Although the market indices have been hitting record highs, there are structural problems that continue to build in the United States economy that may severely impact customer spending and corporate earnings in the next several years.
This article (updated for 2019) will outline four bubbles that are growing in the economy, along with a few potential ways to reduce your investment exposure to them.
None of these are “doomsday” bubbles, and each of them on their own is manageable; it’s the sum of all of them together that seems to be shaping up to cause long-term economic malaise if left unaddressed.
Bubble 1) Student loan debt
The cost of higher education in the country has increased 4-5% per year over the last decade, dramatically outpacing inflation.
To account for this (and possibly also fueling some of this increase, as some would argue), the federal government has expanded its loan asset balance by more than tenfold in the past decade, from around $100 billion to over $1.2 trillion.
This is a rapid acceleration in a short period of time and puts the younger generation in uncharted territory as far as debt is concerned:
Federal Student Loan Assets
Source: St. Louis Federal Reserve
Student loans including from both public and private sources now exceed $1.3 trillion, and account for a larger segment of debt than either auto loans or credit card debt. They are harder to discharge in bankruptcy than other types of debt, and have no collateral.
There are over 44 million Americans with student loans, and the average per-student debt at graduation among students that have loans is over $35,000. And although it dis-proportionally affects people under 40, approximately one third of total student debt is held by people over 40 years of age. Plus, parents are often co-signers for the loans of their children, which exposes them to the risks.
Well over 10% of student loans are in default, and a larger number of student loans are either behind in payment or have received permission to defer payments due to financial hardship.
This bubble can impact stock returns in two key ways:
- It will act as an anchor on consumer spending for decades that didn’t exist in prior generations.
- Because it has gotten so large and continues to grow at a pace that exceeds inflation, the bubble could pop, resulting in a large percentage of loans not being paid back. This would impact federal revenue and increase the federal deficit.
Bubble 2) Per capita healthcare costs
The US pays far more per capita for healthcare than literally any other country in the world; approximately double the average of other developed countries:
And yet, the US does not have better health outcomes than average; life expectancy is mediocre and infant mortality is not that low, among other metrics.
Measuring healthcare effectiveness is a complex subject, but clearly the US is not getting its full money’s worth. Visual Capitalist has an excellent chart that shows how the US has fallen behind in life expectancy while doubling the costs of every other developed nation.
Many companies charge far higher prices for drugs in the United States than they charge elsewhere, because we lack the same level of price negotiation as many other countries have. In this sense, we subsidize other countries.
More alarming is that this spending continues to grow at nearly 6% per year. Healthcare spending as a percentage of GDP was 12% in 1990, and it’s now up to 18% of GDP just a quarter century later, according to the Centers for Medicare and Medicaid Services. This is expected to increase to over 20% of GDP by 2025.
The Affordable Care Act succeeded in insuring more people, but hasn’t truly addressed any of the primary cost drivers and thus did not rein in costs.
Disproportionally increasing healthcare spending obviously benefits the healthcare sector for now, but acts as a drag on consumer spending for the rest of the market. Plus, if this proves to be unsustainable, it would eventually unravel in painful ways for the healthcare sector as well.
As the country with the highest per-capita spending on healthcare, with costs continuing to skyrocket, we’re in uncharted territory here as well.
Bubble 3) Unfunded state pension liabilities
According to Moody’s, the combined sum of state pension unfunded liabilities is $4 trillion, and even in the “best case” scenario of stock returns over the next few years, liabilities won’t go down.
In fact, according to the same report, if markets stay flat in 2019, there would be a 59% jump in unfunded pension liabilities.
Here’s a chart by Pew Charitable Trusts showing the growing divide between state pension assets and liabilities:
The Federal Reserve estimates the unfunded liabilities at $4 trillion and growing:
Chart Source: Bloomberg
According to Ben Carlson, CFA, the Director of Institutional Asset Management at Ritholtz, “there are going to be many, many pension plans that run into trouble in the years ahead. It’s simple math.”
This is mainly due to states having overly optimistic rate of return estimates for their investments, and not paying enough into the system to support their promised pensions. Most public pension funds plan for 7-8% annualized returns on average for their portfolios that consist of both stocks and bonds.
