1/1/10 –

On 12/31/09 the S&P 500 closed at 1115, resulting in a total return of 26.5% for the year. We remain hedged and invested for income. This economic downturn is the most severe since the 1930s.

Market Analysis

Due to the economic factors later mentioned, we are cautious. The stock market, however, is less so. If we were to require a long-term return of 7% for the S&P 500 (see the 12/1/09 comment), we would invest around a level of 853; about 24% below current value.

Reason

The economy is now affected by fiscal policy rather than by monetary policy. The major event presently driving the economy is necessary government intervention: The Fed’s purchase for its own account of treasury bills and mortgage securities, fiscal stimulus, and loan guarantees. There are three possible recovery patterns:

1) The economy bottoms out; growth remains anemic at a new normal level, after a couple of quarters of inventory additions. This scenario is not priced into the stock market, but we think it is the most likely. Due to continued residential and commercial real estate problems, the banks do not increase credit outstanding to the real economy.¹The smaller companies, normally funded by the banks, cannot grow at normal rates. For this and other reasons, the government must remain involved in the capital markets; the economy must restructure towards advanced manufacturing.

2) The economy bottoms out; growth rebounds and continues. Government outlays are then gradually and neatly withdrawn. This cyclical recovery scenario is currently priced into the market. In light of the necessary restructuring of the economy away from real estate investment and consumption we think this high growth is unlikely. There are moreover many uncertainties regarding the effects of weaning the economy away from large-scale government financing. The 12/11/09 WSJ writes, “The recent European government-bond market volatility may be just a foretaste of the turmoil in store if central banks remove liquidity and quantitative-easing programs too abruptly. No one knows for sure what yields the market would demand for U.S., U.K., and euro-zone bonds without central-bank support.

3) The economy bottoms out; after a couple of quarters, it relapses into decline; and international investors start to lose faith in U.S. sovereign debt. We don’t think that this eventuality is likely because the U.S. can issue debt denominated in its own currency, and the credits of other nations would be worse.

We have suggested that economic growth cannot occur without the banking system.

Implications

At an 11/09 Stanford meeting the governor of Mexico’s central bank, Guillermo Ortiz, identified the major problem that caused this financial crisis. He said that “good times” caused a mispricing of risk (we would say caused an avoidable lending binge) and the development of financial innovation. The markets became overconfident in the abilities of financial institutions to manage risks, the system to absorb shocks, and to allocate resources efficiently. Then things came apart with the subprime meltdown, causing a loss of confidence that simultaneously spread all over the world.

How do we get out of this? Recessions are caused by imbalances and at the center is the U.S. trade deficit. The real result of this is the further hollowing out of U.S. industry, that accounted for only 12% of 2009 GDP; down from 27% in the early 1950s, when the U.S. was the only major manufacturing economy. The flip side of manufacturing’s decline has been an overinvestment in real estate.

To reduce unemployment, rebalancing of the economy by industrial growth is crucial. On the 12/13/09 “Meet the Press,” Michigan governor Jennifer Granholm said that the “repetitive” manufacturing jobs are gone from the U.S., leaving workers that have to be retrained in other industries. GE CEO Jeff Imelt said, “ Throughout my career, America has seen so much economic growth that it was easy to take it as a given. But, we started to forget the fundamentals, and lost sight of the core competencies of a successful modern economy. Many bought into the idea that America could go from a technology-based, export-oriented powerhouse to a services-led, consumption-based economy – and somehow still expect to prosper. While some of America’s competitors were throttling up on manufacture and R&D, we de-emphasized technology.”

At the heart of present economic problems is the need of the U.S. to innovate with new technologies and products. The Internet was popularized and further developed in the mid 1990s. Since that time, the major U.S. innovation has been complex financial engineering - not exactly productivity enhancing.

A speaker at the Stanford meeting suggested the U.S. should take as its model Germany, a country that produces innovative manufactures for export.A place to start is dealing with the import problem. The following table might put present economic discussions into perspective:

U.S.Net Imports of Goods, (Jan-Aug) 2009

(dollars in millions)

Calculated from Department of Commerce data, not seasonally adjusted

Crude Oil $ -136,280

TVs and VCRs - 69,082

Vehicles - 40,555

Other -125,249

Total Net $ -371,166

Imports

Crude oil and vehicles account for 48 % of net imports. Progress in reducing trade imbalances starts there. The growth in green energy can reduce energy imports. The Administration’s decision to rescue the auto companies promises to keep higher value-added jobs in the United States. The consumer electronics industry, and its associated infrastructure of designers and suppliers, is now totally abroad.

In The Clean Tech Revolution, Pernick and Wilder (2008) identify both the economic forces and government standards that will increase efficiency and result in technologies using renewable resources. The main cost advantage of renewable energy, the authors point out, is that there is no cost of “fuel.” The only costs are capital costs, which technological progress continues to drive down. add: This document details some preliminary research. The specific applications of these new technologies are solar energy, wind power, smart grids, transportation, and buildings that produce as well as consume energy.

The previous paragraphs have repeated “technology,” a word that implies science and education.

¹This is a crucial observation. Smaller companies are the major source for economic growth, and they are dependent upon bank loans rather than access to the capital markets. The following data show that bank loans and leases outstanding have dropped -7.26% since October, 2008.

Loans and Leases in Bank Credit (Federal Reserve Call Report, Seasonally Adjusted, Including Allowances for Loan and Lease Losses)

Recession Event Peak to Trough

1973 - .66%

1980 - .58%

1990 -1.15%

2001 - .39%

2008 -7.26% (10/31/08-12/16/09, sic)

________

Warren Buffet’s acquisition of Burlington Northern was understood by the market to be bullish, maybe for the very long-term only. Berkshire Hathaway owns more than 70 non-technological subsidiaries in the U.S. The 12/24/09 Bloomberg reports that the company employed about 225,000 workers, 8.6% fewer employees than disclosed in the 12/31/08 Annual Report. This says something about his managers’ expectations.

The current market rally also says something about market behavior. In the past, flooding the system with money would lower short-term interest rates, starting a Keynesian portfolio adjustment process that would affect the fundamentals, ending up with more projects being built in the real economy (like early cycle real estate). Now, the link between short-term rates and the real economy is broken due to an excess of both houses and cars. Central bank liquidity is flooding the financial system, making possible a carry trade that buys long-term assets with free short-term money. Good business if you can get it, that is until the free money becomes costly add: and/or the stock market starts to reflect the new normal of lower growth.

add: Credit is required for economic growth. The major sources of credit are the banking system and asset based securities issuance. SIFMA has just published the statistics for 2009 US ABS issuance that includes: auto loans, credit cards, and home equity. The amount of credit available to the economy has greatly decreased.

Total US ABS Issuance

(dollars in millions)

2007 2008 2009

$509,732 $139,492 $146,198

2/1/10 –

On 1/19/10, Bloomberg published an article in which bullish economists dismissed the new normal assumption that future U.S. economic growth will be a low 2% per year. “I don’t think its different this time…We’ve had financial crises and big workforce changes before, and growth has pretty consistently come in around 2.5% over the past 50 to 60 years,” said an economist. Larry Summers was furthermore quoted, “U.S. business is as competitive as it has ever been, we have a uniquely talented and hardworking labor force, and our economy is resilient by global standards. For all these reasons, we can expect that the productive potential of the American economy will continue to grow. An economist for Eton Vance then said, “The economy will continue to adapt…The potential for jobs may be lower, but I don’t see it for growth…We’re still Americans and we’re still going to consume.” Fight the battle of the shopping mall!

What to make of these bullish arguments? The first and last are historical. In the following we turn to history, in the original sense of the word, as an inquiry*. There are major problems with the economic system, leading to lower growth. The economy must restructure away from consumption; massive government intervention has caused Mr. Zoellick’s “candy high,” not leading to productive enterprise; and most important, deleveraging (due to excessive borrowing) has barely occurred. Our own studies have been focusing on the effect of this crisis on the U.S. A recent publication by McKinsey Global Institute, “Debt and deleveraging: The global credit bubble and its economic consequences,” investigates this economic crisis from a world-wide perspective. Its prose is crystalline in clarity.

To quote the study, “Enabled by the globalization of banking and a period of unusually low interest rates and risk spreads, debt grew rapidly after 2000 in most mature economies, particularly in households.” In the U.K., both private and public sector debt grew by 157% between 2000-08; Spain, 150%; and the U.S. by 70%.”

