From Chaos to Turbulence: Myths and Realities in the Economy, Markets and Policy

8/14/2019 From Chaos to Turbulence: Myths and Realities in the Economy, Markets and Policy

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From Chaos to Turbulence:

Myths vs. Realities in the Economy, Markets and Policy

By Dave Livingston, Managing Principal, Llinlithgow Associates ( www.llinlithgow.com )

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 www.llinlithwo.com/bizzx , 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. Thats a critically important distinction as Chaos iswhen nothing is predictable and where you end up could be disastrous depending on minordifferences 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 predictablebehaviors in the economy, largely as the result of effective and successful monetary and fiscalpolicy.

In the process of laying out this evolution we dig into the structure and patterns of GDP andbusiness cycles, where the economy was at and is likely to go, the interactions between marketsand 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 onand the implications for the future.

While you might think this look back is dated in fact the machinery and long timespans detailedhere will determine the course of the economy for years to come. In particular the explorations ofDebt, Savings and Growth, the role of debt and the future of de-leveraging and the impacts ofTrade, 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 thestrategic outlook for the US economy. It was government intervention, thru fiscal and monetarypolicy, 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 utterlydependent on government support though we can look ahead to a tricky transition. The key to thattransition will be whether or not the economy reaches takeoff velocity and establishes a level ofself-sustaining growth, or whether it remains weak and vulnerable. It will, in any case, remainfragile and were 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.


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Table of Contents

1. Interrupting Your Reported Data Distortions: More Darkside for the Economy 3

2. Same 'Ol, Same 'Ol: Economic Cliff-bottoms vs. Cliff-diving 63. Between Stalingrad and Kursk: Real Economy, Policy and Outlook 8

4. Where's the Money: Markets, Outlooks & Re-Thinks 12

5. Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness 15

6. Refreshing the Economic Outlook: Fundamentals to Business Outlook 19

7. Moscow, Stalingrad, Kursk: Edge of the Abyss to "Recovery"? 22

8. From Mythologies to Realities: Economy, Employment, Credit & Trade 26

9. Markets Away: Run Baby Run? Or Stumble? Or What? 31

10. More De-mythologizing: a Little Markets, Some Economics, Lots of Policy 33

11. Really Different This Time: Liquidity, Rates, Markets & Risks 37

12. Surprise, Surprise: Not a Rally and It's Still Different 39

13. It's Still Different: Refreshing Policy and Market Info 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

http://llinlithgow.com/bizzX/2009/08/interrupting_your_reported_dat.html

We're interrupting your regularly scheduled data dumps of economic data, and ourplanned posting schedule, to bring you this special bulletin about what yesterday'sGDP numbers really said. First off there were not just huge revisions but a completere-factoring of the data. This is not, and for the record, some nefarious governmentplot (though it will again be taken that way) which resulted in better data andrevisions stretching back decades. Which made, among other things, the '01downturn much milder and this one must worse. More importantly our recurrenttheme of needing to really look into things needs re-emphasizing because thereported headlines are based on QtQ data instead of YoY and when you look atproperly 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's WSJ put it all very nicely in historical context though by comparingthe decline in GDP to previous downturns since the end of WW2 with this nicechartporn. We'll dig into all this graphically because it's critically important but whatyou need to know is the headlines reported QtQ changes over the last threequarters in real GDP of -5.4, -6.4 and -1.0%. Which gives great weight to thefantasies of a V-shaped recovery.

In actual fact, on a YoY basis, the last three quarters were -1.9, -3.3 and -3.9%. Letme repeat that - REAL GDP WAS DOWN IN Q209 BY ABOUT -4% !!! If you takeout 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 slightimprovement over the previous -29.8%) GDP x-Trade was down the last fourquarters by -1.1, -2.5, -4.4 and -4.7%. Let's try that again too...DOMESTIC GDPWAS DOWN ALMOST -5% !!!!!.

No way, shape or form that one can read those as good numbers. Nor can oneargue that they show much flattening of the rate of decline, or bottoming out. TheQtQ numbers do tell us that we're in the process of crossing that cusp point though and we'd expect to see betternumbers in the next few quarters, at least in the sense that the rate of declines drops. Positive GDP improvements area ways off, significant positive GDP improvements farther, growth in employment and investment and the return of anaturally growing economy is much...much...much farther off. In fact the Fed expects that after a bump up the long-term outlook is for an average growth rate of 2.4% - that's barely breakeven on required new job creation and meanswe're going to have an organically weak economy - thru 2015 and beyond.


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Letting the Real Economy Stand Up

Let's put all that in context with this graphic so you canwhat the data really says and how it looks in comparisonto the last two decades plus (we'd go back farther but thestructural revisions of the data are a work in progress andit'll be some time before it's completed and we can rebuildall our spreadsheets). There's a pernicious meme in widecirculation, mostly driven by deliberate distortions forpolitical purposes, that the stimulus program isn't working.

In actual fact about $300B of tax cuts and transferpayments have already gone out the door and have beenwhat's kept state and local disasters from turning intocatastrophes. A very rough cut of GDP, with and without Federal spending, shows the downturn would have beensignificantly worse. NB: that initial $300B is about all that could be shoved out the door and actually work. NB2: and thepace, 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 otherwords 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's being mis-reportedand 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 wouldhave been otherwise in Q2.

The Real Outlook: Consumption, Investment and Implications

Current consumption tells you how the engine of theeconomy is doing, investment (real estate andbusiness) tells you how it's likely to be doing and thecombination of wages and employment tell you how thefuture is likely to evolve. The second chart above showsus that Consumption is still bad but it leveled offsomewhat, instead of following over the cliff with GDP as itusually does. For the last four quarters realConsumtion was -0.7, -1.8, -1.5 and -1.8%, so it'sbumping along a bottom for now. That is its not getting betterbut it's stopped getting worse - in some significant partbecause of stimulus. Employment on the other hand isdropping like cliff-diving lemming, along with GDP.

Consumption drives future business expectations whichin turn drive hiring and investment decisions; which, in turn,feedback on consumption decisions. With consumption still very weak and employment dropping we'll be lucky if

demand holds up which means investment and hiring will be constrained for a long time. Take a careful look atinvestment in this second composite - it sharply peaked in early '04 and began declining immediately. The first thingthat tells you is one of the major reasons we had a very weak and jobless recovery - the organic feedback loop nevercaught and the engine was just sputtering along with poor capex spending and hiring. Then it started falling rapidly untilit went cliff-diving very early in '08. The last four quarters were -8.1, -12.5, -25.2 and -27.4% YoY!

Investment dropped by almost 30% in Q2!! Residential investment generally leads the business cycle and this last timehousing price bubbles led to sustaining Consumption on the back of the Housing ATM. That's created a long-termstructural problem where excess inventory will have to be worked off, where Housing won't recover as it normally does


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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. Againthe 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 downInvestment into its two major components so you cansee the RI and Business pieces separately.(Again the revisions to the reported data and the on-going updates make the earlier data a littlesquirrely, technically speaking, but the recent dataappears reliable.). In the top of this graphic you cansee how the cliff-diving real estate drop preceded theoverall downturn and then how businessspending has followed it off a cliff. With all this in mind(the worst downturn, preceded by a jobless"recovery", VERY poor business spendingprospects) we can probably say that getting back to2.4% growth would be an optimistic outcome.

