Q3 ’03:   The Twilight Zone

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.

Q2 ’03:   More of the Same

The purpose of this quarter’s letter is to review the overall market situation and recap risk parameters.

Overview

While clearly a lot has happened in the last three months, things don’t feel much different. The stock market jumped the gun on the Iraq war, beginning its expected rally two weeks before the onset of hostilities. But the rally has been sluggish, taking out the December ’02 highs only just this week. The economic crosscurrents highlighted in the last letter remain and are worse, if anything. On the stimulus side, President Bush and a compliant Congress continue to roll the dice by throwing trillions in tax cuts at the sagging economy, the dollar is down 25% against the Euro (10% trade weighted), and interest rates have hit all-time lows. Still the economy is teetering on the brink of deflation. The result of this massive and unprecedented stimulus is that so far we have seen some improvement in corporate earnings, but those improvements have come mainly at the cost of jobs. The housing sector remains strong but business investment is not picking up. The job situation remains dismal with no indication that it is going to improve any time soon. New jobless claims have been over 400,000 for 15 consecutive weeks and the U.S. has lost over 2 million jobs in the past two years. A variety of deflationary influences (e.g. overcapacity, China) continue to make their influence felt. The Fed has announced its determination to do anything and everything to hold off deflation. Will they succeed? Only time will tell.

International relations have only marginally improved since the war. Trade relations with any country that didn’t support the war (most countries) are tense. The situation in Iraq remains volatile, with Iraqis and U.S. soldiers still being killed almost daily. Lawlessness, Iraqi resentment and the absence of discovery of WMDs are threatening to turn the military victory into a major embarrassment. Volatile seems to be the key word on the international scene, with both hopeful and troubling signs manifesting almost daily. The Administration continues to juggle a huge number of difficult issues both internationally and domestically. President Bush is currently on a European tour to try to shore up troubled relations with our allies there and will soon meet with the major players in the Mideast. Let’s wish him luck.

The stock market is reflecting these crosscurrents. The rally has been sluggish but there is not much enthusiasm for selling either. Technical indicators have gotten as confusing as the economic indicators. Most technical indicators have been overbought for weeks and advisor sentiment (a contrary indicator) is as bullish as it was at the 2000 market top, while price has only just taken out the December high – a bearish divergence. But at the same time market internals show a healthy demand for stock and a steady decline of selling pressure since the October ’02 lows — bullish. Wave analysts are looking for either a new bear market low or a sharp bear market rally followed by a new low. I have read equally impassioned predictions of Dow 6,000 and 12,000 over the last few weeks. Barring some major unexpected event, the market doesn’t appear ready to resolve in a big way any time soon, although it does seem clear that any upside is limited from here.

Risk

The prevailing mood has become rather bullish, and talk of risk concerns seems incongruent with the mood and action of the market. Even consumers, while acknowledging that things are not so good now, are quite bullish looking six months out. But it is my experience that whenever I allow myself to be lulled into complacency, I get whacked, and that is what I believe the market is setting us up for. So, while the intermediate trend is clearly up, and we could have a sharp rally at any time, it is good to remember that we are in a major bear market that is not complete by a long shot. Value investors continue to point out that stocks are still overvalued by 30-50%. So enjoy the rally but don’t be fooled into thinking that a rally equals a bull market.

In the time-honored Washington tradition, the Bush folk are pulling out all the stops to buy votes in 2004. If recent history is any guide, they will be successful. We already have more debt than will ever be repaid. Eventually the market will begin to discount that reality. Meanwhile the current account deficit is running $1 million a minute. Last year it was over $500 billion. This is the real deficit. This is money that the rest of the world is giving us to finance our economy so they can sell things to us. With the latest tax cut, could it reach $750 billion this year?

