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Dan Nestlerode: The Great Slowdown

by on August 14, 2011 5:47 AM

Editor's note: Dan Nestlerode is on vacation and wrote this column before the recent volatility in the stock market. Nevertheless, his long view still applies.

I am either blessed or cursed with foresight.

While many in the investment markets can see only as far ahead as the next calendar quarter, and while many in Washington and Harrisburg can see ahead only until the next election (two years, four years or six years), I am typically looking ahead 10 years or longer. I am also looking for investments and economic trends that are sustainable over the long run, rather than just short-term fixes and patches.

I also have a depth of experience that reaches back into the 1950s as an investor, then as an investment broker to the mid-1960s, and then as an investment adviser since 1985. As a result, I view the current economic and market conditions as rich with both opportunity and peril. I caution the reader that we are not in normal times as far as the investment markets are concerned. Ignoring your investments with a buy-and-hold strategy is likely to be a risky endeavor that will leave you less well off.

After 115 years and 48 changes, only one stock that was in the original Dow Jones Industrial Average of the largest 30 companies remains today. Many others are gone through mergers, takeovers or bankruptcies.

Peter Drucker (1909-2005), the well-known management guru, holds special reverence for the science of demography and its predictive value.

We are now at a watershed moment with the population bulge of baby boomers on average entering their sixth decade. According to the Department Of Commerce, the consumption patterns of people 50 years old and older change dramatically. In a nutshell, they spend less.

This would not be a problem for the growth in an economy where the consumer is 70 percent of the gross domestic product (GDP) except that the subsequent population group (Gen X) is 11 million members smaller than the boomers. As the boomers reduce their consumption, there is a much smaller cohort with lots of buying needs, leaving a large gap in consumption and, as a result, less growth in the GDP.

Growth is a function of the size of the consuming population and productivity. If we have fewer consumers, we have less consumption and, consequently, a slowing or contracting economy. In my estimation, the economy needs to reset to a lower level of activity, 10 percent to 20 percent less than the peak in the GDP in 2007.

Our election-driven officials were not about to let the economy contract on their watch, and they, along with the financial community, moved heaven and Earth to prop up consumption by running large federal deficits, supporting the state treasuries, lowering interest rates to near zero and monetizing more than $1 trillion in mortgages and federal government bonds.

We had a Cash-for-Clunkers program, bailed out the banks, auto companies and AIG, had rebates for first-time home buyers of up to $8,000 and expanded food stamps and federal unemployment benefits, among other things. Yet for all these valiant efforts, we still hover at just over 9 percent unemployment and see only anemic growth in the GDP (adjusted to 0.4 percent growth in quarter one and estimated at 1.3 percent in quarter two for this year).
Lastly, we have nearly $5 trillion more federal debt. So we spent the money and have precious little to show for it except frothy levels of commodity prices and a seemingly vibrant stock market – until very recently – and a lot of bonds coming due in the next five years.

Regardless, the gravity of demographics continues to pull the economy into an adjustment that Washington still seems hell-bent on preventing.

I am not sure what other rabbits the people in Washington can pull out of their monetary and fiscal hats. I was looking for a major correction to the investment markets three years ago and was disappointed as the government moved to prop up stock and prices and the economy. If we have now come to the end of these stimulus programs (maybe not, as commentators continue to talk about QE III – quantitative easing, round three) then we have set the stage for the adjustments needed in the economy, the creative destruction called for by Joseph Schumpeter of the Austrian school of economics.

The price movement in gold in the past four years has reflected the degree to which governments have devalued their currencies in order to avoid the demographic shifts that some forecasters see in our future. As I write this, gold is almost twice the peak price it reached in the early 1980s. Many are placing their paper currencies in gold to avoid the devaluation of the dollar.

I was recently talking with a chap who has a boat docked in New Zealand. He told me that the New Zealand dollar has appreciated more than 20 percent against the U.S. dollar in the past five months.

So how is this all going to work out in the coming weeks and months?

I know that the current policies in Washington are not sustainable and that no one has really told us what is sustainable. Even with the current debt ceiling increase and budget cuts, we will spend more than $1.5 trillion more than we take in from tax collections this year, leading to a massive issuance of new federal government bonds.

Up until June 30, the Federal Reserve bought the bonds from the Treasury under the QE II program. A rise in interest rates seems likely without a QE III program.

The economy continues to slow, housing is moribund and the employment numbers are not getting much better.

Will Washington just stand by and let the economy adjust to the new reality or will they try once more to make things better by taking on more debt so they can spend today to alleviate the current economic pain?

At what point do the all the rating agencies finally downgrade the debt of the United States and when will the bond markets finally just say no to underwriting even larger federal deficits? And how will the stock and commodity markets continue to react to this unfolding drama?

The best I can say is stay tuned. There is no portfolio strategy that I know of that plots a clear path through such a jungle of variables. It is, therefore, imperative to continually pay attention to the markets to avoid an unpleasant investment experience.

Still wondering about that remaining member of the Dow Jones Industrials? The answer is General Electric. And even General Electric, an original Dow Jones member, was excluded from the average for several years as investors pondered if electricity was really nothing more than a flash in the pan like flush toilets and those new-fangled horseless carriages.



Dan Nestlerode is the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. A graduate of Penn State University, Nestlerode has been an investment advisor since 1965. He can be reached at danielj@nestlerode.com.
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