The next question is how is the Consumer going to react, now and in the future. Remember no more stock market orhousing bubbles to subsidize consumption. Then there's the re-balancing and de-leveraging of consumer balancesheets - the fuel that drove the engine the consumption engine for three decades is being taken away. Now at thismoment in time consumption depends, and will depend, on incomes and nothing else. The best indicator of that is thecombination 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 withterrible job creation prospects, will worsen significantly (at least 10% Unemployment and likely worse) and will befollowed 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 putstogether four different graphics we've put upseveral times and like to re-use because they tellthe complete story. One of the advantages ofideographic languages like Chinese is that thecharacters also tell a story because they arepictures. Think of this graphic as fourideograms that also form a fifth, master, picture ofhow the major currents are playing out alltogether inter-actively.

First you have the business cycle whereConsumption drives business spending and hiring

but both Consumers and Business decidebased on income, prospects andfunding/borrowing. As we cycle around thisfeedback loop, which can be either virtuous orvicious (and we're in a vicious one indeed), theeconomy oscillates like a wave pattern.

But we have some deep-seated structural feedback problems where Credit Markets sustain or constrain how theeconomy does. They are self-repairing in the sense that collapse is no long immanent (make no mistake last Fall andthis 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've just been pounding away at, in deeper trouble. As ithappens, no matter what you here in the headlines, the International Economy is much worse. Partly because Japanand Europe are in the deepest dodo but also because China's reported growth is still not good enough to breakeven on

job creation requirements. It's not an accident that so many serious civil disturbances have been breaking out, gettingbigger, more serious and widespread. And also because China acted fast and well but has created terrible problems forthe 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're at in the cycle and what thealternative 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're at the beginnings of a bottoming process. But, especially with poor futuregrowth prospects, the continued deterioration and poor future prospects for Employment - which is IOHO the bestgauge 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, evenif 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

http://llinlithgow.com/bizzX/2009/08/same_ol_same_ol_economic_cliff.html

The immediate prior post actually covered the ground we're going to re-cover with this one. The difference then is thatwe pivoted around the new and revised GDP numbers to hang everything else on while this time we'll focus a bit onemployment and retail sales. While we put up this longish posts that cover some ground and attach excerpted readingsto go with them this time we've outdone ourselves on the readings. In fact normal blog practice would have had almost20 separate posts on just the first item - the hot, recent econ news, alone. This way though you don't get machine-gunned with a bunch of data that doesn't fit into a larger picture. Instead we're going to drop a round of artillery withmany 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 newthing...FRUGALITY! Then we segue to the international consequences with particular attention to China, move on totalking about oil and the dollar and conclude with a few readings on policy. Which, btw, was extensively covered in thelast post ( Interrupting Your Reported Data Distortions: More Darksidefor the Economy ).

Employment and Outlook

Amazingly enough a loss of only 270K jobs had everybodydancing in the streets, completely unjustifiably so in our opinion. Thebasic chart on YoY Employment is shuttled off to the readings. Theonly number that showed any "improvement" was unemployment,which was down "only" -60% instead of the prior '-80%! Jobs andhours continued to deteriorate. Consumer spending is NOT going tocome back until we see significant long-term job creation, which will

be a long time coming. Based on this prior chart of job re-creation (HTCalculatedRisk of course and not the NYT, et.al. who rippedhim off w/o attribution) this is already longer and deeper with more tocome; ioho we're not going to see significant job creation for a longtime indeed. To breakeven we need to create 150K jobs/month, otherwise it's the Red Queen falling farther behind. Weentered this recession ~3million in the hole and are now about 12 million jobs in the hole. It'll take a long period (fiveyears?) to make that up and requires that we hit 4-5% GDP growth (3%+ real growth?). The Fed's looking for 2.5%growth in real GDP at best !


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Consumer Behavior

Some folks outlook is pretty sanguine but some have amore realistic view, as you can see in this chart onconsumer spending recovery . More importantly wefunded the growth in consumption in the '90s on the

wealth effects of the Tech Bubble and during thisdecade by leveraging the housing ATM.

Those are both going away, consumer are converting tosavers, faced with years of having to re-build theirbalance sheets AND we're seeing some fundamental re-thinkings about what we actually need. So for manyyears at least credit availability restrictions will constrainspending, followed by balance sheet constraints and thenwe might reach a new normal. But that new normal will beat a lower set point. The best depiction of all that we've seenis (HT!) from our buddy Jake over at Econpic where he looks at 10yr annualized change vs. net worth.

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

The China Syndrome and Consequences

China's performance so far has been miraculous while India and Brazil's havebeen excellent. But Russia is sliding over the lip of a black hole. We want to talkabout China mostly but a few words on the others as well.

First off, China's recovery has resulted from massive public spending andmoney injections. But unlike in the states where the new money disappearedinto the banks balance sheets China's sloshed on thru to spending. Thequestion 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 theirkumquats are not either our apples or oranges (cf. the Jim Jubak URL in thereadings on China's realities) the real problem is their continued dependenceon exporting.

If the US and the other developed countries become net savers and reduceconsumption the demand for Chinese exports will drop dramatically. That inturn will lower the demand for commodities over what the speculative fantasistsare currently imagining. When you look at the long-term prospects China has tokeep running faster and faster to stay ahead of its population's needs for jobsbut is facing some major barriers.

So, of the BRICS, we'd have to say that Russia is a basket case headed for

worse, India will face many challenges and China is storing up seriousproblems 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 andbalanced economy and has a shot at growing domestic consumption enough tobe self-sustaining.China may eventually get there (certainly they are aware of the problem) but itwon't be easy, will take longer than expected and be at a lower growth rate than we've seen. So for everybodyexpecting commodities and gold to shoot off think again.


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The one major caveat, which we've discussed before, is that folks like Russia, Mexico, Venezuela and Nigeria havebeen over-exploiting their existing oil fields and not investing in new ones. So, even with reduced Chinese growth,we're likely to be back at a D>S imbalance.( Oil Industry II(Analysis): LT Supply-Demand, Outlook and Disruptions )

Note: this will also impact the dollar. The dollar rose in the last several months as a flight to quality play wheneverybody was piling into US Treasuries (so much for the "replace the $" theory) and is since dropping as people arebecoming more comfortable that worldwide Armageddon has been averted. What drove it down secularly, over aperiod 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 flowingabroad; 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're kidding so you may want to play them!

September 4, 2009

Between Stalingrad and Kursk: Real Economy, Policy and Outlook

http://llinlithgow.com/bizzX/2009/09/between_stalingrad_and_kursk_r.html

Stalingrad was not just a terrible battle but anextended, multi-month campaign that was part of alarger operation, but it was the end of thebeginning. Since we like military metaphors,especially ones that work this well, compare last Fallto the Battle of Moscow where Russia almost died andZhukov's troops were marched from the trainsdirectly to the Front. The real point is that we arewrapping up our Stalingrad in that we've stopped cliff-diving but we're lying at the bottom, broken andbleeding with a long and painful crawl across the otherside and a cliff waiting us there. Kursk was in front ofthe Russians in 1942 and a lot of war after that. NB:if you think we're kidding about all this check outTimeline of the Eastern Front of World War II .

