Since the start of the economic recession of 2007, 2008 and 2009, the US economy has lost more than 8 Million jobs.  In addition, the normal rate of population growth dictates that the economy should have gained 2.7 Million new jobs to keep pace.  This leaves the US economy roughly 11 Million jobs short of a “normal” rate of unemployment—this number is worse if you count the number of part-time workers looking for full-time work (source The Wall Street Journal April 12, 2010)

If the economy was to quickly correct and begin generating new jobs at an above average pace of 300,000 jobs per month, it would take nearly eight years to gain enough jobs to return to employment levels of 2006.  Given the current level of unemployment and the economic headwinds created by fiscal and monetary policies of the past three years, it is difficult to see that we could experience such a tremendous recovery.

Given the data, we are likely to see an economic recovery that fails in the incremental creation of new jobs of the order and magnitude that returns to the US economy to a reasonable level of employment.  In fact, the recovery of 2010 looks to be a true unemployment recovery.

In an economic recovery that fails to generate adequate employment levels, companies increase earnings through increases in productivity rather than expansion of employment.  Productivity increases are a result of a more-efficient use of capital and an application of technology, processes and procedures that generate profit gains without a large number of additional employees.

Unfortunately, because of the productivity gains and the skills of the long-term unemployed, many of the jobs that have been lost will never come back in the United States if at all.  This is supported by the fact that the current unemployment rate for college-educated graduates is only 5.0% while the unemployment rate for those without a high-school degree is 15.6%.

A large population of unemployed quickly becomes a drag on an economy.  Unemployed populations spend less, pay less in taxes (or negative taxes in the United States through welfare) and are not able to contribute to the growth, expansion or production gains of an economy—the unemployed become a real, unused resource of the economy.  Financial resources are needed to artificially support the unemployed and the return on those resources is negative.

As we have seen throughout economic history, achieving a high rate of employment is a key to a long-term, sustainable economic expansion.  A full expansion is likely not achievable without a high level of employment.  A recovery during times of weak employment gains is ultimately a weak economic recovery.

First, the Securities and Exchange Commission (SEC), Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) all have rules and regulations that somehow failed in their application.  The rules were good, the laws were good; however, the application of the rules failed to identify risks and violations on the part of some industry participants.

If the rules are there and were somehow not applied, we can hardly believe that additional rules will fix the problem.  There must be a better way to identify problem areas and apply rules that we already have.  Rather than create new rules, can’t we just enforce the rules we have?

Second, the large banking institutions found themselves in trouble, in large part, because of the large amounts of leverage in their investment structures that were allowed to exist because regulators allowed it.  Invariably, investments will sometimes, not turn out the way they were originally intended.  As parts of these highly leveraged institutions began to have trouble, it caused a ripple effect throughout the institution that grew and became contagious.

If the regulation can effectively manage or enforce rules regarding investment and institutional leverage, the larger risks of the financial markets would be reduced exponentially.  The current rules and regulations allow regulators to establish limits on leverage in most markets.  If these current rules had been effectively used, it may have minimized or eliminated the problem as well as the inter-firm ripple effects.

Third, because of the size of financial leverage and the transactions in the system, firms found themselves exposed—directly and indirectly—to problems at competitor banks.  If one bank went down, others were also exposed in a significant way.  This exposure existed because certain, very large, transactional instruments (primarily swaps) were held as privately negotiated transactions.  As one firm owed another firm a large amount on the basis of a transaction, the potential default of the owing firm would have caused a sizeable problem for the receiving firm.  This is because the contracts were not standardized, cleared on a formal exchange or structured with an intermediary guarantor.

By bringing these securities onto formal exchanges and standardizing the contracts, an intermediary counterparty could essentially eliminate this counterparty risk.  Based on the experience of the past two years, this is one change that could be significant and effective.

The proposed 1,300 page bill in congress is more an attempt to prevent all future recessions and less an attempt at a solution to the core problem.  The significant danger in a bill of this type is that as more regulation is created, more work-around systems will also be created and more rules will not be enforced because of the complexity of the regulatory system.  It seems that as we create more regulation, we make it more difficult to identify the next disaster.

The solution to the regulatory problem is first, enforce the laws already on the books; second, reduce the amount of leverage in the system; and third, bring all products—including products that have yet to be created—onto regulated exchanges, in standardized contracts with clearinghouse services.

