Friday, November 09, 2007


After 50 straight quarters of job growth, the tight labor market has been pushing up wages rapidly for the past 2 years. Ed Yardeni and other economist often use the product of wages and growth as an accurate "market based" economic estimator. History has shown that TV pundits rely heavily on anecdotal evidence to reach extreme conclusions. At a time when expectations for continued growth in wages and jobs, some pundits see recession. At a time of tight credit conditions, other pundits see hyper inflation. History also shows that if job growth and wages are both strong, the total economy is strong and if there is not excess credit inflation is weak. After all, individual consumption represents about 70% of the GNP, the core of personal income is wages and inflation is too much money chasing too few goods.


If you think about what is different about the prosperity phase of the economic cycle, it is that the "slack" has been reduced. During the recovery, production inputs that were added by the end of the previous boom are under utilized. Share prices for businesses that are labor intensive, such as hospitals, tend to perform well during the "weak economy" times. In "Cocktail Economics", Victor Canto does a good job of explaining this critical factor in the business cycle. He wisely substitutes the word flexibility in place of the economic term elasticity. He does not use hospitals as an example but I like the contrast between hospitals and drug companies. Each of the S&P sectors includes early cycle and late cycle stocks. It is very easy to fall into the trap of saying it is time to buy one of the sectors without distinguishing which part of the sector is ready to be strong.

The turn is upon us in the health care sector. In the early years of the business cycle, hospitals have traditionally enjoyed the best of both worlds. In the worst of times, demand for hospital beds holds up. The demand is inflexible. In the worst of times, hospitals bill insurance companies, government programs and individuals the full price. The price of health care services is inflexible. On the other hand, in the worst of times, enough people are out of work that hospitals, which are labor intensive businesses, can hire plenty of workers without pushing up the pay scales. Real wage costs are in effect flexible during the early stage of the business cycle.

We are now approaching the the flip side of "the worst of times". World wide the labor market has tightened. New Zealand of all places has a current unemployment rate of 3.2%. The current US level of 4.6% is below the long term trend and we are close to the end of the mid cycle slump. One can tell that the labor market is tight because real wages have risen at a record pace over the past two years. Hospitals have entered the time when they must "pay up" to stay fully staffed. On the income side, the billing rate to insurance companies and government agencies is already set.


Over the years, the volatility of the business cycle has been reduced through various means. In the health care area Medicare, Medicaid and insurance companies have built-in cost recovery clauses. Hospitals have also entered the "elective surgery business". The growth in surgery is in areas such as plastic surgery and eye care. In the auto industry, times when financing is expensive or difficult are no longer a big deal because car companies build financing into the price of autos and then lease them or provide low interest or even no interest loans. However, now is not the time to repeat a mistake that has been made in the past, the business cycle has not been repealed!


When the product of wages times jobs is high, consumers have extra money to spend. All their basic needs were met before they got the last raise. Raises give off "hot money". A family that spends 99% of its budget has only 1% slack. If the family receives raises equal to 5%, they see a 500% increase in their net disposable income. Suddenly, they might purchase the latest and greatest innovation. This might be the latest One Touch from Apple or it might be liposuction. Suddenly, many a product that was once used only by the wealthy or "early adopters" is a product consumed by the masses.

Most of us are familiar with the sigmoid curve that represents the product life cycle. This curve has been called the s-curve, acceleration curve, the growth curve and the innovation curve. It is also the first half of a bell curve. It is important to emphasize that it is only the first half of the bell curve because companies have become good at sending a product through multiple runs of the acceleration curve. A "hot" product during the recovery phase of the economy, might have cooled off during the mid cycle correction. The successful company will update, revise and improve the product just about the time the prosperity phase kicks-in. The "new" "improved" product then hits the next big growth curve.

While the growth rate typically slows down over time, the total sales numbers get larger and larger and the number of vendors declines. Harry Dent says there is a four stage industry cycle, double S-curve. His four stages are 1) innovation, 2) growth boom, 3) shake out, 4) maturity boom. His nomenclature emphasizes that many a small company might jump in to "get rich" off the latest and greatest new product but, after the initial surge, a lot of the little companies are eliminated though failure or through take over. During the maturity boom, the successful players "build out" the innovation.


What I call the prosperity phase of the business cycle is what Harry Dent calls the Maturity Boom. The nomenclature is not important because it is the investment implications that matter. In each investment sector the type of business that does well will be different. In the health care area, labor intensive services such as hospitals will not do as well as drug companies that come up with the expensive but innovative drug that "solves a problem". Consumers with extra money to spend will pay up for the new drug, even though the manufacturing cost of the drug might be very small. In the area of finance, the established business will seek standard and ordinary loans from traditional banks to expand his established business but in this "mature phase" there will be fewer successful new start ups to need the services of the big investment banks. In the area of air travel, the consumer with extra money to spend will take more exotic trips but they will face higher fares because the king of travel during the prosperity phase is the business traveler. The maturity boom will include a "bounce back" in resort real estate because of extra income but the higher rates for mortgage loans due to the greater demand for business construction loans and tighter lending requirements will "keep a lid" on residential construction.


