Take a look back at where we’ve been. Nineteen-ninety-nine was a year of incredibly foolish expectations. The year 2000 was the year the bubble finally burst, and during which the panic stampede began. The year 2001 was a year of crisis and disaster. Year 2002 was a year of pain, suffering, collapse, and rationalization. Last year, 2003, was a year filled with vague anxieties and worry, but the worries consolidated and gradually eased. Potential worries galore remain for 2004, yet the pattern is clear: we’ve not only hit the bottom, but bounced smartly off of it. So while I advocate, as I always do, contingency plans for the unexpected (about which more later), the base case and most probable outcome for 2004 is a year when the economy continues to strengthen, markets continue to rise, and good times begin to roll again. But what will be the source of these good times over the next economic expansion, and how should investors prepare?|
First let’s look at the economy overall. We are clearly still in the early stages of an economic recovery, which explains both the high rates of GNP growth, and the so-called ‘jobless recovery.’ Early stages of any recovery tend to show high rates of growth, yet little in new hiring. Companies, still gun-shy from the losses of the just-completed recession, are cautious about taking on new people, or investing in new plant and equipment. Accordingly, they try to stretch their existing resources by asking their existing employees to work overtime, and extending their hours of operation. Once orders, revenues, and profits rise by enough to restore confidence, and once existing resources are outpaced by demand, companies start hiring again, and placing new orders for equipment, especially as their old equipment is starting to look tired and obsolete, and becoming a drag on production.
This time the jobless phase of the recovery will be slightly longer than in previous recoveries because of a major, secular trend unrelated to the economic cycle: the depopulation of the manufacturing sector. Just as agriculture saw dramatic increases in output coupled with dramatic decreases in employment a century ago, increasing productivity and automation, combined with the rise of new sources of low cost labour, notably in China and India, are gradually but steadily reducing the number of people employed in manufacturing in all developed countries, even as manufacturing output reaches all-time records. So hiring will re-emerge, but later than most economists would expect based on past recoveries.
Which brings us to the global economy – the next major source of good news. While it is true that many traditional jobs are being exported to low-wage countries, simultaneously new jobs are created that demand more creativity and intellectual input, and offer both better pay and more opportunity. This doesn’t help the workers displaced from their jobs, but it does help the economy in two ways. First, average income rises, and along with them the demand for goods and services. And second, it means the costs of production go down, and prices of goods and services decline, leading to an overall increase in the standard of living.
Moreover, the integration of individual national economies, including those of North America, into a world-wide marketplace stretches out and exaggerates the economic cycle. It means the recessions are longer, and can be more vicious, but it also means the periods of expansion are longer and stronger as well. You can see this happening right now. Not only are North American economies strengthening, but so are those of Europe and Asia in concert, reinforcing each other, and providing more demand and stronger markets for all. The net result is that, barring fresh disasters, this economic expansion will gather strength for years to come, and will stretch out into the early part of the next decade, lasting well beyond 2010. And with years of good times ahead, that implies that there will be years of good investment markets as well.
Of course, no economic expansion or market rise happens without problems or hiccups. Investments never go straight up. But this is the stage when the cliché, ‘Markets climb a wall of worry’ is most appropriate. The pattern of strength is now well-established, and investment programs should be designed accordingly. Now is not the time for driving while looking in the rear-view mirror, exercising great caution and clinging to fixed assets that return almost nothing. That should have been the strategy in 1999 through 2002. The greatest risks now are of sitting on the sidelines while the markets charge ahead without you. The biggest single-year gains often happen in the first year of recovery, right off the bottom of a bear market, as happened last year. But the least risky, and most important gains are made after it’s clear that the long-term direction of the market is up, and you can invest while the odds are in your favor.
Earlier I suggested that I was in favor of contingency planning, and now is an ideal time to practice it. Accordingly, I would suggest that investors should sit down with their advisors and come up with a game plan for four possible futures:Base case (most likely scenario): Continuing growthMost likely alternative: Stronger than expected growth2nd most likely alternative: Disappointing weaknessNasty surprises: Preparing for the unexpected
The base case is what we expect, based on what we see and know today. It’s the ‘more of the same’ scenario, a straight-line extrapolation into the future based on previous recoveries and experience. Unfortunately, this is usually the only possibility that most people consider, and then only once they’ve started playing catch-up after clinging to the past for too long.
The next possible scenario is a stronger than expected recovery. If, for example, the gathering economic strength in Europe and Asia winds up dramatically reinforcing activity in North America (and vice-versa), we may see higher growth, stronger profits, bigger paychecks, and better-than-expected stock returns. It makes sense to watch for this possibility, and to have plans in place to take an even more aggressive approach with your portfolio if it emerges. Likewise, if there is some bonus windfall, say from a major breakthrough in trade talks, or an unexpected boost to productivity from technology, or some other, unanticipated source, you will be prepared to make the moves necessary to benefit from it.
A less likely, but still important scenario is one of disappointing weakness, where economic growth sputters and drags along because of trade protectionism, uncertainty caused by terrorism or natural disaster, an attack on the U.S. dollar because of ballooning federal or current account deficits, or some other unknown factor. Few investors, and fewer advisors, like to consider this kind of scenario because it’s not as much fun, and seems like you are inviting trouble. Yet being prepared for potential disappointing growth means being able to find ways to profit from it by moving to those sectors, such as long-term fixed income securities, that will benefit before the herd wakes up and follows.
The same is true in spades for the unlikely, but worth discussing, last scenario: Nasty surprises. If we’ve learned anything over the last five years, it is that the unexpected happens, both good and bad. We’ve already talked about unexpected good surprises in the second scenario (‘Stronger than expected growth’), but suppose there’s another major terrorist attack on an urban center in the developed world, such as a biological attack in the Paris, London, or New York subway? Or suppose the Saudi government is overthrown by fundamentalists, antagonistic to the West, and who double the price of oil and disrupt economic activity? We don’t expect such things to happen, but we can no longer shut our eyes and pretend they can’t happen. Accordingly, it makes sense to have a plan of action prepared, and to be ready to act in the event of a nasty surprise. For the individual investor, it means being mentally prepared as well as having a strategy mapped out. For the investment advisor, it means having prepared the ground ahead of time with your clients, and having concrete plans and ideas to discuss with them when they are shell-shocked and reeling rather than avoiding their phone calls and hiding from them when they need you most.
Having talked about the alternative scenarios a prudent investor should consider at this stage of the recovery, let me say that until we get a concrete indication to the contrary, the base case is the one to buy into. Your investments should reflect this upbeat approach to the market, appropriate to your family situation, income level, tax status, investment time horizon, and all the other pertinent aspects of portfolio management. Keep the other scenarios in your back pocket for the moment, but review them from time-to-time, and be ready to put them into action if needed. You’ll be far better off having taken a strategic approach to an uncertain world, than to continually be surprised and unnerved by unanticipated developments. And if you’re interested in a more detailed description of how to harness the power of scenario planning for your life and business, see the 7th Secret of my recent book, Who Owns Tomorrow? (Viking Press, 2003).
Finally, let me say that this economic expansion is going to see all sorts of marvellous developments in the biosciences, energy, telecommunications, nanotechnology, materials science, marketing, and more, that are going to revolutionize the way business is done, and the will significantly affect our daily lives. The world at the end of this cycle will be very much different than it is today – and that means there are investment opportunities out there, waiting to be found. I’ll talk about those in detail another day, but just remember: we’re heading into an exciting time of radical change – and such times always offer investment profits to those who are alert and prepared.
Let the good times roll!
by futurist Richard Worzel, C.F.A.
© Copyright, IF Research, January 2004.