The Capitalist and Productivity Engine
(June 15, 2008)
Dear Subscribers and Readers,
Let us begin our commentary with a review of our 9 most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
4th signal entered: 50% short position on October 4, 2007 at 13,956;
5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
6th signal entered: 50% long position on January 9, 2008 at 12,630;
7th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
8th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
9th signal entered: 50% long position on June 12, 2008 at 12,172.
We will update our readers (and “clean up” our text above) of our DJIA Timing System's performance soon after the end of this quarter, and then subsequently move to a semi-annual update schedule. Please refer to our subscribers' area for our March 31st update. As of Friday at the close, our DJIA Timing System is still beating our benchmark, the Dow Jones Industrials Average, on all timeframes since the inception of our system.
Over the long-run of a capitalist society, economic growth is driven by the sum of Ricardian Growth and Schumpeterian Growth, as well as the interaction between the two (e.g. the innovation in the US semiconductor industry during the 1950s and 1960s, and which were eventually adopted by the Japanese and Taiwanese to produce semiconductors at a more cost-efficient manner). The former is driven by the secular adoption of free trade policies around the world since the end of World War II, while the latter is driven by technological advances and the creation of new management and business techniques. The concept of “Creative Destruction” is a direct result of Schumpeterian Growth.
As I discussed in our April 27, 2008 commentary (“Reflections and Black Swans”), the projected earnings power (on an EPS basis) of the US stock market is based on the following seven important points.
- Projected corporate profit margins, or more specifically, corporate pricing power and expenses (wages, pension expenses, etc.);
- Projected corporate tax rates around the world;
- Projected financing costs, or cost of capital;
- Projected “float” of the global stock market (given that capital is very mobile today) – as expressed in the dollar value of shares that are available to investors today;
- Projected productivity, employment, and population growth – all of which have a direct impact to the build-up of global wealth;
- The ability and willingness of governments around the world to protect private capital and to allow capital to move freely around the world;
- The freedom to trade and the projected increase in trade flows around the world (Ricardo's law of comparative advantage).
Each of the above has a more direct impact on U.S. and global stock prices than projected GDP growth alone. More importantly, the effects of each of the above could be more easily quantified, unlike the “mixture of stuff” that is ever changing in every GDP computation (or in China's case, a make-believe number).
Furthermore, each of the above is not independent of each other. For example, both the cost of capital and corporate tax rates has a direct impact on corporate profit margins. I included corporate tax rates as a separate line item simply because it does not have a uniform effect on all companies. One example is corporate tax breaks for certain industries. When it comes to cost of capital – it is important to note that in a credit “seizure” such as what we are having now – the cost of capital for certain (highly credit worthy) companies will eventually decline as the Federal Reserve lowers rates, while increasing to near infinity to those which are assumed to be at the margin, such as First Marblehead, Bear Stearns (before its announced takeover by JP Morgan), or Thornburg Mortgage (it had to do an equity offering of around four times its market cap in order to survive). As some of these marginal companies go out of business due to the lack of financing options, corporate profit margins for the companies that survive would dramatically increase as competitors are taken out in their respective industries.
Secondly, the above seven points are meant to be sweeping in nature. For example, the ability of governments to project private capital does not only mean protection from government confiscation or theft, but from foreign invasion as well. Through the U.S. central bank and FDIC, our system has also built in a significant “safety net” that prevents private bankers from seizing our deposits or mortgaged-assets during a liquidity or a solvency crisis in our financial system (the latter of which is a far cry from the 1970s). Another example is projected productivity growth. Embedded within this statement is the assumption that capitalism will not only survive, but will continue to thrive. The reason is this: The best economic system that allows for sustained productivity growth is capitalism, and nothing else (Joseph Schumpeter went as far as associating technological advances directly with capitalism). Another example is consumer price inflation. While monetary policy can and will have short-term effects on the price level of a typical consumer goods basket, it is productivity growth (or the lack of it) that drives long-term consumer price inflation.