Unfortunately, history has shown us that gains in the number of American jobs occurs very slowly, over an unusually long period of time, even as an economic recovery gains speed. For many unemployed Americans, that will continue to look for jobs over the next twelve to eighteen months, it will continue to seem that the economic recovery is passing by without them.

As an economy begins to slide, companies cut back in stages. Many of the early stages of cuts seem to be easy to cut. Sometimes businesses have under-producing departments or less efficient product lines. A severe economic downturn makes decisions regarding these departments and divisions easy.

As an economic downturn transitions into a recession, businesses feel an even greater need to cut back but few easy decisions are available. More importantly, employees quickly recognize the possibility that they may be the next employee let go. Employees begin to work harder, staying longer hours and offering to do more.

In addition, businesses generally have a rate of productivity improvement that doesn't slow down during an economic downturn. In fact, while factory utilization and equipment productivity may decline, worker productivity tends to improve significantly. All this combines to reduce the demand for additional employees. Businesses become more demand flexible and can postpone the hire of additional employees for a period of time.

As we look into 2010, the severe U.S. recession of 2007-2009 will certainly have a rebound in business activity. Unfortunately that will not immediately lead to additional job creation for many months and even years to come. Government efforts to "create or save" jobs tend to be very poorly thought out and even more poorly executed. There is no reason to believe that this time will be different.

In the long run, economies move towards equilibrium. Government incentives, stimulus bills and monetary stimulus can incentivize an economy away from equilibrium periodically. However, the further away from equilibrium the economy moves, the more dramatic and difficult is the snap back towards balance. In the United States, we have been offering incentives that accelerate growth in our economy--low interest rates, tax credits and job creation stimulus. Eventually, the economy will move to equilibrium and the price will have to be paid.

As the economy paces through extraordinary times, it can sometimes seem that the market is simply a tide that moves all boats—and the unfortunate swimmers—in the same direction.  The market has been in this mode from 2007 and 2008 as the markets and economy deteriorated; and, it has clearly continued through the market gains of 2009. 

In 2008 it seemed that all investments—stocks, bonds, commodities and real estate—all fell together.  The supposed diversification benefits had disappeared.  From March 2009, it seems that any investment you could throw a dart at has gone up 50% or more.  While this has clearly been the case for the past few years, the markets, in the long run, don’t behave this way—the market rewards some winners and punishes some losers.

As the market cycles through good times and bad, times of extreme economic and market stress are evidenced by traditional asset classes moving together in a single direction.  Core market growth periods—which tend to dominate over longer time horizons—are evidenced by some assets doing markedly better than others.  As the economic cycle goes—assuming government policy doesn’t get in the way—2010 should see a transition from the extreme market movement period, of the past three years, into a more “core growth” oriented period which hopefully will dominate the next few years.

As a continuation, the recent market moves have a biased view of fundamental economic announcements—when good news is announced, the market rallies; when bad new is announced, the market rallies.  This is the inverse of the evidence of 2008. 

In fact, just this morning, the ADP Employment Data report was much worse than expected and the market rallied 1%.  Yesterday, on the heels of a very disappointing retail sales report, the market rallied 1.5%.  As one analyst said, “It seems that flat to slightly disappointing is the new up for this market.”

This is an indication that there is more going on than simple traders paying attention to fundamental economic information.  Over time, the market will begin to react appropriately to market and economic fundamental information.  As the market begins to react appropriately in the next year, (i.e. rallies on good news and sell-offs on bad news) we expect that the market would be entering a normalized period which may persist through an extended recovery.

While I make it a practice to not give financial advice in a column such as this, as we head into the end of the year, it is a good time to visit with your financial advisor and reflect on your investment, tax and financial plan objectives. 

Given that the market has improved significantly, it is a great time to balance risk versus return and to re-visit your stated investment objectives.  In the past three years, the volatility has given all of us an opportunity to assess our own tolerance for risk.  Although I don’t think the market will crash in 2010, the market is due for a healthy pause and a transition away from the extreme markets of the last three years.  With where we have been and a better understanding of risk tolerance, this is a good time to make sure you are accomplishing your goals.

