Kaizen vs. Complacency
Seeking change and avoiding complacency requires you to know where each are forming at the most basic levels - in people, not numbers.
"The future ain't what it used to be." - Yogi Berra
Less than 5% of the world's population lives in the United States, yet its stock market is home to almost half of the entire world's equity investments. Does the remarkable imbalance in capital and confidence continue to pile up the same amount of chips in only one stack as in the other 100+ stock markets around the world, combined?
Less than 5% of the world lives in the United States yet the American consumer has likely accounted for over half of the total consumption growth around the world over the past decade. Can we continue to afford to be the world's biggest customer and more importantly will they continue to accept our IOU's?
Less than 5% of the world lives in the United States yet our dollar makes up more than two-thirds of the entire world's foreign exchange reserves. In 1980, the U.S. was the largest creditor nation in the world. It is now the largest debtor nation.
In the latest list of "Fortune's Most Admired Companies in the World" more than two-thirds were U.S. companies. Is that truly an accurate global reflection of the most talented and efficient businesses? In small print, a small bias was revealed. The poll is taken from 15,000 (executives, directors and securities analysts), of which 10,000 were from the U.S.
How much are U.S. investors willing to bet this streak of global dominance continues? By looking at Hewitt's Index of 401(k) assets that investors hold in their retirement accounts, it reveals more than 95% of U.S. investor's assets are left inside the U.S. The remaining 5% of the assets are invested in countries where the other 95% of the world happens to live.
So the ultimate question is, do we continue to be trusted with a larger portion of the world's investments? In our opinion and in one word, NO. The imbalances and biases have likely peaked based on what we believe is a developing mismatch between much of the rest of the world and the U.S. which we call "Kaizen vs. Complacency."
Where will new profits be found? Let's cheat. We can look back at what we know already happens when the game of capitalism and democracy come together. You just sat with us and we watched the movie together, witnessing the clues for how to become the destination of choice for investment capital.
From 1966 to 1982 our economy, the GNP, grew 330%. During that time, the Dow Jones Industrial Average declined from 1,000 to 875.
From 1982 to 2000 the GNP grew about half as much as the previous period, a total gain of 170%. During that time, the Dow Jones Industrial Average exploded from 875 to 11,600.
Those two periods destroy some serious myths about the economy and earnings controlling the fate of the stock market; they clearly do not. In our view, the stock market does not measure either; it is priced where supply meets demand for pieces of paper called shares. Too many people spend too much time measuring a company's supplies and its customer's demands, but pay little attention to the supply versus demand for shares of stock. The economy did not drive the stock market up 13-fold over that second period of time, demand from new customers did, just like any other business. More broadly, don't forget it's not just stocks. Successful investing in any asset requires an understanding of what is over-owned and what is under-owned, and what might change.
The Four Tailwinds That Sent U.S. Stocks Higher from 1982-2000
The business of stocks worked so exceptionally well, no different than any other business, because of new customers. At the beginning of this period only two in ten Americans invested in the stock market, by the end over half were investors. The surge came from a group of employees responsible for their own retirement for the first time. Fixed returns from defined benefit plans were replaced by defined contribution plans, and 401(k)'s were born. Previously, only 6% of households owned a mutual fund and that has grown by a factor of ten.
Privatization & Competition
Countless industries were deregulated, opening new opportunities for businesses and for investors. To name one of many striking examples, the business of investing itself was opened up. Regulated brokerage commissions that could cost investors $800 or so to trade a few hundred shares of stock, were replaced by competition that forced the same trade to cost around $8. Investing was no longer a private club on Wall Street, the Dow was democratized and demand soared.
In 1981 the U.S. saw the largest overall tax cut in history. Five years later Reagan cut income taxes almost in half, the top rate falling from 50% to 28%. Falling taxes created new capital for private investment. The stock market was made even more rewarding as a result of dividend and long-term capital gains taxes both falling, eventually all the way to 15% each, the lowest since 1916 and 1933 respectively.
Falling Interest Rates
The ten-year Treasury bond peaked at 15.68% in 1981. The dramatic decline of rates over the next two decades financed businesses and consumers growth. Additionally, many bond holders who could no longer get double-digit rates of return became stock buyers for the first time.
Each Tailwind is Now Becoming a Headwind. So, Which Direction Does the Market Go Now?