A bear market in global corporate profit growth occurs when one or more of the above points are compromised, such as a rise in protectionist sentiment (which inhibits Ricardian growth, and by extension, productivity growth) or a rise in corporate tax rates. A bear market in global economic growth, however, occurs when Ricardian or Schumpeterian growth is inhibited, or when certain countries or sectors of the economy fail to invest the necessary resources (sources that are available using current technology and labor force) in order to promote future productivity growth. The global crude oil industry is one example of the latter. Sovereign governments today control more than 75% of all global crude oil reserves. With the exception of Canada, Brazil, China, and Algeria, all the world's major oil-producing countries have failed to invest in the necessary infrastructure to increase oil production over the last 20 years, including the United States.
Aside from a universal cure for cancer, or the commercialization of carbon nanotubes as a replacement of steel parts and/or semiconductor parts, there is no doubt that the “biggest bang for the buck” for Schumpeterian Growth comes in the form of a breakthrough in the alternative fuels sector – a breakthrough that would lead to below “grid parity” with the cost of fossil fuels, whether that is in solar, cellulosic ethanol, or wind technology. While “grid parity” is a great step forward, the true breakthrough that would have a profound impact on the crude oil industry will come once plug-in hybrid and lithium-ion battery technologies are commercialized. Given that the majority of daily commutes in the US are for short-haul journeys, it makes every sense in the world to run your automobile on electricity for most of your commutes, especially given today's gasoline prices.
But Henry, isn't your thesis of hoping for better technologies in the alternative energy sector bordering on wishful-thinking? After all, solar technology has been with us for the last 30 years, while cellulosic ethanol has been discussed for over a hundred years, and neither one is cost-effective compared with coal, crude oil, or natural gas!
My answer: Not really. As long as the capitalist engine is not disrupted, the scientific innovators, entrepreneurs, and venture capitalists will ultimately come up with the appropriate solutions, as long as the economic incentives are there. In his seminal work, “Capitalism, Socialism and Democracy,” Joseph Schumpeter effectively equates technological progress as part of the capitalist process. Questioning other economists' views that technological progress may not be inherent in the business processes of capitalism, Schumpeter writes:
Was not the observed performance due to that stream of inventions that revolutionized the technique of production rather than to the businessman's hunt for profits? The answer is in the negative. The carrying into effect of those technological novelties was of the essence of that hunt. And even the inventing itself, as will be more fully explained in a moment, was a function of the capitalist process which is responsible for the mental habits that will produce invention. It is therefore quite wrong – and also quite un-Marxian – to say, as so many economists do, that capitalist enterprise was one, and technological progress a second, distinct factor in the observed development of output; they were essentially one and the same thing or, as we may also put it, the former was the propelling force of the latter.
Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary. And this evolutionary character of the capitalist process is not merely due to the fact that economic life goes on in a social and natural environment which changes and by its change alters the data of economic action; this fact is important and these changes (wars, revolutions and so on) often condition industrial change, but they are not its prime movers. Nor is this evolutionary character due to a quasi-automatic increase in population and capital or to the vagaries of monetary systems of which exactly the same thing holds true. The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers' goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.
In other words, the capitalist engine is the most efficient way of generating long-term economic growth, and almost by definition, does it by ensuring continuing technological progress and consequently, increasing productivity. On the other hand, if the capitalist engine is ever inhibited (such as by the failed experiments in protectionism in the 1930s and socialism among many other countries after World War II), technological progress and productivity growth will almost surely halt (with the exception of advances in military technology whose primary purpose is to safeguard national security). This would result in a global equity bear market on the mild side, and riots, revolutions, and a severe global recession on the moderate side. On the extreme side, the perma-bears would be right – the only option at that point would be to stock up on canned goods, guns and ammunition, jewelry and gold coins, and hide out in your bomb shelter or bunker in southern New Zealand, as (what remains of the) world will compete ferociously for a decline in natural resources in general – not just energy.