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


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Current Economic Situation

Sorry if this is a little to much datacrammed into to small a space but wewanted to cover lots of ground ANDpresent it all as one gestalt, in the sameway a pictographic language like Chinese(subliminal hint) convey background ideasby using pictures of real things while itssaying something directly.

All charts are YoY% changes of real dataand the UL chart shows GDP,Consumption & Employment. GDP wasdown -3.9% vs. last quarter's -3.1% whileConsumption was down -1.8% vs. -1.5%,though on the charts you can see it

flattening; that's all despite the hugestimulus effects.Two prior posts spend more time on the shorter-term data if you want to see that flattening more clearly ( InterruptingYour Reported Data Distortions: More Darkside for the Economy , Same 'Ol, Same 'Ol: Economic Cliff-bottoms vs Cliff-diving).

BtW - responsible, non-ideological analysts put the impact of the first round as adding up to +4% to GDP and savingour bacon. Sorry to tell the ideologues, it worked. Employment though is down -1.6, -3.1 and -3.8% over the last threequarters, which explains why we have two your are here lines on the cycle conceptual chart. Output wise we'reflattening but Employment wise we've not hit bottom yet!!!

Strategic Outlook

We re-visited our estimates of job creation andcumulative growth by directly pulling theemployment and labor force growth, estimatingproductivity impacts from historical data andcalculating aggregate job creation. It turns out we needabout 147K/month, or 440K/quarter instead of the 150Kwe were using to breakeven. Breakeven alsorequires at least 2.5% real GDP growth andpreferably 3%. Without that level of growth we dig thehole deeper and we're now about -10 million jobs in thehole, as shown in the LL sub-chart above.

The UR and LR charts compare changes in

Consumption and GDP to changes in nationalincome real wages plus employment (our oldindicator was changes in real weakly (deliberateFreudianism) wages but deflation is badlydistorting that for the first time in decades. As long as

jobs keep disappearing, people keep dropping out oflabor force and incomes are under pressuredemand will have a tough time growing. Especially now that asset-backed borrowing (the Housing ATM) is history. Thatmeans the ugly recovery we should have had after 2001 but were saved from is back and it's really PO'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's the government we'll mention that there projections are consistent with the majorinternational agencies (IMF, World Bank, OECD,...), major players (Roubini, Feldstein, Krugman, et.al.) andprivate/street forecasters (GS/Hartzius,...). If anything they all converge, roughly, but are a little optimistic. We've piledup 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 2012but tails off to 2.5%.

This is going to be the Mother of painful, extended and jobless recoveries we're sorry to say. BtW: for all the gold bugsbuying food and ammo the OMB's interest rates are pretty sanguine for a long-time. Again we're looking at the triumphof ideology and not data or analysis. But that's a really important point - you don't just play the game, you compete withthe player. And if that many people are insisting on using funhouse glasses colored red, by all means, prepare to takeadvantage.

Politics, Policy and Salvation

Speaking of using your forebrain to rationalize what isinto what you want to see we might mention what'sbeen going on the policy front. Which we

discussed extensively in a prior post with looks atspending, the structure of the package and the realhistory and outlooks for the deficits. ( Realities vsRhetorics: Economy, Policy, Real Data ) The reallyfascinating thing to us is that no single member of ournetwork has given any credence to our analysis,bothered to look at the numbers or taken aposition that they didn't go in with.

Menzie Chin has a very straightforward estimate of theimpact of the stimulus so far, and came up with 4%,which he then chopped in half to keep the trolls off hisback. (For an interesting dissection of public

intellectual disputes and bad math click here .) Thepackage was very carefully constructed to get tax cuts,transfers and rebates out the door fast and then gatemore effective and directed programs that are at thelimits of what can be implemented. Other than the Administration itself there are no commentators who have clearly putthe economics, the impacts, the mechanics or the politics together into a holistic assessment. We've done our best withthis graphic, which relates the various alternative paths forward to the structure of the package and the cusp pointswhere we are at risk of mission abort.

Right now we're in for a U-shaped recovery that'll be drawn out as balance sheets are re-built and people turn fromspendthrift borrowing grasshoppers to frugal and saving ants. If the political pressures for killing the remainingprograms mounts far enough the risks of a W-shaped recovery increase exponentially. Worse, that recovery will benon-organic and have high likelihood of stalling us in a long-term malaise where we don't succeed in re-basing theeconomy.

We won't go into the package structure or deficits, which were covered previously with charts on the Stimulus Structureand Deficit History but each is not what you've been told. For recent updates by Menzies on the nature of thedeficit/sources and on the budget deficit outlook click on the highlights. What he highlights is that the higher theeconomic growth rate the lower the deficits, the faster the debt paydown and the lower the burden. But we all know thatfrom our private lives right - when we borrow to spend we dig a hole and when we borrow to invest we get futurereturns? Right? Right? Oh, never mind.


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Seeing the World As It Is...Are You Kidding?

Let's pick up on that point, starting with this graphic from a recentMoney/CNN online survey which tells us what the man in thestreet thinks (sorta), instead of us bloggers, the pundits or thepontificators. Based on what we've just been saying the

people seem to be more realistic than the pundits; orpaying less attention to the so-called "statistical recovery" andfeeling the pain of real job losses, income shortfalls and poorprospects. In some ways, looking out to 2019 with the OMB,they're too optimistic. Compared to the folks who just ran themarkets up they're paragons of pessimism and/or realism ofcourse.

The LT corner sub-chart in the very first graphic might have been a puzzlement, though the reason we shaded certainindicator dials should be clearer. And if you read the excerpts after the break, e.g. on Housing, even more so. But whydid we indicate that the international economy is worse off the US domestic economy? That's a key question and onewe dove into deeply in an earlier post ( Same 'Ol, Same 'Ol: Economic Cliff-bottoms vs Cliff-diving ), triggering off ofMike Pettis' " China Financial Markets " observations, which again in the readings, you'll find is now in wide circulation.

Basically it's this: yes indeed, China has held up well with rapid, forceful and large stimulus actions. Unfortunately itneeds 6% growth to stay ahead of the riots. That would be yellow all by itself but for one thing their accounting is kindafunny (not necessarily deceptive) in that intermediate output is counted in the stats so they look much better than theyprobably will. For another all that sloshing cash injections went into loans that are likely to turn bad. That all takentogether at least turns China pinkish, to be technical. But they, along with the rest of rapidly developing Asia, face amajor structural conundrum. They need to shift from export oriented economies to domestically driven ones and that'snot happening. As US consumers save more they will import less and we will need enormously less in terms of foreignfinancing. That's why they and the rest of the international economy, and for similar reasons in the aggregate, areshown 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

http://llinlithgow.com/bizzX/2009/09/wheres_the_money_markets_outlo.html

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

Markets, Earnings(?) and Euphorillusion

Let's start with the current market situation. The top sub-chart

shows the SP500 YtD and shows some of the technical signals thatcalled for turning points. Some of which panned out and many (theyellow warnings) that didn't. Reviewing the bidding we started the yearsliding until the real economic data led to fears of Armageddon andpanic. When it appeared the banks weren't going to all die (saythank you Timmy) we got a major bear market relief rally that'salmost died again several times but each time found hope in greenshoots and earnings.