The study contains a disclaimer, “While we cannot say for certain that deleveraging will occur today, we do know empirically that deleveraging has followed nearly every major financial crisis in the past half century.” Since this study is 93 pages, the authors undoubtedly think this will occur. They furthermore cross-referenced their findings with the financial crises identified by Reinhart and Rogoff (2009). They found, “…that with only one exception (Japan), every major financial crisis during the period studied (our note: 1929-2008, not including the present one) has been followed by a period of deleveraging.” Based upon an economic sector framework that considers the absolute level of leverage, growth in debt and leverage, debt service capacity, vulnerability to income and funding shocks, the study identifies households in Spain, the UK, the US, South Korea, and Canada as having a high likelihood of deleverage. In the same countries, a reduction in overall financial company leverage is also moderately likely.

How will deleveraging occur? At this writing, the process has “barely begun.” The authors offer four possible archetypes of deleveraging since 1950:

1) Belt-tightening. “The ‘belt-tightening’ archetype was by far the most common, accounting for roughly half of the deleveraging episodes. If today’s economies were to follow this path, they would experience six to seven years of deleveraging….Deleveraging would begin two years after the start of the crisis, and GDP would contract for the first two to three years of deleveraging, and then start growing again….” The study however notes that deleveraging may be delayed. “…current projections of government debt (our note) in some countries, such as the United Kingdom, the United States, and Spain may offset reductions in debt by households and commercial real estate sectors. We therefore see a risk that the mature economies may remain highly leveraged for a prolonged period, which would create a fragile and potentially unstable economic outlook over the next five to ten years.”

2) High inflation. (Absent a strong central bank, often in emerging markets.)

3) Massive default. (After a currency crisis.)

4) Growing out of debt. (After an oil or war boom.)

The historical record “…suggests that today’s mature economies are most likely to deleverage through a belt-tightening process.” The summary concludes, “At this writing, the deleveraging process has barely begun. Each week brings news of another country straining under the burden of too much debt or impending bank losses from over-indebted companies. The bursting of the great global credit bubble is not over yet. Just as worrisome is the fact that deleveraging is likely to be a significant component of the postcrisis recovery, which would dampen growth.”

The conclusions of this study are bearish for equities. Either growth will be at a lower level; or growth will be higher but the U.S. financial system will remain, for a while, highly levered and unstable. We think that it would be prudent to remain in bond-like equivalents higher up in the balance sheet than equities. There will be a time to buy equities, but at values that reflect the above risks and uncertainties. This is also the time for the U.S. economy to get its fundamentals together.

* add: In financial matters, judgment is necessary; if you are a social scientist, conditions are consequential – see the fourth paragraph. In Kling and Schulz (2009), the Nobel Prize winning economist Douglass North said, “…economics as it exists now is about a theory of choice, and it’s static. Its about a once-and-for-all kind of change in a moment of time. All of the interesting issues that we can’t solve in the world are as a result of the fact that it’s a dynamic world in which change over time is at the heart of the issue. Therefore, until we deal with change over time, we are not confronting the important issues of our time.”

So how do you deal with dynamic systems? Initial conditions can be used to calculate dynamic behavior. Forget about the dynamic theories of history, like Marxism in the 19^th century. How do you deal with ~~the~~ this stock market? We think that value investors now have to consider (somewhat) the dynamics of the macro system, how sovereign debt risk and long-term growth rates might change in response to initial conditions. How do you predict complex phenomena like the weather, or the airflow over a Boeing 787? The engineering answer is that you model them using simpler models** using a computer to calculate over and over again in a mesh, step by step, the initial conditions of each subsequent mesh boundary. In other words, observe often; and try not to trip.

Risk and return aren’t independent variables before the fact; but have always depended upon institutional factors, the state of competition, the business idea, and even some luck.

** Supplied by your experience and education.

3/1/10 -

The amount of private credit supplied to the economy is not growing. Bank lending continues its severe drop, and our 1/1/10 note indicated that the securitization markets are not recovering.

Loans and Leases in Bank Credit (Federal Reserve Call Report, Seasonally Adjusted, Including Allowances for Loan and Lease Losses)

Recession Event Peak to Trough

1973 - .66%

1980 - .58%

1990 -1.15%

2001 - .39%

2008 -9.51% (10/31/08-2/17/10, this is truly a problem)

As the U.S. economy has stabilized with the aid of government financing, it is reasonable to ask whether a creditless recovery is possible. This research from the IMF published by Claessens, Kose, and Terrones on 5/22/09 indicated that such a recovery is possible – to a point.

This recession, the authors write, is exceptional because it coincides with both a credit crunch and a housing price bust. Using a dataset of 122 recessions, the study separately identified 21 episodes of a credit crunch and 34 episodes of a housing price bust, then associating the following recession with either a prior credit crunch or a housing price bust. Using this data, the study finds that, on average, “…the recession ends two quarters before the credit crunch ends and nine quarters before housing prices bottom out; equity prices tend to bottom out just as the associated recession ends...When it comes to recessions associated with credit crunches, the real economy typically recovers while credit is still contracting.”

But, and this is the advantage of looking into causes, the authors then ask why this is so. They identify three non-credit causes of sustainable economic recovery:

1) Consumption growth can be a key driver of economic recoveries. Our note: Excessive consumption had been a key driver of the credit boom that turned into a bust. In specific, early cycle investments in housing and automobiles will not occur due to excess inventories and unemployment.

2) External financing from sources other than commercial banks. A 2/7/10 FT article writes, “In the run-up to the crisis, securitisation was a key driver of the boom in mortgages, credit card loans and auto loans as it transformed these loans into securities that investors could easily buy….After being virtually wiped out during the turmoil, the market has shown some signs of life but not enough to lure back many investors.”

3) A switch from more to less credit intensive sectors, “…in such a way that overall credit does not expand, yet, because of productivity gains, output increases.” This is now occurring to a limited extent in the industrial sector that is funding inventory and receivables growth from internal cash flow.

is shifting

These causes are not now present, and the U.S. economy ~~will likely shift~~ to a mode of new normal low growth. Because the U.S. has been able to finance its deficits abroad, it has so far been able to avoid the very tough medicine that the IMF typically prescribes to other countries with problems, fiscal tightening and interest rate increases that force drastic economic restructuring. There is some time; but Washington should spend that time constructively, aiding the restructure of the economy and achieving the political consensus to remedy its projected deficits. The real problem is practical, how to get the U.S. on track again.

Wall Street prices stocks by how actual earnings change relative to trending expectations (like during a market bubble or bust), a market agonisticism that presumes no knowledge beyond reported earnings and volatile market expectations. This method infers that maybe something good (or bad) is happening with the company. Our major problem with this market is valuation; it is overpriced relative to realistic long-term economic growth prospects. However, we recently purchased the specific stock of a (too-big-to-fail) NY money center bank. We wrote down its loan portfolio by 20% and valued its various Level 3 assets at zero, applying these further writedowns against book equity plus loan loss reserves. Given free money from the Fed, the bank will be able to turn its equity, so calculated, positive towards the latter part of this year. Its operating profit on market price is very high. As the bank recapitalizes itself, without further shareholder dilution, it will be able to build value in the future. The CEO has also said before a congressional panel that the bank will be a bank.

add: We sold other stocks to accommodate this purchase. Our S&P 500 hedge remained the same; the total portfolio risk has therefore increased only slightly. We will invest in this turnaround until its turned around.

4/1/10 –

We continue to track the expectations of manufacturers as reflected by their inventory investments. The following table indicates that, at GE and Ford, there are no management expectations for rapid growth. Cisco’s business has improved. Intel’s earnings have improved due to a more profitable product mix and technological progress, in spite of decreased inventories.

Calendar Fourth Quarter Manufacturing Inventories

(millions of dollars)

Ford

Cisco¹

Intel

2008

2009

2008

2009

2008

2009

2008

2009

Total

13674

11987

6988

5450

1299

1377

3744

2935

Change

-12.3%

-22.0%

+6.0%

-21.6%

¹Including purchase commitments.

Economic stabilization ≠ growth. Excluding inventory restocking, this is GDP data as of 12/31/09.

Q.E.D.

The aim of value investing is to pay for the assets of the company, and to get growth for free. In our recent stock purchase – we confess it was Citigroup -, we did the reverse because it’s a bank. We wrote their opaque Level 3 assets down to zero and their loan portfolio down by 20% and could still justify the stock purchase on the basis of their continuing operations.