Fortunately, as we have previously discussed, years of research into better battery and plug-in hybrid technology, and alternative fuel sources are starting to bear fruit, especially since rising fossil fuel prices are now starting to make these alternative fuel sources much more attractive. For example, the GM Volt, a plug-in all-electric vehicle, is slated to be commercialized at the end of 2010. Similarly, Toyota is in now developing its own lithium-ion battery technology to be incorporated into a new line of plug-in Toyota Prius hybrids, which is also scheduled to come online in 2010. Moreover, the first demonstration cellulosic biorefinery designed to produce 1.4 million gallons of ethanol a year (from agricultural waste left over from processing sugar cane) came online at the end of last month. Verenium – the company that operates the plant – plans to build a plant to commercialize the technology starting next year with an initial capacity of 20 to 30 million gallons of ethanol a year. Separately, Brazil – no doubt a pioneer in commercializing energy-efficient ethanol technology – has vowed that it is on track to commercialize cellulosic ethanol production in just five years. Combined with the recent discovery of 50 trillion cubic feet of recoverable natural gas reserves in the Marcellus Formation, the continuing advances in solar energy production, the utilization of the power grid as transportation fuel and the commercialization of cellulosic ethanol have the potential of bringing down fuel prices by a significant margin starting at the end of 2010 and beyond. That is why Goldman Sachs' long-term assumption for oil prices is $75 a barrel, even though they believe crude oil prices could spike to $150 to $200 a barrel over the next six months.
Global economic growth during the 1990s was driven by a combination of Ricardian growth (beginning with the dismantling of the Berlin Wall) and Schumpeterian Growth (driven by the mass adoption of the PC and the internet). Since the end of the global equity bear market in late 2002, global economic and productivity growth has mostly been driven by Ricardian growth, as countries like China, India, Brazil, and Vietnam adopted free trade and pro-growth (capitalist) practices and as the rest of the world embraced free trade policies as well. It is not an exaggeration to state that this has for the most part benefited European companies (and the Euro) much more so than the United States, as European manufacturers have a comparative advantage (actually, German manufacturers for the most part) in producing the goods that the Chinese and the Indians need to industrialize and power their economies over the last six years.
The United States, meanwhile, has for the last one hundred years held the dominant position in promoting Schumpeterian Growth. While this relatively dominant position of the US has declined since the end of World War II (with the renewed rise of Japan and Germany), there is no doubt – given the United States' dominance in many aspects of the information technology, biotech, and nanotech fields – this still continues to be the case. This unique capitalist engine, with its significant pools of venture capital, PhD holders, investment bankers, strict patent laws, and a 300 million strong immediate market, is still going strong. Other major countries that have historically promoted Schumpeterian Growth since the end of World War II are Japan and Germany. Going forward, other countries to watch are Greater China (which includes Taiwan and Hong Kong), South Korea, India, Brazil, and France.
Given the rise in protectionist sentiment around the world, and given the bottlenecks in natural resource production – not only in energy, but also in metals and agricultural commodities – the next engine of global economic growth should logically arise out of Schumpeterian Growth. That is, while the bull market in global equities since October 2002 has tilted towards European equities (and equities of “commodity countries” such as Canada and Australia), my thesis is that the next bull market in equities will benefit to a greater extent the US and Japanese stock markets. The relative weakness in US equities vs. global equities is evident in the bottom panel (which shows the relative strength of the S&P 500 vs. the Dow Jones World Index in USD terms) of the following chart, courtesy of Decisionpoint.com:
Note that on a relative basis, US equities has been on a six-year bear market relative to global equities in general. A similar story can be told in Japanese equities. Note that – as evident in the following chart (again, courtesy of Decisionpoint.com) – the relative strength of Japanese equities (in USD terms) vs. the Dow Jones World Index (also in USD terms) was at its weakest since early 2003 just a few months ago:
Obviously, the short-term picture is murky at best, as crude oil is still in a “blow off phase” and as the 2008 US Presidential Election looms near. Given the rise in protectionist sentiment in the US Congress, and given the prevalence of “protectionist talk” in some of Barack Obama's speeches, I would not be surprised to see the US stock market make new lows should it become obvious that the Democrats would take the White House later this year. Whether Obama – should he win the election – would “walk the talk” and enforce his protectionist rhetoric is another story. Even if the new President and Congress should follow through with some protectionist measures in 2009, the stock market could still perform very well if: 1) the stock market had already discounted the enactment of protectionist measures later this year, and 2) the positive effects of any Schumpeterian Growth outweighs the negatives of rising protectionist measures, i.e. the inhibition of Ricardian Growth. In the meantime, both the fundamental and technical condition of the Japanese stock market looks very healthy, and should be bought if you haven't already done so (the fundamentals of the Japanese stock market were discussed in our January 31, 2008 commentary).
