Consumer spending, which accounts for $10.2 trillion of the $14.4 trillion US economy, is in decline for fairly understandable reasons. Household incomes, the ultimate barometer of budgets for discretionary purchases, have been flat for a very long time and in the past couple years have decidedly trended negative in real terms. Meanwhile consumer debt has reached historic highs thanks to the tireless efforts of financial institutions to figure out new ways for people to spend money that they don’t actually have. The asset side of most household balance sheets is dominated by housing values, and we all know how these have been doing. So these household balance sheets are short assets and long liabilities – not a happy confluence.

All these were facts well before September 2008 – but then came the credit crisis. The difference between August and October can be summed up thus: if you were someone with a good, though perhaps not stellar, credit score and you were thinking about buying a new car in August, by October your thoughts were far away from that as you couldn’t finance the purchase with a new car loan even if you wanted to. The data points in for durable good sales (like cars and other major items that typically require financing) in October and November are dismal and presage a truly terrible 4th quarter GDP. This turn of events, of course, has also driven a stake through whatever remained of the flagging fortunes of US car makers, who are now in the intensive care unit while the Economy Doctors hastily rig up a temporary life support device for a $15 billion injection.

Then came the news last week that jobs disappeared in November by the largest amount since 1974. Yep, the era of “Kung Fu Fighting” and regrettable wardrobe choices for the junior high class picture inexplicably continues to work its cloying influence on our present day Zeitgeist. But even that figure doesn’t properly reflect the magnitude of problems in the US employment environment. Here’s a sobering tale we came across the other week, from a Maureen Dowd op-ed piece in the New York Times. In her November 30 2008 column Dowd introduces Pasadena Now, an online newspaper whose founder pleasantly describes the newspaper business as a “one-way ticket to Bangalore [India]”. All of Pasadena Now’s content is developed and written by journalists in India (including Christmas tree-lighting ceremonies and other arcana local to the Pasadena scene), with the going rate being somewhere around $7.50 for every thousand words (that same thousand words would typically fetch between $200-800 when sourced locally).

The effects and the long-term implications of outsourcing could take up an entire discussion (and probably will resurface later on in this series of articles). But for now let’s return the discussion back to consumer spending. So all these bad trends are depressing the consumer, and so in order to “fix” the economy we have to inject our growth serum into some other part of the body to kick-start the process. But where? Well, the phrase on everyone’s lips these days is “government spending”, for the simple if not entirely correct reason that it seems like something we can just decide to do. We can enact spending-oriented policies and – presto – the economy will grow.

Stimulus math

But the math gets tricky. Say, for example, that consumer spending declines by 2% (that would be somewhere on the rather tame side of current consensus expectations). That would imply a $200 billion decrease to total GDP, going back to our numbers above. So all else being equal (ceteris paribus for the Latin aficionados among us) all we would have to do would be to ramp up government spending by $200 billion to break even – right? And haven’t we already done even more than that with all these bailout thingies that keep coming out every day?

Not really. We did in fact throw money at US consumers back in early 2008 – remember that? That was part of a government stimulus package to stimulate the economy including tax incentives for businesses and a grab-bag of other measures in addition to that $600 check that many of us received from the IRS this year. The government estimated the cost for the entire Economic Stimulus Act of 2008 to be $158 billion – not far from that $200 billion cited above but also clearly not enough to buttress the economy from the howling banshee of the credit meltdown that followed.

So then how much money is needed to fix the patient? Looking back, our whole perspective on money in the world of just two months ago seems rather quaint – remember the $700 billion stimulus package? That caused such a commotion back in late September, what with presidential campaigns being “suspended” and David Letterman blown off and Treasury Secretaries warning that failure to enact radical levels of spending within the next ten seconds would end the Holocene Epoch as we know it.

Of course other quaint little things – like daily swings in the Dow 500 points up or down – also managed to cause a stir back then but barely raise so much as an eyebrow now. Forget $700 billion – we’re into mid-to-upper thirteen figures now. Economists look at our environment and see a landscape so bleak that otherworldly numbers are the only ones that even hold out some faint promise of hope. $5 trillion is not surreal or outlandish – it’s just the ante.

The other thing that is not quite right in that example above is the assumption of ceteris paribus. An injection of $2 trillion or $5 trillion or whatever amount will certainly not result in a state of “all else being equal”. Money injected into the economy through one channel will stimulate others – and now we come to the centerpiece of the Obama team’s vision. Government spending – whether on infrastructure projects or new technologies or bailing out Detroit or Wall Street – should have a kick-start effect on both private business investment and consumer spending to a greater or lesser degree.