The fact that we wrote the Level 3 assets down to zero didn’t mean that if someone called us and offered to sell us billions of these assets, we wouldn’t gladly purchase them for, say $1, to be of facetious. In the first quarter of 2010, Citigroup reported a net income of $4.4 billion, a turnaround from the $7.6 billion loss in the previous quarter. The turnaround was largely due to the valuation of assets held in the Special Asset Pool of Citi Holdings, whose value turned from a large loss the previous year into a $1.3 billion profit, a difference to the bank’s bottom line of at least $6.3 billion. Since the nation’s third largest bank is undoubtedly occupied by FDIC, Fed, and Comptroller of the Currency examiners, we assume that these portfolio marks are rather accurate, provided the economy has stabilized. Maybe some of those subprime mortgages and monoline credit insured assets will be worth at least something in the future.

5/1/10 –

Citigroup stock has been quite volatile, due to the fears that there will be a contagion of credit problems in Greece and Spain to the entire Eurozone. When making our investment in Citigroup we assumed that the entire financial system had substantially stabilized from the panic conditions in September, 2008. We think this is a valid assumption.

Of importance now is the distinct possibility that future economic growth in the U.S. will be slower than in previous years, at a new normal level of perhaps 2% real (the historical level is around 3%). What could invalidate this is a resumption of rapid growth from the private sector. The economic and therefore structural analyses in the articles above suggest that this growth is quite unlikely. Recently published data from the Bureau of Economic Analysis, as of the first quarter of 2010, confirms this empirically. We considered all sources of personal income: from private industry wages, portfolio and rental income, to government transfer payments. The following table, using BEA seasonally adjusted data at an annual rate, shows that since the Q1 of 2007, disposable personal income grew by 8.0% (thus accounting for an increase in consumption and the current stock market boom); but wages paid by private industry decreased by 2.9%; and government transfer payments increased by 30.8%.

Most notably, private wages as a % of total disposable income decreased from 51.4% in 2007 to 46.2% in 2010.

1^st Quarter Private Industry Wages as Percent Total Disposable Income

~~(billions of dollars,~~ annual rate)

	2007	2008	2009	2010 (p)	Change 2007-2010
Disposable Personal Income	10247.4	10610.4	10765.4	11070.4	+8.0%
Private Ind. Wages	5270.3	5407.7	5136	5116.4	-2.9%
Transfer Receipts Mostly Government	1693.8	1794.1	1987.3	2215.4	+30.8%
Private Ind. Wages as % Disposable Income	51.4%	51.0%	47.7%	46.2%

An analysis of monthly data from December, 2009 to February, 2010 furthermore illustrates that private sector activity has not increased appreciably.

	Dec 2009	Jan 2010	Feb 2010 (p)
Private Ind. Wages as % Disposable Income	45.9%	46.1%	46.1%

This leads to a somewhat inconvenient transition question: what happens when the government stimulus money runs out? To get back to the current expected return of the stock market, assume a new normal rate of growth of 2% real and 2% inflation. The S&P 500 is currently trading around 1200. This level implies an investment return of 6.1%; that is a very low expected return relative to the 5.1% long-term rate available from a decent corporate bond.

Speaking about the market generally, we don’t find that rate of investment return particularly attractive; particularly given the risks of transitioning the economy away from government support. To repeat, we don’t expect the world financial system to fall apart; but there will probably be further stock market turbulence as the many issues presented by this financial crisis remain to be resolved: in finance, business, and government.

5/6/10 - The S&P 500 plunged 3.2% to 1128 due to the fear that financial contagion will engulf the entire Eurozone. On 9/29/08 we noted that this financial crisis is dropping as many shoes as a centipede has feet, due to globalization.The Eurozone, lacking a real central monetary authority, and its individual countries lacking exchange rate flexibility, is now beginning to be a problem. There was probably too much dithering over the rescue of Greece; and because markets like to test, that has affected confidence in the finances of many Eurozone countries. We assume, however, that the world’s financial system is stabilized.

We do not particularly mind the fact that the market is valuing our Citigroup investment at a slight loss, or that this loss might increase. The reason is as follows; over a two to three year investment horizon, the bank’s operations and asset values are likely to improve; the stock (we hope) will substantially outperform the U.S. stock market. We therefore are not concerned what the price of the stock does in the interim, since we are comfortable with its original purchase price. This is value investing; not trading.

This crisis also illustrates an interesting point about market dynamics. The market responds to valuation add: – that is dividends (earnings) and interest rates - only over a very long time period. Over the short-term, it responds to events – catalysts that move the market price up or down. The Eurozone crisis might be the catalyst to move the S&P 500 down to a valuation level where we would slowly begin to drop our investment hedge. This requires a contrary mode of thinking; because when we do so, the markets are likely to be in a panic.

add: The economics view of decisionmaking is rational and linear; the markets are therefore the products of due deliberation and should be somewhat stable. Why do groups of investors run like lemmings; when they suddenly encounter true uncertainty, the consequences of their own ignorance (Keynes, General Theory, Chapter 12), or in the case of traders their leveraged situations? A 5/7/10 Financial Times article cites the Roman poet, Virgil, who graphically described the nature of information flow, “Rumor travels through the cities…Rumor, an ill whose speed nothing exceeds, gathers strength with movement…” This is Mr. Market at the emporium.

Value investing handles uncertainty by investing with a margin of safety; sound banking handles uncertainty by relying on cash flow coverage and history.

6/1/10 –

We estimated that the new normal growth rate of the economy will be around 2%, about 1% lower than normal – due to fiscal and economic restructuring. Yet, the market had seemed concerned with everything except that growth rate. Large short-term rate decreases and signs of economic stabilization lead the market to the conclusion that it would be business as usual; that this recovery would be the same as previous ones. We thought this was not likely, for the general reasons outlined in the first three articles. The Eurozone crisis then knocked the S&P 500 down to 1071 on 5/20/10; it will also result in lower U.S. growth. (We trust our readers are comfortable with the proportion of their equities.) The market, however, seems to be less interested in intrinsic growth; but more in actual events. Short-term traders proceed inductively, assessing the general state of affairs from short-term events. To give an example, we have been deducing lower growth as a consequence of necessary deleveraging. Traders are now inferring lower U.S. growth as a consequence of the Eurocrisis.

The way the markets price the euro provides an insight into why they are volatile. The euro was founded in 1999, to provide Europe with a monetary union that might someday become political. At the time of its founding, critics said that the euro had a fundamental flaw; because economic conditions would inevitably differ in each country and there was not the political discipline to enable countries to coordinate their fiscal policies. The structural problems of the euro were then well known; there was one central monetary authority, the European Central Bank, and then six separate national treasuries. It would thus be impossible to develop an appropriate overall monetary policy and to coordinate national fiscal policies without political unification. Since the time of its founding the euro, however, had served as more than a store of value; originally starting at $1.18 per euro (that approximated purchasing power parity) and ultimately rising to $1.59 in July, 2008. The euro was perceived to be a safe currency; until in 2009 Greece disclosed that its true budget deficit was 12.7% of GDP rather than the 6% previously stated. Riots in Athens to protest austerity, dithering by Germany when offering financial support, and fears that Portugal and Spain are next have driven the currency down to around $1.25. add: What’s going to happen to the euro? Josef Joffe, the publisher of Die Zeit, says, “ (the euro won’t fall apart)…everyone dreads the collapse of the euro more than anything else…We Germans dread it because there would be a surge of upward re-valuation of the D-mark which would wipe out our export surpluses. The PIIGS dread it because they won’t know how to borrow money if they went back to escudos and drachmas. By the way, under the treaties (Maastricht, Lisbon), we have no way of kicking anyone out…Now we hope...that we will willingly, in order to avoid the risk of such crises in the future, harmonise our fiscal policies.” This paragraph illustrates rationality in the face of disorder, by considering the consequences. added

Whether dealing with the Internet boom, subprime financings, the Euro, or economic stagnation the market treats things superficially and generally according to the belief that the future will be like the past (the world is a large place) until notable changes manifest themselves to the trading desks of Wall Street. Then traders overreact out of greed or fear (because they are leveraged) until the newly discovered changes have ceased or something else happens. Because human, particularly group, attention is finite, the markets know less than the theory assumes. They react to events.

