From Chaos to Turbulence: Myths vs.

Realities in the Economy, Markets and Policy
By Dave Livingston, Managing Principal, Llinlithgow Associates ( )

Dave is a management consultant primarily focused on improving enterprise performance by coupling strategy with execution thru the design and implementation of workable, integrated management systems. He blogs on this and related issues in Economics, Markets & Investments and specific industries and companies at, his BizzXceleration blog. Where you can keep current on the state of the Economy, the implications for Markets and read explorations into business performance for Industries and specific companies. This collection of blog essays covers the period from August to November, 2009 as the Chaos in the first half of the year gave way to Turbulence. That’s a critically important distinction as Chaos is when nothing is predictable and where you end up could be disastrous depending on minor differences in where you started. In contrast turbulence is still a very disturbed environment, technically a collection of smaller-scale chaotic behaviors, but subject to overall patterns and flows. In other words what we experienced in this period was the re-emergence of more predictable behaviors in the economy, largely as the result of effective and successful monetary and fiscal policy. In the process of laying out this evolution we dig into the structure and patterns of GDP and business cycles, where the economy was at and is likely to go, the interactions between markets and the economy as well as multiple delusions about the future that set into market outlooks and tackle multiple numbers of mythologies that were floated during this period as to what was going on and the implications for the future. While you might think this look back is dated in fact the machinery and long timespans detailed here will determine the course of the economy for years to come. In particular the explorations of Debt, Savings and Growth, the role of debt and the future of de-leveraging and the impacts of Trade, Exchange Rates and trade balances will be things we wrestle with for the next decade. We also spent considerable time exploring the role and impact of government fiscal policy and the strategic outlook for the US economy. It was government intervention, thru fiscal and monetary policy, that kept what could have been a disaster as we fell into an abyss from being much worse than it could have been. An important point to learn is that the health of the economy is still utterly dependent on government support though we can look ahead to a tricky transition. The key to that transition will be whether or not the economy reaches takeoff velocity and establishes a level of self-sustaining growth, or whether it remains weak and vulnerable. It will, in any case, remain fragile and we’re facing a weak recovery with very poor job growth for years. In other words we lay out the groundwork behind the New Normal using machinery that you can, we hope, readily understand and re-apply.

Table of Contents
1. Interrupting Your Reported Data Distortions: More Darkside for the Economy 2. Same 'Ol, Same 'Ol: Economic Cliff-bottoms vs. Cliff-diving 3. Between Stalingrad and Kursk: Real Economy, Policy and Outlook 4. Where's the Money: Markets, Outlooks & Re-Thinks 5. Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness 6. Refreshing the Economic Outlook: Fundamentals to Business Outlook 7. Moscow, Stalingrad, Kursk: Edge of the Abyss to "Recovery"? 8. From Mythologies to Realities: Economy, Employment, Credit & Trade 9. Markets Away: Run Baby Run? Or Stumble? Or What? 10. More De-mythologizing: a Little Markets, Some Economics, Lots of Policy 11. Really Different This Time: Liquidity, Rates, Markets & Risks 12. Surprise, Surprise: Not a Rally and It's Still Different 13. It's Still Different: Refreshing Policy and Market Info 3 6 8 12 15 19 22 26 31 33 37 39 42

14. Cuspiness, Collisions & Conundrums: Market Carry, Employment & Euphorillusions 43

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August 01, 2009

Interrupting Your Reported Data Distortions: More Darkside for the Economy We' interrupting your regularly scheduled data dumps of economic data, and our re planned posting schedule, to bring you this special bulletin about what yesterday' s GDP numbers really said. First off there were not just huge revisions but a complete re-factoring of the data. This is not, and for the record, some nefarious government plot (though it will again be taken that way) which resulted in better data and revisions stretching back decades. Which made, among other things, the ' 01 downturn much milder and this one must worse. More importantly our recurrent theme of needing to really look into things needs re-emphasizing because the reported headlines are based on QtQ data instead of YoY and when you look at properly are much worse than anybody is telling you. The fact that mis-interpretations and resulting distortions are beyond widespread, beyond endemic and would appear to be innate is another critical factor. This morning' WSJ put it all very nicely in historical context though by comparing s the decline in GDP to previous downturns since the end of WW2 with this nice chartporn. We' dig into all this graphically because it' critically important but what ll s you need to know is the headlines reported QtQ changes over the last three quarters in real GDP of -5.4, -6.4 and -1.0%. Which gives great weight to the fantasies of a V-shaped recovery. In actual fact, on a YoY basis, the last three quarters were -1.9, -3.3 and -3.9%. Let me repeat that - REAL GDP WAS DOWN IN Q209 BY ABOUT -4% !!! If you take out the effects of trade (exports were down -15.7% while imports dropped further by -18.6% and net exports as a whole were -28.7% YoY. That last number is a slight improvement over the previous -29.8%) GDP x-Trade was down the last four quarters by -1.1, -2.5, -4.4 and -4.7%. Let' try that again too...DOMESTIC GDP s WAS DOWN ALMOST -5% !!!!!. No way, shape or form that one can read those as good numbers. Nor can one argue that they show much flattening of the rate of decline, or bottoming out. The QtQ numbers do tell us that we' in the process of crossing that cusp point though and we' expect to see better re d numbers in the next few quarters, at least in the sense that the rate of declines drops. Positive GDP improvements are a ways off, significant positive GDP improvements farther, growth in employment and investment and the return of a naturally growing economy is much...much...much farther off. In fact the Fed expects that after a bump up the longterm outlook is for an average growth rate of 2.4% - that' barely breakeven on required new job creation and means s we' going to have an organically weak economy - thru 2015 and beyond. re

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Letting the Real Economy Stand Up
Let' put all that in context with this graphic so you can s what the data really says and how it looks in comparison to the last two decades plus (we' go back farther but the d structural revisions of the data are a work in progress and it' be some time before it' completed and we can rebuild ll s all our spreadsheets). There' a pernicious meme in wide s circulation, mostly driven by deliberate distortions for political purposes, that the stimulus program isn'working. t In actual fact about $300B of tax cuts and transfer payments have already gone out the door and have been what' kept state and local disasters from turning into s catastrophes. A very rough cut of GDP, with and without Federal spending, shows the downturn would have been significantly worse. NB: that initial $300B is about all that could be shoved out the door and actually work. NB2: and the pace, timing and structure of the program thru the rest of this year and thruout next, on which continuing to keep the wolves at bay depends, is beyond what the operational capabilities of the federal departments can handle; in other words about all that can be done is being done. (Realities vs Rhetorics: Economy, Policy, Real Data). Understanding the real data is critically important but it would appear that understanding how it' being mis-reported s and deliberately mis-represented is even more so. Without Federal spending YoY GDP growth would have been -0.6, 2.7, -4.0 and -4.7% the last four quarters. In other words the economy was almost a full percentage better than it would have been otherwise in Q2.

The Real Outlook: Consumption, Investment and Implications
Current consumption tells you how the engine of the economy is doing, investment (real estate and business) tells you how it' likely to be doing and the s combination of wages and employment tell you how future is likely to evolve. The second chart above us that Consumption is still bad but it leveled off somewhat, instead of following over the cliff with GDP usually does. For the last four quarters real Consumtion was -0.7, -1.8, -1.5 and -1.8%, so it' s bumping along a bottom for now. That is its not getting but it' stopped getting worse - in some significant part s because of stimulus. Employment on the other hand is dropping like cliff-diving lemming, along with GDP.

the shows as it better

Consumption drives future business expectations which in turn drive hiring and investment decisions; which, in turn, feedback on consumption decisions. With consumption still very weak and employment dropping we' be lucky if ll demand holds up which means investment and hiring will be constrained for a long time. Take a careful look at investment in this second composite - it sharply peaked in early ' and began declining immediately. The first thing 04 that tells you is one of the major reasons we had a very weak and jobless recovery - the organic feedback loop never caught and the engine was just sputtering along with poor capex spending and hiring. Then it started falling rapidly until it went cliff-diving very early in ' The last four quarters were -8.1, -12.5, -25.2 and -27.4% YoY! 08. Investment dropped by almost 30% in Q2!! Residential investment generally leads the business cycle and this last time housing price bubbles led to sustaining Consumption on the back of the Housing ATM. That' created a long-term s structural problem where excess inventory will have to be worked off, where Housing won'recover as it normally does t

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and where the ATM is never coming back. Business spending fell -6.0, -17.4 and -19.6% the last three quarters. Again the start of a bottoming process but -20% is a LONG way down in our book.

Investment and Future Demand
In this third composite the top part breaks down Investment into its two major components so you see the RI and Business pieces separately. (Again the revisions to the reported data and the going updates make the earlier data a little squirrely, technically speaking, but the recent appears reliable.). In the top of this graphic you see how the cliff-diving real estate drop preceded overall downturn and then how business spending has followed it off a cliff. With all this in (the worst downturn, preceded by a jobless "recovery", VERY poor business spending prospects) we can probably say that getting back 2.4% growth would be an optimistic outcome. can ondata can the mind to

The next question is how is the Consumer going to react, now and in the future. Remember no more stock market or housing bubbles to subsidize consumption. Then there' the re-balancing and de-leveraging of consumer balance s sheets - the fuel that drove the engine the consumption engine for three decades is being taken away. Now at this moment in time consumption depends, and will depend, on incomes and nothing else. The best indicator of that is the combination of real wages and employment. In the second sub-graphic here you can see where real wages have jumped up as inflation has dropped. But you can also see where job market pressures are beginning to impact wages. Meanwhile of course Employment is in terrible shape, and given normal business cycle behaviors in combination with terrible job creation prospects, will worsen significantly (at least 10% Unemployment and likely worse) and will be followed by a really terribly jobless non-recovery. At 2.4% growth businesses will NOT be hiring nor investing much.

What's Really Going On
This rather large and complex composite puts together four different graphics we' put up ve several times and like to re-use because they the complete story. One of the advantages of ideographic languages like Chinese is that the characters also tell a story because they are pictures. Think of this graphic as four ideograms that also form a fifth, master, picture how the major currents are playing out all together inter-actively. First you have the business cycle where Consumption drives business spending and but both Consumers and Business decide based on income, prospects and funding/borrowing. As we cycle around this feedback loop, which can be either virtuous or vicious (and we' in a vicious one indeed), the re economy oscillates like a wave pattern.




But we have some deep-seated structural feedback problems where Credit Markets sustain or constrain how the economy does. They are self-repairing in the sense that collapse is no long immanent (make no mistake last Fall and this Winter that was NOT a given - Bernanke, Paulson and Geithner saved Western Civilization). So Credit and

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Housing are still in trouble but the US Economy is, as we' just been pounding away at, in deeper trouble. As it ve happens, no matter what you here in the headlines, the International Economy is much worse. Partly because Japan and Europe are in the deepest dodo but also because China' reported growth is still not good enough to breakeven on s job creation requirements. It' not an accident that so many serious civil disturbances have been breaking out, getting s bigger, more serious and widespread. And also because China acted fast and well but has created terrible problems for the future by pumping too much money that moved out of their credit system into bad loans. The bottom left-hand chart pulls all this together and tells you where we think we' at in the cycle and what the re alternative paths were and are. A shallow V-recovery is out of the question. Depression 2.0 has been avoided, so far! Judging by GDP one could estimate we' at the beginnings of a bottoming process. But, especially with poor future re growth prospects, the continued deterioration and poor future prospects for Employment - which is IOHO the best gauge of overall economic health - has not begun that process yet.

There's a log of pain to come and our long-term condition will be chronically poor for a longer-time, even if we manage to start putting together positive growth on a sustainable basis.
August 14, 2009

Same 'Ol, Same 'Ol: Economic Cliff-bottoms vs. Cliff-diving The immediate prior post actually covered the ground we' going to re-cover with this one. The difference then is that re we pivoted around the new and revised GDP numbers to hang everything else on while this time we' focus a bit on ll employment and retail sales. While we put up this longish posts that cover some ground and attach excerpted readings to go with them this time we' outdone ourselves on the readings. In fact normal blog practice would have had almost ve 20 separate posts on just the first item - the hot, recent econ news, alone. This way though you don'get machinet gunned with a bunch of data that doesn'fit into a larger picture. Instead we' going to drop a round of artillery with t re many big guns to try and link it all together. We start with the recent economic news (employment, output & consumption and real estate) then we hop to some big picture topics on the longer-term consequences of the new new thing...FRUGALITY! Then we segue to the international consequences with particular attention to China, move on to talking about oil and the dollar and conclude with a few readings on policy. Which, btw, was extensively covered in the last post (Interrupting Your Reported Data Distortions: More Darkside for the Economy).