What’s the special sauce?

That “degree” really matters – and goes to the heart of what exactly the government decides to do. What’s next? In simplistic terms, if all of the stimulus spending is applied to bailing out Wall Street firms, and if those firms in turn dole out most of it on seven and eight figure bonuses for their employees, then the “kick-start effect” of the stimulus will be pretty dismal indeed. Likewise if it all goes into helping auto and other industrial manufacturers avoid bankruptcy and go right back to their failed strategies of the past then our economy isn’t going to get anywhere near that tipping point where stimulus turns into a self-fulfilling virtuous spiral of growth.

The problem with making choices like this is that none of them are glaringly obvious recipes for success. Investment in things that matter for the long term – education, public infrastructure, new healthcare or energy technologies – don’t always produce great results in the short term. On the other hand focusing the solution solely on new ways to put more dollars into American hands to go out and use at the mall today may provide a short-term bump with nothing to show for it after a couple years (this in fact could serve as an apt characterization for that whole illusory mid-decade growth spurt from 2003-07, with empty Neiman Marcus shopping bags and vacant Miami condos as evidentiary proof). A successful plan has to contain a bit of both – something that stimulates more jobs, spending and investment in the short-term but has a real payoff – greater productivity, new industry sectors etc. – in the long run.

Moreover whatever the government spends will likely be much more productively applied if leveraged by private sector investment. The incoming Obama administration wants to achieve energy independence in ten years, and active investment in alternative energy could be a viable way to get there, while creating jobs and other primary and secondary stimuli along the way. Much more viable indeed this objective will be if Silicon Valley and other entrepreneurial hot spots around the country get into the act and attract sizable volumes of private capital formation via venture capital and small-business lending. If there is one thing the US arguably does better than anywhere else in the world, it is to nurture the entrepreneurial spirit and support the animal spirits of innovation and commercialization of promising new technologies.

Will that be enough to slay the dragons of economic crisis that currently beset us? It is a narrow path through unfriendly terrain, but nonetheless it is a path. It’s the best shot we have. The incoming administration should grab it with both hands and do whatever it takes to lead the way with aggressive, forward-thinking policies that upend the status quo, dispel the formidable resistance of the entrenched powers with a vested interest in the status quo, and communicate directly and honestly to grass-roots efforts in communities, businesses and other institutions about the inevitable sacrifices in the immediate term and the rewards in the longer term. Now that would be change we could believe in.

Investment markets are deep pools in which the twin emotions of fear and greed reside. In observing several cycles of fear and greed that have played out over the past years we have noticed an interesting pattern. When markets are on an upwards roll, when bubble fever is pandemic and greed is the order of the day we often hear a chorus of Pollyanna cheerleaders pronouncing that “this time it’s different!” Presumably they mean that whatever “this time” is just happens to be the one thing that will change the world forever and so stock prices will never, ever come down. Such were the atmospherics that in the late 1990s allowed online pet food to be of such world-changing proportions so as fetch stratospheric price-to-sales multiples without a dime of profits as far as the eye could see.

When the bubble bursts and fear takes over we hear a different refrain, from seemingly more sober-minded types than the bubbleheads of the greed cycle: It’s not different this time. That is meant to be a reassurance to the folks whose equity portfolios have just been eviscerated. Yes, you are down 40% now, but the world isn’t going to end, people are still going to buy stuff, and there’s still a reason to stay invested in the market. Stocks do well over the long term, so just stay put – the sun will come out tomorrow, night is darkest before the dawn, light is at the end of the tunnel – comforting catch-phrases like so many cups of chamomile tea.

“It’s not different this time” is a useful thing to say insofar as, yes, we still have a functioning economy, the everyday humdrum of life continues for the vast majority of us and stocks do indeed tend to outperform bonds over the long term. But there is a tendency to take that notion one step further: “it’s not different this time” as shorthand for surmising that the market will shortly resume its inevitable upward course. For the vast majority of professionals toiling away in the salt mines of Wall Street or the City of London that is a perfectly reasonable assumption based on their own professional experience – they came into the profession sometime after the commencement of the Great Bull Market of 1982–2000. Despite a handful of well-known debacles like Black Monday in 1987 or the Icarus-like flameout of hedge fund Long Term Credit Management in 1998, for that entire 18 year period there was only one calendar year (1990) when the S&P 500 stock index showed a negative annual return. Brokers and money managers became accustomed to dips that were sometimes quite intense (over 20% on that one famous Monday in 1987) but nonetheless short-lived. This begat a confidence that gave rise to “it’s not different this time” with a whole supporting phraseology: “bump in the road”, “soft landing” and “time-out for the market” being a particular favorite for those with young children at home.