Something changed at the end of the bull market and investors have been plagued by thousands of possibilities ever since, now stretching over the past 7 years. My analysis is simpler to follow and here it is – each of the four tailwinds are gone. Bulls are debating daily while the object of their affection has gone nowhere for 7 years now. I challenge any of them to simply explain how any one of those four tailwinds could possibly repeat, let alone all four together. The short, bittersweet reality is that we witnessed a remarkable period, but it is over, for now, for us. Rallies have inspired hope but seven years of a flat market is creeping up on that ole 'long-term' in stocks that bulls like to preach always works. The tailwinds are gone, and what's worse? Each of them are now headwinds going forward.
A realistic update on each of the four would have a hard time avoiding the following truths, let's take them one by one. Stocks are no longer under-owned in the U.S. and that part is easy to see. Furthermore, remember that it is allowable for retirement accounts to sell the same stocks they purchased for decades, especially in retirement. Open markets and borders are now political enemy #1 in a nation of voters whose jobs are vulnerable. The loudest cheers these days are for entitlements not competition. Taxes are no longer falling. Assuming those entitlements have to be paid for eventually, taxes are more likely headed higher not lower. Interest rates are no longer falling. To sum up, it is difficult to calculate how our tailwinds could continue at the same growth rate. For that to happen we would need:
- 125% of Americans to invest in the stock market.
- Taxes to get cut in half from here.
- The ten-year Treasury to repeat its steady descent of over 11 percentage points from a starting point of 5%.
I'll wager none of those can happen according to the only crystal ball that works – simple math. Unfortunately, the other of the four tailwinds, the one without numbers looks even less promising. On the subject of privatization and competition, ask yourself a simple question: Looking around you, do you get the sense we are a nation desperate to create and compete, or one that would rather retire and be taken care of?
For every prediction that "long-term our market will always goes up," we wonder if the law of large numbers is being ignored. Empires do not always grow either, according to my history books, and for good reasons – motivations are replaced by expectations. Reality does not straight-line, it cycles. The average size of the 30 Dow stocks is now over $120 billion dollars on the heels of this tremendous period that filled them with investment capital. There are many Wall Street salesmen who can imagine scenarios where they multiply in size by 13 again over the next two decades from here, without the same tailwinds. Their stuff is a lot more popular to read than ours. Just remember that capital flows from the many to the few in any skill game, over time, every time.
So what happens next? Glad you ask.
Bull Market? Bear Market? Nope. Hummingbird Market
An open-mind will be the most valuable asset during this next cycle. How open-minded? Well, we were willing to take the advice of a 4-year old in naming our market prediction that may last his entire childhood. It was 4 years ago that Matthew Catalano asked his dad (my partner) a trivia question – what is the only bird capable of flying forward and backward? We finally had a name to go with all of our data and ideas. His spirit and questions also happen to capture perfectly the essence of our research team and system which are both based entirely on being more curious than our peers, not more convinced.
So how do we make money in a flat market? Remember we get to cheat. After hitting rewind as we just did, why not take those same notes and apply to OTHER markets. We know how this movie ends. If we can go back and find each of the same four plots in another place, we already know what should work. Each of the four tailwinds we enjoyed over the past two decades is just beginning to form in other countries. Copernicus forever destroyed the notion of our planet being the center of the universe, which everything else merely surrounded. We think the laws of capitalism will remind investors the same rules apply to the United States. Those laws were not based on patriotism, they only know about profits which have no boundaries. New profits breed change which crushes complacency. This mismatch of "Kaizen vs. Complacency" is in round one, and what's more? The favorite to win in my opinion, is getting steep underdog odds.
We built a research team of international university students, who we call The Varsity, which will continue to find and organize clues of those first tailwinds forming - Kaizen's signals. Then we compare them to our very own "Entitlement Index" – Complacency's hallmarks. Seeking change and avoiding complacency requires you to know where each are forming at the most basic levels – in people, not numbers. Behaviors ultimately make all of the numbers that Wall Street later focuses on. The key in our research is capturing the TURN in each.
We will search for valuable comparisons like the following:
Ireland has become a major center for U.S. investment in Europe. There are no restrictions or barriers with respect to current transfers, repatriation of profits, or access to foreign exchange. Ireland has one of the most simple and attractive corporate tax environments in the world at 12.5% and not surprisingly they are making new homes for companies around the world, and many of the U.S.'s finest. Ireland accounts for only 1% of the EU's population and accounts for 1% percent of the EU, yet Ireland is receiving nearly one-third of U.S. investment in all of the EU combined. Ireland has become the world's largest exporter per capita.
