Friday, October 23, 2009

The Enduring Impact of the Financial Crisis

Have you ever taken the time to talk to someone who was old enough to remember the Great Depression? My guess is that you would inevitably find that his or her views on the economy, the role of government and the financial markets were meaningfully different from those of a person who came of age during 1960s or 1990s, for example. Specifically, since many of these perspectives were indelibly shaped by the traumatic circumstances of that period, people who lived through the Depression often tend to be more conservative in nature. The lessons of the roaring 1920s were clear: extreme leverage and excess unavoidably lead to financial calamity. However, the takeaway from the 1930s was even more profound: a person can never be certain that current prosperity will continue in the future. The violent swings in the stock market caused by widespread emotional shifts between euphoria and revulsion combined with the extreme unemployment rates left a lasting stain of uncertainty on those who lived through the tumult.

Accordingly, an interesting question to ponder is what the permanent impact of the current financial crisis will have on today’s young adults. While I personally am just outside what is known as the Millennial generation that was born between 1982 and 2004, I have certainly cut my teeth in some of the most volatile and chaotic financial markets in the last 80 years. Being a value investor, I am already very conservative by nature. But, will this experience make me more risk averse? Will I abhor the use of leverage like my grandfather? What will my views be on big government? As I continue to refine my own investment philosophy and framework from which to evaluate the global economy, I have no doubt that the events of the last few years will continually affect my outlook.

While I am unaware of any research regarding the impact of the Great Depression on the formative views of the generation that was forced to navigate that extraordinary period, there is some interesting data on the effect of more recent recessions on young people. For example, my economics professor at UCLA, Paola Giuliano, has recently co-authored a paper on the topic. Now, if you open that link you will a million coefficients and a plethora of statistical analyses. Luckily for those of us who are not econometric specialists, the authors also created a summary of their analytical process and subsequent conclusions:

Our research studies the impact of severe recessions on individual’s broad beliefs and attitudes (Giuliano and Spilimbergo, 2009). Our study relies on answers to the General Social Survey, which has been conducted in the US almost every year since 1972, to analyze how economic shocks have affected the attitudes of different generations in the US. The basic idea is to match macroeconomic shocks during early adulthood with self-reported answers from the General Social Survey…

In order to disentangle the effects of economic distress from other nationwide events, we use the fact that there is considerable heterogeneity in the economic growth across US regions... It turns out that a severe regional recession strikingly alters the attitudes and beliefs of individuals growing up there. Recessions do alter perceptions, especially of people between the ages of 18 and 25. Recession-influenced respondents expressed a stronger preference for government redistribution and tended to believe that success in life was more a matter of luck than hard work.

For investors who are trying to anticipate the types of businesses that will prosper as the people most influenced by recent history become consumers, homeowners and parents, I think the following two conclusions are most relevant:

First, the effects of a severe recession experienced are large when the individual is between the ages of 18 and 24 – the so-called formative age – during which social psychologists think most of social beliefs are formed; the effects are not so strong when the recession is experienced later in life.

Second, these effects are permanent because attitudes of recession-stricken individuals remain significantly altered many years after the severe recession ends.

While these findings may be somewhat intuitive based on the experience of the Depression generation, it is important to remember that these people will eventually become our CEOs and Congressmen. Thus, as we approach the second decade of the 21st century, it behooves investors to understand who these Millennials are, how they view the government and the economy, and what contribution they will make to society as a whole. For some insight into this generation, we turn to Neil Howe, author of a book called The Fourth Turning. The following excerpts are from an interview with David Galland from Casey research. Mr. Howe’s expertise is generational research. He argues that we are the beginning of a Fourth Turning in which today’s youth will play a very important role. Specifically, Howe identifies four different generational archetypes that he believes assume and then lose power in a rather predictable and cyclical way over time. In reference to the current youth, he predicts that the Millennials will fall into the Hero archetype:

Hero generations are usually protectively raised as kids. They come of age at a time of emergency or Crisis and become known as young adults for helping society resolve the Crisis, hopefully successfully. Once the Crisis is resolved, they become institutionally powerful in midlife and remain focused on outer-world challenges and solutions.

