stuff for ponderment

Demographics and U.S. Economic Recovery
Revisiting the Conventional Wisdom

As we know all too well, the pace of economic recovery in the U.S. has been agonizingly slow. Economists and pundits offer a range of reasons and explanations. Recently, however, several reports and studies, summarized in a recent article in The Economist, suggest that two factors explain the slower recovery rate – a major shift in demographics and a slowdown in the rate of technological innovation and productivity.

Presumably, some combination of labor, capital, and technology explain a country’s economic growth. More people in the work force, more capital invested in productive enterprises, and better technology driving productivity add up to economic growth. Yet today, the share of the U.S. population in the work force is 63.5%, the lowest in more than 30 years.

The obvious explanation for this is the absence of jobs in the on-going aftermath of the Great Recession. But the demographics have changed, too. Since the end of 2007, 11.6 million people have reached 16 years of age and, in theory, are eligible to enter the work force. At the other end of the spectrum, the baby boomers are retiring from the workforce at accelerating rates. As the share of population under 25 and over 54 increases, the participation rate in the work force decreases.

To the extent this decrease in the work force does reflect a shift in demographics and not the direct impact of bad economic times, the potential for economic growth diminishes. This negative factor could be offset by a burst of technological innovations and renewed productivity, but as a study by John Fernald at the Federal Reserve Bank in San Francisco recently concluded, productivity powered by technological innovations began to slow as long ago as 2003 and has not changed much since then.

So even if Washington, D.C. were to get the economic policies right, the underlying dynamics of the U.S. economy suggest slower growth in the longer run and certainly slower growth in a period of economic recovery.

Investment Returns and the Credit Cycle
The Credit Cycle versus the Business Cycle

The Economist recently reviewed a new publication that suggests the greatest investment returns follow the credit cycle rather than the business cycle. Under conventional wisdom, the time to invest is during the upswing in the business cycle when the economy is booming. The time to disinvest, it follows, is at the onset of the downturn in the business cycle. But there are several problems with this approach:

        First, many publicly listed companies are multinationals that are impacted by business cycles in numerous countries, not all of which move in unison.

        Second, in periods of economic growth many companies issue additional equity, which dilutes investment returns.

        Third, in periods of sluggish growth corporate profits and stock prices frequently rise as fast as they do in better times. Or faster. Witness recent experience in the U.S. market during a period of marginal economic growth.

The better approach, according to Thomas Aubrey drawing on the work of a 19th century Swedish economist, Knut Wicksell, is to focus on the credit cycle rather than on the business cycle. If the return on invested capital exceeds the cost of capital, invest. If not, disinvest.

Aubrey uses return on assets as the measure of the return on invested capital. For cost of capital, he uses an average for five-year government bonds. Buy a company’s stock when the return on assets exceeds the cost of capital, and switch out of equities into bonds when the cost of capital exceeds the return on assets. With the exception of three years between 1986 and 2011, such an approach to investing outperformed the U.S. equity markets.

(from Shockproof! Training)