Why is the market so choppy? When it finally finds its feet, where will it go?

That’s what Clint Lee, Angela Jirau and I discussed in our Your Money Matters video yesterday.

I emphasized something most Americans don’t know about … the dramatic underinvestment in U.S. productive capacity over the last decade.

For most investors, the last decade has been about the growth of massive technology companies. That’s where we’ve made money. That’s what captured all the headlines.

But the real economy — where physical products are made — has been running on fumes.

The key chart from that discussion shows fixed capital investment by U.S. companies. After rising steadily since 1960, it pulled back after the dot-com crash of 2000.

But the great financial crisis led to a staggering drop in capital investment. We still haven’t recovered:

us fixed capital investment graph 1960-2020

This raises a critical policy question … one that matters a great deal to investors like us.

How that question is answered will determine where the market is headed in the next three to five years.

Inflation: Powell Gets It

As I’ve written many times, one thing you can always count on is a chorus of doomsayers whenever the federal government starts goosing the economy with spending.

The argument is that too much government money chasing after too few goods will lead to inflation. And that — they’ll tell you — is bad news for us regular folks.

But the real concern is that inflation will devalue debt and other financial assets held by the country’s wealthiest households.

So, what happens? Everybody fixates on the Federal Reserve’s interest rate policy. When will the Fed give in and raise rates to slow down economic growth to prevent inflation?

Here’s the shocker: that’s the opposite of what they should do … and Fed chairman Jerome Powell knows it.

Like me, Powell is an economist. He’s done his homework on the U.S. economy over the last decade.

He knows what an increasing number of analysts and commentators acknowledge: the reason we can expect inflation isn’t because of too much government spending.

It’s because of not enough spending … in the past.

Walk a Mile in a Sawmiller’s Shoes

You’ve probably heard that there’s a shortage of lumber in the United States. (For a way to play that, check out this video.) Prices have risen so much that they’ve added an average of $24,000 to the cost of a new home in the last year.

So, are lumber prices high because interest rates are too low and stimulus spending from Washington is increasing the demand for housing unsustainably?

Absolutely not.

This chart shows an index of sawmill output going back to the 1970s. Like everything else, sawmill output tends to decline during recessions. But it recovers the previous levels quickly — except after the great financial crisis a decade ago:

index of sawmill output since 1990

Sawmillers got burned when the housing bubble burst.

They built up their productive capacity to keep up with rising demand for new housing, only to see that demand fall through the floor.

They were left with excess capacity, which they reduced as fast as they could to limit their losses.

They knew the Obama administration’s response to the crisis was inadequate. The economy recovered much more slowly than after any other recent recession:

cumulative change gdp recessions chart

It took a full decade for unemployment to fall to its precrisis levels. During that time wage growth was stagnant:

unemployment rate vs. wage growth 2008-2018

With U.S. households earning little money, homebuilders reduced their output sharply. For most of the last decade, housing supply has remained below long-term historical levels even as the population has grown:

us housing supply 1965-2020

Sawmillers knew this. They refused to waste money on new capacity.

If sawmillers had faced levels of demand like earlier decades, we’d have more than enough milling capacity right now.

Instead, we face sky-high lumber prices because mills can’t produce enough.

Worry About LACK of Inflation

Of course, housing is just one example.

This pattern has been repeated across many industries in the U.S. A decade of anemic policy response to the worst downturn since the Great Depression led to a huge decline in investment in production capacity. It made more sense to use cheap money to buy high-growth but low-employment tech stocks.

Then came “stimmy’ — the relief payments sent to all Americans to cope with the COVID-19 crisis. That and the prospect of further government spending is unleashing loads of cash into the economy.

Now, based on the above, should we raise interest rates to slow down the economy so the prices of things like lumber don’t rise too fast?

Take it from Fed Chairman Powell, who was asked about rising house prices after the most recent Fed meeting.

He said that based on his analysis of the last decade, his goal was to let the economy run hot enough, for long enough, to encourage homebuilders to increase supply. That would bring down prices permanently … and create jobs so people can afford houses.

That is exactly right.

To do otherwise would choke the economy back down to a sluggish level of growth, stagnant incomes … and thus no incentive to invest in new production capacity.

Rising prices are a market signal that encourages business to invest in new capacity. By clamping down on inflation so ruthlessly for so long, policymakers have kept the economy stuck in low gear.

So, here’s my radical advice: If you choose to worry about inflation, worry about too little.

And if I’m right that the current crop of policymakers understands this, get ready for the investment ride of a lifetime … in real-economy companies that have been ignored for more than a decade!

Kind regards,

Turn Your Images On

Ted Bauman

Editor, The Bauman Letter