The fiscal irresponsibility being embraced by Washington is truly shameful and is going to have severe consequences at some point. Presently I would expect these consequences to play out after the ’04 election, but make no mistake, the wildly irresponsible tax cuts are setting up the conditions for an economic “perfect storm.” Some say that the Administration wants to create a fiscal crisis in order to gut entitlement programs, such as Medicare, Medicaid and Social Security. This suggestion sounds outrageous but may not be so far off the mark. The Administration recently shelved a Treasury report projecting that the U.S. faces a future of chronic deficits totaling at least $44 trillion. The study’s chief conclusion is that sharp and permanent tax increases or massive spending cuts – or a combination of both – are unavoidable if the US is to meet the healthcare and retirement benefits promised to future generations. Even the Democrats don’t want to deal with this hot potato. So with Democrat complicity, the Administration gave this report the deep six, dismissing it as a “thought-piece” designed to stimulate discussion.

As the Financial Times put it, “The lunatics are now in charge of the asylum.”

Opportunities

Outside of the occasional isolated situation, there are no outstanding near term opportunities in the U.S. right now. For longer term ideas, see the Q4 ’02 letter, “The Big Picture.” Gold should be bought on corrections. Far Eastern currencies are undervalued by about 15-30% against the dollar but will not likely see much movement until the Chinese float the renminbi. This is a good long term play. The wild card here is the Korean situation, and the uncertainty of when the Chinese might float their currency. It could be a long wait. Otherwise, stick with absolute return strategies.

Summary

With all the crosscurrents, stocks are likely to continue in a trading range with a slight upside bias until the election. There is the likelihood of the occasional sharp, short term move in either direction. The weak dollar is likely to find some equilibrium soon. An all out collapse is not likely at this point, but neither is a big rally. The Administration likes the weak dollar, and finally fessed up to that fact recently. Interest rates could drift marginally lower, but are about as low as they can go. Again, however, don’t expect a big move up (any move up, really) in rates anytime soon. Fiscal and monetary manipulations should be able to hold deflationary pressures at bay at least through next year.

The main caveats here are the possibility of one or more of the world’s hot spots suddenly spinning out of control or a resurgent Al Queda throwing a wrench in the works. From all reports we haven’t heard the last from them.

Q1 ’03:   Gambling, Hubris and the Wages of War

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.

Q4 ’02:   The Big Picture

The purpose of this letter is to review the big picture in terms of risk and take an initial look at some developing areas in terms of long term opportunity.

Risk Overview

In the short and intermediate term it appears that markets have settled down and that we may have some stability for a period of time. Rates are low and likely to stay low for quite a while. Also, it is very likely that the “presidential cycle” will take hold and the stock market will be sideways to higher for the next two years. We could even see some dramatic rallies. But risk remains high. Many excesses remain in the marketplace: the housing bubble, massive debt, deflationary pressure, overcapacity to name a few. The biggest wild card at this time is geopolitical risk. If President Bush initiates war in Iraq, which he seems intent on, anything can happen. Administration hawks are supremely confident that American military action in Iraq will have a calming effect on the Middle East. The rest of the world is worried that war could stoke Islamic hatred of the West to the boiling point, causing the overthrow of pro-Western Arab governments, unleashing an all out war Arab war against Israel and promoting terrorism globally. We probably won’t have to wait long to see who is right. From an investment perspective, the main point here is that while there may be some trading opportunities to the upside over the next two years, we remain in a primary bear market and the risk of economic shocks remains high, with terrorism and geopolitical risks the main risk concerns at this time.

Also, the results of the recent election have the extremists in the Republican Party in a frenzy. Balanced policy making is not in the cards for the next two years. House Republicans demonstrated this in no uncertain terms in the lame duck session by sabotaging a painstakingly negotiated bankruptcy reform bill over abortion issues. A nuanced analysis of the many issues involved is beyond the scope of this piece, but the main point to be taken from this situation is that, borrowing from Nassim Taleb, “Hubris is not corrected by 20%.” Hubris is corrected by disaster. Unless victorious Republicans get a grip and discipline themselves they are likely to precipitate disaster in their blind arrogance. How and when are difficult to predict, as is the scope. In an unstable world there are so many possibilities. The big question is, will the disaster be merely a Republican Party disaster or will it be global?

Opportunities

Despite the veritable minefield of risk extant in the investment world, there are some interesting trends developing with long term investment implications. The “us vs. them” worldview that came in with the Bush administration, and which has become America’s guiding principle since 9/11, is creating an increasingly resented and isolated America. This is a major and fundamental shift with global implications. It undermines, and will eventually be the death knell of, global trade liberalization. It will probably take some years for this shift to become fully entrenched, but with war fever in Washington it could also happen quickly.