Employment and Outlook
Amazingly enough a loss of only 270K jobs had everybody in the streets, completely unjustifiably so in our opinion. The chart on YoY Employment is shuttled off to the readings. The number that showed any "improvement" was unemployment, was down "only" -60% instead of the prior ' -80%! Jobs and continued to deteriorate. Consumer spending is NOT going to back until we see significant long-term job creation, which will time coming. Based on this prior chart of job re-creation (HT CalculatedRisk of course and not the NYT, who ripped him off w/o attribution) this is already longer and deeper with more to come; ioho we' not going to see significant job creation for a long re time indeed. To breakeven we need to create 150K jobs/month, otherwise it' the Red Queen falling farther behind. We s entered this recession ~3million in the hole and are now about 12 million jobs in the hole. It' take a long period (five ll years?) to make that up and requires that we hit 4-5% GDP growth (3%+ real growth?). The Fed' looking for 2.5% s growth in real GDP at best ! dancing basic only which hours come be a long

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Consumer Behavior
Some folks outlook is pretty sanguine but some have a more realistic view, as you can see in this chart on consumer spending recovery. More importantly we funded the growth in consumption in the ' on the 90s wealth effects of the Tech Bubble and during this decade by leveraging the housing ATM. Those are both going away, consumer are converting to savers, faced with years of having to re-build their balance sheets AND we' seeing some fundamental rere thinkings about what we actually need. So for many years at least credit availability restrictions will constrain spending, followed by balance sheet constraints and we might reach a new normal. But that new normal will at a lower set point. The best depiction of all that we' ve is (HT!) from our buddy Jake over at Econpic where he looks at 10yr annualized change vs. net worth.

then be seen

Read a certain way the last four decades of consumer wealth creation has just been destroyed. And people are pricing the market for a quick-hit V-shaped recovery? We don'think so. t

The China Syndrome and Consequences
China' performance so far has been miraculous while India and Brazil' have s s been excellent. But Russia is sliding over the lip of a black hole. We want to talk about China mostly but a few words on the others as well. First off, China' recovery has resulted from massive public spending and s money injections. But unlike in the states where the new money disappeared into the banks balance sheets China' sloshed on thru to spending. The s question is how much of that went to productive investments that will pay off in the long-run. Not a lot. Aside from severe data reporting problems where their kumquats are not either our apples or oranges (cf. the Jim Jubak URL in the readings on China' realities) the real problem is their continued dependence s on exporting. If the US and the other developed countries become net savers and reduce consumption the demand for Chinese exports will drop dramatically. That in turn will lower the demand for commodities over what the speculative fantasists are currently imagining. When you look at the long-term prospects China has to keep running faster and faster to stay ahead of its population' needs for jobs s but is facing some major barriers. So, of the BRICS, we' have to say that Russia is a basket case headed for d worse, India will face many challenges and China is storing up serious problems for the not to far future. On the whole the best of the four is Brazil, which has pursued careful monetary and fiscal policies, has a more robust and balanced economy and has a shot at growing domestic consumption enough to be self-sustaining. China may eventually get there (certainly they are aware of the problem) but it won'be easy, will take longer than expected and be at a lower growth rate than we' seen. So for everybody t ve expecting commodities and gold to shoot off think again.

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The one major caveat, which we' discussed before, is that folks like Russia, Mexico, Venezuela and Nigeria have ve been over-exploiting their existing oil fields and not investing in new ones. So, even with reduced Chinese growth, we' likely to be back at a D>S imbalance.(Oil Industry II(Analysis): LT Supply-Demand, Outlook and Disruptions) re Note: this will also impact the dollar. The dollar rose in the last several months as a flight to quality play when everybody was piling into US Treasuries (so much for the "replace the $" theory) and is since dropping as people are becoming more comfortable that worldwide Armageddon has been averted. What drove it down secularly, over a period of years, was that we were exporting borrowed dollars to buy oil, goods and other stuff from China and the ME. As we shift to a Savings > Investment world net exports will tend to get more positive. And fewer dollars will be flowing abroad; the net result will be the reduction, if not elimination, of the structural down pressures. Welcome to the Brave New World of the New Normal. But bear in mind lots of folks think we' kidding so you may want to play them! re

September 4, 2009

Between Stalingrad and Kursk: Real Economy, Policy and Outlook Stalingrad was not just a terrible battle but an extended, multi-month campaign that was part of a larger operation, but it was the end of the beginning. Since we like military metaphors, especially ones that work this well, compare last to the Battle of Moscow where Russia almost died Zhukov' troops were marched from the trains s directly to the Front. The real point is that we are wrapping up our Stalingrad in that we' stopped ve diving but we' lying at the bottom, broken and re bleeding with a long and painful crawl across the side and a cliff waiting us there. Kursk was in front the Russians in 1942 and a lot of war after that. if you think we' kidding about all this check out re Timeline of the Eastern Front of World War II.

Fall and cliffother of NB:

The really scary metaphor that' so close it' a s s model is how deep in trouble Stalin got by ignoring the intelligence from Richard Sorge that told him the Germans were going to attack. Stalin didn'want to t hear it and Russia almost died. We trust the comparison to the willful denials that got us here are clear but the real problem, in all the sturm und drang, is that people are substituting ideology for analysis and are about to repeat the mistakes. The accompanying graphic, used before, explains where we' at and what the outlook is, and we intend to prove our points as best we can. re

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Current Economic Situation
Sorry if this is a little to much data crammed into to small a space but we wanted to cover lots of ground AND present it all as one gestalt, in the same way a pictographic language like Chinese (subliminal hint) convey background ideas by using pictures of real things while its saying something directly. All charts are YoY% changes of real data and the UL chart shows GDP, Consumption & Employment. GDP was down -3.9% vs. last quarter' -3.1% while s Consumption was down -1.8% vs. -1.5%, though on the charts you can see it flattening; that' all despite the huge s stimulus effects. Two prior posts spend more time on the shorter-term data if you want to see that flattening more clearly (Interrupting Your Reported Data Distortions: More Darkside for the Economy, Same ' Same ' Economic Cliff-bottoms vs CliffOl, Ol: diving). BtW - responsible, non-ideological analysts put the impact of the first round as adding up to +4% to GDP and saving our bacon. Sorry to tell the ideologues, it worked. Employment though is down -1.6, -3.1 and -3.8% over the last three quarters, which explains why we have two your are here lines on the cycle conceptual chart. Output wise we' re flattening but Employment wise we' not hit bottom yet!!! ve

Strategic Outlook
We re-visited our estimates of job creation and cumulative growth by directly pulling the employment and labor force growth, estimating productivity impacts from historical data and calculating aggregate job creation. It turns out we about 147K/month, or 440K/quarter instead of the we were using to breakeven. Breakeven also requires at least 2.5% real GDP growth and preferably 3%. Without that level of growth we dig hole deeper and we' now about -10 million jobs re hole, as shown in the LL sub-chart above.

need 150K the in the

The UR and LR charts compare changes in Consumption and GDP to changes in national income real wages plus employment (our old indicator was changes in real weakly (deliberate Freudianism) wages but deflation is badly distorting that for the first time in decades. As long as jobs keep disappearing, people keep dropping out of the labor force and incomes are under pressure demand will have a tough time growing. Especially now that asset-backed borrowing (the Housing ATM) is history. That means the ugly recovery we should have had after 2001 but were saved from is back and it' really PO' s d. The OBM just published its Mid Session Outlook and gave us its long-term prognostication to 2019.

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Before you upchuck because it' the government we' mention that there projections are consistent with the major s ll international agencies (IMF, World Bank, OECD,...), major players (Roubini, Feldstein, Krugman, and private/street forecasters (GS/Hartzius,...). If anything they all converge, roughly, but are a little optimistic. We' piled ve up a whole bunch of readings and John Mauldin in particular has an excellent series (the Statistical Recovery). Unemployment peaks out near 10% and takes a long.....g time to get back to 5%, GDP peaks up about 4.3% in 2012 but tails off to 2.5%. This is going to be the Mother of painful, extended and jobless recoveries we' sorry to say. BtW: for all the gold bugs re buying food and ammo the OMB' interest rates are pretty sanguine for a long-time. Again we' looking at the triumph s re of ideology and not data or analysis. But that' a really important point - you don'just play the game, you compete with s t the player. And if that many people are insisting on using funhouse glasses colored red, by all means, prepare to take advantage.

Politics, Policy and Salvation
Speaking of using your forebrain to rationalize into what you want to see we might mention been going on the policy front. Which we discussed extensively in a prior post with looks at spending, the structure of the package and the history and outlooks for the deficits. (Realities vs Rhetorics: Economy, Policy, Real Data) The fascinating thing to us is that no single member of network has given any credence to our analysis, bothered to look at the numbers or taken a position that they didn'go in with. t what is what' s real really our

Menzie Chin has a very straightforward estimate of the impact of the stimulus so far, and came up with 4%, which he then chopped in half to keep the trolls off his back. (For an interesting dissection of public intellectual disputes and bad math click here.) The package was very carefully constructed to get tax cuts, transfers and rebates out the door fast and then gate more effective and directed programs that are at the limits of what can be implemented. Other than the Administration itself there are no commentators who have clearly put the economics, the impacts, the mechanics or the politics together into a holistic assessment. We' done our best with ve this graphic, which relates the various alternative paths forward to the structure of the package and the cusp points where we are at risk of mission abort. Right now we' in for a U-shaped recovery that' be drawn out as balance sheets are re-built and people turn from re ll spendthrift borrowing grasshoppers to frugal and saving ants. If the political pressures for killing the remaining programs mounts far enough the risks of a W-shaped recovery increase exponentially. Worse, that recovery will be non-organic and have high likelihood of stalling us in a long-term malaise where we don'succeed in re-basing the t economy. We won'go into the package structure or deficits, which were covered previously with charts on the Stimulus Structure t and Deficit History but each is not what you' been told. For recent updates by Menzies on the nature of the ve deficit/sources and on the budget deficit outlook click on the highlights. What he highlights is that the higher the economic growth rate the lower the deficits, the faster the debt paydown and the lower the burden. But we all know that from our private lives right - when we borrow to spend we dig a hole and when we borrow to invest we get future returns? Right? Right? Oh, never mind.

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Seeing the World As It Is...Are You Kidding?
Let' pick up on that point, starting with this graphic from a s Money/CNN online survey which tells us what the man in street thinks (sorta), instead of us bloggers, the pundits or pontificators. Based on what we' just been saying the ve people seem to be more realistic than the pundits; or paying less attention to the so-called "statistical recovery" feeling the pain of real job losses, income shortfalls and prospects. In some ways, looking out to 2019 with the they' too optimistic. Compared to the folks who just ran re markets up they' paragons of pessimism and/or realism re course. recent the the and poor OMB, the of

The LT corner sub-chart in the very first graphic might have been a puzzlement, though the reason we shaded certain indicator dials should be clearer. And if you read the excerpts after the break, e.g. on Housing, even more so. But why did we indicate that the international economy is worse off the US domestic economy? That' a key question and one s we dove into deeply in an earlier post (Same ' Same ' Economic Cliff-bottoms vs Cliff-diving), triggering off of Ol, Ol: Mike Pettis' "China Financial Markets" observations, which again in the readings, you' find is now in wide circulation. ll Basically it' this: yes indeed, China has held up well with rapid, forceful and large stimulus actions. Unfortunately it s needs 6% growth to stay ahead of the riots. That would be yellow all by itself but for one thing their accounting is kinda funny (not necessarily deceptive) in that intermediate output is counted in the stats so they look much better than they probably will. For another all that sloshing cash injections went into loans that are likely to turn bad. That all taken together at least turns China pinkish, to be technical. But they, along with the rest of rapidly developing Asia, face a major structural conundrum. They need to shift from export oriented economies to domestically driven ones and that' s not happening. As US consumers save more they will import less and we will need enormously less in terms of foreign financing. That' why they and the rest of the international economy, and for similar reasons in the aggregate, are s shown as bright red. But, as usual, none of this is reflected in the headlines or most analysts thinking...yet.

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September 8, 2009

Where's the Money: Markets, Outlooks & Re-Thinks This is going to be another longish post, focused on the current market situation, the outlook, special cases and the emergence of new approaches to investing. The last is the most important, deserves careful consideration and lots of investigation and will be our capstone. But the bottomline is that the old shibboleths are beginning to go into their death throws and new paradigms are emerging. We' be following that line of thinking but the old 60/40 equities/bonds asset ll allocation based on the Efficient Markets Hypothesis, buy-n-hold and ride the trends are going away. We have some thoughts on what replaces them but it' going to be a very different world for a long time to come. s

Markets, Earnings(?) and Euphorillusion
Let' start with the current market situation. The top sub-chart s shows the SP500 YtD and shows some of the technical signals that called for turning points. Some of which panned out and many (the yellow warnings) that didn' Reviewing the bidding we started the t. sliding until the real economic data led to fears of Armageddon and panic. When it appeared the banks weren'going to all die (say t thank you Timmy) we got a major bear market relief rally that' s almost died again several times but each time found hope in green shoots and earnings. There are several huge problems there: the earnings aren'really t but based on cost-cutting and expectations management, much of volume has been concentrated in very few stocks, i.e. the Financials, and is even less grounded in reality and what we' ve really been experiencing is a sentiment driven market. The bottom chart brings back a little reality...the downtrend is intact. Re-visiting some key charts we' concatenated from previous ve discussion might put things back in their proper context. The top shows cumulative growth since 1950 in real GDP, Corporate Profits the SP500. Notice we got two market bubbles, a profit bubble this decade and that the markets barely kissed the long-term trend of growth before taking off again. Where' the reality in that? s Two other major things to notice though - before delusional thinking over everything followed coincident structural trends AND the markets had long secular cycles (uptrends and downtrends) along deeper path. There are two possible futures implied here. One, we return to sanity and enter a decade of the doldrums. we sustain the fantasy based on who knows what. IN EITHER CASE the old "stocks for the long-term" shibboleth dies and active investing based on structural, secular and technical integrated analysis becomes the new paradigm.


good the sub-

chart and real took that Or

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The other thing to notice in the bottom sub-chart is that the profits were a combination of structural sub-par performance in the real world and leveraged risk-taking in the financial. Now do you think the Finance Industry' s going to be able to replicate that? And at what cost to the rest of the world?

