Coming to terms with the ‘new normal’

Repeatedly over the course of the past month, I have read equity analysts who are puzzled by the prolonged summer rally in the stock market, especially when viewed alongside the likelihood of a halting corporate earnings environment. For instance, S&P’s chief investment strategist went on the record to claim,

“We don’t expect this recovery to be spelled with either an upper- or lower-case ‘V’ but rather a lazy ‘U’ … Today’s investor appears to be more willing to embrace the upward price trend than accept the weaker-than-normal economic growth story or the questionable confidence that the huge 2010 EPS estimate inspires. We think the risk/reward tradeoff doesn’t warrant increased exposure.”

This seems on overly tactful way of saying that the investors currently bidding up the market are doing so with very little regard for fundamentals. I largely agree. I have participated in the rally this summer along with everyone else, and while I didn’t beat the major indices during the June-July-August time period due to an excess of caution, I still outperformed my expectations for the summer months. Good enough for me. I went 50% cash this week, and if I leave money on the table, so be it. That caution served me well during 2008, and I see no reason to start overriding what my gut tells me today about the markets just because the markets are being pushed higher by weak companies.

In a service-heavy economy like ours, corporate earnings are driven by the consumption patterns of businesses and individuals. The problem for us is that – in my opinion – we are currently going through a generational shift in those consumption patterns. For too long, these patterns were artificially enhanced by housing values and easy credit. As households and businesses de-lever, consumption will necessarily decrease and will do so on a rather long trend line (over 3 to 5 years, perhaps longer). This is the new normal, but it is difficult to accept for some folks.

Certainly, the government doesn’t want to accept it. After all, what was the Cash for Clunkers program but an overt attempt to swim against the macro-economic current by inducing greater consumption artificially. The Fed’s policies are aimed at the same target: by pumping into the economy huge amounts of liquidity, the Fed basically seeks to re-inflate (or just stabilize) asset values, principally the stock market. This can work – and has worked – in the short term, but it also, potentially, touches off a cycle where similar government interventions will become structurally necessary to keep the economy aloft. Not a great idea for the long term sustainability of the economy at large.

The government’s refusal to accept the new normal is best seen in budget projections. Only within the past week have government economists come round to the notion that our deficits are going to be much, much higher toward the end of the current projected time period. Writing for Forbes.com, Joshua Zumbrun summarizes the situation:

The Congressional Budget Office and White House both released alarming projections for the long-term deficit on Tuesday. When it first unveiled its budget in February, the White House said the deficit over the next 10 years would be $7.1 trillion. On Tuesday, they revised that figure to $9 trillion.

The revision reflects a more pessimistic, or simply more realistic, analysis of the economy. What it does not reflect is any concession that it will not pass its budget initiatives.

Sad, but true. Even when staring at the new normal right between the eyes, we go about our business, as if nothing has changed. These new budget projections confirm what most sane folks could already sense – that this latest crisis has impaired our economic prospects for quite a long time, perhaps as long as a generation, perhaps permanently. Even before this latest crisis, our long-term public finances were in bad shape, especially when considering that Social Security will, one day, become an expense rather than a source of cheap extra revenue.

That we find it impossible to align projected government expenditures with the new normal is quite serious business.