No Stupid Questions

Just about every teacher and professor I ever had, from my earliest days of elementary school through college and graduate school, emphasized to their students that there was no such thing as a stupid question. The instructors knew that when a student hits a snag on understanding one concept, then it is just that much harder to even begin to grasp the next one, as the confusion becomes a major distraction. This willingness to indulge questions of all sorts is also a helpful teaching tool, because it gives the teacher some feedback on how well she is getting through to her class. The challenge for me was always to avoid asking the one question that would prove, beyond all doubt, that I had not read the assignment ("Who said 'To be or not to be?' Oh yes, that was Hamlet. In Hamlet. Read that last night.") These teachers might question their convictions about there being no dumb questions, though, if they ever watched hours of a Federal Reserve Chairman testifying before a committee of the U.S. Congress. The accepted wisdom is that the pronouncements of Mr. Bernanke can send the markets in a tailspin. I suspect, however, that such market reactions may be due--or at least should be due--to the lame and insipid nature of the questions ("Why are there so many bankers on the Federal Open Market Committee?"), revealing as they do a complete lack of understanding of economics and finance among the very elected leaders who are making policy. In Chairman Ben's latest appearance before such a committee, there was one question posed that I found to be both intelligent and important: "What is the relationship, or correlation, between growth in economic output and growth in employment?" Unfortunately, not much time was spent on the answer, so we'll examine it here.

To unpack this question effectively, we need to first point out that the real question concerns how the relationship between output and employment has changed, if it indeed has. A major part of our investment thesis here is that it has changed, and is changing, and this leads us to consider that there are structural, as well as cyclical, factors at work in today's economy. Let's start with a very simplified example of how the typical business cycle has worked since World War II. Our case study involves Acme Car Dealership, a hypothetical seller of General Motors automobiles. For some time Acme has been experiencing robust sales of its cars, and the management has made sure to keep plenty of cars available for sale on the lot to satisfy the demand. Now, for whatever reason, Acme's sales start to slow. Maybe all of the middle-aged men having a mid-life crisis have bought all of the red Corvette convertibles they need, or maybe consumers are just becoming more cautious about their spending because they've taken on all the debt they can afford for the time being. As the cars sit unsold on the lot (a buildup of excess inventory), Acme doesn't place its usual big order with GM. As other car dealerships around the country are experiencing the same slowdown, GM doesn't need to manufacture as many cars, so they start shutting down factory shifts and laying off workers. This means they also do not order things like windshields, tires, steel, and car interiors from their component suppliers. So these firms start laying off workers as well. All of these laid off employees then cut back their spending on everything from new clothing to meals out at restaurants, and the whole process feeds on itself to produce an overall slowdown in the economy, a vicious cycle if you are out of work. Keep in mind that we've jumped on the business cycle for the ride down, to start.

What happens to get the cycle moving back in the positive direction? Well, one possibility is that the situation will resolve itself. Excess inventory will lead to falling car prices, and sooner or later cars will be in short supply as new purchases have been postponed and inventory levels have become leaner. We can consider this as the solution from the "Classical Economics" school of thought, that the economic business cycle is a self-correcting mechanism that ultimately will bring supply and demand back into balance, in the long run. This is where John Maynard Keynes came into the picture to put forth a challenge to that assumption. Keynes said that the long run can be unacceptably long (his famous quote that "we are all dead in the long run"), causing a prolonged period of underutilized resources, chief among those resources being people who need work. Keynes also asserted that the economy could reach a new equilibrium (balance of supply and demand) far short of full output and full employment. Keynes proposed that such inadequate aggregate demand could be boosted by government spending, and this was essentially the idea behind President Franklin Roosevelt's New Deal policies to combat the Great Depression. Keynesian-based fiscal policies have been with us ever since, in some form or fashion. In the case of our Acme example, the government might cut taxes to put more more money into the pockets of consumers, or engage in other forms of outright deficit spending to boost aggregate demand. We might even go to war with Freedonia (see the movie Duck Soup, with the Marx Brothers), requiring some retooling in Detroit so that tanks, and not little red Corvettes, are rolling off the assembly lines. On the monetary side, the Federal Reserve might cut interests rates to make it easier for consumers to finance the purchases of cars and other goods. Whether government spending actually helps the economy is subject to much debate, but for our purposes here the point is simply that the business cycle is just that--a cycle--and the slowdown will ultimately give way to an economic upturn. The implicit assumption is that when the cycle completes itself, things pretty much go back to where they were before the downturn began. Laid off workers get their jobs back, and factories start humming again. Does that hold true in real life today or, to put it another way, does a return to a higher level of economic activity translate into commensurate job growth to reduce unemployment?