I have to say that sounds about right. But of course this is just a general framework from which each sequential generation blazes its own path. So, what is it that makes the Millennials unique? According to Howe what separates Millenialls from Baby Boomers and Generation Xers is oddly enough how conventional they are:

Since Millennials have come along, we’ve seen huge declines in violent crime, teen pregnancy, and the most damaging forms of drug abuse, as well as higher rates of community service and volunteering. This is a generation that reminds us in many respects of the young G.I.s nearly a century ago, back when they were the first boy scouts and girl scouts between 1910 and 1920.

So this is a generation that is surprisingly conventional. When surveyed about what they want to do with their lives, Millennials say they want to be good neighbors, they want to be good citizens, they want to have balanced careers. A record number, according to the UCLA Freshman Survey, said they want to get married and have children. If you ask them how they want to spend their free time, they say with their families. We have never seen a generation so close to their parents. There is a virtual disappearance of the generation gap today.

Millennials actually believe in the market. They believe in globalism. They believe in free trade. Interestingly, they are not a populist generation… It might help to think of the Millennials as capitalists, but they want capitalism with a public purpose. Through regulation, incentives, and social engineering, they want the markets to be orchestrated toward some end that we all want. But they do not want to stop markets with pointless regulations. That is not where this generation is coming from.

As Howe indicates above, this is not your hippie or radical generation. This is a group of people who want to work together to solve the world’s problems and then live a somewhat moderate life with their families. After all of the excesses of the last 30 years and the boom and bust cycles in the economy, maybe the Millennials are precisely what America needs to get back on a more sustainable track.

However, while Howe definitely seems optimistic about the positive ways in which he believes today’s young people will change the world, it is important to remember that generational shifts of influence take a lot of time. Accordingly, Howe is not what I would call optimistic about the near future. In fact he anticipates the need for some sort of calamitous and catalytic event to take place in order to spur on the necessary changes:

We think of Fourth Turnings as a formidable time, a time of danger, a time of crisis, a time to be scared, a time whose most popular images are death and destruction. I think it is very important to keep in mind that a Fourth Turning is a time when society wipes away old ways of doing things so that new, better systems can be built.

This is what nature does. There is a winter, things die, seeds are planted under the ground, and the deck has cleared for new life to come forth. Just as nature needs to do that, society needs to do that. We occasionally have to clear away institutions, not only to make room for new ones, but also to create an atmosphere of new trust. That is what we no longer have today.

While I believe in the need for some Darwinian creative destruction in the business world, what Howe is talking about is revolution. In his estimation, previous Fourth Turnings occurred after the Revolutionary War and the Civil War. My guess is that most people on Main Street and Wall Street are not expecting anything that severe to result from current crisis. But Howe warns that we have not yet seen the worst:

DAVID: But if I’m understanding you correctly, we are not very far into this Fourth Turning. So that the actual Crisis, the Crisis that is really going to test the mettle of humanity, if you will, is still very much ahead of us. Is that a fair statement?

HOWE: Yes, absolutely.

DAVID: On a scale of 1 to 10, if the worst it is ever going to get during the Fourth Turning would be a 10, where are we today?

HOWE: I would say 2 or 3.

DAVID: So what people need to understand is that there is much worse to come, but as with all the cycles in time, this too will pass.

In closing, whether you agree with the dire predictions of Neil Howe or not, it is unambiguous that going forward investors will be well-served to understand the lasting impact of the crisis on the Millennial generation that will only become more powerful and influential in the coming decade. The recent stock market roller coaster has even shown value investors who have traditionally almost exclusively focused on bottom’s up analysis that it can’t hurt to have some understanding of the macroeconomic circumstances. Therefore, my humble advice is to start having conversations with people who are in their 20s. While they may not have as many interesting stories as those people who lived through the Depression, the way they react to their current circumstances may be a good gauge of how they will approach the world going forward.