Benjamin Graham said that the market eventually reflects the fundamentals – that is when they become obvious.* Markets are always interesting, can take a circuitous path, and are contingent upon the play of actual events. Markets are most likely efficient, that is they fully incorporate the information available into price, when the obvious has happened; and the economic system is not newly disturbed. Markets likely become less efficient and volatile when there is a large economic change such as an invention, the beginning or an end of a war, or a crisis (Kindleberger, 2000 ed.). These events introduce uncertainty into developments, shifting the system from a degree of equilibrium to “path dependency.” The good news is that some of these paths can be chosen or charted.** The market may then settle on a new add: social equilibrium.

* In the structured finance business, becoming obvious meant actual defaults; neglecting previous predictive analyses. This graph from the 6/2/10 Financial Crisis Inquiry Commission hearing shows two things: that structured securities issuance continued at full throttle until May, 2007; although beginning in October, 2006 a series of Moody’s reports (ignored by its market share driven CEO) predicted catastrophe in the structured finance market. This graph also shows that massive defaults caused the market to cease. The best way to reform the financial system, Warren Buffet testified, is to reduce its leverage and change its incentives. But since the financial system is inevitably leveraged, and its condition is therefore a matter of public concern, some government regulation of asset quality is also appropriate.

** A NYT 5/31/10 article relates, “The people running BP did a dreadful job of estimating the true chances of events that seemed unlikely – and may even have been unlikely…For all the criticism BP executives may deserve, they are far from the only people to struggle with such low-probability, high-cost events. Nearly everyone does. ‘These are precisely the kind of events that are hard for us as humans to get our hands around and react to rationally,’ Robert N. Stavins, an environmental economist at Harvard, says. We make two basic – and opposite – types of mistakes. When an event is difficult to imagine, we tend to underestimate its likelihood. This is the proverbial black swan. Most of the people running Deepwater Horizon probably never had a rig explode on them. So they assumed it would not happen, at least not to them.”

We think that it is possible to deal with some, but not all, of life’s black swans. First, there is the strategy of simple prudence. If you do things with a margin of safety, that margin will carry you through most of what may arrive. Second, if you’re taking controlled risks in unfamiliar territory (like not backing up your computer), make sure that your key assumption is valid. In the case of BP, the crucial piece of equipment that had to work when drilling in 5000 feet of deep water was the blowout preventer. Cost-cutting BP did not monitor or test that crucial equipment appropriately.*** Third, when dealing with a complex phenomenon like the current financial crisis the subtle warning signs are there if you just heed. These signs exist in reality, separate from your wishes or your incentives. The survivors of the financial crisis like to say it was unforeseeable and just happened. Nothing could be further from the truth. As we’ve been saying, if you just scratched one or two levels below the dodgy CDOs, you would have found (to mix metaphors) a raft of mortgages that violated the time-tested 3Cs of lending and corner-cutting financial practices that kept the structured finance factory running. Finance in the 2000s was a house built upon sand.

And then, there is the uncertainty residual that you just have to deal with by rolling with the punches. ****

*** add: There was also a question whether the blowout preventer technology was even reliable in deep waters. A 2002 study conducted for the U.S. Minerals and Management Service found that “If operational considerations of the...drilling program were (theoretically) accounted for, (drill pipe) shearing success dropped to three of six (that is 50%).” This CNN article states the more general case against blowout preventers in deep waters.

**** add: We will try to summarize with another analogy, applicable to some black swans. There is, of course, the weather; but if you are going on an expedition to summit climb Mount Everest, an extreme feat, wouldn’t you at least make sure that you were fit for the climb and that your gear was in good shape: the GPS communications, the oxygen regulators, and the rappel devices?

Continuing the 5/1/10 discussion, Bureau of Economic Analysis April data show that recent economic growth was not caused by an increased proportion of private economic activity.

Private Industry Wages as Percent Total Disposable Income

(~~billions of dollars,~~ annual rate)

	1^st Q 2007	Dec 2009 (r)	Jan 2010 (r)	Feb 2010 (r)	March 2010 (r)	April 2010 (p)
Private Ind. Wages as % Disposable Income	51.4%	45.7%	45.8%	45.9%	45.8%	45.8%

r = revised, p = preliminary

When the effect of government spending begins to decrease, we expect that deleveraging will lead to lower new normal economic growth. Keynesian economics assumes that demand can be managed and therefore economic growth will occur as a matter of course. Economic growth, however, is the result of entrepreneurship and appropriate government policies. add: In a notable 6/8/10 Financial Times article, Columbia economist Jeffrey Sachs writes that good jobs are “the outcome of years of sustained public and private investments.”

On 6/4/10 the Department of Labor reported that the U.S. private sector added only 41,000 jobs in May, about 77% fewer than estimated. The June 7 Bloomberg reports that economists “have begun to lower their U.S. growth forecasts, suggesting the U.S. may be headed for a slowdown…” Some economists are reducing their July-December annualized growth estimates from around 3% per year to 2.2%. The S&P 500 promptly decreased by 3.4% to 1065.

7/1/10 -

The Commerce Department reduced its estimates of first quarter economic growth to 2.7%, from 3% on an annualized basis. The 6/26/10 Washington Post reported, “Just two months ago, a strong, self-sustaining economic expansion seemed to be taking hold, with consumer spending, output of goods and services, corporate hiring and financial markets all on the rise. The latest string of economic data, however, has thrown cold water on that view.…The components of that revision were particularly worrisome –not only was growth weaker than thought, but more of it came from businesses rebuilding inventories, which amounts to a one-time boost. Real final sales…rose at only an 0.8% annual rate, hardly the stuff of a roaring expansion.” What’s happening? This recession is not merely cyclical, but structural. There is too much debt on the private, and now public, balance sheets of the developed economies that has to be reduced by increased savings, reducing growth. This earlier cited McKinsey study ( p. 10, Exhibit I) shows that the debt problem is not limited to the United States, where the problem will get worse due to the growth of entitlements, adding to the structural deficit.

Could leverage in the financial subsystem have been reduced in 2009, thus improving lending and increasing economic growth? At that time, the administration faced the choices of recapitalizing the banks or letting them earn their way out of the problem by keeping interest rates low for a long period. The first choice was not feasible; due to the public opposition to bailing out Wall Street and due to the difficulty of drastically restructuring large, interrelated *, and highly leveraged financial institutions. The FDIC could not simply walk into a large money center bank on Friday afternoon, replace management, honor all deposits up to $250,000, and then reopen the bank on Monday under a new name. The second course, however, had another cost. In 2009 Paul Krugman wrote, “…maybe we can let the economy fix the banks instead of the other way around. But there are many things that could go wrong. It’s not at all clear that credit from the Fed, Fannie, and Freddie can fully substitute for a healthy banking system. If it can’t, the muddle-through strategy will turn out to be a recipe for a prolonged, Japanese-style era of high unemployment and weak growth.” This may now be happening. Financial policy at the federal level averted a collapse, but the creation of economic growth is another matter.

The Great Recession originated in the U.S. real estate market and resulted from the long-term failures of ~~three~~ four systems:

1) add: A political system that did not develop the consensus necessary to solve the federal government’s budget problems.

2) add: A U.S. trade negotiating system that was indifferent when companies moved their manufacturing abroad, foreign governments supplying the incentives and putting in place trade barriers.

3) A business system that failed to develop new exportable industrial products, resulting in a commodity strategy of buying labor at a low price abroad and selling products at a high price in the U.S.

4) An educational system that did not emphasize technical skills.

In order for the real U.S. wealth to increase, it needs to encourage productivity and the formation of new businesses. As mentioned above, Columbia economist Jeffrey Sachs wrote that good jobs are “the outcome of years of sustained public and private investments.” **

At this 6/29/10 writing, the S&P dropped to 1041. Many countries in the developed world have a significant dilemma. Government spending has prevented a further drop in economic activity, but governments are reaching their debt capacity limits. The problem in the U.S. is the business sector; it has failed to restart because it is configured for consumption.*** Besides government, there are three additional sources of GDP expenditure: consumption, net exports, or investment. In the last decade U.S. consumption has been carried to excess; everyone in the world is now talking about exporting; the third alternative is domestic investment. Developing economies used to speak, not of exports, but of import substitution. For the U.S., a combination of measures would enable it to begin to rebuild industries and incent the exporting economies to address their own domestic markets. Government policy, probably most applied to energy imports along with a reduction of the federal budget deficit, would move U.S. trade in the direction of balance.

