Things have not changed much since my last letter. Oil is $10 higher, at an all-time high of $43 at this writing, but otherwise markets, risk factors and opportunities remain pretty much the same. For the most part we are marking time, waiting for the outcome of the election.

Markets & Economy

Complacency has been the dominant sentiment in the marketplace for the past few months but anxiety has been rising lately over rising rates…how high and how fast will they go? The first uptick in rates was a delicate 25 bp increase on June 30^th, which still leaves the cost of money far below growth, expected to be in the neighborhood of 4% this year, and inflation — currently running in the neighborhood of 3%, with consumer inflation over 5% by some measures. By any measure the Fed is still holding to a very stimulating stance.

Is the recovery really that fragile? Apparently so. After surging for several months, June economic numbers showed softness across the board and the July numbers have continued the trend. Are the stimulants of the past four years wearing off already? According to Alan Greenspan the soft numbers are a transient phenomenon, and the recovery is in a self-sustaining phase.

Someone who takes a different view is Stephen King, head economist at HSBC, a British bank, who recently published a paper entitled “Dicing with Debt.” The Economist reviewed King’s paper in its July 3rd issue. According to King, U.S. policy makers have overreacted to the deflation of recent years, which he claims was not the much feared debt deflation, but rather a benevolent kind of deflation with historic precedent, caused by technology, improved trade relations and other factors. By misreading the threat, pushing rates to historic lows and running up the debt, policymakers have inadvertently created conditions that may well yield the more malevolent variety of deflation.

The Economist summarizes King’s argument…”If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years.”

“There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think – and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid. This could even mean that rates need to fall next year, not rise. And with rates so low and budget deficits already high, America ‘s economic armoury is much depleted.”

We will soon know who is right.

Meanwhile a general malaise has overtaken professional investors, who are lamenting the imminent loss of easy money from the “carry trade” and who don’t see a lot more upside in this market. P/E’s are once again at nosebleed levels and a big part of the E’s has been the direct result of record low interest rates, which are soon to be history…we think. General concern is also rising that Al Queda or related Islamic terrorist groups will try to mount attacks on U.S. soil as we approach election time.

Investors are also suffering from the loss of vitality of the latest fad in investing – “market neutral” strategies. Over the past 10 years or so computer technology has enabled a whole new generation of arbitrage strategies with fancy names like volatility arbitrage, statistical arbitrage and pairs trading to produce outsized returns for awhile, but their success has drawn so much money into these low volatility strategies that they have stripped most of the “inefficiencies” out of the market and have effectively been reduced to operating between the wall and the wallpaper. Returns from market neutral strategies have fallen off dramatically and are not likely to come back. Worse, the low volatility/high return historical profile of these strategies has given investors some twisted ideas of what a good track record should look like. Most investors now want free lunch in the form of outsized returns without the risk and volatility required to earn those returns.

Fiscal update

The fiscal insanity has only slightly abated. House Republicans, having abandoned traditional Republican values and wholeheartedly adopted the “starve the beast” strategy (see the Q3 ’03 letter, “The Twilight Zone “), with White House encouragement, have been pushing for more tax cuts in the face of record budget deficits. Senate Republicans, however, are worried about voter retribution if they run up the deficit even more going into the election, as well they should be. Also, some of the so-called “deficit hawks” are belatedly finding their voices and complaining about the fiscal madness. We will hear more from this group as we approach November, anxious as they are to pretend that they are not in league with those borrow-and-spend Stepford Republicans. Add these cross-currents together and the result is that additional budget busting legislation is unlikely for the time being.

Meanwhile we ran up a whopping $144 billion trade deficit in the 1^st quarter!!! Policymakers have been asleep at the wheel on this matter for a long time, but ignoring it is like ignoring the soil eroding from under your foundation. When it finally lets you know it’s a problem is when your house washes away in a heavy rain.

Recommended reading: an upcoming release entitled “Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It” by Peter Peterson, former Secretary of Commerce in the Nixon Administration.

Risk Factors

Bill Gross of PIMCO fame has put forth the most relevant analysis of economic risk factors I have seen recently in his May/June letter, the theme of which is “walking the tightrope,” with inflation (fire) on one side and deflation (ice) on the other. You may read the entire letter at www.pimco.com. The following quotes sum up Gross’s outlook.

“In a financed-based economy, which the U.S. surely is, the only real way to keep an economy going is via cheap money, more and more tax cuts, and/or additional leverage. With tax cuts politically unpalatable and recent yield movements along the curve making leverage less profitable, the beginning of the end is in sight.”

“What has changed this year in our 3-5 year forward economic forecast is that the conditions for instability have accelerated – more U.S. consumer leverage dependent on cheap financing; more Treasuries in foreigners’ hands; more geopolitical instability; and more risk of a slowdown/shock in Asia…”

The following charts, courtesy of PIMCO demonstrate some of the major challenges facing the economy and U.S. policymakers. These charts tell their own story.

According to Morgan Stanley 98% of global GDP for the past 10 years has been generated by the U.S., and two-thirds of that has been generated by consumers. With U.S. consumers having nearly doubled their debt load over the past 20 years to 80% of GDP, it is not likely that they will continue to be the locomotive that drives the global economy for much longer.

Housing Update

From Mark Zandi of Economy.com, courtesy of John Mauldin, the following housing statistics: housing has been a huge generator of jobs – in the neighborhood of 750,000 over the past five years, which is approximately 30% of all jobs created over that time. Housing was responsible for roughly two-thirds of inflation adjusted GDP growth since the beginning of 2000, and has continued its contribution during the recovery, adding 25% to real GDP growth over the past year. As for consumer spending: for every dollar of housing value gained, consumers spent 8 cents in that year, but for every dollar of housing value lost, 30 cents not spent.

Virtually all of the “experts” assure us that housing will not go down; it may go flat for an extended period of time but not down. But if there is one thing I can tell you with certainty it is this: markets do not go straight up for years and then go flat; they correct. The super-EZ credit and low, low rates have brought in legions of unqualified borrowers, leveraged speculators and other weak hands. During the next recession large numbers of these people will be forced to sell. With virtually everyone who can qualify, even with 100% financing, having bought something, and many having leveraged those purchases to buy additional houses using “subject to” and other creative financing techniques, or having cashed out of equity to meet expenses, who will be the buyers when the market starts down? And how far down will the market have to go with tighter credit and higher rates before new buyers can be found? A typical market correction is 50-65 %; a shallow correction is 30-35 %. Can’t happen you say? That’s what every cab driver, construction worker and actor tells me. I say that in this regard housing is not different from any other market.