PE's, Valuations & Returns: Where's the Money?
The question then becomes where' the money? Equity s returns are composed of earnings and prices, that is, Ratios. In fact the finance community talks about betas alphas. Beta is the weighting factor based on expected market returns, preferably adjusted for risk. It tells you return you should expect if you got a normal return over long-run. In fact much of the bubble returns, before were destroyed, were betting on leveraged Beta. Alpha is the return you get that was unexpected, i.e. resulted from insight, analysis, luck or skill. Beta is to be low for a long time, leveraged Beta (trendfollowing) could kill you so if you want something besides the lowest common denominator it' going to s work to go seeking alpha. We' used Bob Shiller' work several times on longve s PEs so we' taking a different data set from S&P in re charts which show PE' based on 12Mo Trailing s Earnings from 1936. The average PE from 1936-1990 14.4 and from then until 1995 or so the PE' cycled s naturally around that average. Then they went to the and never came back. PE and what the they that going take term these was moon

That' a really critical point - PE's have never s corrected back to the average in the last 15 years or so! The bottom sub-chart looks at the difference between average and current PEs and reinforces that point. It' s critically important to remember that exceptional returns don'result from buying at the highest price. We' used t ve Graham-Dodd' framework to chart the relationships between PE' growth rates and interest many times so we won' s s, t revisit that chart but suggest you review it. Then ask yourself, at these prices, where' the return? s

Assessing the Markets
Taken all together our experience is that at any given time there are four factors weighing on the markets. The first is Structural – what are the long-term secular and structural trends, particularly changes, going on in the economy such as the emergence of the rapidly developing BRICs and the associated impacts on energy and commodity markets. Next is the Fundamental – by which we mean what are the basic economic fundamentals associated with the real state of the business cycle. That can be taken to subsume business fundamentals on the outlook for industries and companies, which build on the first two factors; e.g. the implications for the Energy Industry. The third are Technical factors – that is how is the Market reacting to its own internal pressures and dynamics and can we analyze them. Technical analysis is focused more on the short- to intermediate-terms while structural and fundamental tend to work out over longer timeframes. Moreover the latter two factors tend, as we’ve shown, to converge on basic economic performance. Going back to our description of Mr. Market’s behavior he tends to settle on the sober-sided basics eventually but, as we’ve learned to our sorrow, he can also be volatile and giddy in the shortterm. Which means that Technicals are important part of the toolkit but a sense of the very short-term market

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psychology, Sentiment, is also critically important. Our judgment is that, right now, Mr. Market is almost entirely under the sway of sentiment driven fashion. The accompanying graphic compares our four-factor assessments from Jun08 to Jun09 and, looking back, seems to have held up reasonably well in both time periods. Our take now is as follows:


Structural – C-/C: after the earlier discussion we think the economy’s freefall has been arrested but the longterm prospects are rather poor and dependent on first crossing over into selfsustaining growth. The downturn has led to serious under-investment in energy development so future supply/demand imbalances could return as current proven resources are drawn down. On the other hand structural shifts in world trade as the US saves more will reduce long-term growth rates in China, and lower the imbalance pressures. Fundamental – C: the economy is bumping along the bottom and the chances of a rapid recovery are poor. There is also a downside risk that a recovery will be aborted and we will see a W-shaped pattern. A bigger risk is balance sheet re-building, a deferred Housing recovery, other risks to the Financial sector and the likelihood of very poor job creation dampening demand. We’d also judge the odds of being able to re-base the economy to higher growth as poor. Technical – C/C+: the bear market rally appears to have run its course and was based on a combination Armageddon avoided relief rally, misinterpretation of earnings quality and outlooks. However the market is not particularly oversold or overbought and could have some upside surprises still in store. The biggest surprise risk is that the longer-term earnings and valuation realities will finally sink in. Sentiment – B/B- and dropping: our judgment is that this rally was based almost entirely on sentiment. Probably the best ways to judge sentiment are by a close reading of headlines and pundits comments as well as by market reactions to news. When the market continues to rally on “not-worse” news sentiment is strong and positive. When better news gets a yawn, or worse a drop, then it is shifting. Right now we’re in a very volatile state with regard to sentiment as the last two weeks show. There is a real and significant risk that sentiment will reverse suddenly for




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the worse. As it did, we should remind you, in mid-February when economic realities visible for months were finally accepted. Brave New World, Old World Approaches
It' a brave new world, that seems clear enough. What' not s s is what rules are going to best for surviving and thriving in it. There are some huge re-thinkings beginning to go on but the approaches haven'come up with a new playbook just yet. t think that new playbook is going to be active investing based understanding what' going on and then taking intelligent s decisions while managing risk. The old blind cookbook approach to riding the Markets and hoping for "leveraged Beta" should be dying a natural death. other two critical lessons we think are there for the hearing, if for the listening, are that lots of folks got into lots of trouble letting the ' hindbrain make the decisions. And it doesn' old t appear to us as if many are prepared to put the adult forebrain in charge. Who knows - maybe finding the lizardpopular delusions and mad crowds is the new trend to figure how to take advantage off!? Vitaliy Katseelson has an interesting, fascinating and useful piece up on Scribd on Active Value Investing that we recommend you downloand and memorize. And then apply. We' borrowed a couple of his charts on equities vs bonds ve during uptrend and sideways markets to highlight some of key points. Notice that the periods he' looking at map s exactly to the secular cycles around the structural trends we discussed earlier. One major quibble with his charts though....the apparent advantage of equities in the first sub-chart was a bubble effect, not fundamentals. Think about it! clear new We on

The not by brain out


September 27, 2009

Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness It' time to re-visit, update and wrap-up our discussion of the Finance Industry and the chances for regulatory and s legislative reform. On the one hand this is an important part of the domestic policy agenda, and in some senses, arguably the most important. On the other it' been back burnered ostensibly by the press of events which has resulted s in all the last few weeks punditry commentary getting it wrong, at least in our ' humble opinion. Analogously to Healthcare Reform the administration first focused on the necessary emergency measures while trying to build a sense of cooperative self-interest in the finance community. An attempt that, unlike the HC communities (believe it or not), has foundered on the rocks of short-term and narrow self-interest. A point we' been arguing for a very long time and used ve as our central point in the last post which reviewed the state of play. Here we want to concentrate just a bit more on the stakes, the liklihoods and outcomes and the potential impacts.

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In Fed We Trust: Our Near-Death Experience
David Wessel of the WSJ has written an excellent book on the crisis, which he started before Bear-Stearns went under and which he tracked thru the entire crisis. While he' appeared on several talk shows, of various sorts, the s talk he gave in a Washington D.C. bookstore was the best because he had time to cover his findings in some detail and because of the audience' s pointed and intelligent questions. Before leaving this topic we highly recommend your watching the CSpan video clip ( s_id=288534-1&showVid=true ) He concludes by making three points: 1) we had a near-death experience and were saved by emergency heroics, perhaps largely those of Ben Benanke and the Fed, 2) we' survived the worst of it barely but have a long way to go before we' restored to health and ve re 3) there' been little or no change in the regulatory and legislative framework. s We' come back to that last point at the end, and it' vitally important, but our critical observation is that the ll s commentariat mis-understands the process the Administration is following. First, put out the fire and start the repair work while second, attempt to inclusively line up support. Now they are shifting to a full-bore press and we would suggest that the Industry NOT under-estimate their chances. It wouldn'take much to fan the smoldering torches into a t conflagration.

A Little History Review: Debt Since WW2
These potential reforms are important only insofar as we a) mitigate the chances of it happening again, b) we maintain a healthy, vibrant and contributory financial sector while c) doing away with the socionomic dysfunctions that almost destroyed the economy. The root of all this are debates over the level and role of debt financing in the economy so we thought we' review a little d history to put things in context. To address we built two sets of composite charts from Fed data on money flows and the results make interesting viewing. In the UL sub-chart current dollar debt (our estimates) grew from about $2.5T to about $31T from 1945-2008; and contrary to current headline and political mythology that' not Federal debt that' the largest s s portion, it' Households and Businesses. s post-war prosperity was built on a sea of it.

that the


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In the LL chart though you can see the structural shifts where relatively speaking Federal debt was shrunk while Financial sector debt grew enormously. These shifts are highlighted on the right-hand sub-charts as multiples of GDP where total debt grew from 1.6X GDP to slightly over 3.5X! More interestingly Household and Business Debt grew steadily until the ' when it jump-shifted, and then did so 80s again in the ' and ' 90s 00s. Bear in mind who was making that debt available - which leads to the most startling growth. Financial debt grew 0.01X to 1.18X of GDP, or about 1,163%!!! In addition to pointing out that it was post-deregulation that we began drowning in debt but in fact, contrary to popular political mythology, Federal debt was steadily paid down until the Reagan administration when it ballooned again, then was paid down during the Clinton years only to be re-built during BushII. Not what you normally would think, eh?

Relative Debt Growth
The second chart shows the normalized relative growth and highlights many of these points from a different perspective. All these charts are built around cumulative % growth 1945 to 2008 and show the relative, normalized, growth of each of the major sectors. As you can see in the UL growth in Finance debt outstanding completely swamps other sectors, which is why the other charts break things out separately. The LL sub-chart shows the major sectors, excluding Finance, UR shows Finance by itself and the LR subcharts shows Household debt along with growth in Credit Cards and Mortgages. Here' the fundamental questions these s charts raise in our minds: 1) What' the appropriate level of debt for a healthy economy? We' suggest something more in line with the points s d reached around the mid-80' except for Finance. s, 2) If that' true what kind of regime will be required to evolve back to that point? How long might it take to get there? Is s it feasible and what happens if it' not? s 3) If Banking and Finance need to return to their roots (not say 0.01X of GDP but something on the order of .25-.5X, ala the 1980' what kind of Industry will we have? Is it even possible? Is it politically feasible given the heartfelt opposition s, of the Industry to even modest reforms?


all the

Fighter's Go to Your Corners: the Prospects for Reform
Ah, there' the rub, as they say. It' not an accident that the President made s s a speech directly to Wall St. on this topic nor that Summers, Blair and Shapiro were addressing the Georgetown University seminar on Financial Reform about the same time, nor that a whole slew of regulatory changes were being announced by the Fed, during the same time period. We' ve have to say that the agencies, the Administration and Congress are headed for the mats, as Sonny Corrleone would put it, over this. And should be. But that kind of warfare does no one any good - it may simply be the best alternative that we' all left with. We' continue to argue that after loosing re ll (destroying) almost a decade' worth of funny-money profits it' even in the s s Industry' own evident self interest to proactively and constructively s

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participate in re-shaping the regulatory and legislative framework. Larry Summer' Georgetown speech (http://www.cs aspx ) laid out the Administration' framework pretty clearly, as well as explaining the reasons and intents. Five major s principles were laid out: 1) Capital Adequacy for systemically important institutions (which also implies no more off balance sheet green curtains) 2) Resolution Authority - in other words the end of TBTF (to big to fail). As Larry put it we don'ever want to t find ourselves again where we were with FNM, FRE, LEH, AIG and MER with no institutional recourse. 3) Regulatory Arbitrage - no more shopping among regulatory agencies for the best deal, and that especially includes international comparison shopping (if you don'think that was an important part of the recent G-20 t meetings think again). 4) Regulate Systemically - no more regulatory "prudentially" single institution by institution but ask what impact the collective will have. Think of it as the end of "we will assimilate your distinctiveness and make it ours". 5) Consumer Protection - need a separate authority to focus on the health and well-being of the consumer instead of letting those concerns get swamped by concern for the financial health of financial institutions. That (hopefully of course) means the end of predatory lending practices or exploitative credit card marketing and management.

And the Alternative?
Summers pursued a great analogy when he compared changing the regulatory framework to how we deal with Automotive Safety issues. For many decades the theory of auto safety was that it was the responsibility individual drivers. But as more and more vehicles got the roads with higher and higher performance cars we an "epidemiological" problem - that is there were more more unecessary deaths because cars were changing than humans evolve. By comparison then do we continue to let the death toll mount or do we do something? One thing the Industry is under-estimating outside the Beltway or NYC is the depth and breadth of public anger. One could argue we saw similar outrage after Tech Bubble burst with Enron, Worldcom, and the outrage petered out. The difference though, this time, those actions didn'threaten society. t

of on had and faster

the is

Last June we were at a conference on the future of corporate governance and one session, focused on improving Board decision-making, was taken over by one gray-haired gentleman' anger at the breeches of fiduciary trust by the s Finance Industry. Bear in mind this was a couple of hundred people all of whom were executives, board members or consultants with decades of experience. If they were so anger as to loose control what does the rest of the country think. We suggest you listen to the accompanying vidclip of Michael Moore being interviewed by Dylan Ratigan on MSNBC and listen to Ratigan.

Refreshing the Economic Outlook: Fundamentals to Business Outlook Page 18 of 50 Welcome to the "New Normal"! One of the most fascinating things about it is that, like the "old normal" denial seems to be a fundamental element. We were going to put up a refresh of the economic data yesterday but delayed to catch the most recent Employment numbers, which were about as bad as it gets, not least of which was because the BLS revisited and revised its numbers and took another 800K+ jobs out of the last two years. If there' any debate that this is going to be a long, ugly s and jobless recovery that should start disappearing here, though slowly (that' the denial part) and we have heard s more and more folks singing from the same hymnal that we use. Now there' not many/any radical structural or trend s shifts in the data so, after a "brief" look at the employment data per se we' going to take a different perspective on re what that new normal might look like.Though we' bet it ll looks like this collage to most!

Re-visiting Employment
Starting with the Employment data (& there' a bunch of excerpts and URL pointers in the readings) let' take a scan of s s the data. YoY Employment, Private jobs, Hours worked and Unemployment all continued to worsen (Unemp would have been worse but labor force participation dropped again!). In the LL corner though we highlight the Private Jobs the heavy red line makes a point about the 3rd jobless recovery in the last 20 years: no new private jobs have been created since Q298! That' not after labor force, population or productivity adjustments - that' PERIOD! Speaking of which, we need 440 s s jobs/quarter to breakeven but net job creation was still negative, though improving slightly. On a cumulative basis though we' now about -12 million jobs in the hole. In other words addon whatever we loose over the next 18 months, re the under-employed and that 12 million and we' just back to breakeven. Think we' dig out of the hole by 2019? The re ll OMB doesn' as we discussed (Between Stalingrad and Kursk: Real Economy, Policy and Outlook). And just for the t, record the LR corner compares the business cycle to Employment for a little schadenfreudische unsinn!

Where Away From Here?
So the fundamental question is, when/how/where do things to come back? And what are the liklihoods? We' tried to ve answer that question by looking at cycle relationships and seeing what leads to what, following around the economic circle of life. The driving engine is Consumption where there' s almost 1-1 link which you can read off the first sub-chart in two different timeframes. The real question today' news s makes critical is when are jobs coming back? There the news is less appealing. We need 2.5% job growth breakeven, which would be about 4% growth. Given that the outlook from begin key

an right

for GDP the

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OMB, is for 2.5% GDP growth thru 2019 we' suggest that the chances of reaching that point aren'real good. In d t fact at 2.5% growth it' take a darn long time just to get back. There is NO investment, business or personal decision ll you or anybody you know will make that shouldn'be hedged against that outlook - maybe for the next decade. t Of course whether or not the implications will sink in and be strategically and effectively responded to are other questions entirely.

