Much has been written about the lost decade of Japan, which has now become two decades. Now the United States has lost a decade of its own, which hopefully will not also become two decades. In the 1980s the Japanese economy became overheated: the Nikkei index reached nearly 40,000 but eventually collapsed. Today it stands at about 11,000. The low point of the Nikkei of the last 20 years was about 7,500. In spite of massive spending efforts by the government and near-zero interest rates, Japan has never recovered. Even now, the Japanese economy appears to be headed lower, and deflation seems more likely than inflation.

In the 1990s, the U.S. economy became overheated gyrating from highs to lows to highs under the Greenspan Federal Reserve. Finally, the bubble burst and the economy suffered its greatest setback since the Great Depression. The response of the Federal Reserve was to keep interest rates very low for a very long time. The Fed feared deflation, and Greenspan wanted more than anything to be renamed Federal Reserve Chairman. With interest rates low, every segment of the economy took on leverage. With a government policy that wanted everyone to be a homeowner, housing was inflated. With very little supervision, toxic financial instruments grew to enormous proportions along with spurious banking
practices.
For its part, Japanese borrowing by 2008 reached 172 percent of its GDP, according to the CIA, as the government sold bonds to finance giant stimulus programs. The borrowing percentage is even higher today. Interest rates continue to be nearly zero. These are the conditions in the U.S. today. Will we fare any better than Japan?

The decade of the ’90s began with the sharpest drop in the U.S. economy since the Great Depression, and ended on an even worse note, eclipsing the drop of the beginning of the decade. The Dow Jones industrial average has suffered a 9.3-percent drop in the past decade, the first time the market has dropped over a 10-year period since the Great Depression. And that doesn’t count the losses in purchasing power caused by inflation, or the effect of taxes on returns. The S&P and NASDAQ fared even worse, down 24 percent and 44 percent, respectively. The dollar retreated almost 13 percent during this time, so overall it has been a very bad decade for investors. In the meantime, commodities such as oil increased 210 percent in price, while natural gas declined. Metals, led by goal’s
279-percent jump, generally soared.

Being in the right sector of the market was important but also required nimbleness. Technology stocks, for instance, are down 52 percent for the decade in spite of a 63- percent increase last year. Consumer goods were up 37 percent in the decade, in spite of the collapse of the automobile industry. Health care was up 21.7 percent in the decade and financials were down 20.6 percent as many banks collapsed or had to be propped up by the government.

Homeowners saw their home values fall while the cost of a pair of jeans at Gap soared 20 percent, the cost of a Big Mac jumped 10 percent, and a year in college rose 10. No wonder people felt less wealthy and feared the future. Job losses mounted.

The government’s massive stimulus program and spending may not have lifted the boat, but may have prevented it from sinking further.

We can expect more of the same from the government. It will borrow massive amounts to fund programs and leverage itself beyond any previous measure. Like Japan, U.S. will borrow more than its GDP, and interest rates will remain low. Will the U.S. also experience another lost decade, or will there be a divergence? Is today a historic buying opportunity or will there be doldrums? We have many problems ahead of us.

Housing is still a big issue; unsold houses have yet to be absorbed, and as I have said before, we cannot begin a recovery until house prices stabilize. Unemployment remains stubbornly high and may go higher, although there is some evidence of business hiring. Commercial loans must be rewritten or commercial property will suffer the same fate as homeowners. Banks may have to absorb yet more losses, and they know it. Banks have been hoarding money to save themselves, at the expense of other businesses. The commercial lending market has not stabilized, and must do so for any recovery.

Consumers are still de-leveraging their balance sheets at the cost of spending, although Christmas spending was stronger than most expected. Profits will recover as businesses continue to cut costs dramatically. Employment will follow, but we need some more top line growth, which means consumer spending. With interest rates low, the dollar remains under pressure, but this helps export growth. The question is whether investors will continue to buy U.S. treasuries in the quantity they are being offered. And, by the way, how much of the debt is actually being sold, and how much is the government simply printing money to pay creditors? There are many questions to be answered before we can know our future path, and by the time we answer them it will be too late to act.