Another piece of the housing puzzle is the potential for big problems at Fannie Mae and Freddie Mac, holders of $4 trillion of heavily leveraged mortgage debt between them. Many economists and politicians, including Alan Greenspan, have been publicly expressing their concerns about the twin mortgage giants, particularly about hedging operations. My sources with deep roots in the mortgage business are more concerned about the big banks that are on the other side of these hedges. Fannie and Freddie are fairly well hedged against losses on their portfolios but those holding the other side of these hedges could become liabilities for meltdown if housing comes under pressure, creating counterparty default risk for Fannie and Freddie and the potential for a crisis on the scale of Long Term Capital or worse. Read The Economist , April 7^th issue, “Playing With Fire .”

Regarding housing, the question is not what will happen – housing will correct — but when will it correct, how deeply will it correct and how much of an impact will that correction have on the overall economy? The notion that housing values are going to simply level off is a fantasy.

Political

Until just recently it seemed as though the nasty rhetoric had calmed down quite a bit. I confess that I even had a fantasy about an honest national debate emerging from this relative calm, but clearly I was engaged in wishful thinking. The venom is flowing freely again as partisans are warming up for the home stretch, and the media are only too willing to give broad exposure to every inflammatory remark and attack ad.

“Every kingdom divided against itself is brought to desolation.”
Matthew 12:25, Luke 11:17

An encouraging counterpoint to the gloomy state of our politics is an article by John Tierney in the June 13^th Week in Review section of the New York Times entitled “A Nation Divided? Who Says? ” This upbeat article points out that most voters are still centrists and that our basic differences have actually been shrinking over the past two decades. According to Tierney “…the polarized nation is largely a myth created by people in the Beltway talking to each other or, more precisely, shouting at each other…it’s not the voters but the political elite of both parties who have become more narrow-minded and polarized.”

Geopolitical

I think we can sum it up at the outset and say that things are not going our way on the global scene. Events in Iraq and Afghanistan have soured both enemies and allies alike toward us. Adding to the enmity, it seems that the Bush folk seldom pass up an opportunity to stick a thumb in someone’s eye.

The perception of American omnipotence, a major stabilizing influence in and of itself, has been dealt a serious blow by our inability to force our will in Iraq, and the stain on America ‘s honor from the Abu Ghraib scandal has not helped either. Nor has our failure to follow up and finish the job in Afghanistan where elections have been delayed again due to killings of election workers and registered voters by a resurgent Taliban. Recently, NATO’s Secretary General made an unusual public plea for co-operation on Afghanistan and Iraq, stating that both are doomed to become failed states (read: terrorist incubators) if we don’t all work together to save them, and castigating the U.S. for ignoring NATO except when it wants something.

We are paying a big price in terms of blood, dollars and political capital in order to pursue our “war on terror.” Result: we have killed a lot of people but global terrorist activity has surged since in the years since 9/11, particularly since the Iraq invasion, to 20 year highs. Clearly our “war on terror” has not had the desired impact to date.

Reflecting the seriousness of our global position, the CIA has cleared the publication of a book entitled “Imperial Hubris: Why the West is Losing the War on Terror” by an active senior agent, Anonymous, who was in charge of the Bin Laden station at the CIA. Anonymous laments the “imperial mindset” of U.S. policymakers and predicts that unless we learn to view world events from the perspective of our adversaries, and thus learn to understand them, we are going to lose this war on terror. Michiko Kakutani has written an in-depth review of this important book.

For those who want to follow Anonymous’ advice, see Control Room , a documentary by Egyptian-American director Jehane Noujaim that looks at Al Jazeera’s coverage of the Iraq war. One insightful GI labels Al Jazeera the Muslim version of Fox News. Indeed, Al Jazeera recently announced an ethics standard of “balanced and sensitive” reporting.

China update: World stability was granted an extension in March when Taiwan ‘s independence initiative failed on a technicality: the election failed to draw the required 50% participation for the referendum to be considered valid. Tensions remain high in the area however, and not ones to miss an opportunity, the neo-con geniuses running the Pentagon have arranged to deploy seven aircraft carrier battle groups for what may be the largest military exercises in history off the coast of China and have invited Taiwan to join in. A typical deployment in a genuine crisis, like Iraq or Afghanistan, is three or four battle groups.

Not surprisingly, China has not taken kindly to this provocation. China will be conducting its own military exercises and has announced a crash program to beef up to a level able to counter seven carrier battle groups. Keeping in mind the Powell Doctrine that no nation should be allowed to challenge American military supremacy, a more muscular China will probably not be a stabilizing influence in Asia. Also, any bets on Japan ‘s response? And since it is China that is financing our debt addiction right now, might they decide to exercise a little muscle of their own and dump a pile of U.S. Treasuries on the open market, or maybe just stop buying?

Now that we are bogged down in two unfinished wars in Afghanistan and Iraq and stirring the pot in Asia, neo-cons are beating the drum for war against Iran. Numerous articles have appeared recently about the connection between Iran and Al Queda. The 9/11 Commission raised the question, “why did we go to war with Iraq when, given the rationale for the war, the case was actually much stronger against Iran?” The White House is “investigating” this matter. The Wall Street Journal in a June 14^th editorial entitled “Coddling the Mullahs” called for applying the doctrine of pre-emptive war to Iran.

All of the above is promoting general instability in global relations and undermining the co-operative foundations of global trade. Western interests in general and American interests in specific are now and will increasingly come under attack first in the Islamic world and then elsewhere. If you are doing business or holding interests internationally and have not already done so, you would do well to develop contingency plans to deal with attacks on your interests and even on your person if you need to travel internationally.

Opportunities

No change here since the last letter. See the March ’04 letter, “The Home Stretch .”

Summary

Barring a sudden shock from one of the many potential sources of geopolitical or economic trouble, the Presidential cycle will continue to dominate. Stocks will continue sideways to higher into the election and probably into January. An alternative scenario is a sell-off into September followed by a rally to a new or secondary high in November or January. Rates will rise slightly for the time and more sharply after November and inflation and deflation will continue to co-exist side-by-side. With due consideration of the opening caveat, we are not likely to see any big trends or trend reversals developing prior to November but we are likely to see some market gyrations as positions are unwound going into the election and/or bets are put in place. Most likely is an uneasy peace between the bulls and bears.

One could say that the foundation of my macro outlook going forward is that efforts to manipulate endless “controlled” inflation and avoid recessions have introduced latent instability into the system and are doomed to failure. Recessions are natural corrective phenomena. With each corrective cycle that we charge our way out of, we increase the burden we must carry during the next expansion. This simply can’t go on forever and the longer we delay paying what we rightly owe, the bigger the debt will be and the more painful it will be to pay it. We can only violate natural law for so long before nature takes action to restore balance.