* The Dodd-Frank bill will move 75-80% of these derivative contracts to regulated exchanges.

** add: Businesses have not made the capital investments in the U.S. to create high value-added jobs.

In the 7/5/10 Business Week Andrew Grove, a founder of Intel, wrote, “Startups are a wonderful thing, but they cannot by themselves increase tech employment. Equally important is what comes after that mythical moment of creation in the garage, as technology goes from prototype to mass production. This is the phase where companies scale up. They work out design details, figure out how to make things affordably, build factories, and hire people by the thousands….The scaling process is no longer happening in the U.S.”

Richard Elkus, a high-tech executive wrote, “Volume coupled with performance and reliability can add hundreds of millions of dollars to the capital investment required to produce consumer electronic products, many times that required of a commercial version.” Yet, in the name of shareholder value, U.S. companies have tried to minimize investments in plant and equipment in order to increase return on capital and thus short-term stock prices.

*** The word “Plan” is a four letter world in the U.S. political vocabulary, for it implies central direction and a loss of freedom. The alternative is the free market, where the invisible hand of the market leads everyone who follows the rule: max Profit to social harmony and the general welfare of society. This rule, however, entirely neglects the issue of time, saying nothing whether market participants should seek their interests over the short or long-term. In market societies, people usually seek their interests in the short-term.

The benefit of having a long-term plan at an appropriate level is obvious in the case of the balancing the Federal budget; government actions can also help create new jobs; but these require a political consensus. There are also benefits for having a plan when developing energy resources. A former president of Shell Oil noted that the U.S. lacks such a plan. Coal and petroleum must serve as the bases for U.S. energy policy, with the development of wind, solar, and fuel cell power to be phased in as auxiliary sources over successive five year time horizons.

Left to themselves, short-term commodity markets will favor the lowest-cost sources, regardless of their environmental consequences. add: Jeff Immelt, CEO of General Electric, says that there is a disconnect between the price/barrel of oil today and an investment in a nuclear power plant that will last for forty years. Government has to play a “bridging role.” Other nations plan for their industrial futures. Current economic thinking makes use of market incentives to get the desired result.

Bureau of Economic Analysis May data show that that there has been no increase in the proportion of private economic activity.

Private Industry Wages as Percent Total Disposable Income

(~~billions of dollars,~~ annual rate)

	1^st Q 2007	Jan 2010 (r)	Feb 2010 (r)	March 2010 (r)	April 2010 (r)	May 2010 (p)
Private Ind. Wages as % Disposable Income	51.4%	45.8%	45.9%	45.8%	45.8%	45.8%

r = revised, p = preliminary

On 7/2/10 the Department of Labor reported that the U.S. private sector added only 83,000 new jobs in June. The economy needs to add around 140,000 jobs per month to keep up with population growth.

add: The 7/10/10 WSJ surveyed eleven countries that timely report their jobs data. This survey provides confirmation that “manageable debt burdens and healthy banking systems…are proving to be crucial factors in creating jobs.” Of the eleven countries surveyed, Chile, Brazil, and Australia have been most able to add jobs since 12/07 due to their strong export sectors. Germany held even. Of these countries, the U.S., U.K., and Japan suffered large net losses in jobs. All three of the later suffer from significant structural problems.

Will growth in the developing world trickle down to the developed world? We are somewhat skeptical. According to The Economist 2007 statistics, the U.S., U.K., and Japan accounted for 38% of world GDP. Add to that Eurozone GDP, around 20% of world GDP, we get economic problems in 58% of the world’s economies that borrowed too much and have problems with their banking systems. In an ideal economic system, economies will adjust. Trade deficit nations will produce more; trade surplus nations will consume more. In the long-run this must happen; but in a world of pegged exchange rates, trade barriers, and industry interdependencies this might not happen without turmoil.

We will discuss the investment implications of all this in our next article.

8/1/10 –

A former U.S. government official perceptively noted that people differ over policy due to their philosophies and life experiences. The current polarized debate over appropriate economic policy almost precisely mirrors the major division of Western societies in almost all of the last 2500 years, between the populists and the oligarchs. We hope there has been some progress in political discourse since the time of Plato, because neither category is now useful as the economy confronts real problems.

The Democrats (guess how we vote) presently want to increase government spending, in the hope the economy will recover to build more houses and increase imports. The Republicans want to maintain low taxes, to build larger houses and increase imports. Both strategies will sooner or later result in worsened trade deficits and major economic problems because they do not address how the U.S. consumption economy has developed since the 1980s.*

Other nations have to export to earn the dollars to pay for their energy import bills. The U.S. has been spared that requirement because it can simply print money to pay for its domestic and therefore international trade deficits, thus eroding its industrial base. As discussions in the Eurozone and in England illustrate, the level of sovereign debt is becoming quite relevant. This concern is not yet relevant in the U.S., but will soon be. To decrease imports and restore balance to its economy, the U.S. has to change its trade policies and develop its industrial capacity: to invest in new products, plant and equipment, and human capital - to produce the products that Americans, and eventually the rest of the world, want.

The likely economic result for the U.S., in its present state, will be the “new normal” of low growth. The June 22-23^rd Federal Reserve minutes say, “…economic conditions…are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Translated, that means business growth will not be robust for an extended period. However, economic policy improvements require fine tuning rather than a major overhaul. Matching government revenues and expenses, adjusting trade policy, and incenting investments in new factories and other businesses will require a pragmatic political consensus that Washington has to attain; otherwise controllable events will turn into wrenching adjustments. Doctrinaire political ideology is a luxury that the U.S. can no longer afford; it will not improve the economy. The competition abroad is not hobbled by the kind of ideological debate going on here.

* On a 7/29/10 PBS broadcast, two respected economists came to opposite conclusions - looking at the same economic situation but at different levels of economic data. John Taylor (Econ 1a) argued for no additional economic stimulus citing lack of business investment as the main cause of the current economic slowdown; his economic philosophy is bottom-up. Mark Zandi (Econ 1b) argued for additional economic stimulus; his economic philosophy is top-down. The way to resolve logical contradictions is very often to be aware of the level that each argument implicitly assumes. In this economic crisis, both top-down government reform and bottom-up business reform are necessary. Concentrating on one, rather than both, will further unbalance the economy.

For readers who are interested in economics, specifically macro, this article by Paul Krugman in the 9/2/09 NYT clearly summarizes the state of the art’s current disarray. This is an excerpt:

Unfortunately, …(the perfectly rational and mathematical)…view of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

In 1983, Lester Thurow wrote that a major problem with economics is that it is too prescriptive, telling us how the world ought to be rather than how it is. These are actually two separate questions. This is why we think the other social sciences and history (~~ought to be~~) add: can be usefully applied to the study of economics, particularly the study of markets.

What’s required to restore prosperity to the U.S. is an industrial renaissance of some sort; because industrial growth increases wealth by increasing economies of scale *. This 8/13/10 NYT article on Germany describes what’s necessary for economic growth. It reads somewhat like the bottom up economic formula; but that’s only a part of it, because said formula can apply equally to businesses that are consumption rather than export driven. What’s important at the macro level are: a low budget deficit (and thus low imports); government policy favoring exports (or at least import substitution); an attitude in the society that favors the design and manufacture of high-margin, technologically advanced goods; and a skilled workforce. We visited the Deutsches Museum in Munich. The enthusiasm we saw there was like the enthusiasm that could be seen in Disney World; whole families - literally - went there to learn how the world works. U.S. science museums are now oriented more towards biology (zoology?), a field that requires PhD levels of competence and whose products require years of development.

Question: The Deutsches Museum’s biology and computer exhibits are more superficial than the others. Why?

Answer: Probably has something to do with what economists call innovation clusters.

* An editorial in the 8/16/10 Barron’s provides the contrary laissez-faire view. “Manufacturing can be done anywhere, and U.S. companies do it almost everywhere in the world. Imported goods and offshore services employ millions of Americans in good jobs, many of them with no heavy lifting. Transportation, insurance, finance, real estate, information processing and the like are industries that provide the productivity that drives the wealth of the nation.”