The next chapter in the Outsourcing story might involve as many white collars as blue collars. JP Morgan now has 80 analysts in India, accounting for more than 14% of their New York-based research staff. According to the CFA Institute, the number of people taking CFA tests in India climbed five-fold since 2002. In the U.S., the number of analysts working for the 10 biggest firms has declined 21% since 2001, according to Thomson Financial figures.
How are we competing? According to an AP story which quoted the IRS, the tax return they just received from General Electric (GE) was 24,000 pages long. The Standard Federal Tax Reporter, a reference book for accountants and tax preparers to summarize the code and make it simpler to use is over 60,000 pages.
What type of analysts are we hiring? The FY 2006 budget requested that Congress allocate $41.4 billion for regulatory activities, a 4.8% increase. The regulators budget is growing at a faster rate than other nondiscretionary spending (up an amazing 46%, after inflation, since 2000). Staffing is at an all-time high of nearly a quarter million people. The number of registered lobbyists in Washington has more than doubled since 2000 to more than 34,750 while the amount that lobbyists charge their new clients has increased by as much as 100 percent. Only a few other businesses have enjoyed greater prosperity in this choppy economy.
The World's rankings for mathematics achievement for 15-year old students.
2. South Korea
The U.S. ranks #28 on that list. What are are doing about it? Well, the graduating class of a prominent high school in Oregon just awarded 75 valedictorians in 2006 because instead of the best student, they changed the rule to any student with a 4.0 average.
Samsung is one of the most profitable technology companies in the world. Revenues last year were $56 billion. Because it is based in South Korea, only one Wall Street analyst tracked by Thomson/First Call even follows the stock, which is up over 300% the past five years.
By comparison, the revenue for Microsoft (MSFT) and Oracle (ORCL) was $52 billion last year, combined. Yet their share's attention make the companies worth almost 4 times as much as Samsung's market capitalization, despite the fact that their shares are down 21% together over the past five years. One reason is that a total of 58 Wall Street analysts follow those two stocks.
The New Tailwinds
Businesses and perceptions are changing. We enjoy keeping score of how markets outside the U.S. are competing and who is best positioning themselves to catch the tailwinds, whose formulas are quite clear. The very fact that many of these developments are not well followed on Wall Street simply provides even more opportunity because pricing will be less efficient. One of our favorites to monitor is the Heritage Foundation's Index of Economic Freedom, which measures 161 countries against a list of 50 independent variables divided into 10 broad factors of economic freedom. They have shown quite clearly over the years, with remarkably compelling data, that wealth comes from the actions of people.
Hong Kong is #1 and Singapore is #2 in the 2006 index. The U.S. comes in at #9. The current darling of international investing, China, it is interesting to note, holds the #111 spot. It looks a lot different when you hear the story on television or read it in the newspaper than it does by finding the truths on the ground. The most curious and the most open-minded will make tomorrow's best research, not the most convinced.
As a prelude to our coming headwinds and a forecast of other's new tailwinds, consider the following adjustment the rest of the world has quietly made recently. At the end of the bull market in the year 2000, 9 out of every 10 dollars raised by foreign companies through new stock offerings were done in New York. By 2005, the reverse was true, as 9 out of every 10 dollars were raised through new company listings outside the U.S., primarily in London or Luxembourg, according to data from Citigroup. Why quietly? The paper you read this morning is called the Wall Street Journal for a reason.
The rest of the world will not wait for the next bull market here. Consider the reality of our recent rally if you were a foreign investor in the U.S.
To make the small print perfectly clear, this shows the rally in the Dow Jones Industrial Average over the past 4 years of +13%. But if you lived anywhere else with the other 95% of the world's population that same investment cost you (24%) in the declining value of the dollar. By the time you converted your dollar profits into local currency you were, on average, net negative – 11%, during this "rally." The winds of change have spoken.
Human history is riddled with stories of great booms and busts. Powerful civilizations and proud cities arose, flourished and disappeared time and again. Disease, famine, lack of water caused a few, but was rarely the culprit. In almost every case, failure was brought on by the same thing: tremendous success. There are reasons for cycles. Today, if you ask the average American worker what his dream is, you might hear "to retire yesterday." Around the world there are a number of places where that answer is "to work tomorrow." Our new headwinds are other's new tailwinds. Instead of hoping they change direction it may prove more profitable and prudent to adjust your sails. Are we in a good market? I think that will all depend on where you are willing to look.
To know the road ahead, ask those coming back. - Chinese Proverb
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