The power brokers in Washington have become highly skilled in manipulation and deception, so we have seen and can expect to continue to see many delaying tactics, but in the end I believe that we are going to experience a period of extreme dislocation as the accumulated excesses, weaknesses and corruption are purged from the system. The trigger for this purging could be economic or geopolitical, but once begun, instabilities in both spheres will feed off of each other until the process is complete.

The averages have been drifting higher for months — about 3% off their rally highs at this writing but still holding their uptrend, rates are drifting lower after the big jump up, and the dollar is selling off again. Stocks held up impressively in the face of the vicious bond market sell-off but the subsequent rally has been pretty lackluster. Daily ranges and volume are contracting and it appears that the movement up has been driven primarily by lack of selling, not enthusiastic buying. Wall Street and White House economists are touting the prospects for economic growth even as the long term liabilities are stacking up at an alarming rate. The S&P is now at valuation levels last seen at the market top in 2000. As I observe market behavior and evaluate the underlying social, political and economic trends I find myself feeling as if I have entered into the twilight zone.

From the risk perspective, as I look at the underlying trends I find three particular areas of concern: job formation, fiscal policy and geopolitics.

Jobs

The job situation is dismal and it is not getting better; it is only getting worse more slowly, if that. Officially we have lost over 2.7 million jobs in the last three years. The official jobless rate is 6.1% but that doesn’t begin to tell the real story. To begin with the official number doesn’t count the growing legions who have given up looking for work. Additionally, I suspect that the number is further understated by virtue of the millions of workers in recent years who have become self-employed contractors even though they are (or were) still doing the same functions they were doing as employees. However, what is really troubling about the current jobless situation is not so much the numbers or the duration but the dynamics that are driving the long term trends in job creation.

First, we have overcapacity in every sector. Yes, spending is increasing on technology but as we will see below, this is the exception that makes the point. In large part the pervasive overcapacity is a legacy of the roaring ’90’s which, under normal conditions would take considerably longer than three years to work off. But we are not faced with normal conditions. In our global economy we are not able to control or work through our overcapacity in a normal way. We are faced with an ascendant developing world which is increasing capacity as fast as it possibly can. This is limiting our ability to work through our own overcapacity, limiting our ability to create jobs and it is creating deflationary pressure.

Second, just as with capacity, the competition for jobs is no longer a local or national affair. Service sector jobs have now joined manufacturing jobs in moving offshore – in large numbers. This adds to the challenges of job creation, exacerbating chronic joblessness and promoting wage deflation. Even those jobs that remain in the U.S. are paying less. This is another area where official statistics are misleading because the wage reduction is most often not an actual hourly wage reduction but comes in the form of a lost benefit or deferred cost of living increase, reclassification of employees to management positions, or in fewer hours worked or lost overtime. For years employers have been offloading health care and pension costs onto workers and this trend is accelerating. However, as an example of the backlash that these cost cutting measures are beginning to create, the California legislature has passed a bill requiring employers to provide health insurance. It is uncertain whether Gray Davis will sign this bill before he leaves office (assuming he will be leaving), but it is a sign of things to come.

Third, and most troubling, is the changing impact of productivity. Worker productivity has been the magic sauce of the U.S. economy and is responsible for our economic dominance. But in an era of global and universal overcapacity, global deflationary pressure, anemic economic growth, and global competition for jobs, steady increases in productivity are simply adding to overcapacity and increasing the pressure on job creation and wages. Recently, the sector that has been looking the brightest in the “recovery” has been technology. This has been hailed as a precursor to a more general improvement in economic conditions and job formation. I disagree. In the current macro context, the increased spending on technology is enabling employers to continue to cut jobs outright and continue to expand outsourcing to low wage countries. Since workers are the ultimate consumers, a “recovery” that is built on cost cutting (e.g. laid off workers) is not sustainable.

We will eventually find equilibrium and the beginning of real growth but there are still many distortions and excesses to be worked out of the system before that can happen. A perfect example of how far we still have to go to work off the excesses of the ’90’s is the Richard Grasso pay scandal — Corporate America paying a regulator $188 million for his oversight of their activities! Gee, do you think they got any favorable treatment? If anyone has been looking for an indication of whether anything has really changed in the criminal culture of big corporate America, this is it.

Meanwhile, the disparity in income and wealth between the upper tier and everyone else continues to grow. Even as the number of millionaire households (as measured by investable assets) recently hit a 20 year high, personal bankruptcies were also an all time high, and 90% of those bankruptcies involve middle class families. Contrary to urban legend, the vast majority of these bankruptcies are not due to profligate spending, but to the pincer effect of declining income and rising cost of living, particularly of housing. And on the bottom of the socioeconomic ladder millions of honest, hard working families are only a paycheck away from the street. In fact homeless families are becoming commonplace, now accounting for approximately 40% of residents of homeless shelters.

The bottom line here is that while we are likely to see some modest improvement in the job situation over the next year, the underlying trends are indicating that job creation will continue be weak, wages will remain under pressure and the disparity in wealth and income will continue to grow. Any isolated economic data or up ticks in growth notwithstanding, this is not the picture of a healthy economy, and it is not sustainable. When the next recession arrives (there is always a next recession) the job situation and the growing gulf in income and wealth distribution are going to start causing a severe crunch. Coming on the heels of 30 years of slow erosion in purchasing power and the recent period of real difficulty for workers, this crunch will begin to generate big social, political and economic disruptions.

Fiscal Policy

The fiscal outlook is grim indeed. Fiscal discipline in Washington has collapsed utterly under the weight of partisan politics. Even worse, some key Republicans have adopted a strategy called “starve the beast,” the object of which is to deliberately create extreme deficits which will necessitate a rollback of social spending. Facing a declared deficit for ’04 of $500 billion, an all-time record, which is understated by at least $150 billion, not including additional proposed tax cuts and lord only knows what else is being spent “off budget,” our leaders are gearing up to pass the “mother of all entitlements,” a new Medicare prescription drug benefit, which will add another $40-50 billion or so a year on to the deficit. That’s just for starters. As everyone in Washington knows, once an entitlement is created it takes on its own life. This one has the potential to dwarf all other entitlements and totally swamp the budget. The salient point here is that both the House and Senate versions of this bill pointedly avoid any mechanism to pay for this benefit. Just like the Iraq war ($160+ billion and counting – all borrowed money) it is simply going to be added on to the current ocean of red ink.