John Bogle predicted 4% annualized S&P 500 returns over the coming decade, citing high market valuations as the reason. That’s far lower than the 7.5% that pension funds are planning for from a portfolio of bonds and stocks, on average.
McKinsey & Company predicts 4-6.5% returns for US and European stocks and 0-2% for bonds over the next 20 years.
Earnings multiples simply don’t have room to run much further, so we’ll be constrained by actual corporate earnings growth rates and possibly have them offset by mild or moderate declines in earnings multiples.
Plus, we are ten years into the second longest economic expansion and bull market in US history. The longer we go, the odds move against us in terms of sustaining this without an economic recession and valuation correction. And when that correction happens, the pension funding gap will widen even more.
Four trillion dollars in pension liabilities divided by the 127 million full-time US workers is over $30,000 per worker. At $6 trillion, then we’re looking at a per-worker figure that exceeds $45,000. The tax burden to correct this without major pension cuts would be huge.
Of course, nobody can predict for sure how long an economic expansion could last, or how long stocks can remain expensive. If I were writing this in 1997, I could have been saying, “market valuations haven’t been this high since 1929!”, and yet it would have taken another 3-4 years for that bubble to work itself out and come back down.
The longest sustained economic expansion in US history occurred for 120 months between 1991 and 2001. If we hit July 2019 without a recession, we’ll officially be in the longest economic expansion in US history. And when an inevitable contraction comes, and a market correction occurs, the gap is going to quickly widen in state, local, and corporate pension funds.
Bringing this back to pensions, their assumptions for their rate of return are not conservative enough. They’re assuming a higher rate of return than what a significant amount of evidence suggests the probable range of future returns will actually be, which means their funding gaps will likely keep widening unless they have significant reforms.
Bubble 4) Federal debt
A country can increase its debt forever and never go bankrupt, as long as its economy keeps growing.
The key is that debt as a percentage of GDP has to be stable. For example, if the GDP and tax revenues of a country keep growing by 3% per year, and their outstanding debt keeps growing by 3% per year, then their debt as a percentage of GDP will remain stable over time. The debt stays a consistent fraction of the economy.
Debt crises happen when debt as a percentage of GDP starts to get out of control, and bond buyers start to get nervous, which jacks up interest rates on that debt. The cost of debt suddenly becomes far more expensive, and the country is at risk of default, which further increases skepticism and interest rates for their bonds.
Unfortunately, the United States is growing its debt faster than its GDP and tax revenue, resulting in rapidly increasing debt as a percentage of GDP:
Source: Congressional Budget Office
The country hit a peak debt level during World War II, but then began gradually reducing its debt as a percentage of GDP until about 1980, when it started rising.
The financial crisis resulted in large deficits for a few years, and it started to stabilize a bit but not quite at the level it needs to be long-term.
Recently, the government cut taxes without cutting spending, which adds a couple hundred billion dollars to the deficit each year. If tax revenues don’t increase, or federal spending does not decrease, the debt level will keep rising.
We’re currently at a debt level only surpassed by where we were during World War II. Fortunately, the U.S. has less government debt as a percentage of GDP than Japan and several European countries, so it’s not the worst here, but definitely not great.
However, federal deficits are a type of economic stimulus. It’s a way to inject more capital into the economy than they’re taking out of it. This can mildly boost GDP growth, but is unsustainable for the long term. When or if the federal government takes a more balanced approach and reduces the deficit to a stable level, it will be a headwind against the economy.
So a key takeaway is that current GDP growth levels of about 2% per year over the course of a business cycle include deficit spending. Even these slow levels of growth currently rely partially on debt and are not fully sustainable.
What makes this alarming enough to include as a bubble is that the federal government currently has a large federal deficit even during peacetime and even with a strong economy and low unemployment. This is when we should be in debt-stabilization mode. The next recession we have is likely to widen the deficit considerably.
The percentages shift slightly each year, but this is basically where federal money goes:
Source: National Priorities Project
- 33% goes to social security
- 28% goes to healthcare
- 19% goes to military & veterans
- 13-14% goes to everything else
- 6-7% goes to interest on the debt
Cutting any of those areas would be unpopular. And increasing taxes is unpopular. It’s not an easy problem.