If one wants to continue to invest in the current paradigm then China is clearly in position to be the big winner over the intermediate term. If one is looking for a stable environment, New Zealand is the place to be. But if one wants to put some money into a future-oriented paradigm, then there are some interesting options right here in the USA.

Neighborhood Redevelopment

The global economy is sucking the wealth out of the working and middle classes and concentrating it in the very rich. This is not a formula for social stability. But it is a major engine of change and with change comes opportunity. The trend toward downward mobility generated by the global economy is forcing growing numbers of people to rely more on each other. Social activity and certain sectors of economic activity will become increasingly neighborhood-centric. This trend is nascent but it will accelerate dramatically with the next major downdraft in the economy. The general effect on wealth will be a net loss but there will also be winners.

Financial pressure, urban sprawl and congestion are making neighborhoods increasingly attractive. Neighborhood development and redevelopment are major opportunities, emphasizing multi-use models. (Timing is important. Too early and you will get caught when the housing bubble bursts.) Along with redevelopment there are new business models designed to serve neighborhoods and local and regional economies. Smaller is beautiful. I can’t begin to enumerate all the specific opportunities, but there are and will be many. Security of all types is and will remain a sound investment theme for the foreseeable future. Also, integration of world class learning via the Internet with the vitality of local-focused and home grown enterprise. It sounds a little third-world, but the reality is that America is going to look increasingly third-world for the working and middle classes, with gated enclaves for the rich. The action and the opportunities are going to be related to the massive shift in lifestyle for the working and middle classes.

We have come a long way down the path to the utopian vision of a world-wide marketplace dominated by large corporations. We have come far enough to see that the reality is not what the distant vision promised. (Was there ever a utopian vision that delivered on its promise?) Much, if not most, of the global strife we are experiencing can be traced back to this development. (Read False Dawn by John Gray.) There are some sectors of the economy that are suitable to the machine model of society upon which this utopian vision is built; telecom for example, and information technology. But there are others which are not amenable to that model; food and medicine for example.

Local Grown Food

The typical American diet leaves much to be desired. With our diets and pervasive pollution it is no surprise that cancer rates are skyrocketing, along with many other health problems. Fresh, organic, local grown and processed food is far more nutritious, healthful, environmentally sound and sustainable than the vastly inferior product laced with chemicals, antibiotics and hormones that our current system delivers. Nowhere is the contrast more obvious than in the horrendous practices of the meat industry. Read “An Animal’s Place” in the November 10th issue of New York Times Magazine. Sustainable agriculture offers excellent lifestyle and long term investment opportunities.

Natural Medicine

Natural medicine is another area of long term opportunity. The machine model is currently all the rage in medicine but it is increasingly clear that this model is a disastrous failure. The real opportunity in medicine is in the return to natural and preventive medicine. All medical practitioners are aware that it is not the medicine or the physician that does the healing. The body does the healing. The thrust toward increasingly mechanistic, manipulative and ridiculously expensive medical practices runs counter to what all practitioners know about real healing. Corporate medicine in America has generated the most expensive health care system in the world along with the poorest national health of any developed nation. In addition, we currently have over 40 million uninsured Americans. Even those who do have insurance find out, usually the hard way, that a long term, serious medical condition is a one way ticket to the poorhouse. Financial pressures alone are going to force a return to natural medicine. The NIH has declared a health care emergency. See “Panel, Citing Health Care Crisis, Presses Bush to Act” in the November 20th issue of the New York Times.

Alternative Energy

Despite the obstruction of the current administration, alternative energy is the future. The fossil fuel industry is a fossil, and it is using its political clout to try and stave off the inevitable. The key word here is inevitable. As Buckminster Fuller once said, “We don’t have an energy crisis, we have a creativity crisis.” I would take that one step further and say that we no longer have a creativity crisis, we have a political crisis. Despite technical feasibility, the clear preference of the people and the obvious inevitability of change, our government is doing all that it can to delay and to maintain the current system for the benefit of its patrons. It’s only a matter of time.

