Sunday, December 11, 2011

The bull case for US stocks

Despite what you might hear, it is pretty much impossible to consistently generate outsized investment returns. It's not enough to be skillful in evaluating complex economic situations; it also requires a deeply contrarian attitude, because essentially what you doing is trying to predict a change in everyone else's predictions. Basically, to beat the market you have to be the Quixote whose windmill turns out to really be a dragon. How often does that happen?

With that caveat (that is, if you are smart, you will stop reading now), I think US stocks offer a better than average long term investment opportunity right now. Popular opinion has been slow to acknowledge our improving prospects and at the same time is overly concerned with the potential impact of Europe's problems.

The US economy is improving. Almost every economic indicator in the last couple of months has come in better than consensus expectations. The "conventional wisdom" is only slowly coming around to this, but unless you are a soft-serve ice cream aficionado, you must admit it's been a while since you heard talk of a double dip. I won't go through all of the data here, but I would like to briefly discuss one statistic that has been the source of recent hand-wringing: the labor force participation rate. 

Bears note that a major driver of the recent improvement in the unemployment rate is that people are dropping out of the labor pool at a historically high rate. To the extent these drop-outs are occurring out of frustration, it's a big problem. However, most of the media coverage I have seen omits the impact of the nascent wave of baby boomer retirements. This insightful Pew Research Center report observes that starting this year, on a daily basis 10,000 boomers are reaching traditional retirement age and will continue to do so until 2030. It may be reasonable to expect boomers to retire later than previous generations, but still the overarching trend is undeniable: without substantial immigration, the labor force participation rate will decline. And while this is a serious threat to our long run growth prospects (see: Europe, Japan), assessments of the health of our current labor market need to take this factor into account, and I haven't seen many that attempt to do so.

Europe's problems may not be as big a threat to the US economy as people seem to think. The euro is facing an existential threat, and last week's summit deal doesn't inspire confidence. However, not only is it hard to say how a euro break-up might affect the US economy, I don't think China would let it happen in the first place. 

To my thinking, there are two areas where the fallout will be felt in the US if the EU breaks up: trade volume and credit availability. This WSJ blog post argues that the crisis has had little effect on US trade so far, and that's not surprising, given that only about 10% of our exports go to Europe. Furthermore, the longstanding trend, recently bolstered by Obama's efforts to boot Asian trade, is for decreasing reliance on exports to Europe in the future. Moreover, most of our trade with Europe is with the stronger countries, so even a profound recession in Europe isn't likely to tank overall US export demand. 

The other potential issue is with a potential credit freeze if what's been a slow-motion run on European banks accelerates. The reason why I don't think this is likely to be as significant a problem as it was when Lehman went down is simply that US policymakers and financial institutions more or less just spent the last 3 years learning how to deal with liquidity panics, so they are likely to be more aware of the warning signs and better equipped to manage them than they were the first time around. 

Meanwhile, China's prosperity is heavily dependent on trade with Europe. Not only does China's economy generally rely more on exports than the US economy does, the 27 EU nations are collectively China's biggest export destination. China can't afford for Europe to slide off a cliff and thus when push comes to shove it's likely China will deploy their massive cash reserves to forestall any of the more extreme scenarios.

US stocks are relatively cheap. It's next to impossible to determine the intrinsic value of a stock, but there are some indications that stocks are cheap relative to other types of investments. One indicator I find useful is to compare the dividend yield on stocks to the yield on 10-year US Treasury debt. In other words, comparing the immediate income potential of owning stocks to that of owning bonds. Right now, and for most of this year, the yields have been pretty much the same, and this is unusual. Since the 1950's, government bonds have had higher income yields than stocks, usually significantly so, as investors look to be compensated for the fact that stock investors have more potential for capital appreciation and less exposure to inflation risk. 

Maybe my argument boils down to nothing more profound than the suggestion that if you're feeling quixotic, take a tilt at US stocks. What's your take? How do you see things playing out in the US economy?

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