That the world is rapidly changing is undeniable. A big challenge for everyone is to perceive the ways in which the world is actually changing, and not simply to project onto the world the ways that we would like it to be changing.
The title of this quarter’s letter is taken from a Såalon piece of the same title by Christian Science Monitor columnist Helena Cobban. Cobban is a sage commentator and the bottom line in her piece is that the die is now cast: U.S. influence around the world is shrinking rapidly and will soon contract in a major way. George Bush’s big gamble in Iraq, intended to serve notice to the world of U.S. dominance and resolve has had the opposite effect. The surprise is that this is not entirely a bad thing. The transition will certainly be bumpy but a redistribution of global influence and responsibilities, once accomplished, will be better for everyone.
The overall tenor of the markets at this writing is nervous, highlighted by a general concern over rising inflation and rates, the growing instability in the Middle East, spiking oil prices and growing awareness that the housing market has topped out. Stocks have seen the first sustained sell-off in over a year, so far a modest 8% decline in the Dow and S&P. Sentiment indicators have been at negative extremes recently, indicating that the downside is limited in the near term, and a test of the May highs is likely.
Since the bear market low in October of ’02 the stimulus driven recovery has delivered mixed results in stocks. Small and mid-cap indexes and the Dow Transports have made new all-time highs; the benchmark Dow Industrials has recovered 98% of the bear market decline. The S&P 500 has recovered 71% of its bear market losses, and the NASDAQ has managed only a meager 24%. All-cap stock market gains on a value basis have been 85%.
During the same time period, gold rallied 140% to a high of $732, and after correcting is currently at $625; crude rallied 190% and is currently hovering $4 below its recent all-time highs of $78; the dollar index lost 33% and is currently in position to test its lows.
The 10 year housing bull market has finally petered out. Inventories of unsold houses are growing rapidly and some sectors are seeing high foreclosure rates, particularly in the sub-prime market. Prices are generally holding near their highs, but we are early in the cycle. The large number of ARMS due to reset next year (5% of total outstanding mortgages) will put some pressure on the market. Considering the length and large gains of the housing bull market, this correction will likely be long and/or deep.
Now that interest rates have gradually been hiked to a more natural level and the yield curve is essentially flat, the carry trade is no more. Deficit spending continues unabated, but the big party is over and future economic expansion will have to come for the most part from real organic economic growth. The Fed has a challenge ahead in trying to find a point of equilibrium between strong inflationary and deflationary crosscurrents. Stagflation, anyone? We should all wish Chairman Bernanke great success.
Risk management has become the gold standard among American investors. Most investment capital in the U.S. today is under the control of risk managers who want every risk to be hedged but still want outsized returns. Ironically, the Oz-like culture that the risk managers have created has resulted in massive leverage throughout the financial sector, commonly at levels that make Long Term Capital look prudent. This massive exposure is masked by an array of derivatives — options, swaps, swaptions, caps, floors, collateralized debt obligations (CDO’s), synthetic CDO’s, and more. The various players are swapping, packaging, trading and repackaging positions and laying off their risk in a Byzantine round robin, at each round adding another layer of fees and increasing their exposure, in a system reminiscent of the Japanese keiretsu system before the Japan meltdown. The whole cloth is so vast and complex that it can only be (partially) understood through such risk assessment tools as value at risk, which are backward looking, totally dependent on risk assumptions, and are vulnerable to “the big event” and to counterparty risk, which are not assessed by the models at all.
There is nothing inherently wrong with derivatives or with risk management. In fact, the latter is an essential function and the former are useful tools. However, the managers of our financial institutions are so enamored of their clever models and their ability to leverage up by using derivatives that they have completely lost sight of the basics. The condition is called hubris. This situation is what Warren Buffet was referring to when he said that derivatives are “economic weapons of mass destruction.” If any major player defaults, the entire system is at risk. See Business Week’s June 12th cover story, “Inside Wall Street’s Culture of Risk.”
The massive leverage in the financial sector is a reflection of the unsustainable debt across the board in America. So how is this going to play out? Whether we will be able to manage our way back to sanity or whether nature will take care of it for us, one thing certain is that the dollar is going to continue to be devalued. There is no ability or intention to repay the ocean of U.S. debt floating around the world. That debt is going to be disposed of by devaluing the dollar. What may mask this decline in part is the fact that the dollar is typically viewed in relation to other currencies, which are all, to greater or lesser degrees, being degraded by their own central banks.
