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.


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.


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.


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.