For Example: the Investment Outlook
What we' like to get back to is organic, self-sustaining growth d where increased jobs lead to increased consumption lead to increased investment, which leads to more jobs, higher wages and so on around the "Great Circle". When it works that' called a virtuous cycle - when it runs in s reverse it' a vicious one. From the top sub-chart (note how much s steeper it is) Investment is responsive to growth beyond a certain point. If we get to 3%+ growth it looks like we' get a big jump in ll Capex. On the other hand Tech spending is even more sensitive (the curve is much steeper). As long as the economy stays in the doldrums the outlook for Tech ain'very good. t And clearly the days of 9-16% surges have gone the way of the Dodo. Just as a bit of a test - how much of that do you think is reflected in Tech sector earnings outlooks and PE valuations? We' hazard that the inverse is true - that is people are still locked d into a mindset from the ' and aren'adjusting their thinking at 90s t all; and won'until the smoke signals on the horizon are fires at t their feet. Which does present some interesting trading opportunities but not very good investing ones, in general. RE Investment is the other interesting conundrum. Now as our friend CalculatedRisk has taught us all RI leads the business cycle and helps to drive it. As he also taught us it was Housing floating on a see of bad debt and decisions that was the ATM machine the held up consumer spending this last decade. Does anyone think that ATM is coming back? Anytime soon? Anyone, anyone...Ferris? To get a significant lift from RI it' need to grow at 10% and IOHO we' be lucky to see years of 3% growth, hopefully followed by some five d ll percenters. In other words, by the charts, expect no help from RI and take what comes as a pleasant surprise.

Comes Round Goes Round: Employment & Wages
The economy is a cycle - like we keep hammering on. Future and investment growth, such at is and/or might be, will stimulate hiring and wage growth. Now the (temporary?) of Inflation has driven up real wages short term and helped up spending, of course enormously helped by government spending. So in the next chart we' taken a shot at looking at ve key future indicators of consumer demand, the YoY change in sum of real wages and employment, and used Personal Income (PI) as alternative proxy just to calibrate things a little. Zero % growth in the first basically gets us back to that aforementioned 2% consumption growth but it' worse looking s more like 1.5-1.75%. To get future growth of, say, 4% in Consumption we need the sum of wages and employment to output death hold our the

at PI, grow

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at 4%. If it' PI plus employment it' more like 7%+! Now what in anybody' outlook makes growing real wages and s s s growing employment a strong likelihood!

Welcome to the New Normal Indeed: Where's Mommy?
We wish we could send you off this weekend with better news couldn'figure out how to do that without blowing a lot of t sunshine up your skirts, so-to-speak. The key for this new environment is going to be how well businesses and consumers adapt their behavior. It' not a question of the new s normal being supported by the new frugalities, but the "New Frugality" being forced by it. At the end of the day this is going an economy for a tough-minded Scotsman, a Buffett-economy other words, that will reward insights, analysis, preparation, discipline, patience and persistence. As well as having the courage to change. Now speaking for ourselves we always cowering in terror but we' hoping very sincerely that the re ain'true of our leaderships. URL: t


to be in prefer same

Back in the day when we used to do a little rock climbing there always came a moment when it dawned on the climber that that tiny little thing bracketed by their boots was the six acre parkging lot they' left a few hours ago. It wasn' d t unusual (ahem) for the next step to be clinging tightly to the rock whimpering for Mommy to come make it better. The best response we ever saw was the instructor who shook loose the safety rope and leaned into a loud stage whisper as they rope fell down slack, "you' gonna die"! A little harsh but the student did survive to finish the climb and go on the re next one. Consider this our "stage whisper" and add to your shoppinglist two key readings, one from Mohammed El-Arian: A CEO’s guide to reenergizing the senior team and Return of the old ways of thinking threatens recovery. Good luck...or as the German guy said in the Eiger Sanction...may we continue to climb with style!
October 8, 2009

Moscow, Stalingrad, Kursk: Edge of the Abyss to "Recovery"? We could title this post a lot of things but wanted to focus on a metaphor we' been using because it' powerful and accurate. ve s The Battle of Moscow in 1941 was when the Russians were saved, after letting themselves be surprised thru wishful thinking and ideological self-delusion (our term has been and is euphorillusion) by last minute miracles (Zhukov' Mongolian s divisions were marched thru the streets of Moscow in a "parade" straight to the front). That was followed by many things but a central one was the extended Stalingrad Campaign (as part of the larger Uranus) in 1942 which was only the end of the beginning. URL: The beginning of the "middle game" was the giant battle of Kursk in 1943, where the Russians entrapped the Germans into the world' largest tank battle and defeated them, partly thru better s

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intelligence and decision-making, partly thru luck but mostly thru a lot of darn hard work. Last Fall, as is now becoming all too clear, was our Moscow. We' been saying that for a while but how close we came to the edge of a worldwide ve collapse in the financial markets is becoming clearer and clearer. This last Winter and Spring was, and is, our Stalingrad. So, consider this post an addendum to the last as well as its own thing. We' going to largely let some key re excerpts speak for themselves with a little judicious commentary but will also point to a selected set of excerpts to back up many of the points after the break.

Fall in Moscow: Near-Death Experiences
Don'let anybody kid you, it was as the Iron Duke said in t another context, a "near-run thing, a damn near-run thing". Not only did LEH, FNM and FRE die but MER disappeared but we were within a hairsbreadth of seeing Citi, MS and GS go as well, despite the denials at the time and, especially on the part of GS, since. NB: we have no problem with the artful dodging of Paulson and other policy makers - tell the idiot horses that the fire was out of control would have triggered the panics they were trying to stop. Let us let an excerpt from Andrew Ross Sorkin' just out s book tell the story, but we' draw your attention to the stock ll charts....even might Goldman almost died in those few days and hours. And below we' also point to the charts on ll credit....which we' talked about before. Just in case the ve point' not clear - the financial system is still broke and s credit is shrinking....without continued Fed support the whole thing will blow away. We' a long way from fixed re and from starting to fight Kursk. Wall Street’s Near-Death Experience With the implosion of Lehman Brothers, in September 2008, the realization dawned: Morgan Stanley and Goldman Sachs could be next. In an excerpt from his new book, the author reveals the incredible scramble that took place—desperate phone calls, seat-of-the-pants merger proposals, flaring tempers—as Washington got tough and Wall Street titans Lloyd Blankfein and John Mack fought for survival.‘This is an economic 9/11!” There was chilling silence in Treasury Secretary Hank Paulson’s office as he spoke. Nearly two dozen Treasury staffers had assembled there Wednesday morning, sitting on windowsills, on the arms of sofas, or on the edge of Paulson’s desk, scribbling on legal pads. Paulson was seated in a chair in the corner, slouching, nervously tapping his stomach. He had a pained look on his face as he explained to his inner circle at Treasury that in just the past four hours the crisis had reached a new height, one he could compare only to the World Trade Center attacks, seven years earlier, almost to the week. While this time no lives may have been at stake, companies with century-long histories and hundreds of thousands of jobs lay in the balance. The entire economy, he said, was on the verge of collapsing. Paulson was no longer worried about just investment banks; he was worried about General Electric, the world’s largest company and an icon of American innovation. Jeffrey Immelt, G.E.’s C.E.O., had told him that the conglomerate’s commercial paper, used to fund its day-to-day operations, could stop rolling. Paulson had also heard murmurs that JPMorgan Chase had stopped lending to Citigroup; that Bank of America had stopped making loans to McDonald’s franchisees; that Treasury bills were trading for less than 1 percent interest, as if they were no better than cash, as if the full faith of the government had suddenly become meaningless. Paulson knew this was his financial panic. The night before, chairman of the Federal Reserve Ben Bernanke had agreed

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it was time for a systemic solution; deciding the fate of each financial firm one at a time wasn’t working. It had been six months between the implosions of Bear Stearns and Lehman, but if Morgan Stanley went down, probably no more than six hours would pass before Goldman did, too. The big banks would follow, and God only knew what might happen after that. And so Paulson stood in front of his staff in search of a holistic solution, a solution that would require intervention. He still hated the idea of bailouts, but now he knew he needed to succumb to the reality of the moment. “The only way to stop this thing may be to come up with a fiscal response,” he said. Paulson, who had been living on barely three hours of sleep a night for a week, was beginning to feel nauseated. Watching the financial industry crumble in front of his eyes—the world he had inhabited his entire career—was getting to him. For a moment, he felt light-headed. From outside his office, his staff could hear him vomit.

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Stalingrad - the Stimulus Package & Sausage-Making
Another thing we need to be very clear about is the next time were dancing on the edge of the abyss and how close run a it was and still is, as well as how much cleanup and ripple effect we' going to be dealing with for a long time. Now re we' taken some really deep dives into fiscal policy, the ve stimulus package and the effects it' had as well (Between s Stalingrad and Kursk: Real Economy, Policy and Outlook) so won're-review those in any detail. t But despite all the ideological arm-waving it' been the early s cuts and transfer payments that saved us from much...much worse (and yes we' talking GD 2.0 here), in conjunction with re Fed' unusual actions. It' also going to be Federal spending s s keeps the wheels on the wagon for the next two years while hope a more natural organic recovery begins to emerge from bombed out rubble. The accompanying chart on job losses hopefully brings home the point of deep the chasm is as well how far we' got to go to get to the other side. But the ve excerpt below should make clear the human dimensions of policy-making and sausage-grinding that went on. we thing

we tax the that we the as the

Inside the Crisis:Larry Summers and the White House economic team The most important question facing Obama that day was how large the stimulus should be. Since the election, as the economy continued to worsen, the consensus among economists kept rising. A hundred-billion-dollar stimulus had seemed prudent earlier in the year. Congress now appeared receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion. Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009 and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion. There were sound arguments why the $1.2-trillion figure was too high. First, Emanuel and the legislative-affairs team thought that it would be impossible to move legislation of that size, and dismissed the idea out of hand. Congress was “a big constraint,” Axelrod said. “If we asked for $1.2 trillion, it probably would have created such a case of sticker shock that the system would have locked up there.” He pointed east, toward Capitol Hill. “And the world was watching us, the market was watching us. If we failed to produce a stimulus bill, that in and of itself could have had deleterious effects.” There was also a mechanical argument against a stimulus of that size. Peter Orszag, who was celebrating his fortieth birthday that day, said that, while the argument for a bigger stimulus was sound theoretically, there were limits to how much money the government could practically spend in the near future. Summers brought a third argument to the debate, one that echoed his advice to Bill Clinton sixteen years earlier, when his Administration was facing persistent budget deficits that Summers believed were suppressing economic growth. He, like Romer, was guided by an understanding that in financial crises the risk of doing too little is greater than doing too much. He believed that filling the output gap through deficit spending was important, but that a package that was too large could potentially shift fears from the current crisis to the long-term budget deficit, which would have an unwelcome effect on the bond market. In the end, Summers made the case for the eight-hundred-andninety-billion-dollar option. “A lot of my research has been figuring out what policymakers did, why they did it,” Romer told me. “I have a whole new level of sympathy. Until you’ve experienced it, you don’t realize how hard it is. It’s humbling.”

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Geithner proposed an alphabet soup of programs to entice the private sector to take bad loans off the balance sheets of struggling banks. The crux of his plan was the stress tests. The Federal Reserve and other regulators would examine the nineteen biggest banks to reveal how much capital they would require if the economy worsened, and the results would be publicly released in May. The idea was that the process would restore confidence in the banks and reassure investors. But throughout the spring the plan was attacked by a growing number of economists and members of Congress as a pale alternative to nationalizing the weakest banks. In February and March, Paul Krugman alone wrote seven columns in the Times deriding the plan and calling for nationalization. What was more troubling for Geithner was that the White House seemed to be losing confidence. The political advisers dreaded the bailouts. In the end, though, Summers acknowledged that there were no better options, and Geithner’s plan survived intact. On March 31st, Summers sent the President a page-and-a-half memo outlining the reasoning behind the decision not to nationalize any banks. Obama was on his way to the G-20 meeting in London, and he wanted to be prepared with the best case against it.

Getting Ready for Kursk: Economic Repair plus Regulatory Reform
The final section of the readings is a set of video clip addresses that we recommend you make the time to watch, though the accompanying short interview should set the stage. In it some key players from both of the House discuss the state of things and their outlooks. One observation by Barney Frank we found especially interesting is that he expects a House Bill to be brought to the floor this Fall - and further that they' been working on it since the Spring of 2008, when it was kicked ve based on Sec. Paulson' suggestions! Think about the implications of all s for a minute. highly CNBC sides

off that

Now this is a topic we' spent considerable time and horsepower on, to ve the point of post after post. (Ask Not For Whom the Siren Shrieks: Let the Finance Wars Begin, Refreshing the Economic Outlook: Fundamentals to Business Outlook) So we won're-visit that t ground but you might want to refresh yourselves a bit. URL:

Planning for the Future
But there are several bottom lines here that need to be considered. 1. Regulatory reform is coming and it' be significant. ll 2. The Finance Industry as we know it will, or at least should, not be the Not just because of changes in the regulatory framework but even more becasue a) the debt-driven, leverage-based financial engineering of the three decades didn'work and b) because the business models of the t lines of business are broken. 3. The US economy has floated on a sea of debt, triggered by deregulation, and balance sheets will be re-built and de-leverage will be the of the day. That' reduce demand in the intermediate term and make the ll jobless recovery even more jobless but result in a healthier foundation. 4. This structural evolution is likely to take a decade to work out. 5. Right now, nobody is paying attention to these factors or preparing for The "New Normal" is being met with the "Old Normal" rules of thumb, behaviors and strategies. same. so last major



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6. So, not only do you need to re-think your own strategies, e.g. for investment, job and business development, etc. but you need to re-think them in a world of mal-adjusting laggards. 7. This too is advice and observation that will likely be ignored and so on around the circle until denial is no longer credible, new rules of behavior emerge and adaptations are forced. David Wessel covered some of these bases in a Capital column story from last week from which this graphic is drawn, which is excerpted in the readings. BtW any resemblence between that column and our previous post (Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness) on the topic is purely coincidental. Put it down to great minds converging on the same set of worries when examining the same realities.