Summary

Systemic risk remains high with geopolitical risk the most likely trigger for crisis. Just the same, markets are getting a breather and gaining confidence. Expect rallies, possibly dramatic rallies, but don’t forget that we are in a bear market that is not finished by a long shot.

Long term, the real opportunity lies with investment in business models, methods, products and technology which support the developing trend back to a more natural and healthy lifestyle. Neighborhood redevelopment and synchronous local and regional focused business models, local grown and processed food, natural medicine and alternative energy are all areas offering long term opportunity.

Q3 ’02:   Consumption Exhaustion and The Case for Deflation

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 18th 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 20th 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 5th 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 22nd 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.

Q2 ’02:   Strategies for a Bear Market

The first phase of the bear market is over and pundits are scrambling for indications that the recession is over and recovery is underway. But the pundits, for the most part, are ignoring the obvious – there are still major distortions in most sectors of our economy that have not been corrected. Also, global trade liberalization is under serious pressure from many quarters (although globalization is not) and worse still, geopolitical events are building toward disaster.

Furthermore, the overall economic situation leaves little room for the Fed to maneuver. One can only manipulate a situation for so long before the odds catch up with you. Clearly the economic reaction to the unprecedented easing of rates is much like that of an addict that gets little satisfaction from even a massive dose of the drug. Eventually we will have to take the cure and it’s going to be rather painful. For anyone who is given to seeing what is rather than what they want to see, the investment climate remains very dicey.

So the big question is, “How can I best position myself to ride out the coming adjustments and be intact to take advantage of the outstanding opportunities that will be available once the storm is over?” There are several considerations: what to avoid, what to keep an eye on, and what to acquire, keeping in mind that there are ways not only to survive but also to prosper in a bear market.

In general, the stock market is the number one thing to avoid. Stock valuations have a long way to go to get back into realistic territory, and since the market usually overdoes things at the extremes I would expect to see an extended markdown of stock values before the end of this bear market. Final bottom? Probably far lower than would be thought credible at this point so it is best not to put a number on it. Time frame? Probably another three to five years at the minimum and possibly much longer.

The entire investment world is wedded to vastly inflated values and expectations. People will let go of these inflated expectations very slowly. This is what makes the bear extend time wise. It could all be over quickly if everyone would accept the markdown. (This is the argument that corporate economists give to labor.) Capital will eventually take the markdown but not until forced. And of course the markdown period will be accompanied by major stress all across the corporate sector; so many investment grade corporate bonds could morph into junk ala Tyco. Not that there won’t be excellent opportunities in narrow bands, time frames and special situations, but overall the corporate sector must be approached gingerly and with great skepticism. For another opinion on this matter read David Kuttner’s column “The Market Can’t Soar Above the Economy Forever” in the April 15th issue of Businessweek.

The statistics are overwhelmingly in favor of the bear for the foreseeable future. Historic norms for price-earnings ratio’s and annual returns on common stocks are 14 and 7% respectively. These are averages. Currently P/E ratio’s vary from 22 to 60 depending on whether you divide by expected or current earnings, and average stock returns since ’82 (the beginning of the bull) have been approximately 12%. Will we revert to the norm? I can’t find any reason why we shouldn’t. Even more importantly, we will likely average out to the norm, which means that the odds favor an extended period of underperformance to balance out the recent extended period of irrational exuberance. One more rather telling statistic is that corporate valuations remain at 130-140% of GDP. Historic market lows find corporate valuations at around 30% of GDP. Do you feel the chill?

Fixed income investments hold little appeal on the short end, and taking on an extended maturity is a big gamble, hardly worth the few extra points to be gained. Long maturity bonds of any type are a very high risk investment at this time and best avoided. Even medium maturities are risky. In fixed income, under three years is best for now but of course you aren’t getting much.

In the not-so-obvious category there are two major areas of concern, mostly because they are almost universally considered to be virtually risk-free and don’t get the kind of scrutiny they deserve — the muni market, especially the big municipalities, and the Agencies. For an interesting article on the Agencies, see the May 21st N.Y. Times article “Guess Who Doesn’t Back Fannie, Freddie and Farmer” by Alison Leigh Cowan.

