2009 was an exciting year. It started with the end of the world and finished with euphoria, an early bull run—maybe too early—but certainly convincing in its extent. 2010 will present us with trends that are less clear. Bonds are no longer dirt cheap, spreads are no longer exceptionally large, and equities are no longer available at give-away prices.

The tea leaves are quite hard to read right now. Everyone seems to be talking about inflation given the huge federal stimulus, though it is not yet present. In fact, certain kinds of prices like housing and energy are cheaper than they’ve been in past years. Yet the Fed is going to have to start raising key interest rates to choke off another stimulus bubble (unless it’s already too late to stop it). Until that time, the federal government will continue to do everything in its power to keep bond yields at artificially low levels. The government is still working to give banks the ability to shore up their balance sheets with loans costing them virtually nothing to fund, while propping up the value of treasury and agency securities. The federal deficit! The federal debt!

Why Have the Parties Gotten Worse?

This is a chart of the “velocity of money” measured by dividing U.S. GDP (a measure of economic output) by M2 (a measure of the money supply). This is a lot like an inventory turnover ratio you might find in an ordinary business. How many times was each dollar used and reused by the economy during the year? The more times each dollar is pushed through the system, the “faster” the velocity of money. The velocity of money has a lot to do with the quality of parties. It is pretty easy to understand why the parties have gotten worse over the last few years.

Things to Notice:

First, notice how dramatically the velocity of money increased during the 1990’s. Those were euphoric times when credit and investment flowed freely.

Second, look how dramatically we fell during the last few years. In chart terms, we’ve reset the speed of flowing dollars all the way back to the mid-1980’s. There is no doubt that tighter credit and significant de-levering have slowed down the speed of money flow. As a result, the parties aren’t as good.

Third, notice the little uptick at the right side of the chart. Have we hit a bottom or just taken a breather? It would be great to know, but unfortunately we don’t. The chart would seem to imply that we’ve dropped down near the historic lows for this measure.

The conclusion I draw is that the great “unwinding” has taken place and has been pretty thorough. While it seems unlikely that we will see a heady return to free-flowing capital and great parties for a few more years, it also seems unlikely that we will witness significant slowing from here going forward. The wildcard is what happens when the government slows down the stimulus.

The government has been spiking the punch. Hopefully, that means the party is going to get better. We do know that banks have been given every possible incentive to lend: They can borrow money at extraordinarily cheap rates and the government has been propping up many of the assets banks use to support their balance sheets (such as treasuries and mortgage-backed securities). However, we also know that, even with hundreds and hundreds of billions of dollars in stimulus, the economy still feels uncomfortably shaky.

Some commentators speak of the “new normal,” an economy with tighter credit and lower velocities. Others think that the cycles of greed and fear will continue as they always have. Either way, this graph makes me feel like we’ve already experienced a decent amount of the pain and things will be getting better.

The New Normal is the Federal Deficit

Here’s another chart to ponder. This one overlays the U.S. federal deficit (as a % of GDP) and the U.S. Unemployment Rate (seasonally adjusted).

What are some features to notice?

First, look at that deficit spike on the right. Holy smokes! That’s the worst federal deficit (as a % of GDP) since who knows when.

Second, notice that unemployment is actually not the worst it’s been since the 1960’s. Despite the rhetoric, in this respect, things certainly have been as bad and even worse in recent times. Recall, however, that people who have given up looking for work are not counted in the official unemployment figure. During this recession, that’s a lot of uncounted noses.

Third, notice how the two lines move. Things tend to get “bad” quickly and improve more gradually. It’s not at all clear that we’ve reached the maximum of “badness” yet and, even so, history would suggest that it will take a few years for things to get “better.”

Remember, the federal deficit is a one year deficit figure. Paying back the debt requires digging out from the sum of all the past deficits added together!

