Economic Misdiagnosis Due to Government Stimulus

Most money managers have misdiagnosed what’s currently driving the global economy. The multiple that investors are willing to pay for next year’s earnings means more than any sentiment polling.

The forward P/E multiple on the broad stock market is not nearly as high as it was during the Internet bubble, but it’s at extreme highs if one accurately diagnoses the unsustainable stimuli currently driving global economic activity.

Just like low-quality earnings paint a misleading picture of a company’s value, this low-quality economic activity destroys wealth and promotes a dependence on sustained fiscal largesse.

Such a diagnosis would filter out how fiscal and monetary policies are distorting the efficient allocation of capital. Investors should interpret government spending as noise and interpret private sector behavior as the signal. In today’s state-sponsored economy, you cannot totally separate one from the other, but it’s still important to acknowledge the distorting influence that stimulus programs have on capital spending and hiring decisions.

What happens when the stimulus wears off? Why, we have even more excess capacity in sectors where stimulus was directed. Exhibit A: cash for clunkers. Exhibit B: the tax credit for homebuyers that will exacerbate the structural glut in housing supply. In the financial media, I’ve seen investor after investor defend these programs as valuable and necessary, which demonstrates their ignorance of sound economics.

We’re propping up zombie institutions, throwing good money after bad, and rewarding incompetence — all at the expense of prudent people’s savings and the capital that will be needed to fund the industries of the future. Top investors don’t tolerate low- or negative-return-on-capital decisions by the executives running their companies, so it’s puzzling to me why so many of these investors advocate the same type of economic malpractice on the part of government policymakers.

The latest sideshow for public consumption — a “paymaster” regulating pay at large banks — is another example of the government’s misdiagnosis of the problem.

Rather than regulate pay in the hopes that it discourages risky banking behavior, we should be phasing out the government guarantees of the banking system’s liabilities. That, I assure you, would discourage foolish risk-taking among bankers. Case in point: Goldman Sachs behaved in a much more responsible, sustainable manner when it was a privately owned partnership without government guarantees, rather than the high frequency trading, TLGP-hogging, heavily lobbying institution that it is today.

Like an addictive drug, today’s fiscal and monetary policies have made everyone feel better, but have further weakened the structural health and sustainability of the economy. If you doubt this, just look at the horror in most investors’ eyes when they are confronted with the prospect of a Fed Funds rate above, say, 2% — up from today’s range of zero percent. The addiction to E-Z credit and government support everywhere you look is one of the clearest reasons that this economic recovery is an elaborate illusion.

Yet we still see examples of extreme inefficiencies in the valuation of certain stocks. It feels eerily similar to the tech bubble, with investors behaving as if today is the last chance they’ll ever get to buy Amazon.com stock at less than 80 times earnings.

Whether it’s the sky-high multiple on Amazon’s maturing business, which seems to be discounting that every Chinese citizen will own a Kindle within 5 years, or the expectation that banks employing creative accounting have seen the worst of their credit losses, many investors are putting real money behind their belief in a super-bullish economic environment.

The reasons to be cautious and bearish are overwhelming. A market correction back to more normalized valuations may happen at any point.

Lastly, I attended the Value Investing Congress in New York last week, along with Addison Wiggin and Chris Mayer.

The most important takeaway for me was the audience’s apparent skepticism towards the two most bearish presenters: David Einhorn and Eric Sprott. Both hedge fund managers are bullish on gold and critical of Washington, D.C.’s wealth-diluting fiscal and monetary policies. The tone of the Q&A sessions after these presentations tells me that most investors are still very, very skeptical of investing in gold. That’s good news for gold bulls.

It’s also good news for stock market bears that so many believe in the Keynesian theories they read in their college economics textbooks. GDP growth driven by government spending is misleading, and damaging to capital formation. Much of today’s top line growth is coming at the expense of future profits — when mal-investments will be written off.

Regards,
Dan Amoss

October 28, 2009