The editorial, surprisingly, assumes that subsidiary service industries can create the wealth of the nation. Transportation (of what?), insurance (of what?), finance (we think its fascinating, but it deals with credible promise [equity] or promises [debt] that rest upon the health of the economy), real estate (its consumption rather than production), information processing (the hardware is now mostly imported). This article entirely ignores the causes of domestic wealth creation and the unsustainable trade deficit in goods. Each manufacturing job can create 4 to 5 other jobs, whereas for services the job multiplier is 1 to 1.5 (Prestowitz, 2010, p. 26). With business leadership like that…

This CNET article cites a 2004 McKinsey study, indicating that offshoring is not an optimal strategy when flexibility is important and when direct labor costs are not major factors. “Since it often accounts for just 7 to 15 percent of the cost of goods sold, hard-goods and high-tech manufacturers often say that wage rates are hardly the most critical determinants of their overall economic performance.” If this is true, government incentives and trade barriers abroad are major factors responsible for the loss of manufacturing jobs in the U.S. (We’d be very careful about the practical implications of this statement.)

9/1/10 –

According to Reinhart and Rogoff (1/09, NBER #14656), in the aftermath of severe financial crises, there are “deep and lasting effects on asset prices, output and employment.” The Financial Crisis of 2008 has a major effect on housing and, more generally, stock prices. To cite just two statistics we track:

The private economy has not rebounded.

Private Industry Wages as Percent Total Disposable Income

(Bureau of Economic Analysis data, annual rate)

	1^st Q 2007	Feb 2010 (r)	Mar 2010 (r)	April 2010 (r)	May 2010 (r)	June 2010 (p)
Private Ind. Wages as % Disposable Income	51.4%	45.6%	45.5%	45.5%	45.5%	45.4%

r = revised, p = preliminary

The amount of commercial bank lending to the economy has decreased greatly in spite of an inventory bounce (financed by internal cash flow).

Loans and Leases in Bank Credit (Federal Reserve Call Report, Seasonally Adjusted, Including Allowances for Loan and Lease Losses)

Recession Event Peak to Trough

1973 - .66%

1980 - .58%

1990 -1.15%

2001 - .39%

2008 -10.6% (10/31/08-8/11/10), this does not portend high growth.

On 3/31/10 the Fed added $397.9 billion to loans and leases, net of loss reserves, to consolidate off balance sheet vehicles. We increased the 10/31/08 figures to compensate for this.

According to David Rosenberg, chief economist of Gluskin Sheff (a large Canadian investment management firm), this is a balance sheet recession more like Japan’s. It stems from too much debt rather than from typical cyclical causes.

The solution to this structural recession is not the “quick fix” of a further Keynesian stimulus, increasing consumption demand for the short-term only, but the unavoidable process of reducing debt and fixing the fundamentals: the federal budget, international trading rules, business, and educational systems. The Great Recession of 2008 was caused by a systems collapse, beginning with a collapse of social trust in the markets that had allowed excessive financial leverage. To get out of this, there has to be a broad consensus in Washington and a credible problem solving mindset to tackle its many aspects.

What is required to fix the federal budget? Under current programs, total U.S. government debt as a percentage of GDP will increase from 53% in 2009 to an unsustainable 100% by 2022 due to the structural growth of entitlements. In 2008, the developed countries (excluding Japan) had a ratio of government debt to GDP of 57.9% (McKinsey Global Institute study data). On the Committee for a Responsible Federal Budget website, you can enact measures to fix the U.S.’s finances. We were able to do just that, bringing the debt/GDP ratio down to 60% by 2020; by reducing the growth in entitlements and other expenditures slightly and increasing taxes. This website graphically illustrates that it is necessary to pay for the government that you really want. Simple budget arithmetic trumps political sloganeering. The budget paralysis that is happening in California should not happen to the United States or to California.

If Washington is not able to get its act together to fix these problems, worse difficulties lie ahead. The above reforms may sound impossibly difficult, but they aren’t. Other countries have balanced their budgets and promoted their exports, or at least reduced their imports.

“Advocates of traditional stimulus measures, like increased government spending or tax cuts, rely on recovery models rooted in, respectively, the 1930s and 1980s. Back then government stimulus and tax cuts made sense, because Americans spent almost all the new money on domestically produced goods and services.

For the last few decades, though, our growing trade deficit has undermined the relationship between spending and growth. Today Americans purchase so many foreign-produced goods and services that even large stimulus programs produce virtually no new net growth or employment at home.

Of course, trade deficits have subtracted from American economic prosperity for decades. But until recently, that damage was masked by artificial sources of growth, like the last decade’s credit and housing bubbles. With these phony economic engines gone, the trade deficit’s impact has become painfully clear.”

NYT, 9/9/10; Alan Tonelson; United States Business and Industry Council

10/1/10 -

The fact the economy has not rebounded sharply at this point in the economic cycle means that it is quite vulnerable to shocks: such as a large stock market decrease, economic problems in Europe, further real estate problems in the U.S., or something else.

We can’t say how the U.S. stock market will respond to the U.S. midterm elections because Democratic losses in Congress might be less than anticipated; or if the party loses control of Congress, the short-term traders on Wall Street may conclude that their free market viewpoint has been vindicated, leading to a stock market rally. However, with some further thought, they may conclude that gridlock in Congress will lead to worsening budget problems, “as far as the eye can see,” leading to a stock market decline. Should the far right gain control of Congress, despite initial protestations of bi-partisanship, they are likely to try to dismantle the Administration’s healthcare and financial reforms by refusing to fund them, resulting in gridlock. If you are a U.S. citizen, we hope you vote on November 2^nd because a lot is at stake.

In normal times, there is usually only one cyclical uncertainty, how the economy will respond to monetary policy. That we could happily live with; now there are many uncertainties. We previously quoted the 8/27/08 WSJ:

"...(The increasingly complex financial infrastructure) helped drive the finance boom, but it is now acting as a vector of contagion. And the causal arrows don't point in straight lines from one troubled area to the next (as our descriptions above do). They twist back, creating vicious circles that gain speed and draw more markets and investors into the mess."

Financial institution causal arrows no longer threaten the world’s economic system; but the repercussions of this Crisis, now political-economic, will affect events and therefore the financial markets. We have reduced our exposure to equities by reducing our individual holdings in Citigroup and a few other stocks, each by around 25%. As a matter of policy, we try to stay at least 20% net invested in equities.

The present stock market, to use Jeremy Grantham’s phrase, is a “Fearful, Speculative Market”. There is a struggle between the two wings of the institutional business (like interest groups in politics). “Aggressive institutions carry a lot of weight these days…and their influence can be felt all over the market. They are not easily intimidated when rates are low and moral hazard is in full swing. The other key component is the conservative half of institutional money that is apparently (and reasonably, I think) seriously disturbed by recent negative global and U.S. economic events….what we are seeing now is a tussle between the 50% sustained speculation branch and the branch where two or three things go wrong and crack confidence.” The essay refers to the economy’s many qualitative problems; but on balance he is quantitatively more optimistic about the market because of low interest rates. We think that low rates and an astounding list of qualitative (environmental) problems are syndromes of the new normal economy.

We would like to see favorable election results before even considering an increase in our allocation to stocks. If the Tea Party can dump recent reform legislation, you can forget about the slightest semblance to mean reversion.

QE2 is not an oceanliner; but stands for Quantitative Easing 2, the Fed’s renewed effort to create economic growth by purchasing treasury securities for its own balance sheet. This enables the treasury to “print money” and not to inconvenience the capital markets by raising funds. Will this work? We don’t think so because the problems of the U.S economy are structural. The economy suffers, not from a Keynesian lack of immediate demand requiring economic stimulus of housing and autos; but from large imbalances: the trade deficit and a causal supply side deficiency in manufacturing and therefore productive manufacturing jobs. The 10/8/10 WSJ writes:

The case for QE2 assumes that the problem with the economy is merely a lack of money. But trillions of dollars are already sitting unused on bank and corporate balance sheets. The real problem isn’t lack of capital but a capital strike, as businesses refuse to take risks or hire new workers thanks to uncertainty over government policy, including higher taxes and regulatory burdens.*

* A much simpler explanation is a lack of consumer demand. Adding consumer credit outstanding plus mortgages on 1-4 family residences, consumer deleveraging has been occurring at a rate of 1.7% per year since the peak of 2007. Over another 2 ½ years the cumulative consumer debt reduction could total around 8%, which is not insignificant. In real terms, that reduction is probably twice as great. The consumer debt problem appears to be heading towards improvement, in aggregate.

add: We think it extraordinary that on 9/21/10 the Federal Reserve Open Market Committee (of all people) only stated, “…the Committee was prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” There seems to be no recognition that during a time of general deleveraging, the banks aren’t increasing net lending. Without increased bank lending, the Fed’s QE2 securities purchases will simply end up as excess and unlent bank reserves on the Fed’s balance sheet.