October 12, 2009

From Mythologies to Realities: Economy, Employment, Credit & Trade We didn'really want to circle back to pure economics so quickly but there' so much mythologizing going on, without t s looking at the underlying structure and trends, that it seems necessary. Plus of course we had all this nifty accumulation of information and readings to point to! :) But with stuff like Brian Wesbury writing in the WSJ things like The Economic Recovery Is Well Underway it seemed necessary. BtW if you don'have a sub to be able to read it, don' t t bother (as my blogging buddy Barry put it- not worth the time). This is after all the guy who has yet to get anything right. Instead, for deep insight into the realties, we' point you to The Daily Show, which cuts closer to the quick in the ll accompanying vidclip. URL: . You have to admit it' not very often that you hear the greatest economist of the 20thC being cited s in a hip-hop video, now is it? And, all seriousness aside, the point of the video is actually fairly certainly captures the situation that most people are finding themselves in.

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Current State of the Economy
For something a little more straightforward we' point you to this extract ll the latest Northen Trust economic outlook update. The graphic is a composite taken from Paul Kasriel' s recent road show and if you click on it pull up a Powerpoint presentation with selected excerpts. On the other hand the entire presentation is well worth your time so if click on thru on the highlight you' get ll entire presentation in PDF format and download - we highly recommend it you' be able to see the entire pitch and ll Paul' words that' wrapped around the s re charts. from most it' ll some

you' ll the can since read

We' ask a little patience as well since ll we' re going to cover a lot of composite and complex pictures that deserve their own extended discussions but aren'going to t get it. That' because when you put them all together a large-scale picture emerges that' at the heart of the points we want s s to focus on. In this case the pictures are pretty clear - the worldwide economies appear to be turning back up but be careful to notice that the UL chart is a YoY chart and the rest QtQ changes annualized. On the whole the key take away is identical, except worldwide, to our last major econ post (Between Stalingrad and Kursk: Real Economy, Policy and Outlook).

Employment: Structure Outlook & Surprises
Which brings us to something else we' waxed on about but want to ve highlight as it' central, and that' the strategic and structural outlook for s s employment as well as the current situation. The last Payroll report surprised by showing Unemployment was nearing 10% and indicating soon would be as well as implying that job recovery would take a terrible time. The jobs picture has surprised everybody to some extent though all expectations were for a bad result it' worse than anticipated though it IS s following the standard patterns. The top sub-chart is drawn from Greg Mankiw and shows the expected pattern with and without the stimulus package. As you can it was worse earlier in the year, got much worse recently and is beginning to level off at a higher than anticipated rate. The stimulus package and monetary policy did their job and the situation much better than it would have been BUT that' not saying much. A s part of the problem is continuing credit rationing, another is the beginning large-scale structural shifts between sectors and another is business uncertainty about the duration of weak demand and business decisions hiring. The structural shift part is important, messy and complicated. Normally as the economy cycles up and down the allocation of people resources between sectors isn'changed much but with the overt investment in housing and other sectors those resources are being displaced. That takes time and is subject to a lot of friction. On the

that it long the

is major of about and

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bottom when you add in the under-employed there are 10 openings for every job - which tells you how serious the situation is, how weak the economy is and how long it' going to take to get out of this. s

Credit, Debt and Secular Changes
The next chart highlights some other aspects of the deeper changes will take the rest of this decade to work out. The bottom shows the current state of Consumer Credit, as well as history. A topic we' ve invested some time and effort on exploring in earlier posts (even triggering a WSJ story on the subject!). As we found earlier credit didn'grow appreciably until de-regulation t then accelerated in the ' and bubbled this decade when it fell off a 90s Given the condition of the banks with bad balance sheets, more loan losses, toxic assets to be written down, etc. etc. none of this should be surprise. Nonetheless it tells us that for the short- and intermediatethere will be NO debt-driven surge in consumer demand; as if we didn'already know that from the jobs indicators. t Then we get to the Net Worth problem. People were more badly hurt this collapse than have been since the Great Depression. It' also s unlikely that the majority of the population will ever recover. What made people comfortable with those huge surges in debt was that apparent net worths would support the debt (or so they thought). Now consumers will be focusing on repairing their balance sheets as much more than the banks. Or, put another way, we' going to be forced to re discover frugality which means that we' going to become more of a re nation of savers, not spenders. Another drag on demand growth! that

and cliff. a term

by their or re-

The Trade Equations: S-I-NX
There' an interesting identity in international s economics trade, and when we say identity we that it' a definition, not open to interpretative s debates and that it governs the economy and trade much as gravity governs the orbits of the planets in the same way. It' also grossly mis-understood s it' also felt in every way by everybody every day. s The basic identity starts with the basic economic equation that Output (Y) = Consumption + Government spending + Investment + Exports Imports. Or in h.s. algebra Y=C+G+I+X-M. Since XNet Exports (NX) and Savings = Y-C-G that means S=I+NX, or S-I=NX. mean as and but

M= that

In words that' Net Savings equals Net Exports. s When we import more than we export (NX<0) then Savings is less than Investment (S<I). In other words all that excess spending had to be financed from inflows of foreign money. Turn it around though - if we shift to S>I then NX>0 and we won'be importing Arab oil money or Chinese savings to t support our spendthrift ways anymore! This represents a huge...huge...huge structural shift in the world economy, which few are prepared for (if any) and fewer are preparing for as yet. All of which is captured in the accompanying graphic where the UL sub-chart shows the collapse in trade brought about by the Recession and the UR nets out the impact of oil imports (boy, if we ever wean ourselves!). The bottom two subcharts trace that history back to 1980. Notice that things were largely in-balance until the mid-90s and didn' really get t

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out of whack until this decade. What that really tells us is that this wasn'some vast conspiracy but the natural, t algebraic outcome of our debt-fueled over-consumption. As we continue to maintain a more frugal posture that' lower ll the trade deficits and take a lot of the structural pressures off the dollar. BtW - it' also important to note that almost s nobody is talking about these things, even though they' as natural as the tides (also the result of gravity!). re

Structural Changes in Other Countries
The American consumer has been the driving engine of world economic growth for close to three decades now and Japan, Taiwan, Korea and the Asian Tigers based their economies on an exportmodel of development. As has Germany and especially China. When hear folks talking about a re-balancing of the world economy they' re about two things. Those countries will have to either shift toward a domestically-based and consumer-led economic structure or they will severe and dramatic downshifts in their economic growth. That, in implies huge structural shifts in their economies. If we can take the case of China this graphic illustrates the situation challenges pretty well. While Chinese consumption has been growing rapidly it' a small part of their economy - the smallest part of any of s large economies. For them to continue to grow that' have to change. ll looking at the bottom sub-chart, what we' implying is that Chinese re consumption will have to evolve from being 4% of growth to perhaps more. Actually it' more strigent than that - it will evolve the real s question is what will be the adjustment mechanism. Will it be a drop overall Chinese economic growth or will it be a major structural shift emphasize domestic production for domestic consumption? On the answer to that question depends the economic outlook for the economy over the next ten years and beyond. A failure to cross that will result in political instability that would threaten the viability of the Chinese state. The good news is that they' well aware of the fact re are beginning to move in that direction. The bad news is that it will be difficult and take some time. South driven you talking more face turn, and very the Or, 6%, or in to world barrier and

Debt, Government Spending and Finance
Another shibboleth (an icon that people use to recognize membership in the in group but really meaning an old way thinking that people uncritically worship without recognizing the world has changed) is all the sturm und drang you hear long-term deficits and the crowding out of private investment. As well as the associated one of the inflationary impacts of huge reservoirs of liquidity and the inflation outlook. Let' take that a piece at a time. s of how about

In the UL you see the "credit liabilities" of private vs federal borrowing. Consistent with our earlier points private borrowing skyrocketed until it collapsed while Federal borrowing gradually went down in the ' 90s. Now they' ve displaced one another. Federal borrowing is, right now and for the next several years, the only thing holding the economy together and is NOT displacing private borrowing. And with the slow growth and a shift to savings the demand won'grow as it might have in the past, plus there' be more t ll domestic savings to provide funding. That' be offset somewhat by decreased inflows of funds from abroad of course. ll In the UR chart you see the surge in Fed liquidity flows but, bearing in mind excess reserves are what the banks hold

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on the Fed' books and don'put in circulation, those flows aren'getting into the economy. If they do and aren'sopped s t t t up there might be a problem but, again, a problem which the Fed is well aware of, is not a problem now and won'be t for quite a while and one which they are preparing to deal with. Another shibboleth bites the dust. Which is directly reflected in the LR sub-chart where the stock of money is actually shrinking! The final shibbolethic worry is the "huge" federal deficits that are going to destroy the future of the country. As a side note the biggest problem is Medicare, which would (one would think) lead to a massive surge in conservative support for Healthcare reform but...anyway. The LL sub-chart shows the Federal deficit back to 1950 and ahead to 2020. There' clearly a surge right now and the questions would be what' the alternatives and how bad would it be s s otherwise? The other interesting thing to note is that the prior biggest surges were under Reagan and BushII, while it was actually paid down to a surplus under Clinton. The final de-shibbolething should be to notice that the going forward projections after we get thru the Recession aren'that far out of line with the Reagan spending. Though admittedly t they' projected to stay relatively level and that' not a good thing, but it' also not unaffordable or intolerable. We re s s covered the other side of that coin in discussing fiscal policy btw (Realities vs Rhetorics: Economy, Policy, Real Data). On the whole we' in pretty good shape and NOT facing the kind of really deep adjustments that ALL the rest of the re world is facing. Secular changes, yes. Not a complete re-engineering of the fundamental structure of the economy!

Kipling's Friends and the Outlook
The good news is that the awareness of our needing to wrestle with these issues is growing. Ultimately, as we discussed several times previously (Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness), as US shifts from a dis-saving to a savings economy we free up more funding for investment in productivity and economic growth. The process will not be easy, short painless of course. But it should be some small consolation that the periods of highest growth in the US pre-deregulation when savings and investment were at highest.

the will or were their

There was an interesting discussion on Morning Joe that shows the awareness of these issues beginning to creep into the wider consciousness, which is all to the good in our ' umble opinions. URL: We' close with two sets of thoughts, the first from our ll favorite poet, Rudyard Kipling: Or put another way, be sure when you' reading the re next headline, listening to the next talking head and preparing to sacrifice the burnt offerings of your savings to some of their shibboleths that you' asked ve your six serving-men to take more than a simple look at the realities behind those mythologies and ask for proof. You don'have to like, or agree, with our t answers. But the ones you' getting cheap and easy re are going to be more expensive than you think in the long-run.

I keep six honest serving men (They taught me all I knew); Their names are What and Why and When And How and Where and Who. I send them over land and sea, I send them east and west; But after they have worked for me, I give them all a rest.

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October 21, 2009

Markets Away: Run Baby Run? Or Stumble? Or What? Like a couple of famous bunnies the Market just keeps on running and running - the question we' had for quite a ve while is why and how? The short answer, ioho anyway, is that' running on momentum. Otherwise known as sentiment s or psychology, or in our coined word, euphorillusion! Strangely a recent survey of Wall St. strategists has the market ending the year at the same level they forecast at the beginning and about where it' at now. Now we' recently spent s ve a lot of time, both in gathering, posting and leaving those posts up for you to read, on the Wall St. bonus issue. Strangely enough that' coordinated in multiple ways. s What got all this going was when, after the stress test we remind you, financial earnings stopped dying. On the other hand they sure haven'been very good - the market died a small death today when Dick Bove downgraded Wells t Fargo. A little while ago Whitney put GS on hold/neutral because it' more than fully valued. If you' been paying s ve attention there' a lot of problems lurking on the banks books and the only lines of business making money have been s proprietary trading. To the extent that the Financials have been driving things we think that' a foundation of quicksand. s The other thing is earnings surprises, which were based on cost cuts although some companies have recently been surprising on the top line, after lowering expectations. Our bottomline is twofold - as long as its running let it run and ride along with it. But start prepping and decide what you' going to do; and we' repeat it still might be time to take re d profits off the table if you' the least bit ancy. re

Current Market Situation
Let' take another overly complex look at s market situation with a four-part composite chart. The reason we combine these, aside compression, is that it forces you to consider four time frames simultaneously, which we think is revealing and important. We' come back ' ll round but let' start in the s corner with the key point. After the ' world is ending' collapse in March and the "no it' s rally" what we see is that the market is just reaching back into the downtrend channel that' been going on since Oct07. In other s words we were in a normal recession bear market that collapsed twice. Once when the sandpile of leveraged debt (remember those financials) in Sep/Oct08 and again this last Spring. Now we' still in that downtrend. re the from

LR not

As you can see in the UL corner we' been ve running up ever since. The only other observation we' add is that three separate times it looked like the runup was done for (in fact Doug Kass called a top ll in Aug09 - and since he' the guy who called the absolute bottom to date in March, well...). The UR chart takes Fib s limits from the March low to the range-bound May-early July market and moves them up and over to see what might still be going on. Again notice that the rally hit the 1030 resistance line and started to stop then broke out but looks like it' struggling to get to the 1096. If we finish the year at 1100 we' be surprised; and not to surprised if sometime as the s d new realities (read employment reports) sink in if we don'see 877 again. But not just yet. Which gets us to the LL t

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corner - the longest term sub-chart. There we' taken a straight-forward Fib chart from the ' bottom to the ' top ve 03 07 and guess what - the market is struggling to reach and breach resistance at 1088. Wow, deja vu' over again as they all say.