Although the financial markets have recovered significantly, the business environment, employment situation and bank lending capacity seem to indicate that we have not yet recovered from the economic downturn.  In addition, as we face increasing uncertainty about healthcare, environmental policy and taxation, we look at the current economic environment we have to ask, is this really a recovery?

As the Commerce Department calculates the GDP statistics, specifically the rate of growth in GDP, the calculation is relatively simple.  GDP is the simple addition of Consumer Spending + Business Investment + Government Spending + Net Exports.

The initial GDP statistic is an estimate based on limited information and slowly over the subsequent months, the statistics are revised based on new information which makes the statistics more reliable as they incorporate more data and less estimation.  If we think about the data as a sum of the parts, the parts probably tell more of the story.

The consumer spending part of the equation has fallen significantly in the last two years.  The economic crisis has clearly taken a toll.  The result of the unemployment situation and the pending increases in taxes would have us believe that a recovery for the consumer is not yet on the horizon.  There is nothing that impacts a consumer’s willingness or ability to spend more than having a job and this is clearly shown in the data.  In addition, the foreshadowing of future tax increases by the current administration is a significant deterrent to current consumption.  All combined, the environment for the consumer is difficult and shows no signs of getting better any time soon.

Business investment has also seen a significant decline in the last two years.  Businesses, in many cases, are unable to gain access to credit because of the financial crisis; this forces businesses to cut back on less profitable parts of their business.  In addition, over the next 36 months, a large amount of business debt is coming due, most of it issued during times of low interest rates and better economic times.  This debt will have to be repaid without the prospect of being able to re-issue that debt on favorable or even affordable terms.  Combined with an increasing tax load and health care obligations being proposed, business investment is on the decline and will probably continue to decline for the next few quarters in most parts of the economy.

Net exports, as a calculation net of imports tend to be a smaller part of the equation; however, as a net importer of goods and services, the United States tends to experience an economic drag as a result of this aspect of the calculation.

Government spending seems to be the only part of the GDP equation that is growing; and, in most parts of the economy it is growing quickly.  In fact, it grew so much in the last quarter that it completely overshadowed the declines in consumer spending and business investment to create positive GDP growth.  The long-term challenge to government spending programs is that they can only help in the short term.  In the long-run, the government doesn’t produce or create anything as effectively or efficiently as the private sector.

In the long run, an economy cannot spend its way to recovery, it must produce its way to recovery.  In order to recover, the United States must produce...not spend.

The answer to the question, “Is this a recovery?” is based on the calculation above and yes, moving from negative growth to positive growth is technically a recovery.  Unfortunately, this means little to the majority of Americans who are working longer hours for less money, facing increasing tax loads and dealing with significant uncertainty about healthcare, environmental issues, safety and taxation. 

The reality is that while this may be a technical economic recovery, it may not feel like a recovery for most Americans for several quarters to come. 

Fortunately, or unfortunately depending on your portfolio profile, the stock market rally is for real and it has several things going for it that can cause it to maintain its current levels.

Generally, as an economy comes out of a recessionary period, the stock market will anticipate the recovery and will start to rally six to nine months ahead of the recovery.  Now that this has clearly happened, the economy has started to show signs of life and recovery.  These signs have been and will continue to be “I told you so” moments for the stock market bulls.  Unless we see signs of the economy weakening again, the recovery is positive for stocks.

Another characteristic of strong bull markets is that nobody believes in the rally and most investors are caught on the sidelines holding cash or other more conservative securities.  In the current environment there are a large number of investors representing a large volume of assets that are looking for a pullback in the market so that they can get in.  The mere fact that this condition exists will cause the market to be priced above a long term fundamental price until the condition relaxes.  The truth is that the market can stay this way for a very long time as investors look for an opportunity to buy in.

As analysts and pundits continue to assert that the rally is not based on any fundamental logic, they assume that the market should always be based on fundamental logic.  This is clearly a false assumption. 

Historically, the markets have seen long periods of time where market prices and market multiples have only a loose connection to business fundamentals.  Because these conditions can exist for such a long period of time, an investor cannot reasonably expect the market to revert to fundamentals anytime soon.

In fact, the mere fact that many investors would like the market to pull back causes the market to go higher.  The laws of supply and demand of equity securities dictate that the market will move away from the hopes and expectations of the majority of the participants.

The question investors should be asking now is, “Given that the market has run so far, what should I do now?”