To get at the answer, we also need to understand a concept in economics known as the Natural Rate of Unemployment. This means that at any given time there will be some people who are without work, perhaps between jobs. As the theory goes, any attempt to reduce unemployment beyond that level would result in higher inflation, the result of an over-stimulated economy. For years this natural rate was thought to be around 4% or 5%. What the media commentators and policymakers tend to miss here is that an unemployment rate of 5% in January that is still 5% six months later does not mean that the same people are without jobs. No, the likelihood is that the people who were without jobs in January have found work and were replaced on the unemployment rolls by people who were seeking jobs in July. That is just the ebb and flow of labor in a dynamic economy. My theory is that this natural rate of unemployment has risen over the years, which would mean that the relationship between growth in output and job growth has changed. I strongly suspect that if the economy were growing at 3.5% or 4% and approaching a level of full capacity or full output, we would still see an unemployment rate higher than the 5% or so that prevailed during the strong economy of the 1990s. Unfortunately, we cannot test that hypothesis right now because the economy is languishing at a growth rate well below 4%.

If my hypothesis is valid, that would mean that we are dealing with structural issues in the economy in addition to the familiar cyclical factors. Specifically, it would mean that the economy can produce the same level of output with fewer workers. Before you jump to the conclusion that this is a bad thing, remember that the same level of output produced with fewer workers is the very definition of increased productivity, and productivity is what raises the overall standard of living in an economy. The globalization of the supply chain means that we pay lower prices for everything from cotton shirts to plasma televisions. When companies are doing what they are supposed to be doing, which is gaining efficiency to produce more profit for their owners/shareholders, new competitors, drawn by the potential for profits, will enter their industry, which will heighten competition and keep prices in check. This pursuit of profits is what leads to job creation, a little fact that the politicians seem to forget. Advancing technology is, of course, a major factor behind these structural changes. When you call a customer service number, the chances are that you will be greeted with an automated maze of options, and, yes, someone used to get paid to talk with you. Those jobs are gone, but they have been replaced with other jobs at the companies that make the new technologies. Manufacturing jobs here in the United States are requiring greater skills to operate complex, high-tech machinery, while the lowest skilled functions are performed overseas. Another issue, then, is the mismatch between the skills needed and the skills possessed by those needing jobs.

Another part of this issue involves the overall stagnation of wages. Henry Ford once said that he wanted to pay his auto workers a good wage because he wanted them to be able to afford the cars they were producing. High-paying manufacturing jobs were a key part of the creation of this country's vast middle class, and those relatively unskilled jobs are in shorter supply these days. Making matters worse is that the main source of wealth, or net worth, for people in the middle class is the equity in their homes, and we know all too well what has happened to that piggy bank. Those in the upper categories of income and wealth tend to have more of their net worth in stocks and bonds, and those financial assets have recovered since the worst of the recession. When you add all of this up, you get right back to our "Tale of Two Cities Economy" investment thesis.

As investors, we always seek to understand broad economic trends as a way of leading us to profitable investments. That is an essential part of fundamental research and analysis, but we also need to step back and see what the stock market is telling us. That is, while we might insist that this or that stock should be doing well because it fits with our overall analysis of the economy, it is also important that we avoid the hubris of thinking that the market is going to do what we think it should do. Sometimes these two approaches lead us to the same place, like the stars aligning in some celestial symphony. Here are a few of the stocks on our Radar Screen that are at or very close to 52-week highs:

Costco (COST, $91)
Dollar General (DG, $51)
Dollar Tree (DLTR, $109)
Ross Stores (ROST, $66)
TJX Companies (TJX, $42)

Sound familiar? Round up the usual suspects.

Life is short. Get busy.

Jim


Disclosure/Disclaimer: My family members and/or I own shares of COST, DG, DLTR, ROST, and TJX. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.