This confidence has been rather shaken up in the decade to date. Since 2000 we have already experienced three consecutive negative years for the S&P 500 (2000-2003) and barring some direct intercession from angelic hosts we are firmly on track for a fourth in 2008. Both the Dow Jones Industrial Average and the S&P 500 reached their 2000 highs in the past couple years, which technically is supposed to signify the affirmation of a bull market – but they have subsequently fallen way off those levels and so if the decade to 2007 was really a continuation of the ’82-00 bull market (which already by that time had achieved fame as the longest bull market of the 20th century) then it is sort of a bull market with an asterisk – a Barry Bonds bull market for the sports fans. The economy, which as we write has just formally tipped into negative territory with a -0.3% 3rd quarter GDP reading, shows very little in the way of positive signs of life. Real household income is in decline, consumer debt is at record levels and heading higher still, and the banking system is moribund. Structural problems such as these take more than just one or two business cycles to work themselves out, so we may be in for some more years of anemic economic and stock market performance. If so, then “it’s not different this time” will take on an entirely different meaning: not different than 1906-22, or 1929-54, or 1966-82 – those being the three macro bear markets of the past century.

So that’s the crisis at hand. What about the opportunity?

In any given macro economic cycle the overall markets, represented by broader indexes like the S&P 500 or the Nasdaq Composite, are usually driven by a small number of industry sectors that grow much faster than others and provide forward momentum to the economy. For most of the duration of the last bull market, the one that started in 1982, the twin engines of growth were the financial sector and consumer-related goods and services. Financial institutions as a sector comprised approximately 5% of the S&P 500 market capitalization in 1980; by 2007 that had grown to over 23%. In the consumer sector entire new sub-industries came into being, driven by the proliferation of choice (think of the 70-odd varieties of shower gels and exfoliants at the Body Shop), the micro-segmentation of consumer demographics (Prius-driving suburban 28-37 year-old female office professionals in the $85-110K salary range with a taste for gingerbread-spiced lattes), and the 24/7 availability of the consumer experience for customers and suppliers alike through the Internet.

In fact growth in the financial and consumer sectors was quite closely correlated – banks came up with new ways to give more consumers more credit to spend on more stuff, and the consumer goods and services supply chain rose to meet the challenge with lots of new stuff for them to spend their credit dollars on.

Those twin engines of growth are currently in a vertical downward spiral, and even when they regain their footing they are unlikely to be the engines of growth in the next economic cycle. In terms of the broad economy it is rather hard to predict which industry sector is going to be the next to accelerate from 5% to 25% of broader market capitalization. Here are two that offer better than even odds, though, in our opinion: innovative solutions in healthcare on the one hand and alternative energy on the other. Both presidential candidates have focused heavily on these two areas in their campaign platforms. If Barack Obama indeed becomes the 44th President on January 20th, 2009 then we have two clear mandates in this direction: effective universal healthcare and a pathway to energy independence within the next 10 years. That is not to say that either of these sectors will be profitable overnight. Biotechnology innovations leading to revolutionary healthcare solutions are risky, long-term efforts fraught with high probabilities for commercial failure at critical junctures along the discovery, trial and implementation phases. Alternative energy solutions may present themselves as scientifically viable but economic non-starters.

The opportunities in these two areas and their position in the klieg lights where business ventures and government policies intersect are likely to drive a renaissance in the venture capital market. In a world where many risk-based assets (publicly traded stocks, commodities, currencies, speculative-grade debt etc.) appear systematically unattractive on a risk-return basis, venture capital, though generally considered one of the riskiest asset markets, may look relatively attractive. VC tends to have a very low correlation with other financial assets, so for example if stock markets and real estate markets trend down over a long period investors will want to obtain exposure to assets that exhibit low correlation properties with them – and that enhances the appeal of VC. VC anticipates future, not present-day liquidity, so the idea of taking early stakes in companies with the potential to be leaders in exceptionally high growth markets will, in our opinion, drive private investor money into early stage opportunities in these sectors. There is a lot of investor cash sitting in US Treasury securities today, and that cash is ultimately looking for much higher potential returns. As the dust settles amid the aftershock tremors in global capital markets we will be paying close attention to this funds flow and the opportunities they may help unleash.