With all this being said, the market is clearly at an above average price and the risk is high relative to expected rates of return.  Despite the loose short-term connection between market prices and company fundamentals, the long-term connection will continue and the risk of a significant stock market pull back is real.  Investors should consult with their financial advisor and revisit their asset allocation.  Making small and steady adjustments is the best way to gain exposure or make adjustments as needed.  Investors that choose to be all invested in the market or all out of the market generally take too much risk and live short investment lives.

As we head into the end of the year, investors will continue to bid up prices for stocks.  The new year, at some point, will bring an opportunity for the market to re-evaluate the relationship between prices and fundamentals and the loose relationship will, at some point, normalize.  The question then will be, "Have corporate and economic fundamentals gained enough to justify the higher market prices?"

In the short run, the market is a voting mechanism where the next voter (or trader) can push the market up or down depending on the direction and size of the trade.  In the long run, the stock market is a measuring tool that reflects the profitability, predictability and growth prospects of the underlying company as represented by the share price.

Technical analysis tends to measure the emotions of the next marginal trade and attempts to identify direction and magnitude without regard for company profitability, predictability and growth.  Fundamental analysts tend to believe that the technical movements of a market are emotional driven, inherently volatile and ultimately simple random noise.

In the last two years, it is hard to argue that the short-term technical movements in stocks were simply driven by the emotions of the marginal trader.  Similarly, it is difficult to argue that changes in company profitability could change as quickly as the market has seemed to believe that it has.

While day-to-day “noise” in the stock market is impossible to predict, the long-term fundamentals can’t account for the rapid changes we have seen in the stock market averages.  One technical indicator that is helpful for fundamental analysts is the market’s 200-day moving average.

The 200-day moving average is a long-term trend view of the direction of the overall stock market.  It measures the average market price over the last 200 trading days.  The reason people use the 200-day moving average is simply because a large number of technical analysts use it, that it begins to have merit.

The 200-day moving average is best used as an indicator of times when the market has trended to either an abnormally high level or an abnormally low level.  For example, on November 20, 2008 the S&P 500 was trading more than 32% below its 200 day moving average. 

As the market digested what had happened in the economy and the marketplace this would have been an attractive time to begin accumulating stock market positions.  Historically the market has rarely traded more than 30% below it’s 200-day moving average—twice during the 1930’s and once during the 1970’s.

Conversely, the stock market has rarely traded more than 20% above the 200-day moving average.  The reason for the bias is that the market is generally more orderly on the way up than it is on the way down.  At one point in the early 1980’s the market did trade higher than 120% of the 200-day moving average—however, it was quickly reigned in.

Today, the stock market (as measured by the S&P 500) is trading 19% above its 200-day moving average—a range we have rarely seen.  For those of you who like to pick tops and bottoms, perhaps this is interesting.

For those of us who manage investment risk, this is clearly a time where the market should pause and evaluate the fundamentals.

One of the key challenges to a market rally in the face of poor economic data is that investment managers are evaluated based on relative performance rather than absolute performance.  This causes a crowding effect that magnifies, in the short term, any market move of significance as investors “chase” the prevailing market direction.

While Wall Street economists and strategists continue to try to predict market tops and market bottoms, investors who follow such advice tend to suffer consequences in high risk and low real dollar performance. 

Wall Street economists and TV pundits make a name for themselves by being the first to forecast unpredictable market events like tops and bottoms.  In doing this they are forced to evaluate incomplete data and pick a point in time without good basis or conclusive reasoning. 

The risk for them is low because when they are wrong, as anyone who has followed the advice knows, they can then identify the new data that was previously unknown and a new thesis will make sense.  If they are mysteriously correct, they will broadcast their “correctness” for the duration of their career as the one professional that saw “it” before anyone else.

For investors, this type of investing game is dangerous with real dollar consequences.  Investors that pick market bottoms and market tops are difficult to find because they disappear so quickly.  These types of investors take the most amount of risk for the least amount of risk adjusted return—the odds are not with them.

For example, throughout 2008, month after month, economists were calling the bottom in the stock market and encouraging investors to buy more stocks.  They gave several reasons that were well thought out and suggested that we had seen the worst. 

By September, investors that had listened to this advice had tried and failed several times with the thought that this time they should be right.  As investors added to stock positions, the losses grew and by the end of the year most bottom-picking investors decided they weren’t very good at picking market bottoms.