The real value of the dollar is seen in terms of its purchasing power, which has been in steady decline for a long time — down over 90% in the last 70 years and down 50% just during the 18 years of Alan Greenspan’s reign. In fact, Greenspan’s singular achievement as Fed Chairman is that he engineered a 50% devaluation of the dollar without anyone realizing he had done it. Greenspan’s motto: Keep it slow and no-one will know. (Thanks to Richard Russell.)
Since purchasing power is the real measure of the worth of the dollar, one would think that one could monitor the real value of the dollar by simply tracking inflation, which, all things being equal, would be a simple matter. But alas, all things are not equal. The problem is that the official inflation numbers are not what they used to be. (Are we surprised?) If inflation was calculated the same way it was in the Carter years, current inflation would be 8%, not 2-3%. To put this in practical terms, 2% annual inflation means that the dollar will be devalued by another 50% in 35 years; 8% inflation will do the same in 8 years.
For more information on the sad state of government statistical reporting, go to John Williams’ Shadow Government Statistics. (Thanks to Al Beimfohr of Knightsbridge Asset Management.)
The scent of desperation is emanating from the Republican camp. Recent efforts by Republicans to shore up their dismal poll numbers have generated a rather sleazy series of diversionary campaigns: a Pledge of Allegiance amendment, a flag burning amendment, a “cut and run” Democrats are cowards campaign, frequent attacks on the treasonous liberal press, and general hysteria over illegal immigrants.
Most of this effort has been rendered ineffective by the daily onslaught of bad news from Iraq.
The upcoming election certainly looks like a good opportunity for Democrats, but the big question heading into election season is: will the Democrats actually show up for this one? They seem to be hoping that the fruit will just fall out of the tree into their waiting hands. Not a promising strategy. Despite the rosy polls (from a Democrat perspective) there is a lot of time between now and November, and one should never underestimate the capabilities of Karl Rove & Co.
Going into election season, political junkies will want to sign up for the free daily feed from non-partisan CQPolitics.com…”Every district. Every state. Every day.”
On the corruption front, one can only marvel at the audacity. It just doesn’t pay to get upset about it. I was shocked recently to learn that municipalities have taken to spending taxpayer money to hire lobbyists to get their Congressmen to send them money. Apparently this has worked quite well for the early adopters. Also, new House leader John Boehner has hit the ground running, outstripping even his mentor Tom Delay in fundraising, living large on the donations of his patrons and wearing his corruption like a badge of honor. And from the seamy side of government contracting, Brent Wilkes, a defense contractor implicated by jailed Republican Congressman Randy Cunningham as “co-conspirator #1” recently shared his experience in the Art of Greasing Palms in Washington. This reading is strictly for adults. Of course Wilkes is denying any wrongdoing.
The geopolitical stage is where the real action is taking place.
The Middle East is smoking…literally. Israel has demolished southern Lebanon in its quest to root out Hezbollah. Whether this action will introduce greater stability or instability into the region is uncertain at this time. Condoleezza Rice is reportedly enthralled by what we can call a reverse domino theory. (See “Domino Diplomacy ” by Sidney Blumenthal.) Rice’s theory is that our proxy war with Iran (Israel vs. Hezbollah) will demolish Hezbollah and Hamas, weaken Syria and Iran, and help to turn around Iraq. Another clever strategy from Foggy Bottom. We can only hope that this one works out better than our previous attempts at geopolitical engineering in the Middle East. Indications in the immediate aftermath are not encouraging, and I would expect to see round two of this conflict coming up soon.
Iraq is an unmitigated disaster, with 100 people a day succumbing to violence in the burgeoning Sunni-Shiite civil war. The best that can be hoped for there is that the inevitable dismemberment can be achieved without igniting a regional free-for-all. The White House regularly announces new policies, campaigns and progress reports for Iraq but from all the information I have been able to gather, our troops there are primarily occupied with just staying alive. Read The Last True Story I’ll Ever Tell by John Crawford.