A Foreign Perspective: Exchangerate Market Adjustments
Via BigPicture we found the Financial Times had an interesting perspective on things by looking at the US markets from a foreign perspective, i.e. by adjusting the SPX for the drop in the Dollar. We took that idea and spun it some more by looking at the inflationadjusted and the inflation- and exchange-rate adjusted SPX. The inflation-adjusted (blue) SPX has yet, if you' please note, to return to the BOTTOM of ll the ' low! So much for this rally, fading or 03 not, as we suspect. And it' not as if inflation s has been all that much of a problem. The quick lesson here is that if you' in this market you' automatically TRADING, not investing. We show two exchange rate re re adjustments - one for the major currencies and the other for our broad trading partners but both trade-weighted. Fascinatingly the three indices roughly track each other, though the broad rate-adjusted performance shows some much wider swings. Let' try that again - for thirty years from 1973 to 2003 the major currency adjusted and the s inflation-adjusted SP500 tracked each other almost identically. From 2003 forward there' been a wide swing! And, in s fact, not only has performance been abysmal but the recent highs are FAR below the ' lows! 03

Trading in a Range-bound Market
Or, put another way, the death of buy-n-hold! Now point we' made before. But everybody' still ve s into the views that got ingrained as religious icons 1980 to 2000. Markets always go up. Lots of folks, including us, started to suspect that was no longer that we were in a secular, range-bound market as as the early noughts. Now most of the brighter and analysts and strategist have reached similar conclusions. In the readings below you' find a large collection ll into three categories: current state of the market some very interesting vidclips (we particularly recommend the BNN clip with David Rosenberg), interesting stuff on strategies and particularly and concluding with a section on some of the best on strategic positioning and managing your investments in a range-bound market we' ever ve of it is at least worth skimming but, if we had to the single must read article is Jim Jubak' that s key major factors and how they' likely to play out, re starts with "Know What to worry about..." that' a s locked from true and far back better

divided with some cases advice read. All pick, looks at the title

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Barry had another great chart of his own devising, which we' combined with the exchange-adjusted chart to link the ve points. He and his firm, FusionIQ, took a look at previous range-bound markets and created a composite of what happens in range-bound, secular bear markets. BtW - where the loop closes is that if you' paid any attention ve whatsoever to what we' had to say about the longer-term economic outlook we' not going to see decent economic ve re growth for years and this will be a weak and jobless recovery. Which means consumer demand aint' coming back and on and on. Again review the discussions but ultimately it indicts all of the current shibbolethic thesis that are running around, from China to commodities to gold. So three points on the bottome-line: 1) You can't be playing buy-n-hold anymore. You need to be prepared to adjust your market position as the market fluctuates. 2) This market is running on nothing much whatsoever and the fumes are thinning out. 3) Ride it for however long your comfortable but start thinking about moving toward highquality bonds and on the shorter end of the curve. Not just yet but start prepping. There are two keys to this energizer market (both id' and discussed by Doug Kass among others). The first is that this d is a momentum largely driven by liquidity (really wow, deja vu' over again!). The second is that anticipation of a all continuation is ostensibly based on earnings expectations beats but, underneath that, is that the folks speculating merrily away see a V-shaped recovery as likely. Despite the fact that a) all the grounded outlooks are based on a weak recovery AND b) supposedly this is widely recognized and internalized. It is, as Jim Jubak points out, NOT! To that end these are two stories you should really read: (…). Both are excerpted more fully at the end of the readings after the jump.

October 23, 2009

More De-mythologizing: a Little Markets, Some Economics, Lots of Policy Well today' market might be taken as confirmation, a tad, of our red-flag waving twer it not we' been here before. s ve Instead of Bove on Wells Fargo as on Tu. we had some reality from the transportation companies, not to mention that earnings have been beating "expectations" but, as usual, not very well on revenue, mostly on continued cost cutting and careful management by the Investor Relations departments. We so remind ourselves of the broken records we were playing thruout 2007 on this but at least it' a song we know by heart. Recall that we started the last post (Markets s Away: Run Baby Run? Or Stumble? Or What?) re-warning about fumes and euphorillusion. Now we' going to run re ahead and visit some more economic realities but just for the record we start the readings after the jump with some excerpts that could have been added to that post (Stocks Slide as Railroads, Oil Lose Ground, Andrew Ross Sorkin: Banks Look Stable But "There's Got to Be Another Leg Down", Roubini: A Big Crash Is Coming, But I Don't Believe in Gold) just to close the loop and set the table, so to speak. Let' shift gears now and pick up some s more economic de-mythologizing, in the spirit of our last post on the economy.

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Current State of the Economy
Fortune has done a nice little job creating an interesting straight-forward index of the state of the economy which recommend you look at. Fortunately there wasn'a lot of t major/surprising econ news this week so we don'need to t into that. The early warning indicators may be telling the technowizards that a recovery is in the offing (which it is by the but they also reinforce how weak it' going to be. For the s mostly coincident indicators that Fortune works with we' re at the bottom of a trough. and we dig

way) still

( ) In the readings you' find some more current economic information on retail outlooks, employment and housing. None ll of which are looking particular good. There, that said, we can shift to the some more neglected and deeper structural factors. BtW - this post is intended as a complement to an earlier one looking at some other realities: From Mythologies to Realities: Economy, Employment, Credit & Trade . We really.....really suggest you re-read and review those arguments there because they' start showing up over the next several months as well. ll

Let's Put Inflation to Bed
In terms of slaying another mythology let' start with the s a huge surge in inflation which is being used as one justification for all the frenzy in gold. The Atlanta Fed did favor of looking at some interesting inflation data by at core inflation. Instead of the standard sans food and they trimmed the statistical outliers in the top chart. On (red) we have inflation basically stable and at a comfortable level early in the year then dropping abruptly very low, deflationary level (green) and then dropping lower (blue) in Sep. Our take, and the ATL Fed' as well s CalculatedRisk' is that in the short- to intermediate-term s, facing deflation more than anything else. In the longer-term and beyond if all the injected money moving into the economy there might be some danger of inflation but the Fed is already preparing for that. NB: now it' only the Fed' money plus things like TALF and s s purchases of Mortgage Backed Securities that are keeping the credit markets open at all. The bottom sub-chart compares official Fed Funds rates couple of flavors of real interest rates. Now tell us what mean when the gap between near-zero(or lower) Fed are showing a huge gape with market rates? It tells us credit markets may not be broken but nothing is flowing risks of us the looking energy top to a even as we' re starts right their to a does it rates the thru

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the system' piping to get that credit to consumers and businesses! s

Banks, Deposits and Credit
Well if you take a look at the accompanying chart you can see what happens when the Fed injects and the banks sit on that money. As you see deposit growth is a far bit higher in 2009 loan growth. And to top it all off the biggest banks are getting bigger and more dominant. The top five banks grew their deposits considering in 2009 over 2008, which when you think about it, is kind of surprising considering state of the economy. Meanewhle their share of deposits grew considerably in 2009 over the previous several years.

can than


In other words that money is just sitting there, like we' been saying for a lot of other reasons. Or put another way, it' ve s not an accident that small businesses can'get loans nor that your credit card statements are showing more fees, credit t limit cuts or being shut down entirely. In the readings you' find some more discussions on all that, and again we suggest you pay attention, particularly to the ll discussions of the Fed policy outlook. The general consensus is that the Fed might start raising rates, at best, in the latter half of 2010. But if our assessment of the state of the economy is correct then they may keep rates low until well into 2011, if not 2012. At least they should. One of the most hawkish governors (Bullard of STL) has come out and said they need to be wary but also that raising rates shouldn'happen until unemployment starts going down. From previous t discussions you know that won'happen for a long time. In fact the OMB doesn'expect Unemployment to return to 5% t t until about 2019!!!

More on Trade, the Dollar and Rebalancing
The other mythology that' running around is s the death of the dollar (on which topic you' find ll several excerpts in the last post and which we' ll up in horrific detail in a future post). Two things though. If rates are kept low you' see continued ll pressure on the dollar but you should bear in that the runup last Fall in the dollar was a flight safety and the flight away from it recently a "risktrade. The major counter-vailing pressure that build up is the coming gradual evolution of rebalanced world trade. If the US consumer moves to a more savings oriented posture then buy less, import less and there will be less US$ flowing out and coming back as loans from the Chinese. So let' re-visit trade a bit and see how s adjusted and are adjusting. about take down mind to on" will we' ll folks

Fortunately Uncle Ben gave a recent speech tracing out the impacts though his real sub-text was that the world we knew is not coming back and you need to start adjusting. Both are traced out in his charts, the first directly and the second by implication. Reading the charts clockwise starting in the UL you can where world trade fell

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off a cliff and is only starting to crawl back up. We' have to say despite rumors of a recovery it too is proving slow and d reluctant. The next chart tests who was the most impacted by looking at below trend GDP growth vs openness to trade while the third chart compares GDP to financial openness. Not surprising the most heavily trade-dependent nations who were the most open (the two aren'independent btw) suffered the most. It' the fourth chart that' really interesting when you t s s compare industrial production to exports vs pre-crisis levels. China held up the best on IndProd but not particularly well on exports. The question you should ask is how does one get production to hold up better than exports if you' an export-driven re country? Well we could all have been wrong and a country might be more driven by domestic production and consumption than we thought. OR...OR... government policy could have stimulated production by stimulating investment thru fiscal stimulus and loose money. Now the real question, particularly in China' case, is for a country s already in danger of igniting inflation and badly over-capacitated what happens when those chickens come home to roost?

Keeping the Wheels on the Wagon and Policy
Speaking of policy the Council of Economic Advisors estimated that the stimulus program added 2-3% to GDP in Q2 and 3%+ this quarter. NB: independent and trustworthy (i.e. non-ideological) analysts concur. Now there' more to come but that stimulus starts s fading out in the second half of the year. So what happens then? Well if we' lucky the pump priming kept the wheels on the wagon re and will get the economy back on a path of self-sustaining, organic growth. On the other hand the employment data makes that, shall we say, highly problematic at best. Which is why even the optimistic forecasters are anticipating growth slowing, though not a return to a recession per se. Go draw yourself a square root sign and reverse it. That' the optimistic outlook for now. s We' covered the whole issue before(Between Stalingrad and Kursk: Real Economy, Policy and Outlook) so we won' ve t re-visit the subject in detail but we' make three key points. ll 1) Right now things are being held together by public policy not by anything innate in the economy. Don't let the folks substituting ideology for analysis trick you into believing anything different. 2) That means that we're going to be dependent on monetary and fiscal policy for a few years to come. For example the minute the Fed quits buying MBS's the Housing market dies. 3) As a corollary that means that the other government programs, oddly enough for our normal thinking about business cycles and the economic outlook, will be critical. On that last point we' simply point to the chart on wages vs total benefits costs. This last decade wages went nowhere ll while total benefits went to the mooney. Gee....what do you think caused that? Well a small hint: healthcare costs have been going up around 7%/year for almost two decades. (A Taught/Taut/Taunt Moment: Healthcare Speech, Policy, Politics & Realities) Getting those under control might be as important for incomes and consumer demand and the overall health of the economy as anything else that' likely to go on; particularly now that borrowing against your house s or tech stocks is gone forever!

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October 28, 2009

Really Different This Time: Liquidity, Rates, Markets & Risks After the last three days in the market our prior post on the Markets outlook might be looking a tad prescient, but who knows? Two other previous posts focused on longer and deeper structural issues (From Mythologies to Realities: Economy, Employment, Credit & Trade, More De-mythologizing: a Little Markets, Some Economics, Lots of Policy) and tried to debunk a lot of the ideological shibboleths (including a definition of shibboleth!) that' influencing too much of s people' thinking. If you' been reading along we' hammered several themes repeatedly: a weak economic outlook, s ve ve a jobless/loss recovery, a market that' widely and wildly over-valued based on any of the fundamentals and a s deep...deep...deep need to re-think investment strategies (more on that we hope in a subsequent post). Between aberrant behaviors and poorly grounded shibboleths the really central question is WTF is going on? We think we' ve finally arrived at a fundamental answer - or at least the beginnings of one. To summarize the rest of this post, somewhat, we think what we' seeing is a shift from a Risk Off (fear and loathing on re Lombard Street) to a Risk On set of speculative trading where vitally necessary policy steps that kept and are keeping the economy from collapsing are also both restoring confidence but are also putting to much liquidity back in the markets and lowering the risks of screwball trading while simultaneously re-assuring folks that the risks of catastrophe are reduced. Which, as a bottomline consequence, means that all the running up markets are built on foundations of sand! Which means that our advice to start preparing your storm shelter should be taken to heart - think back to BSC as an early warning sign. Or, in some ways, the March Market Madness which resulted from economic realities finally sinking in. It looks to us as if sentiment is shifting so we' going to have one re hexx of a fight between sentiment and sense.

Reviewing the Bidding: Current Valuations
We won'review the bidding on earnings, profits, the economy and valuations in any t great detail since we' run off quite a bit about it. But we will point to this chart ve drawn from a BNN interview with David Rosenberg of Glushkin-Sheff, a gentleman whom we' cited several times before. ve Frankly we don'think there could be any worse news, particularly when you look at t the realities of earnings. NB: despite what the MSM is telling you earnings are NOT coming in that good. In fact, despite 75% of companies beating estimates, they are beating those estimates because they managed expectations down so low. Something that happened beginning the Tech Bubble and has, if anything, continued to get worse. When you check the readings excerpts after the jump you' find a ll couple of key sources on that and several other topics. Operating earnings are before minor details like interest, depreciation and taxes while reported earnings are after those adjustments have been made. You actually need to look at both, and implied in our prior comment, put them thru a very finetooth examination. Which the sell-side analysts are NOT doing for you!

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From all our prior postings on various takes on long-term earnings and PE valuations you might recall that we think a 15 PE is optimistic and a 20 PE indicates somebody under the influences of massive hallucinogenic optimism. What can we say though about a PE of 120? We' let that case rest there but will also point you in particular to the first ll reading (again from Jim Jubak) discussing the relationship between stocks and the dollar.