The spin out of the White House is that we can beat deflation and grow the economy by flooding the economy with money, keeping interest rates below their natural level (thus cannibalizing future sales), running record deficits for the foreseeable future (deficits don’t matter) and devaluing the dollar (while posturing for a strong dollar). Well, maybe; maybe not. When you put a strategy in play that is going to hurt a lot of people, the laws of action and reaction and unintended consequences become activated. For example, foreign governments now purchase approximately half of U.S. Treasury bonds. Will they continue to buy these depreciating assets, or will they at some point decide that financing our debt so they can continue to sell things to us is no longer worth the cost?

Another consideration is: are people actually doing something constructive with all the money that’s floating around, or is it just causing a series of bubbles and unsustainable debt? I say the latter, but either way our leaders are destabilizing the system with their machinations and we will end up in the same place. If reckless efforts to reflate don’t work, we will sink under the weight of the massive debt when the next recession arrives. If it does work, can it be controlled? With the partisan competition to buy votes and implement policy fantasies regardless of cost we could end up with a $50 loaf of bread – we can call it a Weimar loaf. We can say that we whipped deflation, but we’ll wish we hadn’t. Like a drug addict, we are violating every principle we know to be right and true, delaying the inevitable, squandering our inheritance, and impoverishing ourselves and our heirs in the process.

Geopolitics

On the world scene we have gotten ourselves into big trouble. Our peerless military is stretched thin around the world and the troops are not happy. Don Rumsfeld continues to insist that everything is under control in Iraq and that more troops are not necessary, even as more reserves are called up (for those of us who were around in the ’60’s all this sounds very familiar). The Bush Administration continues to play hardball with the rest of the world over the World Court, global warming and a wide range of trade and other issues, thereby continuing to alienate those we are asking to help us out in Iraq and in the war on terror. Not surprisingly the rest of the world is becoming less and less interested in helping us with our problems.

The Iraq situation is threatening to turn into a fiscal and political swamp. Jihadis from around the world are flocking to Iraq like moths to the flame to meet the Great Satan and die in glory. Unless we find a way to offload this fiasco onto the U.N. we are going to bleed both fiscally and literally for many years in Iraq. Wherever he is, Osama bin Laden must be a very happy man. We have given him everything he could have hoped for. We are out of Saudi Arabia, his number one goal, and we have made Iraq the rallying point and the central event in the global guerilla war pitting Islam against the West.

Last week, after our prior insults to “old Europe” and the “irrelevant” U.N., President Bush returned to the U.N., hat in hand to plead for help in Iraq. France is preparing a sumptuous dish of crow for the Bush folk to eat. Will they eat it? Not likely but stay tuned and find out after this message from our sponsor…Halliburton. This is like a soap opera. Dallas goes global. If the consequences were not so serious it would be great entertainment.

Meanwhile Treasury Secretary Snow, in an effort to deal with our out-of-control trade deficit, has been conducting a campaign to pressure the Chinese and Japanese to revalue their currencies. Never mind that it is the Chinese and Japanese who are purchasing the bulk of our Treasury obligations, enabling us to continue to run our huge budget deficits. If they revalue and stop purchasing our debt, interest rates will soar.

Also on the global front, the trade liberalization juggernaut is losing steam and protectionist sentiments are rising. At the WTO the Group of 21, composed of developing nations, walked out of the recent round of talks over the issue of agricultural subsidies in the developed nations. In Washington, three Southern Senators have sponsored a bill to add a 27% tax onto Chinese imports until China floats its currency. This bill is not likely to pass but it shows you which way the wind is blowing. Democrats are trying to make “unfair” trade a campaign issue.

Summary

Economic growth and thus continued corporate earnings growth are facing strong headwinds. Job formation will remain anemic and a real economic recovery cannot be sustained without robust job creation. Fiscal insanity in Washington is threatening to kill the golden goose, and increasing geopolitical instability is a constant background threat. Extreme political polarization is making it difficult to find balanced solutions to these and many other issues.

Investment strategy should remain conservative and primarily defensive. Market neutral strategies provide the best risk adjusted opportunities at this time. Also, cash is good, gold is good on pullbacks, and foreign currencies are good, especially Far Eastern currencies.

Since there is a great deal of political commentary in this letter, I would like to remind my readers that the purpose of the Risk & Opportunity newsletter is to consider systemic and structural issues, including social and political as well as economic issues from the perspective of their impact on markets and investments. It is my opinion that much of the risk in the marketplace is being politically driven at this time.

That said, the purpose of this letter is to take a fresh look at the universe of market risk in the shadow of war, to review prospects for various investment categories and to suggest some strategies for the intermediate term.

Overview

This has been an especially difficult letter to write due to the turmoil and emotion surrounding the impending war. On the one hand, looking at the charts, the market is weak but it wants to rally. We are certainly due. And there are some fundamental reasons to think that we should get a rally. Foremost is the enormous stimulus of the last two years that has not yet borne fruit. On the other hand there are some very big negatives, including the fact that the enormous stimulus has not borne fruit. Fed Chairman Alan Greenspan, in his recent testimony to Congress, repeatedly emphasized his opinion that the major drag on the economy is coming from geopolitical concerns, and that he expects things to improve as soon as the situation in Iraq is resolved.

The obvious big issues weighing on the market are the war, potential terrorism and the anemic performance of the economy. The media are pounding away on these themes. But behind these obvious concerns I believe there is a growing sense of alarm over the high-risk behavior of the Bush administration. The persistent belligerent rhetoric and aggression on all fronts, domestic and international, is creating widespread anxiety over the stability of the world order, the economy and even over the constitutional foundations of our society. The markets hate uncertainty, especially when it relates to such fundamentals.

President Bush is dominating the political landscape and it has become quite clear that our President is a gambling man, and he’s no ordinary gambler; he’s a high roller. In the words of Business Week’s editorial staff, 2/17 edition, “President George W. Bush is throwing the dice in a flurry of audacious economic plans that promise to greatly stimulate American growth – or bust the budget and the economy with it.” The Economist takes a similar stand in its 2/1 review of the State of the Union address, “Caution to the Winds.” The article’s lead states “The President’s address shows him to be a risk-taker on a grand scale.”

On the international scene aggressive U.S. action is causing alarm in enemies and allies alike, and catalyzing a global realignment that could end up leaving us the odd man out. Who would have imagined that Russia, China, France and Germany would stand shoulder to shoulder against the U.S. on any issue? Yet this is case on Iraq and it is entirely our doing. France, Russia and China in particular, sensing opportunity, are positioning to displace American hegemony in Europe, the Asia and the Far East respectively should we stumble.