An investor who attempts to pick market bottoms or market tops inevitably takes more risk in a portfolio than one who follows a defined trend over time in a methodical, well-founded discipline.  In other words, those who saw the market decline begin to define itself in late 2007 would have determined to reduce stock exposure until a clearly defined uptrend had established itself. 

While Wall Street will always encourage an investor to trade to earn a commission, truly disciplined investors will not take the risk of picking market tops or market bottoms.  After all, timing a market move is a risk that in the long run doesn’t compensate an investor very well.

In the later stages of a down market cycle, the market will tend to overshoot on the upside, just as it tended to overshoot on the downside. The challenge is that while there is a sign of recovery, much of the data hasn’t confirmed it and market participants will experience a bull market life cycle in a short-term window.

Those that are early predictors of market recovery will be the first in and will bid up the market causing mid-stage adopters to join in the market and buy the market higher. Volumes will tend to be reduced because market participants will have decided to either get out because it is too painful or to hold on because it is too painful. The low volumes combined with a large number of market participants now wanting to get into the market will cause a short-term over-bought condition in the market that can last for several months and can be significant in percentage terms.

The more important challenge for market participants occurs as the data coming from critical measures of economic activity continue to be inconclusive or “lumpy”. Some data may show improvement while other data will show further declines—in fact, some data my look great one month and terrible the next. While the market will predict the recovery six to nine months in advance—the market has seemingly predicted twelve of the last three recoveries. In other words, the market as a short-term forecaster is not particularly accurate.

The mixture of positive data with patches of negative data and large sets of neutral data make for a volatile market. The combination of market participants wanting to get back into the market, low relative market volumes and mixed signals from the economic data confirms and exaggerates market volatility.

For example, if the market believes that the economy is recovering quickly, the market may increase by a significant percent in a continuous set of daily gains. However, this is not necessarily an indication that the economy has recovered and the market is at risk of giving back those gains if new data does not confirm the recovery.

While strong recoveries sometimes follow deep recessions; historically, recoveries following financial crises have been slower and more painful recoveries. As history would suggest, we are now working through a significant financial crisis which would indicate that the recovery would be slow and painful with data that is lumpy and inconclusive.

A normal market response to this financial crisis recovery with inconclusive data would tend to be unusually volatile in the short-term and less profitable in the long-term. If this is indeed the case, the market will likely offer a less-volatile, abnormally profitable investment opportunity at some point in the future—but not today.

If, for example, in September 1929, with the Dow around 350, you look backward 17.6 years, the market experienced incredible prosperity.  On the other hand, if you look from September 1929 forward 17.6 years, the markets and economies of the world experienced intense uncertainty and the Dow fell until sometime around May of 1947.

In May 1947, the war was over, the Dow was around 170 and investors made money in nearly anything they bought until January 1965.  In January 1965, with the Dow around 900, the market and the economy struggled.  Nearly anything an investor bought experienced extreme volatility and ultimately not much gain.  With the economy languishing, political leaders passed stimulus packages, re-ordered taxes, created jobs programs and spent billions of dollars in order to stimulate the economy—all without success until July 1982.

In July of 1982, President Regan’s tax reduction and spending limitation policies had taken effect and new life was given to business enterprise and capitalism.  In fact, from 1982 through the end of the century, nearly anything an investor bought went up in value—that is until sometime around February 2000.

From early 2000 to today, the market has crashed, recovered and crashed again.  Nearly anything an investor has bought has struggled to increase in value and in most cases has decreased in value.  If the 17.6 year cycle theory is accurate, this could perhaps continue to be the case until 2017—wow, could this possibly be true?

Economic theorists have long taught the difference between a long-term secular economic cycle and a short-term cyclical economic cycle.  Whether the long-term cycle is exactly 17.6 years or not probably doesn’t matter very much.  The key for investors is in determining how best to invest and manage the challenges of different economic environments.

Investors should maintain perspective on the markets and their long-term investing goals.  Markets will go up and markets will go down.  We can count on the markets creating the most pain possible for the largest number of people.  Successful investors are long-term investors focused on objectives rather than short-term profits.  The volatility of market swings are more comfortable for investors with well founded long-term objectives.

In the short-run, the 17.6 year cycle is probably as good a forecast as any.