America's seismic shift

PORTFOLIO POINT: The debt cycle that was stimulating the US economy for so long is no longer there.

The All Ordinaries index fell to a nine-month low of 4547 yesterday as some of the fundamental forces that are placing pressure on the global banking system – forces I identified in last week’s column – erupted this week.

As the market came to accept that European banks are facing big losses and will have to recapitalise, the selling continued to outweigh the buying.

The market is assuming these pressures will boil over some time soon. But as we all know, politicians and public servants have a habit of creating short-term solutions and papering over the cracks, enabling markets to recover; so many traders are out there punting on a rally (for more on this, click here).

Many of these traders are using ETFs for broad market exposure, because of the ease of which they can enter and exit the market. I remain concerned about this $1.5 trillion market and the impact that such a volume of easily moved capital will have during a market sell-off. Not everyone shares my concern.

It is possible the traders will come out on top and book a profit, but it is most definitely a trading situation and the long-term forces I highlight in that previous column should remain at the forefront of your mind if you are at a time of your life where you cannot afford to take any losses.

So as the market was concentrating on Europe, I received a note from an American economist I have been following since the 1960s, Dr Albert Wojnilower.

Two and three decades ago Wojnilower was, without doubt, the best economist in the United States. He is older now but he has an uncanny knack of putting his finger on the forces that are going to shape the direction of the US in years ahead.

And so today what I want to do is look at how the shape of the US economy has changed over the years and how this dovetails with Wojnilower’s view of the US economy for the years ahead.

One way to get a quick grasp on the key components of an economy is to look at the constituents that make up its large-cap index.

When we compare the companies that make up the Dow Jones index with the 20 largest companies on the ASX we can immediately notice the considerable differences between the economies as you can see below.

-The Dow Jones
Company	Code	Market cap ($US)	P/E
3M Co	MMM	65.19 billion	15.7
Alcoa Inc	AA	15.73 billion	20.8
American Express Co	AXP	58.20 billion	13.5
AT&T Inc	T	180.21 billion	9
Bank of America Corp	BAC	107.41 billion	N/A
Boeing Co	BA	56.64 billion	16.3
Caterpillar Inc	CAT	61.54 billion	17
Chevron Corp	CVX	199.60 billion	9.7
Cisco Systems Inc	CSCO	82.78 billion	11.8
Coca Cola Co	KO	149.92 billion	12.6
E.I. Du Pont De Nemours And Co	DD	45.82 billion	13.8
Exxon Mobil Corp	XOM	392.82 billion	11.3
General Electric Company	GE	195.82 billion	14.8
Hewlett Packard Co	HPQ	72.53 billion	8.6
Home Depot Inc	HD	54.93 billion	16.5
Intel Corp	INTC	113.57 billion	10
International Business Machines	IBM	198.38 billion	13.7
Johnson & Johnson	JNJ	181.79 billion	15
JPMorgan Chase and Co	JPM	160.38 billion	9
Kraft Foods Inc	KFT	60.30 billion	19.9
McDonalds Corp	MCD	84.90 billion	17.3
Merck & Co Inc	MRK	180.59 billion	66.4
Microsoft Corp	MSFT	202.34 billion	9.6
Pfizer Inc	PFE	159.92 billion	19.1
Procter & Gamble Co	PG	179.98 billion	16.9
Travelers Companies Inc	TRV	24.19 billion	7.9
United Technologies Corp	UTX	77.70 billion	17.1
Verizon Communications Inc	VZ	98.67 billion	28
Wal-Mart Stores Inc	WMT	183.46 billion	12.3
Walt Disney Co	DIS	71.84 billion	16.7