The biggest risk embodied in this administration, however, may not be in any one crisis that it is managing (or creating), but in the aggregate. A recent survey of White House staffers from past administrations from both parties found unanimous concern that the Bush administration is trying to do too much at once. There was general agreement that any administration can manage well only one crisis at a time. This administration is trying to enforce its will on the whole world at once. Despite broad-based opposition it is pressing its agenda on Iraq, trying to contain Korea, Israel/Palestine, Afghanistan and India/Pakistan, manage the global war on terrorism and the sick economy; plus it is trying to ram an array of controversial domestic policies and right wing judges through Congress, all at the same time. With so many balls in the air at once, the concern is that one of these balls is likely to fall, and once one falls the whole lot of them could come down. Given the high stakes the consequences could be catastrophic.

Hubris is defined as “exaggerated pride or self-confidence often resulting in retribution.” Those affected by it are convinced that they can do no wrong. Critics are dismissed out of hand. Risk is ignored, no matter how great. Negative consequences are denied. Sound familiar? “Hubris is not corrected by 20%.” Hubris is corrected by disaster. The movie “Ran” is instructive.

The War

The atmosphere around this war is much heavier than Desert Storm, Yugoslavia or Afghanistan. The world is becoming deeply polarized over this war and regardless of the immediate outcome that polarization is not a welcome development. Polls consistently show that the majority of Americans are opposed to unilateral action in Iraq, and despite a fair showing of foreign government support, the people of the world are overwhelmingly opposed to this war. Anti-Americanism is rising steadily around the world.

The U.N. could well become history over this war, and even NATO is being sorely stressed. We are alienating our allies at a time when they are desperately needed for the very real “war on terrorism.” In my efforts to understand how America is seen abroad I came across a remarkable piece of journalism in the 2/16 New York Times, “Looking at the Enemy as a Liberator,” by John Burns, in which he discovers that Iraqi refugees desperately want Saddam dead and are enthusiastic for the war, but at the same time they see the U.S. as a “greedy, menacing imperial power.” Also, a recent poll in England, our strongest ally, found that the British feel the most dangerous country in the world is not Iraq or Korea, but the United States. Food for thought.

Our relations with the rest of the world do not exist in isolation from commerce and investment opportunity. Trade relations are built on, and create, shared interests and trust. If we manage to make the whole world mistrust us, even our strongest allies, then our trade relations will suffer. The administration counters that being seen as a bully is the price of leadership. This is an unfortunate and short-sighted attitude.

If things go well in Iraq the administration will be vindicated and much of the damage done to relationships will be temporarily repaired, especially if we can demonstrate hard proof of nasty WMD enterprises in Iraq. However, given the administration’s determination to punish “evildoers,” both domestically (John Ashcroft recently ordered U.S. Attorneys to seek more death penalties) and globally, it is hard to see the end of militarism and war, and the resultant strain on international relations. We currently have Special Forces in 35 countries. And those are just the ones we know about.

There is little doubt about the final outcome of the war, but at what price? We could get lucky and be greeted at the gates of Baghdad by Saddam’s generals carrying his head. On the other hand, if they hunker down for a bloody street by street, house by house battle, will we pound Baghdad into rubble? If Saddam gasses our troops will we use nukes? There has been a lot of loose talk in Washington about using tactical nukes and the administration refuses to rule out that possibility. I can’t think of any one act that would be more destabilizing to world peace or more damaging to the world economy. (See Nicholas Kristof’s 2/14 column “Flirting With Disaster.”)

And regardless of any past enmity between Saddam and Muslim terrorist groups such as Al Queda, the insistence on war by the U.S. gives them both reason to overlook their hatred for each other and work together. (The enemy of my enemy is my friend.) This could give the terrorists of the world a big boost in resources and capability.

There are a few ways in which this war and its aftermath can go smoothly and many ways that it can go badly. There is little doubt that the Bush folk have good intentions and have a vision of a vastly improved situation in the Middle East as a result of this war, but there is clearly a large element of denial about possible negative outcomes. Good intentions notwithstanding, I find the thought regularly floating through my mind that the road to hell is paved with good intentions.

Also, let’s think for a moment about how we are paying for all of this. This military action and subsequent occupation will cost hundreds of billions of dollars that are not accounted for in already dismal budget projections. Unlike Desert Storm we are on our own on this one.

Economic Crosscurrents

War, record fiscal stimulus, deflation, low-low interest rates, overvalued stocks, earnings growth, job losses, housing strength, stratospheric oil prices. Are you dizzy yet?

I have been reading the economic numbers. For the most part they are pointing to recovery and a positive stock market. Record stimulus over the past two years is providing plenty of fuel for growth. Rates are low and will remain low. A falling dollar is improving exports and pricing power. Corporate profits are turning around. (Let’s not talk about AOL.) The consumer is still hanging in there. Housing is still strong. Job and unemployment numbers appear to be improving somewhat. The biggies on the negative side are deflationary pressures, oil prices and global instability. Assuming the latter concern eases soon, the consensus is that we will soon see a surge in economic activity.

Regardless of the numbers, however, the job situation is pretty grim. Recently, Chicago experienced a scene right out of the depression. An area of town became gridlocked one morning for no apparent reason. It turned out a rumor was circulating that a large corporation was interviewing for jobs at a local community college and thousands converged on the location. The rumor was false.

Also on the job front, due to the relentless ongoing impact of globalization, white collar jobs are now following manufacturing jobs overseas. So even if we do get something of a real recovery, future job prospects are not looking so great unless you are interested in the military. (See Business Week’s 2/3 edition “Is Your Job Next?”) I have a simple question to ask the economists. How can you have a recovery without jobs?

Economic Policy???

America long ago jettisoned fiscal prudence as a guiding principal. For the most part it is no longer even talked about seriously among policymakers. Happy talk and fraudulent projections seem to pass for fiscal responsibility these days and the debate is all about whether we should be using fiscal or monetary stimulus. A few scattered diehards have expressed alarm about the skyrocketing deficit and the irresponsibility of enacting tax cuts at the same time we are opening the spigots for war. (Does anyone remember Lyndon Johnson?) But they are all on the happy juice in Washington and they are gambling that growth from the record stimulus will inflate away the deficit — in a controlled fashion of course. (Let’s not talk about the destruction of values and the devastating consequences to our growing legions on fixed income.) If recent history is any guide, President Bush will get his way and we will be in for lots of fiscal stimulus and big deficits.