There are several huge problems there: the earnings aren't really goodbut based on cost-cutting and expectations management, much of thevolume has been concentrated in very few stocks, i.e. theFinancials, and is even less grounded in reality and what we've

really been experiencing is a sentiment driven market. The bottom sub-chart brings back a little reality...the downtrend is intact.

Re-visiting some key charts we've concatenated from previousdiscussion might put things back in their proper context. The top chartshows cumulative growth since 1950 in real GDP, Corporate Profits andthe SP500. Notice we got two market bubbles, a profit bubble thisdecade and that the markets barely kissed the long-term trend of realgrowth before taking off again. Where's the reality in that?

Two other major things to notice though - before delusional thinking tookover everything followed coincident structural trends AND themarkets had long secular cycles (uptrends and downtrends) along thatdeeper path. There are two possible futures implied here.

One, we return to sanity and enter a decade of the doldrums. Or 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.


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The other thing to notice in the bottom sub-chart is that the profits were a combination of structural sub-parperformance in the real world and leveraged risk-taking in the financial . Now do you think the Finance Industry'sgoing 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's the money? Equityreturns are composed of earnings and prices, that is, PERatios. In fact the finance community talks about betas andalphas. Beta is the weighting factor based on expectedmarket returns, preferably adjusted for risk. It tells you whatreturn you should expect if you got a normal return over thelong-run. In fact much of the bubble returns, before theywere destroyed, were betting on leveraged Beta.

Alpha is the return you get that was unexpected, i.e. thatresulted from insight, analysis, luck or skill. Beta is goingto be low for a long time, leveraged Beta (trend-following) could kill you so if you want something

besides the lowest common denominator it's going to takework to go seeking alpha.

We've used Bob Shiller's work several times on long- termPEs so we're taking a different data set from S&P in thesecharts which show PE's based on 12Mo TrailingEarnings from 1936. The average PE from 1936-1990 was14.4 and from then until 1995 or so the PE's cyclednaturally around that average. Then they went to the moonand never came back.

That's a really critical point - PE's have nevercorrected back to the average in the last 15 years or so!

The bottom sub-chart looks at the difference betweenaverage and current PEs and reinforces that point. It'scritically important to remember that exceptional returns don't result from buying at the highest price. We've usedGraham-Dodd's framework to chart the relationships between PE's, growth rates and interest many times so we won'trevisit that chart but suggest you review it. Then ask yourself, at these prices, where's the return?

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 theeconomy such as the emergence of the rapidly developing BRICs and the associated impacts on energy andcommodity 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 theoutlook 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 canwe analyze them. Technical analysis is focused more on the short- to intermediate-terms while structural andfundamental tend to work out over longer timeframes. Moreover the latter two factors tend, as weve shown, toconverge on basic economic performance. Going back to our description of Mr. Markets behavior he tends to settle onthe sober-sided basics eventually but, as weve learned to our sorrow, he can also be volatile and giddy in the short-term. 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 underthe sway of sentiment driven fashion.

The accompanying graphic compares our four-factor assessments from Jun08 to Jun09 and, looking back, seems tohave held up reasonably well in both time periods. Our take now is as follows:

1. Structural C-/C: after the earlierdiscussion we think the economysfreefall has been arrested but the long-term prospects are rather poor anddependent on first crossing over into self-sustaining growth. The downturn has ledto serious under-investment in energydevelopment so future supply/demandimbalances could return as current provenresources are drawn down. On the otherhand structural shifts in world trade as the

US saves more will reduce long-termgrowth rates in China, et.al. and lower theimbalance pressures.

2. Fundamental C: the economy isbumping along the bottom and thechances of a rapid recovery are poor.There is also a downside risk that arecovery will be aborted and we will see aW-shaped pattern. A bigger risk isbalance sheet re-building, a deferred

Housing recovery, other risks to theFinancial sector and the likelihood of very poor job creation dampeningdemand. Wed also judge the odds of being able to re-base the economy to higher growth aspoor.

3. Technical C/C+: the bear market rally appears to have run its course and was based on acombination Armageddon avoided relief rally, misinterpretation of earnings quality andoutlooks. However the market is not particularly oversold or overbought and could have someupside surprises still in store. The biggest surprise risk is that the longer-term earnings andvaluation realities will finally sink in.

4. Sentiment B/B- and dropping: our judgment is that this rally was based almost entirely onsentiment. Probably the best ways to judge sentiment are by a close reading of headlines andpundits comments as well as by market reactions to news. When the market continues to rally onnot-worse news sentiment is strong and positive. When better news gets a yawn, or worse adrop, then it is shifting. Right now were in a very volatile state with regard to sentiment as thelast two weeks show. There is a real and significant risk that sentiment will reverse suddenly for


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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, whichhe started before Bear-Stearns went under and which he tracked thru theentire crisis. While he's appeared on several talk shows, of various sorts, thetalk 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'spointed and intelligent questions.

Before leaving this topic we highly recommend your watching the CSpanvideo clip ( http://www.c-spanarchives.org/library/index.php?main_page=product_video_info&products_id=288534-1&showVid=true )

He concludes by making three points:1) we had a near-death experience and were saved by emergencyheroics, perhaps largely those of Ben Benanke and the Fed,

2) we've survived the worst of it barely but have a long way to go before we're restored to health and

3) there's been little or no change in the regulatory and legislative framework.

We'll come back to that last point at the end, and it's vitally important, but our critical observation is that thecommentariat mis-understands the process the Administration is following. First, put out the fire and start the repairwork while second, attempt to inclusively line up support. Now they are shifting to a full-bore press and we wouldsuggest that the Industry NOT under-estimate their chances. It wouldn't take much to fan the smoldering torches into aconflagration.

A Little History Review: Debt Since WW2

These potential reforms are important onlyinsofar as we a) mitigate the chances of it

happening again, b) we maintain a healthy,vibrant and contributory financial sectorwhile c) doing away with the socionomicdysfunctions that almost destroyed theeconomy.

The root of all this are debates over thelevel and role of debt financing in theeconomy so we thought we'd review a littlehistory to put things in context. To address thatwe built two sets of composite charts from theFed data on money flows and the resultsmake interesting viewing.

In the UL sub-chart current dollar debt (ourestimates) grew from about $2.5T to about$31T from 1945-2008; and contrary tocurrent headline and political mythologythat's not Federal debt that's the largestportion, it's Households and Businesses. Ourpost-war prosperity was built on a sea of it.


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In the LL chart though you can see the structural shifts where relatively speaking Federal debt was shrunk whileFinancial sector debt grew enormously. These shifts are highlighted on the right-hand sub-charts as multiples of GDPwhere total debt grew from 1.6X GDP to slightly over 3.5X!

More interestingly Household and Business Debt grew steadily until the '80s when it jump-shifted, and then did soagain in the '90s and '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-deregulationthat we began drowning in debt but in fact, contrary to popular political mythology, Federal debt was steadily paid downuntil the Reagan administration when it ballooned again, then was paid down during the Clinton years only to be re-builtduring BushII. Not what you normally would think, eh?