The negative side of our failure in Iraq is that our enemies globally are emboldened. Iran has been the primary beneficiary of our blunder in Iraq and it is flexing its muscles by stirring up trouble in Iraq and with Israel, and by flaunting its nuke program. The Taliban is resurgent in Afghanistan. North Korea is launching long range test missiles and is reportedly preparing for a nuclear test. Russia is re-asserting itself on the global stage and China continues on its forced march to dominate its sphere of influence, militarily as well as economically. Cesar Chavez has just completed a major arms deal with Russia, and anti-Americanism (anti-USism?) is sweeping South America and the globe. All of these events are occurring in direct contradiction to publicly stated U.S. policies and in some cases outright U.S. threats.
The positive side of all these events is that they are hastening the day when America will be relieved of the burden of being global policeman and enforcer. As we work our way through this transition, America will dramatically reduce its global military footprint and the gargantuan expenses that go along with that global presence. The world will find a new equilibrium and we will be freed of the distractions and responsibilities of empire. We will be able to turn our attention and resources to dealing with neglected domestic and regional problems, and to repairing the extensive damage that has been done to our national character, our national unity, and our relations with our friends and neighbors.
America still has much that is good to offer the world. But the good that America has to offer cannot be given at the end of a cruise missile. Our national character is not that of an imperial people. We cannot be true to ourselves and simultaneously be slaughtering tens of thousands of people and destroying the lives of millions in imperial wars on the other side of the world. We need to withdraw from empire to heal our collective spirit and regain our moral center. Events are leading us to that place, whether we realize or want it or not.
The current situation on every front reminds me of the ancient Chinese curse, “May you live in interesting times.” Instability and change are everywhere…but where there is change there is opportunity.
I do believe that we have gone past the point of no return as far as fiscal responsibility is concerned. I suppose I am late in coming to this, or have been too idealistic to want to admit it, but going forward I believe it will be critical to stay ahead of the falling dollar while implementing one’s investment and business strategies. On the trading front, the dollar should be sold on rallies, and geopolitical instability guarantees that there will be plenty of volatility. On a portfolio basis, a diversified currency overlay weighted toward Far Eastern currencies and gold is basic insurance against a potential dollar debacle, and should be profitable on its own merits over time.
Over the long run, the inevitable dollar decline augers well for assets of all kinds, in nominal terms anyway, and also for emerging markets. But timing is everything, and quality will pay dividends. The dollar decline also argues for leverage, but systemic risk is increasing which argues for debt liquidation. It’s a coin toss on leverage, and the choice will be an individual one depending on ability to control exposure.
The latest round of the WTO has failed, placing the entire thrust of globalization in jeopardy. The basic concept of globalization needs a fundamental overhaul if it is not to collapse entirely. The advanced nations cannot expect the third world to continue to give up the lion’s share of the fruit of their economic growth to global corporations when they are still struggling just to feed their people. Either way, investment in community — global localization — will become a trend at some point and will offer good value and use of capital in a time of uncertainty and potentially serious global disruption. Service to elders, local agriculture and infrastructure, education, alternative energy and alternative medicine are viable prospects going forward. Also, good opportunities exist in certain areas of Mexico and Central America, which are becoming meccas for U.S. retirees and artists. And skill-based management programs, in the form of well run hedge funds or managed accounts still offer good returns and liquidity. Commodity markets are in the early stages of a major bull market and should offer good upside for the next 10-20 years.
We are subjected to so much noise from the media on a daily basis that it is very difficult to maintain perspective on the economy and the marketplace, or anything else for that matter. In order to stay centered, grounded and clear, and thus make good decisions, it is essential to have recourse to high quality economic reports such as those put out by BCA Research or Ned Davis Research. Business Week and The Economist are also valuable sources of un-spun information. It is hazardous to one’s economic health to even turn on the television.
Tectonic shifts are taking place in the geopolitical order. As America withdraws, willingly or by force of events, from its position as global hegemon, there will be a cascade of realignment which will have major economic consequences. The globalization experiment will be recast or it will collapse. Whether these changes will take place in slow motion, over decades, or in a few short years is impossible to tell at this point. And how this will play out at home economically will depend to a large extent on policy responses to the changes. What we need more than anything is a sea change in attitude in Washington. We need leadership that is genuinely concerned with the wellbeing of our nation and our world and is willing to put that wellbeing ahead of personal or partisan advantage. Since it is we the people who choose our leaders, ultimately it is we the people who decide our fate.