If you want to gain an understanding of what the Bush fiscal proposals really mean over the long term, I strongly recommend Paul Krugman’s 2/14 open letter to Alan Greenspan, “On the Second Day, Atlas Waffled.” The operative phrase in this piece is “…past the point of no return.” Also, for an excellent review on why the Administration’s economic plan is not going to get the desired results in the short term either, read “An Economic Plan That Cancels Itself” by Maya MacGuineas. Also, see Business Week’s 2/17 edition , “The Growth Gamble.”

But there is even more (or should I say less) to the Bush economic plan than that. In one of the more stunning and discouraging political developments of my lifetime, conservative House Republicans, who have long been the stalwarts of fiscal responsibility, have adopted a strategy of pushing up the deficit as a way to limit government spending. Sound insane? Probably because it is. (See David Firestone’s 2/11 column, “Conservatives Now See Deficits as a Tool to Fight Spending.”) This is a “scorched earth” policy for which we are all going to pay dearly. If this kind of thinking carries the day, I predict that we will very soon see trillion dollar declared deficits. If that happens the dollar will collapse, which will cause wholesale dumping of dollar denominated assets including treasuries, which will cause a huge run-up in rates, which will cause an economic collapse and all that goes with it. The consequences of decades of fiscal irresponsibility are getting ready to come home and roost.

Fortunately Greenspan threw some cold water on the “deficits don’t matter” crowd by insisting that deficits do matter, but it looks like his job may be on the line for his intransigence. We will likely soon have a new Fed chairman who is more malleable.

Opportunities

We remain in a primary bear market, and will be in one for years to come. Therefore, the number one investment concern should be preservation of capital. However, there are significant rallies in bear markets and from the looks of things there is a strong probability that we will see a rally once the Iraq situation is resolved. There is a mountain of cash with no place to go and a general consensus that the commencement of hostilities or shortly thereafter will be a good time to buy. If this opportunity materializes, it should be seen as a trading turn, not a long term hold. Participants should identify their profit targets and be disciplined about taking profits. Also, considering the high level of geopolitical risk, any commitments to stocks should be hedged.

Bonds are not advised right now. In fact they might be a very good short. Muni bonds in particular are a very high risk item. Municipalities across the country are having big budget problems. There will soon be a flood of offerings, increasing defaults and steadily rising rates. Real estate is also about as highly valued as it can get in this cycle. I hear from my real estate friends that it’s a great market, if you can find any deals. They’re not finding any. Gold, which has been an excellent hedge in this depressed market is currently overbought and in need of a correction. Ditto the Euro. Gold and the Euro should be considered for purchase on corrections.

In my opinion the investment strategy that holds the greatest promise for the next 10 years or so is a general category of managed investment called “absolute return strategies.” These are strategies that are deployed in many different asset categories and are designed to generate returns in all market conditions. For the most part these are hedge fund strategies that are not available to average investors. But there are some new products being developed for the general public that offer many of the advantages of absolute return strategies, such as PIMCO’s new All Asset Fund. Qualified investors who would like more detail on available opportunities should contact Cuddehe Capital Management. Contact info is on the Risk & Opportunity website.

Summary

Entropy is increasing. The aggressive behavior of the Bush administration is creating anxiety domestically and turmoil internationally, and with the presidential campaign season gearing up soon, we can expect that turmoil to start manifesting domestically as well. This is not an environment that will foster a booming economy or a bull market in anything other than perhaps gold.

The general feeling in the marketplace is heavy. Despite all the analytical talk that goes on about markets, they are really all about emotion. People buy because they are optimistic and sell (or refrain from buying) because they are pessimistic or fearful. All the analytical stuff is what people use to justify their feelings. The economists are all noting the improving numbers and looking (hopefully) for an upturn in the market once the Iraq situation is stabilized, and considering that there is a mountain of cash out there not earning anything there is a good prospect of a rally. This, however, will not be a rally to buy and hold.

I still expect the “presidential cycle” to take hold and that markets will be generally sideways to higher over the next two years as the forces of deflation and efforts to stimulate battle it out. The economy may strengthen somewhat and earnings improve due to the huge stimulus that has been pumped in and likely more on the way, and the falling dollar, but the good jobs are going to be hard to find because they are going overseas. All of this is assuming that things in Iraq go reasonably well; that global terrorism doesn’t spiral out of control; no nukes, no dirty bombs; that Korea can be pacified; that India and Pakistan don’t get into it; that Israel and Palestine don’t blow up; that there are no mysterious epidemics. In other words, there is a lot of geopolitical risk. If the world doesn’t explode into an orgy of violence, we should be able to stabilize until the next election.

Policy makers in the West, particularly in the U.S., no longer think of their constituents as “citizens.” Rather they are “consumers.” This point was imbedded in my consciousness in the days immediately after 9/11 when President Bush’s advice to the people of New York was to “get out there and shop.” Of course the intent was to not let the terrorists disrupt our lives, but the emphasis on shopping as the appropriate response to such a heinous act reveals the underlying vision of what people are and what their function is in society. And herein lies a central issue that I see nowhere on the policy radar or in the public debate. Economic considerations have become the all and everything for politicians and policymakers. (“It’s the economy, stupid.”) Furthermore, the prevailing economic mindset is grounded in a machine model of society which considers people to be “consumers” and utilizes any and every method to prod, manipulate and stimulate consumers to consume and thereby “grow” the economy with disregard, even contemptuous disregard, for community, philosophy, values, culture, environment, morality and religion. Indeed, it is canon in the WTO that these higher values are impediments to economic liberalization and to the realization of a global marketplace, and therefore to be overcome by “science based” considerations and rules. Notions of what passes for “science based” in the WTO are defined and interpreted by corporate lawyers and economists according to the agendas of their corporate constituents and have little to do with the philosophy of science, which is a discipline for discovering truth. “Corporate science” is the term that has been coined for these exercises in propaganda and policy manipulation. For an excellent review of the problems with the WTO and globalization, and potential solutions, see Tina Rosenberg’s article, “The Free Trade Fix” in the August 18^th edition of The New York Times Magazine.

The fundamental problem with the machine model of society is that people are not consumption machines, although we have seen that they can be fooled for quite a long time on this issue. People are human “beings.” They do have legitimate economic needs and desires and will respond to economic stimuli, sometimes even to their own detriment, but they also have personal, social and spiritual needs that reach far beyond the economic sphere. In recent decades, especially during the 90’s, global fiscal and monetary manipulations and a compliant, cheerleading, sensationalist corporate press created an illusion of vastly expanding and easily obtained riches for everyone, whereas the reality is that even in America the average working person has been losing ground for the past 30 years. The relentless drumbeat of economic utopia entranced virtually all of humanity, causing rich and poor, elite and the masses alike to forsake a balanced, community based, spiritually grounded and morally healthy life in order to pursue “easy” riches, simultaneously generating great frustration and even murderous rage in those left out. The resulting every-man-for-himself, get-all-you-can-get, gold rush mentality generated unparalleled excesses. (See Extraordinary Popular Delusions and the Madness of Crowds by Charles MacKay.) As the crowning example of historic excess, the specter of corporate chieftains being paid tens and even hundreds of millions in bonuses, forgiven loans and severance after they have devastated the corporations under their command, and having the gall to actually accept the money, is enough to turn the stomach of any honest person, and to create rage among those whose livelihoods were terminated and retirements ruined by these gilded criminals.

