ICangles Investment Post…
In hindsight it’s ironic that the economy of the nineties was described as the Goldilocks economy—not too hot, not too cold, but just right for high employment and strong growth. Ironic, because the real moral of the story people should have heeded is that there is no free lunch. And, like in the Goldilocks’ fairy tale, three unfriendly bears emerged. If the nineties was the Goldilocks economy then the period we now find ourselves in of both weak growth and employment might best be described as the three bears economy. Since 2000 there was the baby bear of the dotcom bubble, the mamma bear of the residential real estate bubble and the daddy bear of the government debt bubble—corporate, consumer and now government-led bubbles of unproductive and hence unsustainable spending.
It used to be different. In the latter part of the twentieth century capital flowed into the technology sector, and new companies flourished. Sustainable growth and real wealth creation followed. But it turns out that in the real world, just like in fairy tales, there are no free lunches. Looking back the economic porridge we enjoyed in the nineties was never free, anymore than that of earlier eras of prosperity. On the back of considerable technical achievements IBM introduced its personal computer to business in 1982. Thus began a period of economic growth around the microprocessor that would last until the dotcom bubble burst in 2000. The regulatory and business environment of the time meant a good portion of the economic activity around the microprocessor happened in the United States.
The multi-decade economic cycle around disruptive technologies is in fact repeated regularly. The microprocessor fundamentally changed the world much in the way the internal combustion engine and electricity did previously. At the beginning of the twentieth century the productivity benefits of electricity were tapped first in factories and finally in the home. It meant reliable lighting, mechanization and in the final stages new consumer devices, like refrigerators and radios. The advantages of the internal combustion engine (and also petroleum-based materials like plastic) were unleashed starting in World War II with modern mechanized and aerial warfare. After the war, interstate highways, modern airports and petrochemical facilities provided the infrastructure to make the world smaller, enabling more efficient travel and shipping, as well as fundamental lifestyle changes such as the suburbs.
Secular Bull Market Periods of Economic Prosperity
The microprocessor, electricity and internal combustion engine each defined prolonged periods of global prosperity. Counterintuitively, when the productivity benefits of electricity, the internal combustion engine, the microprocessor, or other big innovations such as the steam engine, were finally being exploited at levels approaching their real potential what next transpired wasn’t an era of even greater prosperity. What followed, as productive places to invest capital dried up, were stock bear markets, economic crashes and recessions. This time is no different, as the same economic cycle repeats. The golden age of the microprocessor industry ended with the death of classical scaling, as device gains required new materials and architectures, as well as increasingly expensive lithography fixes. Since then meaningful gains in clock speed performance have come to a screeching halt, due to the physical laws of nature. Today, a secular bear market is well underway and historically these economically difficult periods tend to last over a decade.
People no longer need to regularly upgrade their computers because the performance isn’t getting much better. Yes, chip companies can still cram more transistors and now cores onto a single chip, as they manage to keep extending Moore’s Law at great cost. But the industry’s little secret is no one knows how to efficiently leverage all those cores with parallel computing and devices aren’t really going that much faster as a result. A car manufactured many years ago if properly maintained will get you where you want to go just fine and so will a computer from early in this decade still successfully navigate the Internet. This doesn’t mean there won’t be new products, like the iPhone or iPad. But it does mean the gains achieved increasingly resemble those of mature industries and their constituents, such as automotive companies. And unless efficient parallel processing becomes a practical reality, the next big thing of tomorrow will not center around traditional processors no matter their number of cores.
Previous Secular Bear Market Periods of Economic Distress
More importantly this also means that in the three bears economy, when governments inject money into the economy the capital doesn’t have much in the way of productive places to go. That quest for a free economic meal just leads to an angry bear market and a recession. This is the reason the initial public offering market has dried up this decade after the growth stage of the microprocessor life cycle giving birth to a multitude of companies from Microsoft and Cisco to Oracle and Apple. It’s the reason for businesses holding onto record cash stockpiles. The low hanging capital fruit of the microprocessor has all been picked, and there is currently no new big innovation replacing it. It is also the cause for currently persistent high unemployment despite government stimulus efforts that were promised to solve this problem.
Today, instead of sustainable, prolonged growth we now get recoveries followed by assets bubbles, recessions and bears. One of the first signs along the road to this paradigm was the East Asian credit crisis in the late nineties, which along with Y2K fears spurred the U.S. Federal Reserve to pursue an easy money policy to keep the Goldilocks economy humming. With no productive place for all that cheap money to go it flowed into dotcom stocks resulting in the Internet bubble and a recession. Still chasing a free economic lunch the Fed cut interest rates and with nowhere productive to go the cheap money next flowed into residential real estate. Corporate Internet-related investments that went belly up were followed by a cycle of bad consumer debt with mortgage defaults that devastated the credit markets.
The Baby and Mama Bears of the Current Secular Bear Market
We are now in the midst of fueling a recovery with bad government debt (a good chunk of it not just U.S. government debt partly in the form of the bond bubble, but bad Chinese debt, which is a story in itself). In 2009 alone investors poured $380 billion into bond mutual funds, even as they pulled $40 billion out of U.S. equity funds. With investor enthusiasm for a “sure thing” reminiscent of the dotcom and real estate bubbles another $134 billion was added to U.S. bond funds in just the first five months of 2010. When it pops the bubble in the debt market will end asset inflationary pressures and may prove to be the worst of the three bears. A double whammy of borrowing costs rising versus the real value of money and growing unemployment could even send residential housing to new lows as deflationary forces also gain more traction across assets, including commodities. However this likely will not transpire, until economic conditions lead governments to tighten the money supply. Keep in mind the last up move by the stock market fueled largely by asset inflation in the real-estate market lasted about five years.
At some point after the third bear’s recession, the signs of the growth stage of the cycle beginning anew will be seen in commercial infrastructure being deployed around an immature technology. Electricity required transmission lines and power stations to realize its economic potential. The internal combustion engine needed roads, highways and airports. Personal computers didn’t take off until IBM deployed its sizable sales and support infrastructure. Yet, even when one of today’s nascent technologies moves into the mainstream, the Goldilocks not too hot, not to cold economy is unlikely to return. The illusion of government debt being risk free will have vanished and investors will demand higher real rates, while asset inflationary forces will be spent. Companies will also gain pricing power from a new innovation and investors places to deploy capital now on the sidelines. Strong, sustainable growth will emerge, but in a much less benign monetary environment with real potential for consumer inflation. As the saying goes history doesn’t repeat, but it does rhyme.