Relative Debt Growth

The second chart shows the normalizedrelative growth and highlights many of thesepoints from a different perspective. All thesecharts are built around cumulative % growth from1945 to 2008 and show the relative,normalized, growth of each of the major

sectors. As you can see in the UL growth inFinance debt outstanding completely swamps allother sectors, which is why the other chartsbreak things out separately. The LL sub-chartshows the major sectors, excluding Finance, theUR shows Finance by itself and the LR sub-charts shows Household debt along withgrowth in Credit Cards and Mortgages.

Here's the fundamental questions thesecharts raise in our minds:

1) What's the appropriate level of debt for a healthy economy? We'd suggest something more in line with the points

reached around the mid-80's, except for Finance.2) If that's true what kind of regime will be required to evolve back to that point? How long might it take to get there? Isit feasible and what happens if it's not?

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, alathe 1980's, what kind of Industry will we have? Is it even possible? Is it politically feasible given the heartfelt oppositionof the Industry to even modest reforms?

Fighter's Go to Your Corners: the Prospects for Reform

Ah, there's the rub, as they say. It's not an accident that the President madea speech directly to Wall St. on this topic nor that Summers, Blair and

Shapiro were addressing the Georgetown University seminar on FinancialReform about the same time, nor that a whole slew of regulatory changeswere being announced by the Fed, et.al. during the same time period. We'vehave to say that the agencies, the Administration and Congress are headedfor 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 bestalternative that we're all left with. We'll continue to argue that after loosing(destroying) almost a decade's worth of funny-money profits it's even in theIndustry's own evident self interest to proactively and constructively


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participate in re-shaping the regulatory and legislative framework. Larry Summer's Georgetown speech (http://www.c-span.org/Watch/Media/2009/09/18/HP/A/23338/Georgetown+University+Conference+on+Future+of+Global+Finances.aspx ) laid out the Administration's framework pretty clearly, as well as explaining the reasons and intents. Five majorprinciples were laid out:

1) Capital Adequacy for systemically important institutions (which also implies no more off balance sheetgreen curtains)

2) Resolution Authority - in other words the end of TBTF (to big to fail). As Larry put it we don't ever want tofind 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 especiallyincludes international comparison shopping (if you don't think that was an important part of the recent G-20meetings think again).

4) Regulate Systemically - no more regulatory "prudentially" single institution by institution but ask whatimpact the collective will have. Think of it as the end of "we will assimilate your distinctiveness and make itours".

5) Consumer Protection - need a separate authority to focus on the health and well-being of the consumerinstead 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 andmanagement.

And the Alternative?

Summers pursued a great analogy when he comparedchanging the regulatory framework to how we deal withAutomotive Safety issues. For many decades thetheory of auto safety was that it was the responsibility ofindividual drivers. But as more and more vehicles got onthe roads with higher and higher performance cars we had

an "epidemiological" problem - that is there were more andmore unecessary deaths because cars were changing fasterthan humans evolve. By comparison then do wecontinue to let the death toll mount or do we dosomething?

One thing the Industry is under-estimating outside theBeltway or NYC is the depth and breadth of publicanger. One could argue we saw similar outrage after theTech Bubble burst with Enron, Worldcom, et.al. and theoutrage petered out. The difference though, this time, isthose actions didn't threaten society.

Last June we were at a conference on the future of corporate governance and one session, focused on improvingBoard decision-making, was taken over by one gray-haired gentleman's anger at the breeches of fiduciary trust by theFinance Industry. Bear in mind this was a couple of hundred people all of whom were executives, board members orconsultants with decades of experience. If they were so anger as to loose control what does the rest of the countrythink.We suggest you listen to the accompanying vidclip of Michael Moore being interviewed by Dylan Ratigan on MSNBC and listen to Ratigan. http://www.msnbc.msn.com/id/32450072/vp/33019751#33019751

Refreshing the Economic Outlook: Fundamentals to Business Outlook


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http://llinlithgow.com/bizzX/2009/10/refreshing_the_economic_outloo.html

Welcome to the "New Normal"! One of the most fascinatingthings about it is that, like the "old normal" denial seems tobe a fundamental element. We were going to put up arefresh of the economic data yesterday but delayed tocatch the most recent Employment numbers, which wereabout as bad as it gets, not least of which was because theBLS revisited and revised its numbers and took another800K+ jobs out of the last two years.

If there's any debate that this is going to be a long, uglyand jobless recovery that should start disappearing here,though slowly (that's the denial part) and we have heardmore and more folks singing from the same hymnal that weuse. Now there's not many/any radical structural or trendshifts in the data so, after a "brief" look at the employmentdata per se we're going to take a different perspective onwhat that new normal might look like.Though we'll bet itlooks like this collage to most !

Re-visiting Employment

Starting with the Employment data (& there's a bunch of excerpts and URL pointers in the readings) let's take a scan ofthe data. YoY Employment, Private jobs, Hours worked and Unemployment all continued to worsen (Unemp wouldhave 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 beencreated since Q298!

That's not after labor force, population or productivity adjustments - that's PERIOD! Speaking of which, we need 440 jobs/quarter to breakeven but net job creation was still negative, though improving slightly. On a cumulative basisthough we're now about -12 million jobs in the hole. In other words addon whatever we loose over the next 18 months,

the under-employed and that 12 million and we're just back to breakeven. Think we'll dig out of the hole by 2019? TheOMB doesn't, as we discussed ( Between Stalingrad and Kursk: Real Economy, Policy and Outlook ). And just for therecord 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 beginto come back? And what are the liklihoods? We've tried toanswer that question by looking at keycycle relationships and seeing whatleads to what, following around theeconomic circle of life. The drivingengine is Consumption where there's an

almost 1-1 link which you can read rightoff the first sub-chart in two differenttimeframes.

The real question today's newsmakes critical is when are jobscoming back? There the news is lessappealing. We need 2.5% job growth forbreakeven, which would be about 4% GDPgrowth. Given that the outlook from the


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OMB, et.al. is for 2.5% GDP growth thru 2019 we'd suggest that the chances of reaching that point aren't real good. Infact at 2.5% growth it'll take a darn long time just to get back. There is NO investment, business or personal decisionyou or anybody you know will make that shouldn't be hedged against that outlook - maybe for the next decade.

Of course whether or not the implications will sink in and be strategically and effectively responded to are otherquestions entirely.

For Example: the Investment Outlook

What we'd like to get back to is organic, self-sustaining growthwhere increased jobs lead to increased consumption lead toincreased investment, which leads to more jobs, higher wagesand so on around the "Great Circle".

When it works that's called a virtuous cycle - when it runs inreverse it's a vicious one. From the top sub-chart (note how muchsteeper it is) Investment is responsive to growth beyond a certainpoint. If we get to 3%+ growth it looks like we'll get a big jump inCapex. On the other hand Tech spending is even more sensitive

(the curve is much steeper). As long as the economy stays in thedoldrums the outlook for Tech ain't very good.