So what does all of this have to do with investments? Well, unfortunately, everything. The success or failure of any investment strategy is dependent on markets, and markets are manifestations of collective psychology. The central point of this piece is that recent decades have seen the manipulation of collective psychology to a fever pitch of enthusiasm for easy riches, resulting is historic distortions and excesses in every sector of the economy as well as in fiscal policy (fantasy budget projections), monetary policy (unsustainable expansion of money and credit), corporate valuations (way down and still grossly overvalued), corporate governance (nonexistent), accounting standards (fraudulent), elite values (corrupted) etc, etc. But now the bubble has burst.

The daily revelations of criminal behavior, betrayals of public trust and moral depravity among the leaders of economic utopia, including our President and Vice-President; the seemingly endless bankruptcy, restructuring and layoff announcements, and the destruction of investment portfolios and pension assets are taking their toll. The elite are beginning to express their concern over the failure of the economy to respond to stimuli (tax cut and unprecedented easing of interest rates), and the rank and file are realizing that they have been suckered. The consequnces to collective psychology are discouragement, mistrust and depression. There will be lots of ups and downs along the way but the correction of past excesses is not going to be accomplished by a few hastily passed “reform” measures and the jailing of a few criminal executives. Like withdrawal from a drug addiction, it is going to be a long and difficult process and will not be over until we have been sufficiently humbled to honestly confront the issues that got us here. We’ll know we are close when the collective assumption is that we will never recover.

When I think about how we got to our current situation I am reminded of the wisdom of the great William Shakespeare, “Oh, what tangled web we weave, when first we practice to deceive.” Policy makers on both sides of the aisle have been complicit in a decades-long deception and manipulation which has seen the deliberate destruction of value and savings through a policy of “controlled inflation.” This policy has turned “citizens” into “consumers,” and in the process impoverished pensioners and others on fixed incomes, effecting a gradual and massive shift of wealth from the working and middle classes to the very rich.

It has been clear for quite some time that the driver of the current phase of economic “expansion” is the consumer. We have global overcapacity in every other sector and as the developing world brings on ever more capacity and as technology increasingly infiltrates every sector, this overcapacity is only going to increase. So the hopes of continued expansion lie with the consumer. But what is happening to the consumer? As we have seen above, the consumer is getting hammered. Many are losing their jobs, their retirements and their trust, and those who haven’t lost these things are experiencing growing anxiety about them. The cost of living, particularly housing, is crushing many and the stress of keeping up is taking its toll on almost everyone. New York City had all-time record family homeless before 9/11. Now the city is overwhelmed with homeless families and has started to house these unfortunates in a former jail that was no longer deemed fit for inmates. See “Jail Reopens as a Shelter for Families,” NY Times, August 12th, 2002. I personally know two families anchored by honest, hard working parents that, for various reasons, cannot afford the high cost of housing and have been itinerant (read “homeless”) for over a year. In my entire 54 years I have never known a working family that couldn’t afford a place to live, until now.

The recent strength of the consumer as an economic force has been largely driven by the downward manipulation of mortgage rates and the massive extension of easy credit. This phenomenon is reaching the end of its run, and even now, despite continued easing of rates and endless creative financing schemes, including “interest only” mortgages, home sales have been falling off. The huge move into housing by marginal buyers and refinancing, often for 100% or more of market value, at the top of the cycle is going to result in a wave of defaults, personal bankruptcies, bank failures and big losses for Agency bondholders and other mortgage investors. The prevailing wisdom, perhaps better called faith, is that the government will bail out any problems in the Agencies. The vast majority of mortgage investors, including banks, insurance companies and even most hedge funds, do not hedge their investments in Agency bonds, relying on the “implicit” government guarantee to bail them out if there is trouble. Perhaps they will be lucky, but as I see it this is nothing less than gambling. If, in a crisis, the government has to choose between defending the dollar and Treasury-direct obligations or supporting Agency paper there is no question that the Agencies are going to be left to fend for themselves. For further reading on this issue see “No Shelter,” by Newsday columnist James Pinkerton and “Mortgage Myopia” in the July 20^th issue of The Economist.

It is my contention that on a financial as well as psychological basis, we have reached a point of “consumption exhaustion.” On every level, personal, corporate and government, the U.S. is deep in debt. We are simply too overextended and the problem areas are stacking up. People in general have run themselves to ground in an effort to stay on the economic utopia merry-go-round and the last wave of buyers has hopped on in the housing bubble. But increasingly people are falling off, being left behind, and/or seeing the handwriting on the wall. The party is over and they didn’t get in, or else they got in for awhile and subsequently lost all their gains in the stock market sell-off. Now what are they going to do?

Just this week I saw the first of what I expect will be many articles, books and debates that look into the relationship of materialism and happiness. The conclusion by economist John Easterlin from USC – we don’t get happier as our wealth increases and our possessions grow. Not that economic wellbeing doesn’t factor into happiness, but our wants keep expanding along with increasing means so we tend not to experience greater happiness with the expansion of wealth and possessions. A review of Easterlin’s paper, “Why Rising Incomes Make Us No Happier” can be found on the Royal Economic Society website.

According to the RES reviewer, Easterlin opines that we might begin to look more seriously at alternatives to the pursuit of ever more material consumption, “perhaps to enjoy family, friends, and relatives; to get to know our neighbors; to participate in community, national and international affairs; to engage in music and the arts, philosophical contemplation or religious pursuits; to pursue athletic activities; to develop our learning through continuing education; or simply to commune with nature. Whether these things would make us happier is not sure, but it does seem that they would make for a fuller, better-rounded and more meaningful life for most of us.” For those interested in looking deeper into this issue, Easterlin’s paper, “Income and Happiness: Towards a Unified Theory” is published in the July 2001 issue of Economic Journal. Also, there is a new release entitled The High Price of Materialism by Tim Kasser.