Real estate generally has been the shining star in the investment universe recently. High quality real estate is probably one of the best places to have your money, but the smart money knows this and these deals are increasingly difficult to find. I have heard some people touting real estate as the technology of the 2000’s. I can’t buy this outlook. Once the current buying panic is over where will the exit come from? How high can we push prices? People have been buying rates, not price, and even as prices hit new highs, buying power is declining and defaults are spiking in certain sectors. This is not a healthy market. I have heard some say that we may be in for the Europeanization of real estate in the U.S. – low turnover and perpetually high prices. Perhaps, but such an outcome would mean a dramatic shift in lifestyle which is not likely to happen voluntarily. Demographics, rates and panic are pushing prices higher, especially in the Sun Belt, but historically we have never had a recession without a dramatic drop in real estate values. I would bet on history here. As I write this, high end spec projects are already feeling the downdraft and it is my contention that the middle and low end remain vulnerable to renewed recessionary pressure and to a potential blowup in the Agencies.

Things to keep an eye on are basically everything. We are in an unstable economic environment greatly complicated by an unstable geopolitical environment. If the economy goes into another swoon the Fed will be helpless to do anything about it. Another major terror hit could do it, and if Administration Pollyanna’s are to be believed such an event is a virtual certainty and could come anytime. A nuclear war between India and Pakistan or a full out war in the Middle East could also do it. Also, from a geopolitical perspective, something to keep in mind for the long term is that the Muslim world has the world’s highest percentage of young people – for the most part young people with few or no prospects. There is nothing more dangerous than young men with no prospects. Put those young men in a context of hatred and incitement to violence in the name of God and you have the makings of decades of global terrorism and warfare. The black swans (rare events) are descending upon us, and they are currently feeding upon Muslim extremism. For an in-depth discourse on the issue of black swans read “Fooled by Randomness” by Nicholas Taleb. Also, for an in-depth analysis of the economic foundations and implications of global unrest read “False Dawn” by John Gray.

Despite the many challenges of a general bear market there are a variety of ways to prosper, and it all begins with the right attitude. Realism is the desired approach, with flexibility, and a certain amount of creativity. Investors have become checklist and spreadsheet bound in recent years as quantitative thinking swept over the financial landscape like a tsunami. In the coming period we will no longer to be able to stay within the neat bounds of our spreadsheets and checklists if we hope to maneuver through the coming turbulence. It is going to take some market vision; some outward focused attention, and a certain amount of creativity and common sense in addition to the excellent quantitative tools that have become available over recent years.

What to invest in? This is a highly personal matter depending on each investor’s financial situation, background, interests, risk tolerance and other constraints. That said, high quality (preferably) unleveraged real estate and economically useful physical assets, keeping in mind that the market value of these assets could drop substantially. Also, sound basic businesses which can be leveraged up or down according to changing conditions (my favorite), the highest quality muni’s (avoid large municipalities), hedge funds – preferably well managed multi-strategy and/or multi-manager funds, select foreign (preferably cash flowing) investments, value funds, venture funds, special situations and future oriented energy and environmental projects, and of course T-bills (not Notes, Bonds or Agencies). Operative principles are active management, diversification, generally short-term or liquid commitments, generally unleveraged but with a willingness to take controlled risk and aggressive advantage of short term opportunities. This approach is admittedly a lot of work, but that is what it is going to take to survive and prosper over the next decade. The days of easy money are over. This is not the time for complacency or cookie-cutter approaches.

Q1 ’02:   Why Alternative Investments?

As anyone who has been paying attention can tell you, current opportunities in traditional investments are less than inspiring. While conditions in the near term are likely to improve somewhat over what we have seen for the last two years, that still leaves a lot to be desired. For an excellent review of the current traditional investment landscape I refer the reader to a March 17, 2002 L.A. Times article by Tom Petruno entitled Allocating Assets Gets Tougher For Investors. But this article focuses only on the surface level of current and prospective returns. What it does not delve into is the deeper political and economic trends, imbalances and excesses – the big risks – that are extant and which have direct bearing on the traditional investment arena.