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2006 to the present:
For the week ending June 13, 2008, the Dow Industrials rose 97.54 points while the Dow Transports declined 101.44 points. Even though the Dow Transports diverged from the positive action in the Dow Industrials last week, it still remains the stronger index. Moreover, given the new-found pricing power by the airlines and the continuing bottlenecks in the US transportation infrastructure, I expect the Dow Transports to make new all-time highs sometime over the next few weeks (as long as crude oil doesn't spike to $150 a barrel). Given that the Dow Transports has been a leading indicator of the broad market since October 2002, the relative strength in the Dow Transports will need to be respected. However, without an increase in technical strength in the broad market or in the A/D line of the Dow Industrials, it will be difficult for the Dow Industrials to sustain any rally going forward. For now, we will remain 50% long in our DJIA Timing System – and will look to add to our position only if the market becomes more oversold or if the technical condition of the US stock market improves.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators decreased again from last week's reading of 7.2% to 2.7% for the week ending June 13, 2008. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
Note that while the latest decline in this sentiment indicator only represents the third consecutive weekly decline since the nine-week consecutive rise from its extremely oversold reading of -13.9% in mid March, this latest three-week decline has now erased much of the short-term overbought situations in bullish sentiment. As a matter of fact, with the exception of the plunge in sentiment earlier this year, this indicator is now at its most oversold level since early September of last year. For now, I am still comfortable with our 50% long in our DJIA Timing System, and will not add to our long position unless we get a more oversold condition in this indicator/the stock market or until our technical indicators improve.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
While the ISE Sentiment Index has reversed dramatically since its mid March low, the 20 DMA of the ISE Sentiment Index has consolidated over the last few weeks and is now in the process of working off its short-term overbought conditions. More importantly, both the 20 and the 50 DMAs are still oversold relative to levels over the last five years. Given this, the probability for much further downside is minimal, although I would still prefer to see a more oversold condition in this indicator before adding to our 50% long position in our DJIA Timing System.
Conclusion: While the short to intermediate outlooks of the US and global equity markets are still murky, my sense is that the next global equity bull market – whether it occurs later this year or next year – will rotate back into US and Japanese equities, as both the US and Japan hold dominant positions in promoting Schumpeterian Growth. Japan, in particular, is a buy right now and should be bought on any weakness going forward, given the huge undervaluations in the Japanese stock market and the renewed rise in Japanese real estate prices coming off of a 16-year bear market (note that real estate is marked-to-market on corporate balance sheets in Japan). Moreover, while crude oil prices can do anything over the next two years, I believe a significant deflationary force will start to help bring down crude oil prices by the end of 2010, as new and more cost-efficient transportation technologies are commercialized and adopted.
For now, the US stock market is slightly oversold, and should continue to rally over the next couple of weeks. However, unless the stock market or investor sentiment declines to a more oversold level, I would prefer to stay with our 50% long position in our DJIA Timing System for now. Should the market ever get overbought, and should it be accompanied by weak breadth in the stock market, then we would not hesitate to get rid of this long position and move back to a completely neutral position.
Henry To, CFA