Technology, innovation and the spread of knowledge all lead to lower volatility. Forty two years ago one could finance a home for thirty years at 5.25% interest, not much different than today. However, attitudes and financing options have certainly changed in those 42 years. In those days, taking out a 30 year mortgage was a painful endeavor. Many a family preferred to live in a trailer park to avoid the pain of making a monthly mortgage payment for 30 years. Suggesting that consumers take out variable rate mortgages, out of the control of the borrower, would have been insanity. A few months ago, when my daughter bought her home, I encouraged her to accept a 30-year variable rate loan from her credit union. She was able to lower her financing cost during a time of high 30-year fixed rates. Only two or three years before, I encouraged her older sister to convert her 30-year variable rate loan to a 30-year fixed rate loan during a time when 30-year rates were low. The key point is that tight money did not prevent either daughter from buying a home while financing costs were high. Indeed, their willingness to buy during times of tight credit enabled them to get better deals.

To make the above story possible, the technology had to be developed to give the credit union the ability to calculate the monthly payment and keep track of the balance owed. Second, attitudes had to change. The attitudes of the bankers and the attitudes of the home buyers. Third, buyers had to gain the understanding that it was time to buy even though the news media said it was not.

Even in the middle of this crazy "sub prime" cycle, I write that the innovation of the variable rate mortgage has done more to smooth out the business cycle than any other innovation. Around the world, "assets are being unlocked". People are less and less likely to live in trailers or shanties for half of their lives while they wait to accumulate the cash to buy a home.

My brother enjoys saying that the social security system is upside down. He says that he needed government help when his first second and third child was born. Young families are the ones who struggle to have adequate food, clothing and shelter. My brother says every parent should be able to draw social security until the kids get through college and then they should work without government stipend until the day they die.

There is truth in my brothers joke. The truth is that people spend most of their incomes when they are young but build significant wealth during their "personal maturity boom". The understanding needed by the public and thus the politicians is that a lightly regulated free market does the best job of distributing wealth. It is funny to hear an old timer or a new timer with an old time attitude say, "people today live like kings". The implication they make is that the higher standards of living we enjoy are somehow sinful. Those who sacrificed by living in a "cracker box" house are apt to view the young person who has little equity invested in a modern house as a fool. In truth, there is nothing wrong about a young person buying a house by using the savings of those who have reached the mature growth phase of their lives. Just like free trade, both the borrower and the saver wins.


Three years ago, when fewer people were working, when wages were not rising as fast and when Americans were about 2 trillion dollars less wealthy than today, the prices of stocks and houses were soaring because buyers could not get enough. The economy is great. Wages and jobs are providing the "great harvest". Peace is breaking out in Iraq. The troops are starting to come home. Hundreds of millions of people around the world have recently moved out of poverty. There are no more poor people in America. Times are good. Americans are currently riding around in big trucks with nothing better to complain about than high oil prices. We have such few problems that we make up stuff to worry about. Larry Kudlow sums up the current situation well when he says "how can things be so bad if everything is good"?

The only thing needed for life to be grand is for attitudes to improve. When Don Hayes moved his last 8% back into big cap growth yesterday, he did so because negative sentiment is so bad. He recognizes that the public will buy heavily once it gets over its current funk. Don will sell these people some of his shares when their attitude is once again, "buy all you can because prices are going even higher". BUY, BUY, BUY.


Before I run, I have to mention that the new oil find in Brazil is turning into another "elephant". The "oil is running out" crowd has told us that there are no more "elephant fields". How many "elephant fields" do we have to find before it is admitted that the "elephant" is nowhere near extinct.

Brazil had total reserves of 12 billion barrels before the two most recent discoveries. A recent discovery bumped total reserves to 14 billion barrels. The new find is estimated to be 5 to 8 billion barrels. It keeps getting better. Just a few years ago, oil drillers had not even bothered to drill into the type of formation where this oil was found. After a deep water "elephant" was found in the Gulf of Mexico just a year or so ago, drillers decided to take a look at this formation type off the coast of Brazil. After the latest discovery, drillers have moved other rigs to similar areas.

The energy bills passed by the democratic house and by the democratic senate both increase taxes on oil companies in order to give more money to corn farmers. How comical? Those who understand business and investment know that the returns demanded by investors does not change just because a business is paying more in tax. In other words, higher taxes on corporations are passed on to consumers. Do you want to pay higher taxes so members of congress can dole out more goodies to corn farmers, wind mill builders, algae pond builders... in exchange for higher campaign donations?

A number of "elephant fields", in places such as Angola, Uganda, Libya, Canada. USA and now Brazil are in various stages of development. Not to mention fields ready for development in trouble spots such as Iraq, Iran, Venezuela and Nigeria. Please don't let the oil market fear cause you to miss the "big turn"! Relief from extra high prices could start when December contracts expire this coming Tuesday.