-The ASX 20
Company	Code	Market cap ($A)	P/E
AMP Ltd	AMP	13.28 billion	12.66
ANZ Banking Group	ANZ	56.06 billion	10.79
BHP Billiton Ltd	BHP	233.94 billion	14.75
Brambles Industries Ltd	BXB	10.37 billion	23.85
CSL Ltd	CSL	17.44 billion	19.02
Commonwealth Bank Australia	CBA	77.43 billion	13.88
Foster's Group Ltd	FGL	8.87 billion	N/A
Macquarie Group Ltd	MQG	11.03 billion	11.54
National Australia Bank Ltd	NAB	53.22 billion	11.99
Newcrest Mining Ltd	NCM	28.14 billion	25.57
Origin Energy Ltd	ORG	16.4 billion	26.61
QBE Insurance Group Ltd	QBE	17.91 billion	15.04
Rio Tinto Ltd	RIO	153.77 billion	11.54
Suncorp Group Ltd	SUN	10.47 billion	16.47
Telstra Corp Ltd	TLS	38.20 billion	11.82
Wesfarmers Ltd	WES	36.61 billion	19.67
Westfield Group	WDC	20.37 billion	18.46
Westpac Banking Corp	WBC	64.28 billion	8.87
Woodside Petroleum Ltd	WPL	33.82 billion	20.43
Woolworths Ltd	WOW	32.64 billion	15.93

As a popular proxy for the health of the US stockmarket, the Dow Jones has a much greater emphasis on technology and pharmaceutical companies than Australian indices, which are dominated by banks and miners.

Financials are represented on the Dow Jones by American Express, Bank of America and JP Morgan, but before the financial crisis took its toll it was much larger and included both AIG and Citigroup.

In the past we saw that the high proportion of leading US technology stocks as one of the great wealth drivers of the US and that is why seven of the 30 stocks that make up the Dow Jones could be regarded as tech stocks.

Tech stocks are usually on price/earnings (P/E) multiples of 20 or more, but most of the Dow constituents have P/Es of 10 or below, including Hewlett-Packard, Intel and Microsoft, which indicates that investors believe these companies will struggle to maintain their earnings.

The same could be said for the financial stocks in the index, which are discounted just as heavily. The big problem is that these companies are not providing lending where it is needed the most: in housing and business.

The Dow is being carried by mature companies that have been around for a long time, including Johnson & Johnson, Kraft, Pfizer, Procter & Gamble, Caterpillar, Walt Disney, and Boeing.

Right now what America needs is a growth-oriented banking system and it needs a strong tech sector, but its technology managers have made too many mistakes.

In Australia our market has its own problems. Outside of the miners you will find a number of companies that are struggling but not to the same extent. Importantly our banking system is holding up much better than America’s but will be dependent on the resilience of our housing sector and if it doesn’t we will follow the US.

This brings me to Wojnilower’s views. Earlier in the year he was hoping the upward trend in motor vehicle sales was the start of a long and lasting economic recovery. As a mark of just how much the US economy has changed, GM dropped out of the Dow Jones in June 2009. There are no other car manufacturers in the index.

But those sales were snuffed out by higher energy prices and problems with the spare parts supply chain after the Japanese nuclear disaster. While these forces may pass, the flower of confidence is easily crushed – especially when real estate prices continue to be depressed.

Wojnilower’s views have changed since then and now he believes that the economy could be held back for several years.

Growth in the US has been maintained for decades because consumers have borrowed on their houses or borrowed to buy cars. In the case of business, their borrowing boosted stock levels, which generated more income for manufacturers, which washed through the system and on and on it went.

This so-called virtuous circle of more debt led to higher incomes, and continued growth underpinned the American economy. There was a similar process in the government sector, and government spending regenerated itself in bigger tax revenues and other income to help service the debt.

Wojnilower says we are now entering an era where private debt levels are either not rising or not rising enough to generate the required income. The debt that was once stimulating the economy is no longer having the same effect that it would have in years gone by as its tolerance has built up.

This is a new and dangerous development for the US economy. Making it worse is the fact that the Congress will demand savage expenditure cuts in exchange for lifting the debt ceiling and ensuring that the US Treasury does not default.

Given the state and composition of the US economy, this is the last thing the Americans need. This will further stunt growth and the US will enter into a quite dangerous period of low growth and high debt which could cause a recession after the next election.