The New-New Normal

The Bears think that Stagnation is going to be the "New Normal." We agree with the concept of a "New Normal" except our "New-New Normal" is better than the "Old Normal" due to the exponential power of Human Nature, existing knowledge and the Internet to generate new ideas and innovation. New ideas and innovation generate Productivity which is the source of all real gains in employment and wealth. Over the next ten years, we think the Productivity increases and associated increase in real wealth will be higher than in any decade ever.

The bulk of this piece tries to put our current economic crisis in historical perspective with the Stagflation that we had in the late seventies and early eighties. But let us just try to put the stock market in a simple valuation comparison. The S&P today is the same price as it was in 1998 when Internet Fever was omnipresent. The difference between today and eleven years ago is that the earnings have doubled. Unlike many investment fads, the Internet has delivered and will continue to deliver on its promise. Whereas in retrospect the 24 multiple in 1998 was way too high, we think the future will judge that the current multiple of 12 is way too low. If we just return to the "Old Normal" the market has a 40% upside. If we are right that the "New-New Normal" is going to better than the "Old Normal," then the upside is considerably greater.

The Bears argue that we are caught in a negative feedback loop that cannot be reversed for years. Nothing is working or will work. Recent massive Stimulus programs have failed. But even if they had not failed, that policy lever to potentially help Housing and Unemployment cannot be used again because it would exacerbate the deficit and the nation's credit rating. "Contagion" is now the most popular word in the financial press. Nobody knows how far a Greek default would spread and nobody seemingly has the power or the knowledge to wall off the European banks from Contagion. STAGNATION IS THE NEW NORMAL. It all adds up to the classic Bear case: there is no upside, only unlimited downside.

So how can we possibly be Bullish?

The current period reminds us very much of the late seventies and early eighties which also had high unemployment and housing troubles. During that earlier time period, we did not have the over-extended leverage for countries and consumers, but we had double digit inflation and double-digit interest rates. STAGFALTION WAS THE NEW NORMAL. Short-term rates were just under 20% and mortgages were north of 10%. Like today we were in a negative feedback loop that supposedly could not be reversed because any economic policy to help unemployment would stimulate inflation which would, in turn, keep interest rates high and economic activity low.

Everybody knows that the supposedly "Irreversible Negative Feedback Loop" of the late seventies was broken to smithereens by the policies of Fed Chairman Volker and President Reagan. Not only was the negative feedback loop reversed, but we had the 25 most prosperous years in the history of the world.

We believe there is an immutable law of economic feedback loops: Every positive feedback loop contains the seeds of destruction; and every negative feedback loop contains the seeds of correction. Given the choice of having to correct Stagflation or the current Stagnation, the latter is a much easier problem. If nothing else, Human Nature's innate desire to improve its economic lot through productivity will with time correct the debt imbalances. And if some of the more onerous and questionable regulations were cut back, investments would be unleashed and the negative feedback loop could turn positive in short order. Moreover, it does not take a Nobel Lauriat in International Economics to realize that the European banks need to be walled off from Contagion. It is difficult to get 17 countries to act in unison, but a firewall for the banks will be created this fall.

Investing is all about "Unknowables and Knowables". "Unknowables" are, by definition, "Unknowable." But we Know these five things which keep us incredibly bullish:

-- On the psychological front, The Fear is so thick that it can be cut with a knife. Market tops are characterized by Maximum Greed; Market Bottoms have Maximum Fear.

-- Moreover, the Expectations Bar is so low that not even a snake can slither under the bar. Any good news should send this market on a tear.

-- On the fundamental front, the dividend yield on the S&P 500 is identical to the yield on the 10-year Treasury bond. We repeat: the dividend yield on the S&P 500 is identical to the yield on the 10-year Treasury bond. Until last week, this had never occurred before in the modern day history of the stock market.

-- At its most basic, investing is always a choice of mix between the two platinum standards: the 10-year Treasury and the S&P 500. Today, you can buy a 10-year treasury and receive a 2.05% coupon for each of the next ten years. Or you can buy the S&P with a current yield of 2.05 % and the high expectation that the earnings and dividends will compound at a 6% rate for the next ten years. Thus, in the 10th year, you have the choice of receiving 2.05% on your original investment in Treasury bonds or you can likely receive a 4% dividend yield on your original appreciation plus the capital appreciation from the 80% growth in earnings. This is just another way of saying that at 12 times earnings, the stock market is incredibly attractive.

-- In tough times, we tend to think that only government is responsible for creating wealth. In our opinion, the laws, regulations, infrastructure, spending and tax policies that the government can control are responsible for something like 20% of the wealth creation process. Clearly, a successful economy needs an efficient, stable and compassionate government. But Human Nature and the Free Market create the vast majority of the wealth. Specifically Human Nature and the Free Market create wealth through increases in productivity. As we have written ad nauseam, the outlook for Productivity due to the power of the Internet to generate ideas and innovation has never been brighter.

The Bears think that Stagnation is going to be the "New Normal." We agree with the concept of a "New Normal" except our "New-New Normal" is better than the "Old Normal" due to the exponential power of Human Nature, existing knowledge and the Internet to generate new ideas and innovation. New ideas and innovation generate Productivity which is the source of all real gains in employment and wealth. Over the next ten years, we think the Productivity increases and thus the associated increase in real wealth will be higher than in any decade ever.

Peace be with you and your portfolio,

Harry E. Wells, III

WellsAssetManagement.com

October 10, 2011: S&P 1185