Investing in 2010

It seems pretty likely that the “end-of-year everything is back to normal” head-rush we all felt at the end of 2009 has run its course. There is no shortage of commentaries discussing the ambiguity of the present situation. But it seems like a more interesting challenge to try to discuss the things we do know for sure and try to figure out where they might lead us. As you know, we like to base our bottom-up investment picks on significant long-term trends. We see some interesting and definite trends:

• U.S. Competitiveness: American industry, including manufacturing, has done a significantly better job of improving productivity and efficiency through the downturn than most equivalent firms in Europe. This is the flipside of unemployment and should help American firms compete as things get back on their feet. While a cheap dollar dilutes our international unilateral muscle and raises the cost of imported goods, it will dramatically improve the competitiveness of U.S. exports. Despite popular wisdom, we are still a global manufacturing power and have some of the best food, defense products, services, entertainment products, and electronics in the world.
• Real Estate: Commercial real estate is still in deep trouble. The popping of the commercial real estate bubble has still yet to fully play out. While residential real estate has already taken a lot of its fall, there is still a long road to recovery. The amount of crap debt still on the books of banks will take additional toll.
• Internet: The music, movie, publishing, radio, TV, and cable industries are about to go through another period of vicious fighting and consolidation as online streaming, mobility, and the iTunes-ization of everything continues. Internet commerce is still making great strides in rewriting the behavior of consumers and businesses in the U.S. and the world.
• The Dollar: On average and over time the damage we’ve done to the U.S. dollar must take its toll. It simply isn’t worth as much as it once was. There is no denying that fact. Once again, however, this could take long time to play out.
• Treasuries: The yield curve is extremely steep. Investors all want extremely short duration bonds and dislike long dated notes. The U.S. government can’t keep propping up treasuries forever, and eventually interest rates must go up (i.e. the value of treasuries must fall). Therefore, bonds must fall also. Once again, the only question is when.
• War: Our presence in Iraq and Afghanistan are both going to be political, military, and economic fixtures for some time to come. Foreign wars are expensive in every sense. The U.S. may be fully-extended militarily, certainly in the present economic and political context.
• Energy: Energy in this country is going to be strangely and unusually cheap for the near term. We are awash in cheap domestic natural gas in a way that no one could have predicted only a few years ago. The price of coal in China is 50-100% higher than the spot price in the U.S. Furthermore, natural gas is transitioning from being a regional commodity (pipelines) to a global commodity (shipped via liquefaction). Coal, uranium, and oil will stay “cheap” until they get very, very expensive again. The only question is when.
• China: China will continue to flex its growing economic and military muscle. Eventually they will tire of lending us money, especially if we continue to use it to antagonize their interests. China has a voracious appetite for natural resources. Will their banking and real estate bubbles burst or will their heady times continue? My prediction is that they will see boom/ bust cycles that will make the U.S. 19th century blush. We’ll see how I do on this one.
• Brazil: Brazil is going to be “China” before China is going to be China. In other words, economic development in Brazil is significantly farther along compared to China. In addition to its amazing oil resources, Brazil has an impressive manufacturing base and a solid (at least until recently) economic base.

America is Not Over

My sincerest hope for 2010 is that we will finally see the end of 2008. However, I cannot be more emphatic: America is not over!

People who bemoan the demise of the United States might want to look at these charts. The most interesting question to me is how long we’ve been able to defy “mean reversion” to world averages. Now without accidently challenging any actual economists to an intellectual wrestling match, if you measure long-term wealth averages using just about any useful statistic, the United States became the wealthiest nation in the world (arguably in the history of the world) by an impressive margin and has remained so for a surprisingly long period. This is even more remarkable if you factor in the cost of the Cold War and the startling rates of growth in other parts of the world.

Maybe you don’t like how the trends feel, but numbers don’t lie. America is far from over.

Eric Wanger, JD, CFA, President of Wanger Investment Management, Inc. and Portfolio Manager, Wanger Long Term Opportunity Strategy