And clearly the days of 9-16% surges have gone the way of theDodo. Just as a bit of a test - how much of that do you think isreflected in Tech sector earnings outlooks and PE valuations?We'd hazard that the inverse is true - that is people are still lockedinto a mindset from the '90s and aren't adjusting their thinking atall; and won't until the smoke signals on the horizon are fires attheir feet. Which does present some interesting tradingopportunities but not very good investing ones, in general.RE Investment is the other interesting conundrum. Now as ourfriend 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 thislast decade. Does anyone think that ATM is coming back? Anytime soon? Anyone, anyone...Ferris? To get a significantlift from RI it'd need to grow at 10% and IOHO we'll be lucky to see years of 3% growth, hopefully followed by some fivepercenters. 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 outputand investment growth, such at is and/or might be, willstimulate hiring and wage growth. Now the (temporary?) deathof Inflation has driven up real wages short term and helped holdup spending, of course enormously helped by governmentspending. So in the next chart we've taken a shot at looking at ourkey future indicators of consumer demand, the YoY change in thesum of real wages and employment, and used PersonalIncome (PI) as alternative proxy just to calibrate things a little.

Zero % growth in the first basically gets us back to thataforementioned 2% consumption growth but it's worse looking at PI,more like 1.5-1.75%. To get future growth of, say, 4% inConsumption we need the sum of wages and employment to grow


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

Welcome to the New Normal Indeed: Where's MyMommy?

We wish we could send you off this weekend with better news butcouldn't figure out how to do that without blowing a lot ofsunshine up your skirts, so-to-speak. The key for this newenvironment is going to be how well businesses andconsumers adapt their behavior. It's not a question of the newnormal being supported by the new frugalities, but the "NewFrugality" being forced by it. At the end of the day this is going to bean economy for a tough-minded Scotsman, a Buffett-economy inother words, that will reward insights, analysis, preparation,discipline, patience and persistence. As well as having thecourage to change. Now speaking for ourselves we always prefercowering in terror but we're hoping very sincerely that the sameain't true of our leaderships. URL: http://llinlithgow.com/bizzX/pics/ClimbingFall.jpg

Back in the day when we used to do a little rock climbing there always came a moment when it dawned on the climberthat that tiny little thing bracketed by their boots was the six acre parkging lot they'd left a few hours ago. It wasn'tunusual (ahem) for the next step to be clinging tightly to the rock whimpering for Mommy to come make it better. Thebest response we ever saw was the instructor who shook loose the safety rope and leaned into a loud stage whisper asthey rope fell down slack, "you're gonna die"! A little harsh but the student did survive to finish the climb and go on thenext one.

Consider this our "stage whisper" and add to your shoppinglist two key readings, one from Mohammed El-Arian: ACEOs 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"?

http://llinlithgow.com/bizzX/2009/10/moscow_stalingrad_kursk_edge_o.html

We could title this post a lot of things but wanted to focus on ametaphor we've been using because it's powerful and accurate.The Battle of Moscow in 1941 was when the Russians weresaved, after letting themselves be surprised thru wishful thinkingand ideological self-delusion (our term has been and iseuphorillusion) by last minute miracles (Zhukov's Mongoliandivisions were marched thru the streets of Moscow in a "parade"straight to the front). That was followed by many things but acentral one was the extended Stalingrad Campaign (as part of thelarger Uranus) in 1942 which was only the end of the beginning.URL:http://www.msnbc.msn.com/id/3036789/vp/33175376#33175376

The beginning of the "middle game" was the giant battle of Kurskin 1943, where the Russians entrapped the Germans into theworld's largest tank battle and defeated them, partly thru better


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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 becomingall too clear, was our Moscow. We've been saying that for a while but how close we came to the edge of a worldwidecollapse in the financial markets is becoming clearer and clearer. This last Winter and Spring was, and is, ourStalingrad. So, consider this post an addendum to the last as well as its own thing. We're going to largely let some keyexcerpts speak for themselves with a little judicious commentary but will also point to a selected set of excerpts to backup many of the points after the break.

Fall in Moscow: Near-Death Experiences

Don't let anybody kid you, it was as the Iron Duke said inanother context, a "near-run thing, a damn near-run thing".Not only did LEH, FNM and FRE die but MER disappearedbut we were within a hairsbreadth of seeing Citi, MS andGS go as well, despite the denials at the time and,especially on the part of GS, since. NB: we have noproblem with the artful dodging of Paulson and other policymakers - tell the idiot horses that the fire was out of controlwould have triggered the panics they were trying to stop.

Let us let an excerpt from Andrew Ross Sorkin's just outbook tell the story, but we'll draw your attention to the stockcharts....even might Goldman almost died in those fewdays and hours. And below we'll also point to the charts oncredit....which we've talked about before. Just in case thepoint's not clear - the financial system is still broke andcredit is shrinking....without continued Fed support the whole thing will blow away. We're a long way from fixedand from starting to fight Kursk.

Wall Streets Near-Death Experience With the implosion of Lehman Brothers, in September 2008, the realizationdawned: Morgan Stanley and Goldman Sachs could be next. In an excerpt from his new book, the author reveals theincredible scramble that took placedesperate phone calls, seat-of-the-pants merger proposals, flaring tempersasWashington 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 Paulsons office as he spoke. Nearly two dozen Treasurystaffers had assembled there Wednesday morning, sitting on windowsills, on the arms of sofas, or on the edge ofPaulsons desk, scribbling on legal pads. Paulson was seated in a chair in the corner, slouching, nervously tapping hisstomach. He had a pained look on his face as he explained to his inner circle at Treasury that in just the past four hoursthe crisis had reached a new height, one he could compare only to the World Trade Center attacks, seven yearsearlier, almost to the week. While this time no lives may have beenat stake, companies with century-long histories and hundreds ofthousands of jobs lay in the balance.

The entire economy, he said, was on the verge ofcollapsing. Paulson was no longer worried about justinvestment banks; he was worried about GeneralElectric, the worlds largest company and an icon ofAmerican innovation . Jeffrey Immelt, G.E.s C.E.O., hadtold him that the conglomerates commercial paper, used tofund its day-to-day operations, could stop rolling. Paulsonhad also heard murmurs that JPMorgan Chase had stoppedlending to Citigroup; that Bank of America had stoppedmaking loans to McDonalds franchisees; that Treasury billswere trading for less than 1 percent interest, as if they wereno better than cash, as if the full faith of the government hadsuddenly 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 wasnt working.

It had been six months between the implosions of Bear Stearns and Lehman, but if MorganStanley went down, probably no more than six hours would pass before Goldman did, too. Thebig banks would follow, and God only knew what might happen after that . And so Paulson stoodin front of his staff in search of a holistic solution, a solution that would require intervention. He stillhated the idea of bailouts, but now he knew he needed to succumb to the reality of the moment. Theonly way to stop this thing may be to come up with a fiscal response, he said. Paulson, who had beenliving on barely three hours of sleep a night for a week, was beginning to feel nauseated. Watching thefinancial industry crumble in front of his eyesthe world he had inhabited his entire careerwasgetting to him. For a moment, he felt light-headed. From outside his office, his staff could hear himvomit.


