Q1 ’08:   Back From the Brink

The world seems to be moving in slow motion right now, waiting to see whether the central banks can contain the credit bubble contraction, and whether the U.S. will attack Iran. At the same time the U.S. presidential campaign has completely overshadowed every other aspect of national life. The media are blathering endlessly about the campaign to the exclusion of almost anything except housing foreclosures and the latest scandals. The campaign itself has devolved into a parody. John McCain has taken to pandering to the lunatic fringe he once derided while stumbling from one senior moment to the next. On the Democrat side the seemingly endless Clinton / Obama demolition derby may finally, mercifully be coming to an end. Only six more months of this lunacy!

Meanwhile, there are three overriding macro concerns in the world at present: (1) Will the world’s central banks be successful in containing the collapsing global credit bubble? (2) Directly related to this issue is: will the dollar survive the actions taken to try to contain said bubble? (3) Will George Bush attack Iran before he leaves office?

The answer to questions one and two appears to be yes, at least for now. The underlying instability of our financial system remains an unresolved matter, but for now the banks have survived the sub-prime meltdown and are busy writing down their losses and gathering equity. The muni market has survived the collapse of the auction market and is beginning to function normally. The stock market has stabilized and rallied in the face of a relentless barrage of negative news. The Dow is now down only 10% from its all-time high. That says a lot. Even housing is beginning to show some signs of stabilizing, in spite of ongoing record foreclosures. See the Wall Street Journal May 6th op-ed, “The Housing Crisis is Over.”

For its part, the Fed has demonstrated it is willing to do whatever it takes to prevent an economic meltdown. From the Bear Stearns shotgun marriage, to the largest ever reduction in the Fed funds rate, to the massive injection of dollars into the economy (M3 is currently growing at a smoking 16% rate), the Fed is doing whatever is needed to hold the line. The question is: Can the dollar take all of this benevolence?

The dollar is already down 40% since George Bush took office. If it picks up speed on the downside from here we will soon see a massive global rush out of the dollar. The full extent of the disruption this would cause is not even predictable, except to say that it would be epic. However, technically the dollar is hugely oversold, and sentiment is almost uniformly negative. This leaves the dollar ripe for a short covering rally, which is already underway, and if the ECB starts lowering rates as expected, that rally could extend considerably. Under these conditions a coordinated central bank intervention would put a bottom on the dollar that could last for quite some time. That would be a major stabilizing development.

Unfortunately, the sad reality is that long term the dollar is toast. The actions of our “leaders” in Washington have assured this outcome. The best that can be done at this point is to engineer a continued gradual devaluation of the dollar. If the inevitable happens too suddenly that sad reality could easily turn into a catastrophe. So let’s hope that Mr. Bernanke and cohorts are up to the task. For the real skinny on the long term outlook for the dollar, I recommend the recent “Hyperinflation Special Report” by John Williams at Shadow Government Statistics.

Regarding issue number three:
We can look at our current geopolitical situation through the lens of the “poetry” of former Defense Secretary Donald Rumsfeld:

As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don’t know
We don’t know.

We are spending $3 billion and sacrificing the lives of 10 or more soldiers every week in Iraq. This is a known known. Why we are doing this is a known unkown. Those who have been wrong about everything related to this war since before the beginning seem to get endless face time on Fox and CNN to explain their ever changing rationale for the war. I recently saw a political cartoon with troops marching in formation chanting “we’re here because we’re here because we’re here.” That seems to be the bottom line. We’re there because we’re there and our “leaders” don’t have the courage to say “enough, we made a mistake, we’re out of here.” The acronym “fubar” was the term coined in Vietnam for this kind of situation. Fubar in Iraq is a known known.

Centcom commander William Fallon was fired by President Bush and replaced by George Petraeus. This is a known known. What this means for the prospect of an attack on Iran is a known unknown. It is not a good sign, however, since Fallon had let it be known he thought attacking Iran would be a reckless act, and Petraeus is known to be a political general, willing to do whatever it takes to curry favor with the President. What might trigger an outbreak of hostilities is an unknown unknown, but the stage is well set.

Debka recently published a piece taking note of all the strange events going on in the Middle East: A super-secret Israeli bombing mission in Syria that is suddenly not a secret any more; the firing of Admiral Fallon; additional warships heading to the gulf; a sharp increase in U.S. saber rattling; $125 oil; Israel’s first ever nationwide civil defense drill; military maneuvers in Syria; stepped up preparations for war by Hamas and Hezbollah, and increasingly harsh rhetoric between Israel and Iran. There is no smoking gun, but taken together all of the unusual goings-on point in the direction of war. There is also the domestic political consideration. War has been great politics for Republicans. Another war would presumably be to their advantage going into the fall election.

The biggest unknown unknown is what will happen if we do attack Iran. There has been a lot of bluster from Iran, and the talking head “experts” predict regional chaos. Given the track record of all these experts, I would assign equal probability of Iran folding under the onslaught and suing for peace, or of a dirty bomb exploding in Cincinnati, or of Russia moving in to protect Iran. The truth is that no-one knows what will happen. One thing worth considering, however, is the track record of the Bush regime in its military activities. Gives one pause. Do we really want these guys to initiate something in their final hours that is so fraught with uncertainty and potentially disastrous consequences? On the other hand, the only way to stop them if they are intent on another war is to impeach Bush and Cheney. Given the track record of Congress in standing up to Bush and Cheney, I’d give that outcome the probability of nil. So it appears we are subject to the whims of our President, who is clearly living in his own world. If he wants unleash the dogs of war one more time, we’re stuck with it. The weight of the evidence points in that direction, but is not conclusive. Stay tuned.

The Bottom Line

We all need to try to take a long term perspective on our world. That is difficult to do with all the spin and distraction aimed at us daily, but it is essential in order to make sound decisions. I have been over this numerous times in past editions of this letter, but just to recap: It will be wise to reduce debt to that which will be manageable in difficult times. Zero if possible. Tangible assets are generally desirable over paper. Some amount of gold is a good idea. Your own debt free, cash flowing business is probably your best investment. Non-dollar denominated assets are desirable, but one needs to be very careful in identifying “where and what”, in addition to the timing issue. Recent developments in Russia are a good example. Russian “raiders” have been expropriating assets of every kind, often using the courts to make their thefts “legal,” and investors have been left with little recourse. At least one Western fund manager with substantial investments in Russia has been denied entry into the country. Let the buyer beware.

For the immediate future the Presidential cycle is still operative and the Fed is in hyperactive firefighting mode. Thus, barring another major shock to the system, I expect to see a general improvement in economic activity and the stock market moving sideways to higher into the first quarter of ’09. After that all bets are off.