Let the Real Valuations Standup
Martin Wolf of the FT has an excellent discussion of this whole topic where he' channeling an economist s and market analysts named Andrew Smithers, who' recently come out with a s new book. You might note that his previous book was published at the height of the Tech Bubble and issued the same warnings about over-valuations based on euphorillusions that he' issuing s this time. Only now he' suggest a couple of metrics that are well worth paying attention to, as well as being entirely consistent s with our previous posts on long-term valuations where we channeled Shiller and our own work. His bottomline conclusions - the SP500 is over-valued by 40%. Which means, btw, that back at the trough in March when we were arguing that the market was much more fairly valued, even accurately valued based on economic fundamentals, we might have been on to something. Smithers introduces two fundamental metrics of valuation. The first, Q, compares market valuations to a company' net s worth. If you stop and think about it for a minute it makes perfect sense, and in fact, resonates strongly with GrahamDodd and Buffet' long-term approach to equity valuation. His second metric is Cyclically Adjusted PE, which looks s back at the 10 year average of real earnings. (Wow, shades of Shiller indeed). Not surprisingly his conclusions are both stark and congruent with Shiller' and ours. Almost as interesting Jeremy Grantham, a notorious and very well s respected analyst and investor, comes to similar conclusions in his latest newsletter, though he sees the market as "only" being under-valued by 25%.

Bill Gross on the Big Picture
Mr. Bill brings it home for us by both returning to economic fundamentals and relating profits to GDP growth, a topic we' explored as well. He also points ve the total universe of asset valuations. His basic conclusion (more in the final reading excerpt) is that can'reasonably expect profits to grow faster than t nominal GDP and earnings should grow with them, as should stock prices. That they haven'for the last three t decades he attributes to financial leverage and engineering! Which seems to be our basic theme here, doesn'it? t We borrowed both these charts from his latest newsletter and, not surprisingly his top chart on Profits GDP looks a lot like ours. Which we find encouraging though he uses nominal GDP and not real; but then again we used deflated profits as well. It' his second chart we find really...really interesting. It s compares the trailing five-year growth rate in assets vs GDP growth. Notice that the two most recent major

at you


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bubbles stand out rather starkly indeed, at least IOHO. And just as another reminder this is precisely consitent with our look at long-run cumulative growth rates in real GDP, Profits, Earnings and the SP500. So now you' got at least four of us who are coming to identical conclusions, showing roughly equivalent results and ve arriving at these end points by very different, on the surface anyway, methodologies. Yet coming to the SAME endpoints! We don'think the conclusions could be any starker - Mr. Gross goes on to point out that as savings t increase and de-leveraging becomes necessarily widespread that future valuations and returns are going to have to return to a new normal which is in actual fact the Old Normal. Which has all sorts of implications for investment strategy BtW! NB: in other words the markets are running up on all the new liquidity sloshing around, which means that not only is the last three decades of aberrant market behavior and recurrent bubbles due to financial engineering and de-regulation. Which also means that reforming Financial regulation is a sine qua non of getting back to a stable new/old normal. Rather than point back at previous discussions we' instead point you at two key posts on another blog: ll

The Chinese Goldsmith, Finance and the Next Big Fight

Banks Hate Banks, Voters Hate Banks: Hear the People Singing!
October 31, 2009

Surprise, Surprise: Not a Rally and It's Still Different Surprise, surprise is the start of the punchline to a terrible junior H.S. joke about Gomer Pyle and the neighbor girl told when you' to young to know better and still puzzled by life' mysteries. Now that we' all older the supply of re s re mysteries seems to keep going and it' one damn surprise after another. In fact there were so many that instead of a s couple of updated additions to the prior post we ended up with a huge inventory that calls for a separate one, driven by the two big surprises: Th. GDP number and Fr. market shock. What they have in common, other than surprise, is that they' tied together by a mystery. That mystery is the mythologies we' been working our way thru, doing our best to re ve debunk and de-mystify, and look for the structure and relationships.

A Quick Look at the Market
That we' completely being bombarded re shouldn'be a surprise - we are after all dealing t the after-shocks of the biggest disruption in the economy and markets since the 1930s where all old structural relationships got shaken up. One that happens in complex systems subject to shocks is that it takes them a long time to return stability and normal operation. When the shock severe enough the linkages and parameters get changed so that the old system is not the new That' exactly the case here. Let' take a quick s s at the markets to start with. You should read this chart composite clockwise starting with the UL corner and working round. with the thing to is one. look

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The point there being that March saw the world is ending as economic reality sank in and as fears of bank failures exponentiated. When that got fixed by the stress tests we got back to some measure of sanity but followed it with illgrounded optimism bordering on illusion and went for a liquidity and leverage driven mini-bubble not based on realism about economic growth, earnings and profits or valuations. All of which led immediately to the UR chart - the real question is will fantasy return triumphant or will self-delusion be reduced enough to return to reasonable estimates and ve valuations? In the readings BtW Prieur du Pleiss has one of the best summaries we' read (Stocks and risky assets stumble ) on the subject. The bottom two charts tell us something, technically speaking, about where things might end up if reality wins. That reality is defined by whether or not the continuing turbulence of a fragile system continues to see the Central Banks trying to pump money in and what the Financial System does with it.

And a Look at GDP
One way to sort out the pattern from the noise is to find a set of instruments and filters, we like YoY% changes, which makes economic patterns about as crystal clear as get. The bottom chart here shows us GDP, Consumption and Employment and, on the surface, it' nothing but good news. We' s ll make it official - the Recession is indeed over measured by GDP. and they


Of course there are several catches which we' yaddayaddad about forever. The ve recovery is not just highly but utterly dependent on government policy (Fed rates, quantitative easing, tax cuts & transfers, stimulus spending) which are going to be vitally necessary for a long time. The real key is how fast, when and if the economy transitions from a dependency on policy to internal, self-sustaining and organic growth. Which really means when does it start creating jobs and beyond that when does it make up for all the lost ones. There' a second deep and vitally important idea to note here. Normally in our four factor model (Structure, s Fundamentals, Technicals, Psychology) Structure is the factor with the longest time-horizon - measured in years and decades and heavily dependent on the socio-political environment. Which means that it doesn'change very often. t Now with policy having to respond monthly or weekly structural factors are changing as if they were a highfrequency variable. In this turbulent environment where we' clearly crossing a turning point it pays to look at YoY vs re QtQ changes which the top two charts do. At least on the surface the QtQ changes indicate a positive direction.

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Consumption, Outlook and Markets
So what happened Fr. in the markets and what' the relationship s with the economic data? We start to answer that by taking a more granular look at Consumption in the top chart comparing monthly YoY changes to MtM changes for Consumption. Guess what monthly consumption dropped almost -2.0% after booming from Cash for Clunkers! Oops...welcome to Reality Land. As you know we like to look at the future outlook for demand by looking at the changes in Real Wages and Employment. Wages are continuing to show strong positive improvement while Employment continues to deteriorate so the net effect is still negative. In other words demand growth will be weak at best. But there' a catch s real wages are going up because of declining inflation, not increasing labor demand. The bottom sub-chart compares Consumption to Wages+Employment to Real Personal Income+Employment. And the latter is definitely in the strongly negative camp. Remember the argument that relationships get changed by strong shocks and turbulence so you have to re-think the rules-of-thumb you' been ve depending on? Well, there you go.

Readings Guide
As usual there' a fairly extensive collection of readings excerpts and links (btw - the highlighted title takes you to the s original source, is our way of giving credit where due and letting you read the whole thing). Aside from Prieur' very s nice summary you' find a bunch on the state of the economy but one in particular is worth paying close attention to. ll The IMF has found that after severe shocks like we' working our way thru that long-term growth rates take a while to re recover and, when/if they do, we' at a much lower base. Now we were already facing an outlook where the new re normal was projected to be 2.5% growth. What if it' lower than that? At 2.5% growth we don'create enough jobs to s t breakeven, let alone recover all the lost jobs. At the end of the readings you' find the links to some recent TechTicker interviews with Martin Wolf of the Financial ll Times. We STRONGLY recommend that you listen, take notes and even listen more than once. Oh, by-the-way, on the top economic chart you' notice that long-term employment hadn'turned up yet. At this point ll t nobody expects it to do so until late next year. They also expect it to take years to painfully work our way back to 5% Unemployment (the OMB estimates 2019!). That' the new reality. Whether it is truly incorporated in people' thinking is s s another question, verses whether everybody gives it intellectual lip service but keeps trading as if the new normal would return to the old normal. And that explains why the markets tanked on Friday. They' beginning to get it on a gut re level that the New Normal is really New.

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November 3, 2009

It's Still Different: Refreshing Policy and Market Info We were going to add a few links with some interesting stories that came out since our last post on the Markets. Interestingly there were so many that adding a couple, or a mere few, to that post seemed in appropriate. Nonetheless if you' consider this as at least partly an extension it might be a good idea. d The basic themes we struck, and have been striking, are: 1. We could never justify the rally on the basis of fundamentals, economic outlook or valuations and have been viewing it as a relief rally. The continued triumph of optimism over experience, otherwise euphorillusion. 2. The central fact that we think explains about everything is the world' Central Banks have been pouring liquidity into s the world' banks who have largely been sitting on. In that process they' in turn made their returns, where they made s ve them, in the last two quarters thru proprietary trading of one form or another. 3. Generally we' taken to calling this the RiskOn trade where the saving of the financial system combined with all that ve surge in homeless cash led to money pouring into risky assets. If you checklist your way thru all the markets and asset classes it explains about everything from China to Gold to the rise and fall of the dollar. For example when Risk is on money flows out of the US, thereby dropping the dollar, and visa versa. 4. As the recovery gets underway several Central Banks are beginning to tighten up their policies and are preparing to withdraw liquidity. That will tend to reduce the liquidity pools. 5. At the same time it is slowly and reluctantly beginning to dawn on folk that the economy is not going to see a VRecovery. Which shows up, for example, in last Friday' debacle when consumer spending was so much worse than s expected. Or, as we put it, supwise, supwise (in the immortal words of Gomer Pyle, FRB).

A Glance at the Markets
Given that the markets are all moving together we continue to look at the SP500 as the proxy for just about everything else, suitably adjusted for differences in liquidty, risk preferences and illusions. So here' a little market snapshot we took s yesterday that highlights the situation as we see it. What we see is a technical pattern called a "fallling wedge" where the market is very shortly going to have to make up its mind about which way to break. On the last several months history having it break yet again to the upside wouldn'be a great t surprise. Having it break to the downside would be merely rationale and on any number of grounds (earnings, profits, economic outlook, valuations). Barry Ritholz put up a couple of David Singer annotated charts on Head & Shoulders patterns today that are linked in the readings you ought to at as well, though they are a bit more complicated. Notice as well that volatility is increasing. Prior to sandpile collapse last Fall when the VIX got to 30 it can

look the

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meant a major drop in the market. Now we' see, won'we? Notice that the MACD indicator is beginning to tip over on ll t the bottom of the weekly chart as well. Since everybody' expecting a correction it ought not to exceed 15-20%. It' be s ll when the real economic realities sink in next year that fundamental re-thinkings set in on valuations. In the meantime we suggest you at least skim the readings on Central Bank policy as well as several others on the market situation and outlook.

November 5, 2009

Cuspiness, Collisions & Conundrums: Market Carry, Employment & Euphorillusions An amusingly alliterative title, don' you think? With just that touch of the common with the hattip to what' his name the t s comedian..John Stewart was it? :) An alternative might be it' still not any different but the delusions are rampant. We s also find ourselves in the familiar position of having to much to add to let it go with just an update, especially since the mythologies and delusions continue to run rampant. Specifically we' in a trading market being pushed along by re speculative momentum and sentiment and based on the US Fed interest rates funding an all market carry trade. That' s one major delusion. A deeper one is that, despite all the claims to the contrary, most of these folks think that it really was going to be a V-recovery and it' dawning on them that' not true, though they haven'adjusted their positions. The s s t third is that the number of ungrounded and ideological shibboleths driving investment and trading decisions is monumental, including mis-understandings of rate outlooks, employment, debt and deficits, inflation and the dollar. Our next major scheduled post was going to be on the dollar and further de-mythologizing in fact. Instead we' going re with the flow and putting up our fourth major post on the markets, three in a row in fact, to try and keep trying to correct some of the euphorillusions. Actually this whole set of market discussions are really one long giant post that fits into our series on de-mythologizing so we start the readings off with the complete inventory of Market and Mythologies history and will hope to get back on track sometime in the future. The net result of substituting ideology for analysis is two colliding mis-understandings that are on major tipping points. The first is the obvious carry trade and asset bubbles. The second is employment and the implications for rate policy. We won're-visit all the mythologies but will concentrate t on two: Rates vs Employment and the Bubble(s), but we' also spend a little time looking at Emerging Markets and ll Illusions.

Rates, Employment and Inflation
The first thing to understand about Fed rates is they don'raise rates until employment is growing t again. That' one of the primary purposes in life, a s strategic goal and explains why Greenspan' Fed s rates so low for so long (Employment didn'begin a t "recovery" until ' btw). The other thing to 03 understand is the other key factor is Inflation. Now we' discussed both of those repeatedly and ve some of those discussions are listed in the readings for your review. As it happens almost all the standard thinking has got it wrong - which means almost all of the headlines and investment decisions floating around are ill-founded, to say the and being very polite. that left

of least

Employment is going to be very weak for a very long time (it takes 5%+ real GDP growth to start making a dent and we' going to have 2.5%). Inflation is likewise not a danger for the foreseeable future because banks poor position re means that all that excess liquidity is going to stay on their books and not in the economy - technically that' called s money velocity and it' a measure of how fast the supply of money turnsovers in the economy (cf. the readings). What s

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ties it all together is a modified Taylor Rule that links Employment and Inflation to rates. A version that works very well is: Rates = 2.07+1.28*Inflation-1.95*Excess Unemployment. With low inflation and high unemployment the Fed should be setting rates at -5.6% and keeping them there for well into 2011 or beyond. That may lead to future problems but it also means that the only thing keeping the wheels on the wagon is stimulus spending plus quantitative easing where the Fed buys various debt instruments to try and lower rates directly. That means that fuel could be added to the carry trade fire for a while and that the dollar could continue under pressure. It also means that all the surge in asset prices is policy-driven, not based on fundamentals and all the talk you hear about Gold, Emerging Markets, is based on very shaky foundations.

Bubbles to the Left, Right & All Around
Let' take another look at that question of widespread and s endemic bubbles. There a a couple of things to notice First, that we are indeed riding into the valley of the Six Hundred Again and, second, that lots of folks have noticed. Though we think the first to really point to the problem are, not surprisingly, Roubini and Simon Johnson. But this week both the IMF and the World Bank issued major warnings. here.