But real growth will have to gradually occur by rebuilding the earnings power of the American economy, of domestic American industry. Coordinated government policies could be very helpful. It would be most effective for Washington implement a long-term plan to reduce the budget deficit, thus also reducing imports. *

Strategic thinking by government, deciding how the future economy should look, also matters. This article describes how an 100% American content rule might unrealistically apply to proposed high-speed trains. There is no domestic manufacturer of railway cars. Foreign companies like Siemens, Kawasaki, and Alstom only assemble rail cars in the United States (as the U.S. auto industry used to run assembly plants abroad in the developing economies). These companies source critical components, like computer chips (also probably entire control systems, motors, and of course systems design) abroad. The result is a sophisticated product produced by the global supply chain at the lowest immediate effective cost. A large amount of U.S. government funding therefore ends up abroad, producing no exportable goods.

In the complex world-wide economy, government has to choose the spots where the U.S. is going to compete and develop. Intellectual property from R&D is mobile; so another crucial competitive advantage is what Pisano and Shih (HBR, 7/2009) called, “the industrial commons.” The market is only going to ask one question: what is the lowest present cost (with or without the intervention of governments). This example illustrates that neither 100% or 0% government intervention are likely to be effective.

* Except in specific circumstances, trade quotas are less effective because they are likely to provoke retaliation. That having been said, the U.S. has a right to expect generalized reciprocity from its trading partners.

On 10/10/10, Bloomberg broadcast a speech by Pimco’s co-Chief Investment Officer, Mohamed El-Erian before the IMF and the World Bank. It provided a macro view of the present financial crisis. (If you don’t want to be disturbed, we recommend you don’t read this….)

“The first step,” he said, “to solve a problem is recognition and then to frame the question.” This financial crisis was created by balance sheet contamination; as a fall in U.S. house prices contaminated first household balance sheets, then the balance sheets of financial institutions – leading to a sudden stop in world-wide economic activity, and now affects public balance sheets. But “having won the war, industrial-country societies are in the process of losing the peace…If they are not careful, they risk slipping into a lost decade of low growth, high unemployment, and welfare destruction.”

This condition, he calls, “the new normal,” is a structural rather than a cyclical condition. The industrial countries will be out of balance for many years and suffer balance sheet destruction. Growth will migrate to the developing world. In the developed world, companies (having suffered a near death experience in 2008) are self-insuring, hoarding cash on their balance sheets. Households are selling their equity funds and going into cash at 0% or bonds earning a low interest rate. This conservative trend towards self-insurance frustrates actions on the policy side. Low asset yields means that pension promises (requiring 8% returns) can’t be kept.

Balance sheets matter; it’s the level and not the growth rate that matters. The industrial countries face bad balance sheet issues, and we won’t escape until they are solved. Latin America in the 1980s is an example. Low growth is due to debt overhang, and with debt overhang a lot of new capital won’t be engaged. The global system is under enormous pressure; the “new normal” has a 55% chance of occurring and you also have to consider the dynamics. The system could tip into (a Paretian distribution), with either good or more likely bad outcomes (like a second recession) due to policy mistakes or a market accident.

Reality is fragmenting at the global level to a local focus, also for lack of a common analysis. This will happen the longer the “new normal” exists. International institutions better think about experimentation and course (error)-correction. Emerging markets know this well; China knows this well; but industrial countries don’t know this. Tradeoffs have to be made, As the philosopher Yogi Berra said, “The future ain’t what it used to be.”

We’ve always thought that it’s a good idea to be prudent; now is the time for that.

11/4/10 –

In anticipation of QE2, the S&P 500 has rallied by 14.2 % since the end of August to 1198 (7.4% for the year). The crucial economic assumption of that rally is as follows:

The U.S. economy is still cyclical in character. Thus a large purchase of long-term treasury securities will lower long-term interest rates, driving cash into riskier assets and promoting more investments in the future. The market assumes a stock market model something like this: P ↑ = f (long-term interest rates ↓, assumed economic growth ↑ )

But the economy has problems caused by its structuring for consumption rather than for production. Large purchases of long-term bonds will no longer affect long-term interest rates, due to assumed inflation far into the future, these purchases also not promoting more real investment due to consumer debt overhang, low present capacity utilization in the U.S. of existing plant and equipment, budget problems in Washington, trade problems with the partners, and problems with the U.S. educational system. We think the likely stock market model will eventually be: P ↓ = f (long-term interest rates ↔, assumed economic growth ↓ ). If a continuing series of adverse events occur, such as low economic growth; or if there is some crisis, the stock market will probably be driven by events to drop in value. Requiring (a reasonable) 7% return on the S&P 500 and (not realistically) that companies immediately increase their dividends by 18% to account for increased cash and earnings, we calculate a S&P 500 level of 945.

It is through the prism of continuing economic problems that we view the mid-term elections. Elections can clear the air, setting the stage for necessary economic reforms. However the outcome of this election, with the Republicans achieving a blocking majority in the House, and an increase in the Senate, will likely be a GOP under the increased influence of ideology. The Republican recipe for renewed economic growth are the mantras of less government and less taxes. This return to an imagined U.S. past might be comforting to some and profitable for others, but it was never true. The U.S. government has been intimately involved in aiding the land-grant railroads and colleges; setting up the interstate highway system in the ‘50s; and more recently; sponsoring research that produced semiconductors and the Internet.

Another problem with the Republican solution, in addition to its never having been tried, is that the competition is doing the exact opposite. The U.S. confronts China’s state capitalism, an economic form that combines company access to state resources with a technical meritocracy at the management level to compete in the export markets*. The U.S. will not be able to easily compete with this economic form, least of all if it continues to see government as part of the problem, rather than as part of the solution. The way for the U.S. to handle this sort of challenge, within its social traditions, is to accord government a long-term economic planning and research role and business a short-term implementation role, drawing fairly clear distinctions as to what is what. Left to themselves add: without government regulation, market societies are trading societies and therefore inevitably short-term.

By invoking not useful tradition, but an imagined one, the conservatives will, in effect, prevent the U.S. from developing the resources necessary to manage its many challenges. In the modern economic world, things don’t just happen. This article in Fortune Magazine says it all; there is no magic bullet to create economic growth.

Economic growth will occur when U.S. industry has been rebuilt and reforms effective. That takes time. The way to get out of this is to chip away at seemingly unsurmountable problems that were years in the making. It is also said, “Politics is poetry” (we won’t mention the author). Washington should get Americans working together again.

* The 12/5/09 Economist discusses the growth around the world of hybrid companies, “that blur the line between the public and private sector…confusing entities,” that are politicized and can collapse like Dubai World. But what if these organizations are, to varying degrees, meritocratic; their managers have MBAs; and governments support their foreign sales?

The January/February 2010 issue of the Atlantic magazine contained an article on the financial travails of New York’s massive Stuyvesant Town. Explaining the real estate calamity that hit the United States, Megan McArdle wrote, “The best explanation for the calamity that has overtaken us may simply be that cheap money makes us all stupid.” In the earlier part of the last decade, it was international inflows of capital into the United States, kiting up real estate prices. Now, it’s the Fed’s quantitative easing, kiting up financial asset prices beyond the fundamentals.

There is a saying, “Don’t fight the Fed.” We would almost always agree with that, except now. In the first instance, a Fed loosening would invariably lead to the rebound of the economy. Now, with interest rates at zero, quantitative easing is leading to the rebound of financial asset prices, most likely not affecting the real economy.

As housing illustrated, economic reality eventually catches up with the symbolic financial markets. Investors have to decide whether or not to play the market timing game. In the 11/5/10 Bloomberg, the portfolio manager Mark Mobius of Templeton Asset Management says, “I’m pretty optimistic…I don’t see any risks any time soon. These things can last for years and years.” On the other hand, an 11/5/10 Fortune Magazine article gives the United States another ~~two~~ three years before, “…the total federal debt will total 76% of GDP if Congress remains gridlocked *, and digging out at that point will be unimaginably painful.” We are not going to suggest a major commitment to stocks at this point, because most of our readers worked very hard for their money; and we would not like to see it simply disappear.

add: * With tax cuts extended and AMT indexed, CBO 10/27/10 presentation, note especially p.p 17-18. In the present situation, it would be a better use of monetary policy simply to ensure the stability of the financial system and to use a number of government programs to help rebuild the U.S. industrial base, to really make a difference. The problem with alternative proposals, for instance one article suggests restoring family-owned farms, is that economies of scale and productivity improvements only come from large-scale industrial enterprises. This has been so since the 1850s.