As this theme gets more airtime I predict that we will see the development of a trend away from materialism and eventually a tidal shift in the attitudes and aspirations of the masses toward endless consumption. The continuous strain to keep up the payments on ever more, bigger and better possessions will increasingly be seen as futile and growing numbers will give up on it. Awareness will start to dawn, as it already is, that there are other things in life worth pursuing. Family, community and spiritual needs that have long been neglected will become increasingly attractive as the illusion of economic utopia fades. Pressure will build for more balanced, people-friendly and sustainable ways of living. “Consumers” will gradually be transformed back into “citizens.” Grass roots political activity will soar and this activity will likely not be centrist. Under pressure from hard times it will likely swing hard to the left, although there is the danger that demagogues will seize the opportunity and cause a swing hard right. Ironically, as the surge of corporate bankruptcies grows into a tidal wave and individual investors and pension plans take huge losses on their stock and bond holdings, consumers simultaneously forced into bankruptcy will be greeted by new laws, courtesy of the banking and credit card lobby, making it much more difficult for them to escape their obligations to these same corporations that have defaulted on their obligations. Historically this will probably be seen as the high water mark of corruption in America, and it will surely be a rallying point for public outrage and big political changes.

In light of the above it is my opinion that deflation is inevitable and that falling housing prices will likely be the final blow that brings it on, possibly triggered by war with Iraq or other geopolitical disruptions or terrorist activities, economic contagion from the Far East or South America, or simply by the sheer weight of aggregate debt. Of course deflation and all the fallout that will come with it is not going to happen overnight. In particular the Fed and the Administration will do everything in their power to forestall any disruptions to the economy going into the 2004 presidential election. Whether they have enough ammunition to hold back the tide that long remains to be seen. There will be many twists and turns along the way, most of them unpredictable. But it is coming.

Until the last month or two the long held mainstream consensus opinion was that deflation is simply not possible in the U.S. But just last week the venerable Bank Credit Analyst began to sound the alarm on deflation. The BCA calls for relaxing economic policies if economic activity slows further, noting that “inflation is now close to zero in the U.S. and Europe and it is worrisome that the global economy is showing signs of stumbling, undermined by the excesses of the late 1990’s and the resulting meltdown in equity and corporate bond prices.”

Following is a summary of what deflation really means, particularly for a leveraged economy, company or investor, and what might trigger it, also from the Bank Credit Analyst: “Deflation becomes a dangerous force when it undermines the ability of individuals and companies to service their debt. Deflation can cause declines in nominal incomes and in asset prices, but the nominal value of debt does not change. This may result in forced selling of assets in order to make debt payments, unleashing a vicious spiral of falling incomes, imploding asset prices and even greater real debt burdens…Debt deflationary dynamics could perhaps unfold even if aggregate price levels did not decline. For example, a major drop in house prices could be the trigger (italics mine) for serious problems given that home mortgages accounted for almost three-quarters of the increase in household sector debt during the past five years. A broad-based fall in home prices would be a more potent force than lower equity prices in terms of undermining consumer balance sheets.”

The BCA goes on to say that Fed policy has been correct to date and calls for continued easing if economic activity continues to slow. Let’s hope that we can “muddle through” (the current buzzword) but the Fed will soon run out of interest rate bullets leaving the printing of money as its remaining weapon, which in the long run will create even more problems and won’t alter the final outcome. We would be far better off to bite the bullet, manage the inevitable write-down and start over than to resort to desperate measures. But modern politicians are not known for holding to the high road regardless of personal cost. One should never underestimate the capabilities of Washington policymakers for manipulating, masking and delaying the inevitable. And we should not completely write off the possibility of political heroism, but I suspect that when deflation starts taking hold we will see some unwise policy decisions that will bring unfortunate consequences.

Governments on all levels are already under tremendous financial pressure so I wouldn’t expect much support from government as the crisis grows. The projected surpluses from the 90’s bubble have vaporized and deficits are soaring. The federal government reported a $127 billion surplus for fiscal 2001 but this is a number that could only come from Washington (or I suppose from any number of large corporations). According to Michael Granoff and Stephen Zeff, “Fiscal Shell Games, Government Style,” Los Angeles Times, August 18, 2002, if unfunded pension liabilities and related benefits are factored in, the federal government actually ran a $515 billion deficit for 2001 – a $650 billion claimed/reality spread! If this is not fraud, what is? Also, reflecting the fiscal strain on the state and local levels, defaults are on the rise in the Muni marketplace. See “So You Think Munis Are Safe?” by Dean Foust in the August 5^th edition of Businessweek. I predict that within two years we will pass $500 billion in reported federal deficits and soon be looking back wistfully at $500 billion deficits. What will Washington be able to do under such constraints? Decades of fiscal mismanagement, monetary manipulations and financial engineering to fine tolerances have left little if any room to maneuver. Long gone are the days of keeping reserves for a rainy day. Like the Wizard of Oz our political and corporate leaders are being exposed for the frauds that they are. Once the leadership has lost the confidence of the people, due to the faith-based nature of our fractional reserve system (which isn’t even fractional any more), we are going to have to hit rock bottom and see some major political changes before confidence will be restored.

On could argue that sound policy changes could allow us to manage our way to a healthy, sustainable economy. I would agree, but the problem with this argument is that it requires leadership. We don’t have any of that. Our leaders “lead” by following the polls, manipulating the press, seeking personal and partisan advantage, and pandering to the lowest common denominator. We don’t have the kind of noble, visionary, self-sacrificing leadership that would be required to manage a challenge of this magnitude. We are going to have to go through this adjustment the hard way. In the end, if we can hold on to our basic democratic principles, we will be leaner, meaner, stronger and healthier, but it’s going to be painful in the interim, and in my opinion, we ain’t seen nothin’ yet.

For a compelling multi-faceted development of the case for deflation I strongly recommend that the reader purchase and read Robert Prechter’s recent publication Conquer the Crash. Robert Barker’s review, entitled “Lend Half an Ear to This Doomsayer,” is in the July 22^nd issue of Businessweek. One of many interesting points made in Prechter’s book is the stunningly poor track record of economists at major turning points in economic activity. Citing annual surveys conducted by the Wall Street Journal he notes that 52 of 54 economists were bullish for 2000, 53 of 54 bullish for 2001 and a unanimous 55 of 55 bullish for 2002. Remarkable consistency. I would keep an eye on this group. When you see 55 thumbs down on the economy, it’s time to buy.

Note: Where possible links have been provided to articles referenced. If no link is provided, the article is not readily available in electronic format or must be purchased to be viewed. In the case of books the link provided is to Barnes and Noble.

Copyright 2002 Cuddehe Capital Management, Inc.