- in Investing
I've been watching U.S. and global stock markets for decades. In my judgment, the key medium-to-long-term risks to the U.S. stock market have remained the same since at least the early 1990s. There are two main risks--the overall debt load to the U.S. economy and demographic trends. Let's take each of these stock market risks in turn and explore why I don't think these concerns are enough to keep you from investing.
Stock Market Risk - The U.S. Debt Load
The U.S. debt load (amount owed by the federal government) stood at approximately $19 trillion as of early 2016. This represents an estimated 104% of the entire size of the U.S. economy. This degree of indebtedness in peacetime (not fighting a World War) is extraordinary, disturbing, and the debt continues to rise. In addition, there appears to be no appetite on the left or right of the political spectrum to try to get the debt under control, largely due to the demographics of which population cohort votes the most in the U.S. (old people).
The U.S. deficit and debt used to worry me more. In fact, several of the countries where I served as a diplomat defaulted on their debt soon after I left. I've seen this up close. A default is an ugly event that triggers depression-style conditions in the country where it takes place.
Nonetheless, I am less concerned now about the United States' debt load. Here's why.
- First, it appears that dominant economies that have their own currency are held to a different, more tolerant standard by the global markets in terms of how much debt they can carry. By this, I mean that whereas a Greece or Latvia will be crushed by the so-called bond vigilantes (hedge funds) as soon as their indebted economies show stress, countries like the United States and Japan are not.
- The fact is that the authorities in these countries can print money like mad and buy their own debt in a crisis. Before the financial crisis, I would have thought such a "quantitative easing" strategy of money printing would lead to total disaster--either a hyperinflationary spiral or a debt collapse as the world lost faith in a country's ability to repay its debts.
- In particular, the experience of Japan has altered my thinking. Japan's debt to GDP ratio stands well above 200 percent at present. I would never have dreamed that global markets would allow Japan, a low growth economy with a very old population, to build up this level of indebtedness. It is ugly. It is disturbing. But the status quo has held for many years longer than I would have expected. Indeed, there is a famous hedge fund manager named Kyle Bass who make a fortune betting against U.S. mortgages in the financial crisis as well as against Greece's sovereign debt. He has been flat wrong on Japan for years now.
- It is now clear what the playbook for the principal central banks will be when debt dynamics begin to spiral out of control. They will print money and buy bonds directly to stave off a nosedive in bond prices. Particularly as countries' debt loads get worse and worse, keeping interest rates low will be only more important (forcing intervention by central banks).
- In particular, as the U.S. dollar is the dominant reserve currency of the world, the U.S. will be given even more leeway than other countries as our debt low goes up.
- We now know the playbook if things start to get out of hand--and it appears all large global central banks agree on this approach. Within this context, stocks will be a much better place to park your wealth than cash--as the purchasing power of cash will become eroded. Another name for this process of keeping interest rates artificially low and boosting inflation is "financial repression." This is something the United States has done before (after World War II) and will probably do again. With financial repression, you can continue to provide health care and general benefits for the elderly in your population. You print the money to provide these services--at the cost of higher inflation. The people who "pay" for this are those with savings whose wealth is eroded due to inflation.
All of the above is not how I would craft economic policy if I were a policy maker. I would get U.S. spending under control--mostly through freezing the rate of spending increases, but also through higher taxes if necessary. But this is the world we live in. Once the debt becomes even more unsustainable, the only path for central banks will be to print money to generate higher inflation that "inflates away" the debt.
Stock Market Risk - Demographics
In the 1990s, I was aware that the baby boom generation would start to retire in the coming decades. I was concerned that this wave of retirements would lead to the widespread selling of stocks as the older generation sold these assets to pay for living expenses. However, if you look at stock ownership in the twenty-first century, a very significant percentage of stocks are owned by super-high net worth individuals and institutions. There comes a level of wealth, around $10 million in assets, where the investor never sells his/her stocks. They just ride out the ups and downs, collect their dividends, and plan to pass the assets on to their heirs. I do not believe baby boom retirements will have a noticeable impact on asset prices. What's more, with so much wealth concentrated in the hands of the super wealthy institutions, were stocks to get beat down to attractive values due to baby boomer sell-offs, the institutions would buy up the stocks as a value play.
(Bonus Worry) Geopolitical Shocks
The two above risks, debt and demographics, are the key concerns. However, I should mention an additional concern that often comes up when considering stock market risk--the threat of geopolitical shocks. Geopolitical risks always exist. At present, the two greatest geopolitical threats to the United States in the medium-term (after our own debt dynamics) are North Korea's growing and more lethal nuclear capabilities and China's growing assertiveness in Asia. These risks will be with us for the foreseeable future.
(Sidebar: In the immediate wake of the September 11, 2001, terrorist attacks on the United States, legendary investor Sir John Templeton instructed his brokers to buy millions of dollars' worth of airline stocks on September 12, 2001. According to a book by his granddaughter, his specific instructions were to buy any U.S. airline stock that dropped by at least 50% on September 12. You could argue that this was a mercenary move, but it turned out to be quite profitable and demonstrates contrarian investing at its most extreme--and the ability to recognize that the investing world usually overreacts to geopolitical shocks.)
The Market Always Seems Overvalued
None of the above is a commentary on the overall valuation of the stock market. U.S. stocks are currently richly valued by historical norms. But, to me, the stock market is always overvalued. The point is that I believe we should invest in stocks even if we think they are overvalued unless we think they are in an extreme bubble. Those who invest based on worst case scenarios, in my experience, never build assets. Their attachment to doom and gloom macroeconomic scenarios keep them poor.
So that's it. The two key stock market risks (plus a bonus). Nonetheless, I don't think these risks should keep you from investing. But what do you think?