The highly influential economist, Paul Samuelson, set the agendas for modern macro and mathematical economics. It was thought possible for governments to fine-tune their economies to avoid extreme outcomes, using the tools of fiscal and monetary policy. Reality, however, proved to be more intractable. Fiscal policy turned out to be too political and therefore unwieldy. In the 1970s, monetary policy was likewise politicized. Present monetary policy cannot overcome the problematic structural flaws of the economy. Robert Samuelson (no relation) writes about Japan, that after a delay, apparently did everything right; but could not revive its economy for structural (business) reasons.

Japan’s cardinal sins, we’re told, were skimping on economic “stimulus” and permitting paralyzing “deflation” (falling prices)….

Just the opposite is true: Japan’s economic eclipse shows the limited power of economic stimulus and the exaggerated threat of modest deflation. There is no substitute for vigorous private-sector job creation and investment, and that’s been missing in Japan. This is a lesson we should heed….

Despite massive stimulus, rapid growth hasn’t resumed two decades later. Although the Japanese reacted slowly, they adopted the advice of economic textbooks. They raised spending, cut taxes and let budget deficits balloon….

So Japan’s economy is trapped: A high yen penalizes exports; low births and sclerotic firms hurt domestic growth. The lesson for us is that massive budget deficits and cheap credit are at best necessary stopgaps. They’re narcotics whose effects soon fade. They can’t correct underlying economic deficiencies. (Our note: that’s what we’ve been pounding the table about.) It’s time to move on from the debate over “stimulus.”

Economic success ultimately depends on private firms (Our note: rather than on broad-brush macroeconomic policy).

Robert Samuelson, 11/15/10 Washington Post, “How to Avoid Japan’s Economic Mistakes”

Vincent Reinhart, former director of the Fed’s Division of Monetary Affairs, said on the 11/22/10 Bloomberg that if one were to make a list of the fifteen most effective things the government could do to help restart economic growth; quantitative easing would be the fifteenth. Political gridlock in Washington is the main reason that the Fed has to resort to this, to appear to be doing something.

12/1/10 –

A slight recent improvement in the U.S. economy: increased GDP growth in the third quarter to a 2.5% annual rate, declining jobless claims, and increased inventory builds has been due to massive government interventions – supporting the mortgage market, increasing spending on infrastructure and social benefits. The cost to the U.S. government of this spending has been an increase in the deficit from $161 billion in 2007 to an estimated $1.3 trillion in 2010. In spite of continuing private sector financial problems, the U.S. economic situation is somewhat improving because the U.S. is still free to spend on its economy, not being subject the IMF kind of financial discipline that the Eurozone is imposing upon Greece and Ireland.

In almost all developed countries, the problem is too much debt, that has first gone into real estate and then into funding massive government deficits. The only way out of this crisis, short of default, is to reduce the growth of that debt through decreased consumption and increased investments in the future, industrial growth and education, to produce a more competitive work force. Whether for individuals or societies the fundamental long-term issue is very simple, bread today or bread and jam tomorrow. In the 11/28/10 NYT, Thomas Friedman writes that the US requires nation-building. (Except it will be much easier here than in Afghanistan because the necessary societal values still exist, although they are somewhat dormant.)

In the short-term, however, investors need concern themselves not only with the solution, but with the present risks to their investments. The stock market has rallied this year so far to a S&P 500 peak of 1227, a level that is considerably above the level of 945* that an optimistic assumption justifies. Those who have read our article, “The Nature of Stock Market Equilibrium”, know that markets can considerably overshoot or undershoot their equilibrium levels due to the press of events. Since the present stock market is around 30% overvalued by this optimistic measure, and could even increase somewhat further, it is quite vulnerable to the following risks:

1) Congress, at this point, may not be able to reach a consensus to reduce the U.S. budget deficit. U.S. government debt will reach 100% of GDP by 2022.

2) The IMF expects lower U.S. economic growth due to high debt, weak credit growth, and high unemployment. The 2010 World Economic Outlook base case scenario makes the following projections for U.S. GDP growth:

2009 2010 2011 2015

-2.4 3.1 2.6 2.4

What is notable is not the exact level of these projections; but their trend. The IMF expects lower growth in 2011 than 2010. Peter Orzag, former director of the Office of Management and Budget, expects headwinds to reduce real economic growth to the 0%-2% range. Companies have already increased their earnings this year by laying off workers. They may not be able to show increased top-line growth to sustain their earnings growth next year.

3) The U.S. housing market has already dropped 28.6% from its peak in 2006, according to the Case-Shiller. Due to more than 10 months of inventory (5 normal), it may decrease further.

4) If actual U.S. economic growth is lower than long-term IMF projections, its ratio of debt/GDP will increase greatly. Lower U.S. economic growth will not only impact stock prices, it will also impact the fiscal condition of the government – and eventually its ability to fund its deficits abroad.

5) Unable to issue debt in their own currencies, the peripheral nations of the EU are already beginning to undergo their own sovereign debt crises. Their problem, as in the U.S., is too much debt, high deficits, and low economic growth.

6) This would also be a most inconvenient time for a foreign policy crisis.

It is, of course, up to our readers to decide whether they want to bear these risks. We think its better to have both feet on the ground, rather than to be in an aircraft at 7,000 feet when all the alarm bells start sounding. A portfolio manager once noted that those who focus upon macroeconomic events (bond investors) are usually more pessimistic than those who focus upon company events (equity investors). We ordinarily emphasize company analysis; then go as far as Fed policy, leaving aside what is happening in the macro economy. However, this crisis of the world’s financial system is not yet over; and we are not increasing our allocation to stocks at these price levels.

* We calculate the present value of dividends, making one realistic low-growth assumption (4% = 2% real + 2% inflation) and one optimistic assumption (assume a dividend payout ratio of 40% on adjusted operating earnings; the dividend level we calculate is $27.26 rather than the actual $23.19).

Citigroup’s new management (and of course the bank’s occupation by newly vigilant bank examiners) has had a salutary effect. Three items to note: 1) According to Morgan Stanley, Citigroup’s risk-weighted Basel III net worth calculation is 10.3%, (7% is the minimum requirement), the highest of any large U.S. bank and exceeded only by Britain’s Standard Chartered that had emerged unscathed by this financial crisis. Net worth calculations alone do not address the issue of asset quality. 2) Citigroup could lose only 4% of its net worth in adverse mortgage putbacks, compared 10-14% for other large financial institutions (Barron’s). 3) According to the 2009 10-K, Citigroup’s cross-border exposure to Spain is less than .75% of total assets. We think the fundamentals of the bank are looking up, although the world financial crisis continues. We own their stock within an equity asset allocation that is lower than normal.

Value investors try to act according to facts, or at least the facts as they develop. Modern financial markets respond according to estimates, which are frequently wrong. Take, for example, November’s employment report. According to the 12/3/10 CNN, economists had expected a 150,000 gain in employment coming at the heels of a 172,000 gain in October. An economic recovery seemed to be baked in the cake, an employment gain of that magnitude being necessary to keep the unemployment rate from rising. The Labor Department reported the actual November figure, 39,000. The structural problem of a non-competitive U.S. economy has to be dealt with before there can be any benefits.

~~What’s now important is the New Year’s resolutions for 2011.~~

In this holiday season, its nice to know that everyone gets what they want. In the budget deal just announced in Washington, the Republicans get their tax cuts; the Democrats get their social spending; and it all goes on the national credit card, financed by the developing countries.

Speaking in somewhat more considered tones, the deal isn’t that bad if a serious national conversation starts now on the measures required in two years to reduce future deficits. The Bowles-Simpson debt commission achieved a surprising consensus (11/18) that something has to be done and soon. The alternative to making future sacrifices (specifically tax increases, budget cuts, and economic reforms) will be a sustained financial market panic, when the U.S.’s credit and credibility finally run out.

In a political science course, the prof started by saying, “In Washington, he whose ox is getting gored, yells the loudest.” There should be a lot of bellowing in Washington over the next two years.

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