Putting it all together
What all four of these bubbles have in common is that they will impact middle class consumer spending, with no end in sight.
The rate of home ownership has fallen to its lowest point since 1965, partly because younger families have too much student debt to take on the obligation of buying a house.
The public debate on how to fund healthcare and who should pay for it is among the most bitter of partisan issues, partly because we have the highest healthcare costs in the world and it’s costing people at least an extra four thousand dollars per year compared to just about any other developed country in the world without any quality superiority to show for it.
The pension debacle and the federal debt level are not yet affecting most people. They’re accumulating red ink, and neither taxpayers nor pensioners in most regions have been hit with the effects yet. When these items hit a point where they need imminent reform, it will add yet another burden onto the public to either pay for these services or cut these services, and either of those scenarios will impact consumer spending.
Investing strategies to stay ahead
A rational investment strategy in this type of macro environment needs to be ready for the possibility of a market correction, and needs to be able to make good returns even in flat or choppy sideways markets without trying to do any timing predictions.
Historically, almost every time the CAPE ratio or Capitalization/GDP ratio hit the levels that they are at now, returns over the next 10-20 years were poor. Combine that fact with these increasing structural problems that are hollowing out the middle class spending engine of the economy, and we’re almost certainly headed for a significant correction or period of flat returns.
Maybe the bear market that started in 2018 is the beginning of it, or maybe we’ll reach new highs first. I don’t really know.
Long-term bonds, however, aren’t necessarily the safe haven that they’ve traditionally been. Over the past 35+ years, they have benefited from high and falling interest rates.
Source: St. Louis Federal Reserve
Now that interest rates have hit rock bottom and are inching back up, bonds barely keep up with inflation and may face extra volatility in the years ahead, because bond prices are inversely correlated with changes in interest rates.
Unless the federal funds rate comes back up to 3%, long-term bonds simply aren’t very interesting as an investment from a risk/reward standpoint. I keep some money in cash-equivalents and short-term securities, but overall it’s just a way to preserve capital rather than generate real returns.
Here are a few tactics that can make decent returns in current conditions.
Strategy #1: Invest for Income
If you’re concerned that forward stock market returns might not be as good as recent returns, then an emphasis on investing in income can help quite a bit.
The first method here is to include some defensive high dividend stocks in your portfolio. Ones with great balance sheets that can continue to print cash for shareholders whether there’s a recession or not.
A more advanced tactic is to sell options for income. Rather than buy companies at today’s overvalued prices, you can sell put options and get paid to wait to enter companies or ETFs at a lower cost basis. I have a put-selling tutorial here if you want a more comprehensive overview of how this works.
The benefit of this approach is that you don’t have to try to time the market by trying to predict exactly when a recession or correction will occur. You simply keep selling puts, making a double digit rate of return during a flat or upward market, and then automatically buy into stocks when they fall to undervalued prices.
This is a solid strategy for markets like this that are highly valued and likely to trend sideways or down for some time. Even if the market continues to be priced upward for a while, you’re still making money in that scenario as well.
Strategy #2: Look Abroad
U.S. stocks make up about half of the global market capitalization of publicly-traded companies, with the rest of the world accounting for the other half. American investors, however, have an average of just 15% invested in foreign stocks and the bulk of their portfolios heavily concentrated in the United States.
Every market in the world has a different CAPE currently (see here), along with their own strengths and weaknesses as a region. The US is basically the most expensive stock market in the world based on the majority of valuation metrics.
Taking some money off the table in the US to make sure you have a decent amount of international exposure may be warranted.
I think it’s a smart time to have significant international stock exposure, including into emerging markets.
Strategy #3: Own Some Gold
Putting 5% of a portfolio into gold and silver is a smart move in my opinion, especially when times are good and gold is cheap. More enterprising investors may also wish to own some gold stocks.
In times of severe economic uncertainty and low real interest rates, investors tend to flock to gold and push the price of gold up.
When banks don’t pay interest that keeps up with inflation, it makes more sense to hold hard money. Cash and bonds are all liabilities of governments, banks, and corporations, whereas gold is an asset that is nobody else’s liability.
With global interest rates so low and global debt levels so high, I can’t imagine not having at least some small allocation to precious metals, even if just for the sleep-well-at-night factor.