Aside from Gold another really bad example is Emerging Markets, which have just roared ahead. But it' not the s only one as the graphs of South Korean and Australian home prices show. Can you believe it? That might bring us full circle back to China and the now multiple stories about liquidity injections showing up in stock prices, real estate, and mis-placed investment in infrastructure investment (a point we won'dig into since we' been hammering away at it so many times before, largely courtsey of Michael Pettis. t ve NB: the world appears to have picked up on Michael' warnings and his themes are now widely written about and s accepted but he' still the original and the deepest IOHO.). Here' you homework assignment - actually two, and they s s ARE for extra-credit. What asset class do you think is NOT part of all this? What happens when realities set in? Which they will sooner or later.
EM as Representative Futures

Lest you think we' picking on Emerging Markets too much rather than re treating them as representative let' take a sideways segue and look at s Strategic Outlook. Emerging Markets crossed a cusp point at least five years ago where they' moved onto entirely new footings with regards ve stability, security and safety and returns. Many have noticed that recently but have still not adjusted their investment strategies. A state affairs we think is well-captured in this graphic. In our reading the top chart shows both the double-bubble in EM stocks, which anticipated the inflow of investment funds surge, and the continuation of that surge after investors discovered the cusp point crossing. BUT...the bottom half perfectly well proves the other point allocations to EM stocks relfect the old realities not the new ones. Which calls for major re-structurings of portfolios and investment strategies. The question is when and based on what information? Which leads to the really critical point. There is no substitute for actually understanding what' going on. Too many folks have substituted "invest s the BRICs" for actually digging even the slightest into the underlying realities. Now in several previous posts we' tried to apply our Vulcun ve

the to of


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methodology of evidence-based analysis instead of relying on ideological shibboleths by pointing out that Brazil appears to solidly grounded, then India, then China and way behind, Russia. On a 1-10 scale we' rate Russia as at d best a 3, China a 4-6, India a 5 and Brazil a 7 from a long-term perspective. Anticipating a burst bubble though we' d apply a systemic downgrade that would take everybody down several notches. In other words if you' interested in re protecting your investments it' time to start getting out, or getting prepared to get out and re-position yourself for the s anticipated future.

Warren Is a Vulcun: Lessons From the Master
One of the interesting, among many, West Wing episodes is the one in which one sub-theme is about a bunch of Chinese Christians who fled persecution and are seeking asylum in the US. President Bartlett proposes to test their Faith by testing them for Shibboleths, a label we' often ve used repeatedly. A shibboleth is, as the Chinese leader says, an outward sign of an inward Faith. catch is that one can'apply evidence and t analysis on this topic but one can and must to questions of investment strategy or decisionmaking in general.


One of the most startling learnings for us over the last year is the extent to which people let their hindbrains entirely dominate their thinking and really on their forebrains as engines of rationalization to justify the conclusions they' ve already reached. Warren Buffett is famous for his results, for his folksy wisdom and for his principles. What almost all the commentators ignore is that Warren DOES NOT make his decisions in 15 minutes of gut-level response. Instead he invests enormous time and effort, which he doesn'talk about very often, on acquiring a detailed knowledge of how t things really work. The most difficult of his principles is never invest in anything where the intrinsic value is not far less than current market value, preferably by at least 25% if not more. The difficulty of course lies in determing that value, which is where careful investigation is required. If you' not willing to Pay the Piper then go to the Dance. The other, re among several key lessons, he follows is not to let ideology substitute for thinking. It' all right to have emotions and s principles. It' not all right to let them dictate your decisions - they are ideals and goals. s Right now all the evidence points to almost all assets being vastly over-valued based on reasonable analysis of the best available data, the Spockian approach. What does that tell you? Especially when so many are are arriving at their conclusions based on ideology instead of analysis and converting the resulting conclusions into Shibboleths. Your hindbrain will win if you let it so it' up to you to substitute thinking and discipline. Easy to say of course and very hard s to do - and not something we' found many (sadly including ourselves) are willing to do in all circumstances (cf. ve Cognitive Dissonance, Double-Bind). But that way lies salvation!

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November 7, 2009

Turbulence Isn't Chaos: Dollar, Rates, Trade and Markets Recently when the dollar' been up stocks s have been down, and visa versa. Lying behind that turbulence is the gyrations between RiskOn/RiskOff trading based on liquidity-fueled speculation and the dollar carry trade. All this turbulence has been with in some form for almost two years but seems to be dampening down. The two problems with a turbulent environment is the risk and uncertainty is higher so everyone' looking for the patterns and s explanations to make high-information signals out of the noisy data. Part of that filtering is the one we just applied (RiskOn/RiskOff) but there are layers behind well. A lot of those layers have to do with outlook for deficits, trade flows, interest rates and exchange rates.

us that

it as the

And because we' in a policy-driven re environment where deep structural changes that are normally predictable and evolve slowly are moving more like high-frequency technical information and subject to changing policy decisions. In this environment it' hard to decide whether or not turbulence is chaos - unpatterned or s unpredictable - or not. Sometimes in fact it' not only hard to tell the differences but there aren'many (aerospace s t engineers talk about turbulent flow which is best modeled with chaos math for example but can be approximated by better behaved equations work ably enough). What makes the chaos more likely is when to many folks substitute simple-minded ideologies based on philosophical or political preferences for the best available data, analysis and information. In other words when they worship at certain political shibboleths. We' going to attempt to keep on de-bunking yet another set of those shibboleths as part re of our continuing efforts to find the patterns and develop the workable, good-enough models for our needs. This time we' going to focus on the Dollar and its relationships to Trade and Rates, while trusting you to review the prior re discussions on the economy, deficits, economic policy, inflation, etc. Just to close the loop though the chart is two analysis of the same 3yr weekly SP500 chart which shows that a) all the downtrends we' been talking about are still ve intact and b) despite the recent rise it' both bumping against the Fib limits from the Oct07 high and churning around s now on shorter timeframes of the recent bear rally. Which way it breaks is going to be a tradeoff between liquidity and reality.

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Talking About Trade and Rates
To sort the chaos into patterns and make it merely turbulent we' going to try and present some machinery, admittedly re conceptual, to try and explain how trade flows are linked to exchange rates and how those are linked to interest rates. The basic relationship is that Net Exports = Savings-Investment, which makes sense when you think about it but also follows from an accounting identity we' talked about before. Briefly (sorry for the shortness but...) Y=C+I+G+X-I. If ve Net Exports NX=X-I then Y-C-I-G = NX. But Y-C-G is savings so S-I=NX and voila' . In the long run (at the bottom of this layer cake) you' like for trade flows to d balance out, that is we buy as much stuff abroad as we sell. That requires that we either make lots of stuff they want or don'buy as much from them t as we want or they' like to sell. NB: we' just explained the last ten years d ve inter-dependency between China and the US. In this example Europe buys US goods but needs $ to do that while we need E to buy their stuff. When we buy too little or they sell to much we end up with fewer E than we' like d and they have a hoard of $. One way for that to balance out is for the E:$ exchange rate to adjust, in this case since they' got to many dollars by a ve drop in the E:$ rate, which would then work backward to reduce the demand for their goods until things are balanced out again. Another way to re-balance is for that excess hoard of European $ to be invested in US assets, say stocks, bonds or loans. Which is exactly what' s been happening between the US and China, or the $ and the Renminbi. We buy more stuff from them, they end up with too many $ so they loan us the funds which we use to buy more stuff. Simple right? In our equations NX<0 => S<I and R:$ should increase to re-balance things. Oops..that didn'work. t So now the machinery runs backward, so to speak. Since R:$ is to low money keeps flowing to the US and we keep borrowing to buy things. Before you get to upset about all that let' bear in mind both sides are culpable. We kept s playing grasshopper and they got to bring millions and millions of people out of poverty and keep their country from blowing up. There trade and international relations in one easy two paragraph lesson, right?

SPX vs. Dollar
Or it could make your head hurt, like it does mine but let' s it worse by circling back to the markets vs dollar question. A back we took a long look at the impact of exchange rates on real returns on the stock market using the top part of this chart. shows the inflation-adjusted vs exchange-rate adjusted SPX up until 2003 there was no practical divergence. (Now there' a s potential investing lesson!). Since then as trade imbalances grown so has the divergence and so has the tendency of the to drive the markets inversely. The second sub-chart looks at directly by comparing the trade-weighted exchange rate for currencies ($TWX) to the SPX. Pre-bubble there didn'appear t a lot of relationship but during the bubbles we start to see more...and more with the recent aberrational environment. make while the It and have dollar that major to be

From the machinery you' expect that there' be a fairly strong d d relationship between business cycles and exchange rates since during a recovery demand goes up which would increase imports and increase the outflow of $. In the last sub-chart there' some relationship but it doesn'strike us as very clear-cut or stable. So what' going on? s t s

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Dollar Driving Factors
Well that' kind of complicated and involves multiple relationships all gyrating together. From the top sub-chart and our s trade layer-cake machinery you' expect one factor would be Net Exports. As NX gets more negative you' expect the d d dollar to start dropping. From the top part there' clearly a relationship but it' also another one of those it depends s s things as well. For example during the ' the dollar was strengthening while the trade imbalance was getting 90s increasingly worse. Could that have been demand for US equities during the Tech Bubble? Which eventually caught up with us on both fronts (the bubble burst and the imbalances got "too big")? We think that' part of it. And from the s middle sub-chart clearly there are business cycle influences, as we noted. Another major factor though is interest rates. In fact from the bottom sub-chart that seems to be the most clear-cut driving factor, if not the dominant one. As US rates came down and started their long secular decline the dollar followed suit with its own long secular decline, interrupted from time-to-time by other factors, e.g. the Tech Bubble or the recent "Flight to Quality" during the panics last fall. In fact if you look at a shorter-term dollar chart you' find that after a rapid ll runup during the flight the dollar is basically returning to that trend. You' also find that it' flattening out around the 75 ll s level.

Wrapping UP: Long-term Secular Implications
There' a whole bunch of shibbolethic thinking floating around driving Emerging Markets, Dollar depreciation and other s asset bubbles. Briefly it' that huge and unaffordable US budget deficits will increase demand for government funding. s Now some of that' true and there will be some major impacts. But, paraphrasing Mark Twain, the death of the dollar is s greatly exaggerated. 1. A reserve currency must be safe, secure, large and liquid. It' going to be a long time before any s other currency can match those requirements and best intermediate term candidate is the Euro. But at the end of the day that will come back to relative growth rates and the long-term prospects of the US are still much better than Europe' or China' for that matter with the latter' long-term demographic s, s s and institutional problems as well as their need to re-structure their economy on a more domestic foundation. 2. As the US saves more it will import less and that will decrease the outflow pressures on the dollar AND increase the domestic pool of funds available for investing in US assets. That means that deficits become more financable domestically for one thing. Coupled to that is the fact that while deficits will be large as the results of previous policy decisions (90% of the deficit problem comes from Bush administration decisions and the financial crisis not new programs) they will not be historically excessive. Again that means that the demand to borrow abroad to finance deficits won'be what people t are thinking. A third coupling is that as we demand less and shift to lower energy consumption a similar dynamic sets in with regard to Oil imports. 3. The world needs to re-balance trade flows which requires signifiant adjustments in domestic economies. The US is already making those adjustments and China knows and acknowledges that it needs to but will take time and have political and stability challenges in making them speedily and forcefully. The bottomlines here are that the US will be a reserve currency for a long time, though perhaps the only one and is likely to remain the most important. Another bottomline is that rates will adjust back up since they were abnormally low as not the

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result of the crisis and policy interventions. But we' not likely to see any many surge in rates for a long time and they re aren'likely to surge out of control. And, over time, as we get the economy growing again, control deficits and start t working them down the doomsayers will find their worries not well-grounded. Which is not to say we aren'facing a t decade of slow growth, employment problems and difficulties in writing down the debt. It' what always happens when s you' been partying to hard for to long. The hangovers are terrible. ve The bottom bottomline is that all the simple answers on investment and business strategy that you' been hearing in ve the headlines or from the talking heads need to be carefully examined. Will Oil and Commodity demand return to their old levels, speculation included? Unlikely though there are counter-vailing pressures. How about speculating in BRIC equities? Ditto. More than at any time in a long time this next decade is going to require understanding how things really work from trade to rates to business performance. That' how Warren does it anyway. s

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About Llinlithgow Associates
Llinlithgow Assoc. is a management consultancy focused on evaluating businesses to reduce risk, leverage under-developed opportunities in operations and increase overall enterprise performance to improve investment return. Our approach is based on BizzXceleration, a proprietary framework with 25 years of development, to review and analyze Business Models and Strategy, key operating functions and supporting infrastructure and management systems. From there we develop comprehensive, integrated operating plans that tie all the components of the business into a highperformance enterprise.
Customer Problem • Value Proposition • Business Model • Strategy

Management System •Budgeting system •Management Controls •Operating Plans •Resource Development

Marketing, Sales & Service • Customer value focus • Process Discipline • Business-driven

Core Operating Functions • Functional Efficiency • Inter-function Integration •Value Alignment

Several years ago Michael Lewis published an interesting book on how the Oakland A’s took a systematic look at how the game really works, and what investments in players, strategies and tactics were most likely to result in the most wins for the lowest cost. Our approaches are similar in taking a systematic look at the whole business, each of the major components and the best way to tie everything together into a highperformance system. We start by looking at the basic core value proposition and it’s translation into the Business Model and Strategy. Typically we next examine Marketing and Sales operations, where it is possible to reduce operating costs by 30%, shorten the sales cycle by 30% and increase the closure rate by 30%. This is primarily the result of establishing good processes and discipline. BizzXceleration is comprehensive but integrated across the total reach and range of business activities and issues. And emphasizes a pragmatic, workable approach that results in a stepwise path to performance improvement. We believe that our approach mitigates business risks, improves operational performance and can lay the groundwork for 10-30% EBITDA improvements in post-deal execution.
If you would be interested in further discussions, more detailed descriptions or the review and testing of specific opportunities we would enjoy hearing from you. We can be reached at .

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