What we can see is that during the last disastrous decade, those investors who had a prudent asset allocation of 50 percent bonds, 25 percent stocks and 25 percent international stocks, and who stayed the course, and who invested $1000 per month with annual rebalancing, saw their portfolio rise 250 percent against the 24-percent loss of the broad market. That isn’t a bad result for slow and steady.
William Rutherford is the founder and president of the Portland company Rutherford Investment Management, listed in Barron’s as one of the nation’s leading separate account managers. He is also the author of a critical appraisal of Alan Greenspan’s term as Fed chief, “Who Shot Goldilocks?” Contact him at 888-755-6546 or
wrutherford@rutherfordinvestment.com

As I have stated before, the economy won’t hit the bottom until housing prices stabilize. Recent reports show that single-family home prices in the U.S. posted a slight 0.2-percent increase in the third quarter. This was the first quarterly gain in two years. The biggest increases were in the West, despite California, Arizona and Nevada being some of the most troubled states. Sales of new homes unexpectedly increased in October.

Sales of new single-family homes increased 6.2 percent. Sales of existing homes increased 3.7 percent. All of these reports augur well for the economy.

Also, job losses in November slowed to 11,000, the fewest since this recession began, and the unemployment rate fell unexpectedly, indicating that the economy is in a healing process. Unemployment remains stubbornly high, at around 10 percent, although most believe the real level is much higher. Nevertheless, payroll data reflect a notable improvement in the jobs market. Some think that firings have been too aggressive and that firms will have to start hiring in the next few months. There is a long way to go, however; nearly 8 million people have lost their jobs since the start of the recession.

Average hourly earnings rose a penny in November and the average workweek expanded by 0.2 hours.
Another report showed U.S. factory orders rose for the sixth time in seven months in October, posting a larger-than-expected gain of 0.6 percent. In the third quarter, the U.S. economy grew 2.8 percent, expanding for the first time in more than a year.

The economy still faces stiff headwinds, including higher taxes and more regulation. But perhaps the strongest is banks’ reluctance to lend. Banks have taken billions of dollars from the government, put the money in a lock box and thrown away the key. They are able to borrow from the government, essentially free, and lend money at higher rates, pocketing huge profits. Additionally, they are making billions of dollars from trading gains with the rising market. According to a Federal Reserve survey of senior loan officers, banks continue to tighten lending for loans of all types, credit cards, business and real estate – even to prime borrowers. Only six banks out of all those surveyed reported easing of loan standards. Small businesses and consumers are the hardest hit. Small business contributes significantly to the overall economy, and the consumer is 70 percent of GDP, but loan activity is at deep recession levels.
Bank loans outstanding peaked in October 2008 at $7.3 trillion. Now they stand at about $6.7 trillion, an 8-percent decline. The money supply fell by 25 percent in the Great Depression, and that is why the Fed is buying mortgages. The Fed does not want to see a further decline in the money supply because that would likely mean a depression. But as fast as the banks take in money, they lock it up. If the Fed were not proactive, the money supply would be falling by 1 percent per month. http://djcoregon.com

Even as the banks fail to lend, they pay out billions of dollars in bonuses. Democrats can take some consolation in the economic numbers. The ruling party was, and maybe still is, headed for an election disaster next fall if they economy does not improve; it cannot take much comfort in the division between Wall Street with its billion dollar bonuses, and Main Street, where credit is unavailable and job prospects are dim. For the time being, expect the Fed to be lenient with interest rates and monetary policy. Expect the government to take on huge amounts of debt as it seeks to stimulate the economy. Expect the dollar to remain weak as interest rates remain low and government spending remains high. Expect the politicians to worry a lot about reelection.

William Rutherford is the founder and president of the Portland company Rutherford Investment Management, listed in Barron’s as one of the nation’s leading separate account managers. He is also the author of a critical appraisal of Alan Greenspan’s term as Fed chief, “Who Shot Goldilocks?” Contact him at 888-755-6546 or wrutherford@rutherfordinvestment.com.

Are Investors Ready for Higher Interest Rates?

If the economy keeps growing, it hastens the day when the Federal Reserve ends the era of 0% interest rates

By Ben Steverman

Data showing the U.S. economy is growing again has renewed the debate about where interest rates are headed—a question with big implications for both the economy and investors.

The U.S. gross domestic product report released Oct. 29 showed that the economy grew by 3.5% last quarter, a higher percentage than many were expecting, and fixed-income markets took it as a sign that a rate increase will happen sooner. Treasury prices fell after the release of the GDP figure, and the yield on 10-year U.S. Treasuries rose 0.08 points to 3.5%.

That’s still a historically low rate, reflecting the fact that the Federal Reserve is holding the short-term federal funds rate near zero in order to stimulate the economy. It’s the reason why yields on bank savings and money market accounts are so paltry.

Such low rates aren’t sustainable for long periods of time out of fear, among other things, that low rates can overheat the economy, spark inflation, or drastically devalue the U.S. dollar. “At some point the Fed needs to be thinking about tightening monetary policy,” says Villanova School of Business economics professor Victor Li.

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