The defining characteristic of all investment mediums today is pervasive risk. After an eighteen year bull market there are many excesses in the marketplace that need to be purged and an eighteen month bear market without even an “official” recession is not going to do the trick. Purification is the function of bear markets. It is a natural and necessary function and it never ceases to amaze me that this natural market cycle is looked upon with such fear and loathing. As investors we need to accept and work with the markets as they are, not as we would like them to be. We are in the early stages of a bear market that began with the dotcom sell-off. The Enron fiasco has ushered in a major round of purification, but it will not be the last. Stock market investors should beware of rosy but entirely unfounded predictions of a renewed bull market. Quoting Warren Buffet from the Berkshire Hathaway 2001 Annual Report, “Though Enron has become the symbol for shareholder abuse, there is no shortage of egregious conduct elsewhere in corporate America.” This sentiment from the dean of value investors places the rampant and unabated greed in the executive suites in focus – a fundamental excess that needs to be purged.

There are also serious problems festering in the fixed income world. The agencies are currently carrying an enormous amount of leverage — a problem that will eventually have to be dealt with and which is going to cost plenty. How will that inevitability impact real estate values, the cornerstone of the public’s economic sense of well-being? For that matter real estate values have long been out of wack with rental values and dependent on inflation to make up the difference. This imbalance will not continue forever. When and how will it be resolved? And let’s not even think about looking under the carpet in the muni marketplace. Most investors are also not paying much attention to our long-term dependence on foreign investors to fuel our capital markets, not to mention our continuing dependence on the volatile Middle East for our energy needs and our government’s steadfast refusal to take measures to correct that dependence. These are just a few of the excesses that have built up during the good times. Any and all of these imbalances could impact us at any time. If we’re lucky they will be resolved sequentially and not simultaneously.

Add to this toxic stew geopolitical instability and the fact that our current administration seems to be intent on pressing its own agenda regardless of anyone else’s interests or concerns, upending the status quo globally. Policy issues aside, when you disrupt the status quo, persistently and globally, unexpected things are going to happen. And let’s not forget the very real prospect of periodic acts of terrorism. As investors, it’s not the known risks that we have planned for that are going to hurt us, it’s the unexpected, the “rare events,” that are the real risks that we need to be prepared for. This means structuring an investment portfolio that is properly diversified and sufficiently liquid to be able to sustain repeated shocks and hopefully profit from them as marketplace excesses are corrected and geopolitical events play themselves out.

Alternative investments provide an avenue to take the best that the investment world has to offer and to simultaneously hedge against the unexpected “rare event,” which seems to be not so rare as statistical models would have us believe, especially these days. In an environment with pervasive risk throughout all sectors, a well-managed alternative investment strategy that employs aggressive risk management will provide vastly superior risk-adjusted returns over a traditional investment strategy.

Alternative investments are often painted by traditionalists as high risk strategies that are only for the most adventurous. While this characterization is true for some alternative strategies, it is a gross oversimplification and misrepresentative of the excellent risk adjusted returns available from alternative investments, which range from very tightly controlled, low volatility arbitrage strategies to more volatile directional strategies.

Furthermore, those sectors and strategies in which risk is an accepted and recognized part of the landscape have evolved systems, methods and strategies to manage that risk. Meanwhile those sectors and strategies that assume a stable underlying growth environment and which believe that they have limited risk have lagged in risk management and remain vulnerable to the so-called “rare event.”

Putting aside the issue of pervasive risk, there are other reasons to favor alternative investments. Technological advances have created new opportunities and disruption to traditional models in every field, and the investment world is no exception. Alternative investment managers have embraced the opportunities presented by technological advances to create and deploy advanced systems for market research, statistical analysis and risk management and to utilize these systems to produce superior risk-adjusted returns all along the risk/return spectrum.

Finally, the foundation of good investment management is diversification. Alternative investment strategies support the optimum application of the principle of diversification, making available a broad range of strategies and mediums that are not readily available otherwise. For a somewhat more technical but very readable explanation of the value of diversification I refer the reader to an article archived on this site entitled Not All Apha is Created Equal by Jon Lukomnik.

For further reading and another perspective on this matter, I refer the reader to another article archived at this site entitled The End of the Benign Economy and the New Era for Managed Funds by Mark Rzepczynski.

For those who want to spend some time to gain a deeper understanding of the current global economic and political crisis, I refer the reader to a book entitled False Dawn by John Gray.