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Stalingrad - the Stimulus Package & Sausage-Making

Another thing we need to be very clear about is the next time wewere dancing on the edge of the abyss and how close run a thingit was and still is, as well as how much cleanup and rippleeffect we're going to be dealing with for a long time. Now

we've taken some really deep dives into fiscal policy, thestimulus package and the effects it's had as well ( BetweenStalingrad and Kursk: Real Economy, Policy and Outlook ) so wewon't re-review those in any detail.

But despite all the ideological arm-waving it's been the early taxcuts and transfer payments that saved us from much...muchworse (and yes we're talking GD 2.0 here), in conjunction with theFed's unusual actions. It's also going to be Federal spending thatkeeps the wheels on the wagon for the next two years while wehope a more natural organic recovery begins to emerge from thebombed out rubble. The accompanying chart on job losseshopefully brings home the point of deep the chasm is as well as

how far we've got to go to get to the other side. But theexcerpt below should make clear the human dimensions of thepolicy-making and sausage-grinding that went on.

Inside the Crisis:Larry Summers and the White Houseeconomic team The most important question facing Obama thatday was how large the stimulus should be. Since the election, asthe economy continued to worsen, the consensus amongeconomists kept rising. A hundred-billion-dollar stimulus hadseemed prudent earlier in the year. Congress now appearedreceptive 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, eighthundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009and 2010. Because of the multiplier effect, filling that gap didnt require two trillion dollars of government spending, butRomers analysis, deeply informed by her work on the Depression, suggested that the package should probably bemore than $1.2 trillion.

There were sound arguments why the $1.2-trillion figure was too high. First, Emanuel and thelegislative-affairs team thought that it would be impossible to move legislation of that size, anddismissed the idea out of hand. Congress was a big constraint, Axelrod said. If we asked for $1.2trillion, it probably would have created such a case of sticker shock that the system would have lockedup there. He pointed east, toward Capitol Hill. And the world was watching us, the market waswatching us. If we failed to produce a stimulus bill, that in and of itself could have had deleteriouseffects. There was also a mechanical argument against a stimulus of that size. Peter Orszag, who wascelebrating his fortieth birthday that day, said that, while the argument for a bigger stimulus was soundtheoretically, there were limits to how much money the government could practically spend in the nearfuture. Summers brought a third argument to the debate, one that echoed his advice to Bill Clintonsixteen years earlier, when his Administration was facing persistent budget deficits that Summersbelieved were suppressing economic growth. He, like Romer, was guided by an understanding that infinancial crises the risk of doing too little is greater than doing too much. He believed that filling theoutput gap through deficit spending was important, but that a package that was too large couldpotentially shift fears from the current crisis to the long-term budget deficit, which would have anunwelcome effect on the bond market. In the end, Summers made the case for the eight-hundred-and-ninety-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 youveexperienced it, you dont realize how hard it is. Its humbling.


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

Getting Ready for Kursk: Economic Repair plusRegulatory Reform

The final section of the readings is a set of video clip addresses that we highlyrecommend you make the time to watch, though the accompanying CNBCshort interview should set the stage. In it some key players from both sidesof the House discuss the state of things and their outlooks. Oneobservation by Barney Frank we found especially interesting is that heexpects a House Bill to be brought to the floor this Fall - and further thatthey've been working on it since the Spring of 2008, when it was kicked offbased on Sec. Paulson's suggestions! Think about the implications of all thatfor a minute.

Now this is a topic we've spent considerable time and horsepower on, to thepoint of post after post. ( Ask Not For Whom the Siren Shrieks: Let the Finance Wars Begin , Refreshing the EconomicOutlook: Fundamentals to Business Outlook ) So we won't re-visit thatground but you might want to refresh yourselves a bit. URL:http://www.cnbc.com/id/15840232?video=1287062674&play=1

Planning for the Future

But there are several bottom lines here that need to be considered.

1. Regulatory reform is coming and it'll be significant.

2. The Finance Industry as we know it will, or at least should, not be the same.Not just because of changes in the regulatory framework but even more sobecasue a) the debt-driven, leverage-based financial engineering of the lastthree decades didn't work and b) because the business models of the majorlines of business are broken.

3. The US economy has floated on a sea of debt, triggered by de-regulation, and balance sheets will be re-built and de-leverage will be the orderof the day. That'll reduce demand in the intermediate term and make the

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 them.The "New Normal" is being met with the "Old Normal" rules of thumb, behaviors and strategies.


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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. butyou 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 longercredible, 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 mindsconverging on the same set of worries when examining the same realities.

October 12, 2009

From Mythologies to Realities: Economy,Employment, Credit & Trade

http://llinlithgow.com/bizzX/2009/10/from_mythologies_to_realities.html

We didn't really want to circle back to pure economics so quickly but there's so much mythologizing going on, withoutlooking at the underlying structure and trends, that it seems necessary. Plus of course we had all this niftyaccumulation of information and readings to point to! :) But with stuff like Brian Wesbury writing in the WSJ things likeThe Economic Recovery Is Well Underway it seemed necessary. BtW if you don't have a sub to be able to read it, don'tbother (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'll point you to The Daily Show, which cuts closer to the quick in theaccompanying vidclip. URL: http://ccinsider.comedycentral.com/2009/10/09/the-daily-show-and-slim-thugs-music-video-still-a-boss/ . You have to admit it's not very often that you hear the greatest economist of the 20thC being citedin a hip-hop video, now is it? And, all seriousness aside, the point of the video is actually fairly accurate...it certainlycaptures the situation that most people are finding themselves in.


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Current State of the Economy

For something a little more straight-forward we'll point you to this extract fromthe latest Northen Trust economicoutlook update . The graphic is acomposite taken from Paul Kasriel's mostrecent road show and if you click on it it'llpull up a Powerpoint presentation with someselected excerpts.

On the other hand the entirepresentation is well worth your time so if you'llclick on thru on the highlight you'll get theentire presentation in PDF format and candownload - we highly recommend it sinceyou'll be able to see the entire pitch and readPaul's words that're wrapped around the

charts.

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

Employment: Structure Outlook & Surprises

Which brings us to something else we've waxed on about but want tohighlight as it's central, and that's the strategic and structural outlook foremployment as well as the current situation. The last Payroll reportsurprised by showing Unemployment was nearing 10% and indicating that itsoon would be as well as implying that job recovery would take a terrible longtime. The jobs picture has surprised everybody to some extent though all theexpectations were for a bad result it's worse than anticipated though it ISfollowing the standard patterns. The top sub-chart is drawn from GregMankiw and shows the expected pattern with and without the stimuluspackage. As you can it was worse earlier in the year, got much worserecently and is beginning to level off at a higher than anticipated rate.

The stimulus package and monetary policy did their job and the situation ismuch better than it would have been BUT that's not saying much. A majorpart of the problem is continuing credit rationing, another is the beginning oflarge-scale structural shifts between sectors and another is businessuncertainty about the duration of weak demand and business decisions abouthiring. The structural shift part is important, messy and complicated.Normally as the economy cycles up and down the allocation of people andresources between sectors isn't changed much but with the over-investment in housing and other sectors those resources are beingdisplaced. That takes time and is subject to a lot of friction. On the


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

Credit, Debt and Secular Changes

The next chart highlights some other aspects of the deeper changes thatwill take the rest of this decade to work out. The bottom shows thecurrent state of Consumer Credit, as well as history. A topic we'veinvested some time and effort on exploring in earlier posts (eventriggering a WSJ story on the subject!).

