September 19, 2019 in Articles & Newsletters | by Chris Pate

SECOND QUARTER 2019

True North Second Quarter

Every era brings certain trends and for the last quarter century society has been inundated with rankings and lists as the internet has grown and attention spans have shrunk. This fad first got legs at the end of the 1990s as people raced to quantify the unquantifiable “best of” everything from the 20th century, and it has accelerated recently as a reflection of the desperation of modern media outlets in the internet age. Companies battle for every last click and view, and ranking lists make for reliable click bait. Common lists include the best films of any given year/decade/era/genre, any athletic achievement ranking that one could imagine, the best hotels and tourist destinations, etc. There are even websites with rankings of the top rankings lists. Of course, most of these are created by some faceless, self-anointed “experts” giving their baseless opinion about the subject du jour.

Some lists, though, actually involve more quantifiable metrics. The Forbes 400ranks America’s wealthiest people, just as commercial aviation’s on-time rankings help travelers determine whether their favorite airline’s poor reputation is truly deserved. Certain economic statistics, similarly provable, provide real, impactful data. One ranking in the news recently compares the length of economic expansions in modern recorded history, and as of June 2019 we are living in the single longest expansion ever. The previous best was set in the 1990s at 120 months, and the current expansion sits at 121 months and counting.

US business Cycle Expansions and Contractions

According to the National Bureau of Economic Research, there were 33 business cycles in the United States between 1854 and 2009. As recently as the 1980s the prevailing wisdom was that economic expansions lasted no more than four years. Throughout the 33 cycles, the average expansion lasted 39 months and the average recession lasted 18 months. The only thing as sure as death and taxes over this period was the constant back-and-forth of the most reliable economic trend in history: the boom-and-bust cycle.

If the bust is inevitable, today’s obvious trillion-dollar question revolves around when the next one is coming. Although it is impossible to know with certainty, responsible investors peel back the onion on this topic regularly and glean any information they can from the available economic data. One question that sticks out: Why have we seen the two longest-ever expansions within the past 30 years? Said differently, are 10-year expansions the new normal or an anomaly? Considering what has led to such lengthy periods of growth helps investors envision how things could look after we come out the other end.

Government stimulus seems to be the most stock answer for what has led to the length of the current run, initially through the Federal Reserve’s QE programs and more recently with the Trump tax cuts. The 1990s expansion was very different though. Many factors contributed, but at the forefront were productivity gains at the corporate level ushered in through technology-related efficiencies. A healthy portion of that improvement came in the form of inventory and supply chain management. Large corporations invested heavily in technology throughout the late 1970s and 1980s, and the 1990s is when systems finally communicated with each other effectively. Andy Kessler’s Inside View column in The Wall Street Journal on July 7, 2019, argued that technology-enabled management of inventory cycles has been the single most important contributor to cycle smoothing:

In the previous era, before pervasive computing, economies would live and die by inventory cycles. Heck, biblical times record seven years of feast and seven of famine. The expansion starts, consumers buy, investment and hiring ramp up, wages and prices rise, inflation emerges, consumers buy ahead of price increases, investment peaks, inventories build, consumers are tapped out, recession starts, inventories are drawn down, and layoffs begin - then start all over every four years. Until recently, price signals didn’t travel very fast, and inventory tracking used clipboards.

AtariIn a micro version of this cycle, the video game industry had a huge bonanza in the early 1980s that ended in ’83 with bust of the highly anticipated “E.T. the Extra-Terrestrial” game. Warner Communications literally buried about 700,000 unsold cartridges of “E.T.” and other titles, and lost more than $500 million. The semiconductor industry got stuck with loads of chips in inventory that had to be written down. It was ugly. After a similar inventory mess related to then-newfangled personal computers, the tech world started implementing just-in-time delivery. Companies like Compaq would ask for chips to be delivered Tuesday for PCs shipped on Wednesday. This gradually smoothed out the cycles of a very volatile industry.

Alamogordo NMThirty-six years later, much of the global economy has perfected this just-in-time supply chain. Digital cash registers and bar codes log consumer purchases. Logistics software allows manufacturers to track every production detail everywhere on the globe. Data is fed into giant databases that forecast demand. Manufacturing, transportation and retail are a highly choreographed water ballet of delivering inventory right before it’s needed. Exactly the right amount of toothpaste is magically dropped onto Walmart shelves each night.

While corporate inventory management contributed greatly to the productivity increases of the past few decades, other innovations within management, technology, logistics, and transportation can be lauded as well. If all these corporate efficiencies really do act to smooth out the boom-and-bust cycles that investors are used to experiencing, then what catalyst will be the proverbial wrench that causes the machine to break next time? The 2007-2008 catalyst was overwhelmingly financial issues, rather than operational, breaking the system. An over-abundance of consumer and corporate debt – much of which was related to the housing market – overwhelmed banks and mortgage companies like a tsunami, starting in 2007 and culminating with the Lehman bankruptcy in September 2008. The real economy soon followed suit as consumers and companies panicked and stopped spending.

Housing Starts Historical Chart 1960-2015

So what happens this time around? Economically, within the corporate world, this cycle’s expansion has been exemplified by slow and steady real growth rather than the rocket ship profit gains experienced in the late 1990s or mid-2000s cycles. Valuations have seen the real gains and are at the high end of historical norms while still not approaching bubble levels (in most cases anyway; there are some exceptions, such as certain venture-backed companies that leave us scratching our heads). As with the previous cycle, some of these investment gains have been fueled by increased debt loads, but most of the increased debt in the world today is stashed in different places compared with the last cycle: primarily on the balance sheets of governments themselves. When things go wrong, governments have access to more levers than mortgage companies and banks. Government-funded stimulus will likely come quickly and aggressively when economic circumstances look dire. Today the real question revolves around what the catalyst for ending this cycle will be. The saying goes that bull markets don’t die of old age, but this one does appear ready for the nursing home.

Economic statistics are a bit like the Forbes 400 list: Consider the data output to be an educated guess. They may not be quite as subjective as that ranking of the “Best Game of Thrones Characters” or “Most Outrageous Sports Brawls,” but neither can we set our watch by them. The underpinnings of today’s economy in the United States are strong. As would be expected, corresponding asset prices are high. Investment bargains are in short supply. A well-known economist said early in this cycle that we were in a “muddle through” economy, akin to a slow train climbing at steep grade. A more appropriate current description might be a late model race car moving quickly on a windy mountain road. Everything is running nicely at the moment, but when asset prices are this high there is little margin for error.

Top Ten Game of Thrones characters

About The Author

Chris Pate is Managing Director of the Fort Worth office and joins True North as a result of the Western partnership that became effective January 1, 2019. His duties include managing the firm’s Fort Worth presence and sourcing/evaluating investment opportunities for clients of the firm.

Chris previously spent eight years managing the investment activities for Western. His responsibilities included oversight of both public markets and private investments within Western’s investment advisory operations, including equities, fixed income, alternatives, and hard assets.

Before joining Western, Chris spent 11 years at Q Investments, a $2.5 billion (as of 2011) Fort Worth multi-strategy hedge fund founded in 1994. He graduated Cum Laude from Texas Wesleyan University in May 2000 with a Bachelor of Business Administration in Finance and Economics.

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