q2 2010, it represented a meaningful move down for most of those same stocks. Behavior that I have taken for granted over the past two decades did not occur, which leads me to believe that there are new fundamental drivers and conditions affecting the market. In other words, there appears to be a “new normal” emerging from this recession that is impacting not only the narrow band of technology stocks that I follow, but also the broader economy. The trends are sobering. However, as a generally optimistic individual, I am hopeful that Americans will find a way to alter their path. The world economy will depend upon it.
I have organized the New Normal into ten themes. Within each theme, I attempt to identify the risks, opportunities, and investment sentiment. Without changes to policy that could alter the present course, the overall indicators are that the United States appears to be entering a period of persistent low economic growth with high volatility and increasing polarity between rich and poor. As with all things, Americans have the ability to alter course. The interesting question is whether they have the will to do so.
Here are the 10 themes:
1. Demographic Shift
2. Tax Inequity
3. Media Saturation
5. Education Deficit
6. Health Deficit
7. Innovation Deficit
9. Accountability & Ethics
10. Political Intractability
I expect to publish one or two themes over the next several days. Here is the first and most in-depth theme.
1. Demographic shift
Affluent Baby Boomers, who make up 14% of the cohort and represent 62% of US net worth, are entering a wealth preservation phase of life as they prepare for retirement. Of the 2% of Americans that control 37.2% of the net worth of the US, 80% of them are Baby Boomers. In essence, after accumulating massive wealth while helping to power growth in the American economy over the past three decades, these people are less interested in growth.
- New Normal: American ingenuity is about to become “underfunded”. Wealth preservation means less risk capital available for American entrepreneurs to commercialize ideas and grow companies as affluent baby boomers shift investment strategies away from perceived higher risk equity to perceived lower risk hard assets (like gold), bonds, cash and treasuries as they attempt to preserve wealth. The effect is to sideline immense amounts of capital that would otherwise be available to fund investment in the real economy.
- Risk: To thrive, modern economies need to invest in innovation. Without available capital, US innovation and entrepreneurship may face a funding shortage, resulting in fewer high paying “creative” jobs. Typically, these jobs create more jobs. Worse for Americans, emerging economies are beginning to evolve into engineering and design-based economies – which creates competition for skilled labor, and capital – both of which tend to flow towards innovation.
- Opportunity: Incent affluent baby boomers to put their capital to work. Government can help via direct stimulus like the Energy Recovery Act, or via potential tax incentives which compel baby boomers to invest in economic growth and domestic employment. The Small Business and Credit Act 2010 is an attempt that was recently passed by Congress. Notwithstanding government intervention, entrepreneurs may be required to re-set cost-of-capital expectations versus recent historical pricing. Growth capital will be more costly. Export markets should become a priority…please see my next point.
- Investor Sentiment: De-emphasis of growth should reinforce declines in forward valuation multiples for technology and services sectors. I believe that these declines should persist for the next three to five years. High growth companies with strong balance sheets should begin to offer investors dividend yield in order to better align to emerging Affluent Baby Boomer risk profiles. Investors have seen recent moves by both Cisco (CSCO) and Microsoft (MSFT) to introduce dividends.
- New Normal: The US consumer is old and tired and redefining consumption as they “hunker-down” entering retirement. Leading up to the 2007 recession, these baby boomers leveraged their modest assets to become the most powerful consumer group in the world. Spurred on by the federal government to spend post-9/11, they imperiled their future to buy new homes, appliances, and cars. After the resulting credit crisis, household balance sheets are being repaired, removing consumer spending horsepower from the economy, which has represented 70% of the economy since the end of WWII and is counted on by economists for sustained GDP growth.
- Risks: The American economy needs another horse to ride besides the consumer. Currently, the economy, measurement and policy are aligned to the consumer. What if housing starts are no longer meaningfully correlated to measuring GDP? There will be less domestic consumption which implies that there is a high probability of an extended period of disinflation and an ongoing risk of deflation in an American economy that relies on domestic consumption. Central bankers have become adept at managing inflation over the past two decades, but have had little experience managing deflationary risk, which infers systemic uncertainty.
- Opportunities: While baby boomers embarked on their two decade-long spending spree, the United States became a net importer of goods. GenXers and Echo Boomers need to more than ever look outside of domestic borders to return the US to its net exporter status prior to 1990. The US Administration appears to recognize the opportunity by recently announcing the National Export Initiative with an objective to double exports within five years. A devalued USD could also spur on export activity. However, China would need to agree to stop pegging the Yuan to USD in order to give the dollar room to move. There is a reason why the United States is filing a grievance to the WTO in this regard right now.
- Investor Sentiment: U.S. stocks that derive more than 50% of business outside of the United States should show revenue growth and margin expansion, especially if the USD declines in value. Focus on US domestic spending yardsticks such as home starts may become a less valid measurement of economic health. Accelerate investment into companies that sell innovative products and services to emerging BRIC middle class.
|Wealth Creation 1995|
|Wealth Preservation 2010|
- New Normal: It is assumed that a growing economy needs increasing productivity, investment, and labor force. For the first time, the available labor force is about to shrink as Baby Boomers retire. In addition, the spending power of the post-Baby Boomer cohorts is likely to decline as more of their earnings are diverted to pay for the unfunded liabilities of their baby-boomer parents such as healthcare.
- Risks: A smaller productive labor force with less spending power implies that GDP growth will be impaired in comparison to recent recoveries as the US economy exits from the 2007 -2009 recession.
- Opportunities: The single largest opportunity is for the US to follow the lead of other industrialized economies and increase the age of mandatory retirement in order to maintain the size of the labor force, and to delay the impact of a declining workforce. Notwithstanding, unless the US introduces policy to attract a large number of skilled immigrants, the long-term trend for the US labor force is downward, implying that GDP growth is likely to be subdued for at least a generation.
- Investor Sentiment: If the current trend continues over the next few years, investors should look to information technology companies that help US producers offset reduced labor access with more automation and efficiency. Off-shore investment should accelerate as capital flows towards growing skilled labor pools elsewhere.
- New Normal: The GOF Syndrome (Grumpy Old Fart Syndrome) should shift US policy increasingly towards the preservation of individual wealth with priority investments in healthcare and security at the expense of investment in education, and economic development.
- Risks: Funding will be less available to arm people with skills to compete with innovators and entrepreneurs of emerging economies. In an environment where China graduates 30M engineers per year, reduced investment priorities in education imperils future US competitiveness, productivity, and wealth creation.
- Investor Sentiment: Investors considering US domestic stocks should look at health related stocks with particular emphasis on pharmaceuticals, genetics, long-term care, and disease management.
McKinsey Global: Talking ‘Bout My Generation: The Economic Impact of Aging US Baby Boomers 2008