As we found earlier credit didn't grow appreciably until de-regulation andthen accelerated in the '90s and bubbled this decade when it fell off a cliff.Given the condition of the banks with bad balance sheets, more loanlosses, toxic assets to be written down, etc. etc. none of this should be asurprise. Nonetheless it tells us that for the short- and intermediate- termthere will be NO debt-driven surge in consumer demand; as if wedidn't already know that from the jobs indicators.

Then we get to the Net Worth problem. People were more badly hurt bythis collapse than have been since the Great Depression. It's alsounlikely that the majority of the population will ever recover. Whatmade people comfortable with those huge surges in debt was that theirapparent net worths would support the debt (or so they thought). Nowconsumers will be focusing on repairing their balance sheets as much ormore than the banks. Or, put another way, we're going to be forced to re-discover frugality which means that we're going to become more of anation of savers, not spenders. Another drag on demand growth!

The Trade Equations: S-I-NX

There's an interesting identity in internationaleconomics trade, and when we say identity we meanthat it's a definition, not open to interpretativedebates and that it governs the economy and trade asmuch as gravity governs the orbits of the planets andin the same way. It's also grossly mis-understood butit's also felt in every way by everybody every day.

The basic identity starts with the basic economicequation that Output (Y) = Consumption +Government spending + Investment + Exports -Imports. Or in h.s. algebra Y=C+G+I+X-M. Since X- M =Net Exports (NX) and Savings = Y-C-G that means thatS=I+NX, or S-I=NX.

In words that's Net Savings equals Net Exports. Whenwe import more than we export (NX0 and we won't be importing Arab oil money or Chinese savings tosupport 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 aboutby the Recession and the UR nets out the impact of oil imports (boy, if we ever wean ourselves!). The bottom two sub-charts trace that history back to 1980. Notice that things were largely in-balance until the mid-90s and didn't really get


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out of whack until this decade. What that really tells us is that this wasn't some vast conspiracy but the natural,algebraic outcome of our debt-fueled over-consumption. As we continue to maintain a more frugal posture that'll lowerthe trade deficits and take a lot of the structural pressures off the dollar. BtW - it's also important to note that almostnobody is talking about these things, even though they're as natural as the tides (also the result of gravity!).

Structural Changes in Other Countries

The American consumer has been the driving engine of worldeconomic growth for close to three decades now and Japan, Taiwan, SouthKorea and the Asian Tigers based their economies on an export- drivenmodel of development. As has Germany and especially China. When youhear folks talking about a re-balancing of the world economy they're talkingabout two things. Those countries will have to either shift toward a moredomestically-based and consumer-led economic structure or they will facesevere and dramatic downshifts in their economic growth. That, in turn,implies huge structural shifts in their economies.

If we can take the case of China this graphic illustrates the situation andchallenges pretty well. While Chinese consumption has been growing very

rapidly it's a small part of their economy - the smallest part of any of thelarge economies. For them to continue to grow that'll have to change. Or,looking at the bottom sub-chart, what we're implying is that Chineseconsumption will have to evolve from being 4% of growth to perhaps 6%, ormore. Actually it's more strigent than that - it will evolve the realquestion is what will be the adjustment mechanism. Will it be a drop inoverall Chinese economic growth or will it be a major structural shift toemphasize domestic production for domestic consumption?

On the answer to that question depends the economic outlook for the worldeconomy over the next ten years and beyond. A failure to cross that barrierwill result in political instability that would threaten the viability of theChinese state. The good news is that they're well aware of the fact and

are beginning to move in that direction. The bad news is that it will bedifficult and take some time.

Debt, Government Spending and Finance

Another shibboleth (an icon that people use to recognizemembership in the in group but really meaning an old way ofthinking that people uncritically worship without recognizing howthe world has changed) is all the sturm und drang you hear aboutlong-term deficits and the crowding out of privateinvestment. As well as the associated one of theinflationary impacts of huge reservoirs of liquidity and theinflation outlook. Let's take that a piece at a time.

In the UL you see the "credit liabilities" of private vs federalborrowing. Consistent with our earlier points privateborrowing skyrocketed until it collapsed while Federalborrowing gradually went down in the '90s. Now they'vedisplaced one another. Federal borrowing is, right now and forthe next several years, the only thing holding the economy together and is NOT displacing private borrowing. And withthe slow growth and a shift to savings the demand won't grow as it might have in the past, plus there'll be moredomestic savings to provide funding. That'll be offset somewhat by decreased inflows of funds from abroad of course.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's books and don't put in circulation, those flows aren't getting into the economy. If they do and aren't soppedup there might be a problem but, again, a problem which the Fed is well aware of, is not a problem now and won't befor quite a while and one which they are preparing to deal with. Another shibboleth bites the dust. Which is directlyreflected 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 sidenote the biggest problem is Medicare, which would (one would think) lead to a massive surge in conservative supportfor Healthcare reform but...anyway. The LL sub-chart shows the Federal deficit back to 1950 and ahead to 2020.There's clearly a surge right now and the questions would be what's the alternatives and how bad would it beotherwise? The other interesting thing to note is that the prior biggest surges were under Reagan and BushII, while itwas actually paid down to a surplus under Clinton. The final de-shibbolething should be to notice that the going forwardprojections after we get thru the Recession aren't that far out of line with the Reagan spending. Though admittedlythey're projected to stay relatively level and that's not a good thing, but it's also not unaffordable or intolerable. Wecovered the other side of that coin in discussing fiscal policy btw ( Realities vs Rhetorics: Economy, Policy, Real Data ).On the whole we're in pretty good shape and NOT facing the kind of really deep adjustments that ALL the rest of theworld 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 towrestle with these issues is growing. Ultimately, as wediscussed several times previously ( Debt, Wealth,Finance & Outlook: Sixty Years of Bubbliciousness ), as theUS shifts from a dis-saving to a savings economy we willfree up more funding for investment in productivity andeconomic growth. The process will not be easy, short orpainless of course. But it should be some smallconsolation that the periods of highest growth in the US werepre-deregulation when savings and investment were at theirhighest.

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:http://www.msnbc.msn.com/id/3036789/vp/33290333#33290333%20

We'll close with two sets of thoughts, the first from ourfavorite poet, Rudyard Kipling:

Or put another way, be sure when you're reading thenext headline, listening to the next talking head andpreparing to sacrifice the burnt offerings of yoursavings to some of their shibboleths that you've askedyour six serving-men to take more than a simple lookat the realities behind those mythologies and ask forproof. You don't have to like, or agree, with ouranswers. But the ones you're getting cheap and easyare going to be more expensive than you think in thelong-run.

I keep six honest serving men(They taught me all I knew);

Their names are What and Why and WhenAnd 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?

http://llinlithgow.com/bizzX/2009/10/markets_away_run_baby_run_or_s.html

Like a couple of famous bunnies the Market just keeps on running and running - the question we've had for quite awhile is why and how? The short answer, ioho anyway, is that's running on momentum. Otherwise known as sentimentor psychology, or in our coined word, e

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From Chaos to Turbulence: Myths and Realities in the Economy, Markets and Policy