Q3 ’05:   Uncertainty and the Fruit of Hubris


All the talk these days is about the “housing bubble.” Do we have a housing bubble? Housing prices have clearly gotten ahead of themselves, especially in hot markets such as California, Florida, DC and Las Vegas, and the growing popularity of such mortgage products as zero down, interest only and option ARMS, which allow negative amortization, are downright alarming. The double digit increases certainly cannot go on forever, and a correction of some degree is inevitable. But the increase in housing prices, while substantial, is a small blip compared to the 90’s run-up in technology stocks, which was a genuine mania. Of course the size and import of the housing market to the overall economy also dwarfs the tech market, so a smaller correction in housing will have a relatively bigger economic impact.

So the big question is: since the Fed has made clear its intention to bring the party to a halt and we are clearly coming to some kind of top, how will the housing market resolve? With a severe shakeout and a nasty recession? Or with a soft landing and long sideways consolidation? Let’s all hope for the latter. In any case the bubble, if that’s what we have, is not likely to burst until long rates move decisively higher, and is also not likely while the national press is on “bubble watch.” Real bubbles are recognized by the public in retrospect, not ahead of time.

One thing that is clear is the continuing impact of the disparity in incomes and the hollowing out of the great American middle class. As of last fall, approximately fifteen percent of economic growth was going to wages and salaries, the smallest share since WWII. Adding to the squeeze is the steady shift of the burden of health care and pensions from employers to workers. These trends have combined to make take-home pay as a share of the economy the lowest since 1929 when the government first started keeping track of this statistic. As a result, large numbers of workers are in ever more precarious financial condition. Throughout the recovery the number of American families living in poverty has steadily increased. The next recession will generate a dramatic and probably unprecedented increase in this number.

Official inflation is low, but the soaring cost of housing, energy, health care and education, along with relentless corporate downsizing and outsourcing are making upward mobility for large numbers of Americans a fond memory. Bullish commentators cite aggregate numbers in making their case for a healthy economy, but they fail to factor in the combined influences of technology, globalization and government policies causing the fruit of the growth to go to a shrinking number of people on top. We have, in fact, two economies: one for the well connected, well educated and technically proficient, which is doing very well, and another for everyone else, which is struggling.

When thinking about our economy these days, the image I get is that of a huge updraft extending outward at the top like a thunderhead. This vision represents the transfer and gathering of our wealth in the upper tier where it is being deployed in increasingly sophisticated, risk-averse strategies, perpetuating and exacerbating this re-distribution. Wealth is being hoarded on a broad scale, real opportunities are becoming scarce, and the natural vitality of our economy is being eroded at the base. This development is being masked by low interest rates and excess liquidity.

I have made my case over the past three years. Briefly, it is and has been my position that unless there is a dramatic transformation in the behavior of those in power, we are soon going to experience some serious pain. In fact, given the excesses of the past five years, we may already be past the point of no return. It is ironic that the allegedly conservative Republican Party, so long the (ostensible) party of fiscal responsibility, would be the vehicle for this development. As I see it, what is happening in Washington is our greatest market risk.

I recommend re-reading “America’s Truth Deficit ” by William Greider. This article goes to the heart of the matter.


Fortunately the public has begun to take notice of the dysfunction in Washington. Recent polls show increasing concern over the behavior of the President and Congress. The President’s approval rating is at his lowest ever, plunging into the 30’s at press time, and it’s only that high because the public still generally supports his aggressive policy on the war on terror (ex-Iraq). Congress fares even worse. Only one-third of the people approve of Congress right now and more than 80% think that Congress does not share their priorities for the country.

The national political scene remains hyper-polarized. For insight into the root causes and possible solutions to our political dysfunction, I recommend an article by former Republican Senator John Danforth entitled “Onward Moderate Christian Soldiers” and also a recent David Brooks commentary, “The Designated Hitter.”

The Bush team has used war and the terror threat skillfully to its advantage up until now. As the scandals and indictments pile up and the approval numbers plummet, I would expect those cards to be played again in ’06. If Iran does not yield on their nuclear program before next year, there is a very good chance that President Bush will order an attack in the spring. Even if we don’t have another hot war in ’06, I would expect a lot of saber rattling and numerous “terror alerts” in the lead up to the election.

Abuse of power, hubris, corruption, cronyism and related issues, as well as Iraq and the economy, will weigh heavily on the Republicans in ’06. The ’02 election, under the cloud of the buildup to the invasion of Iraq, defied the normal mid-term election pattern, in which the party in power loses seats. The normal pattern will almost certainly reassert itself in ’06, quite possibly with a vengeance. Democrats have a fair chance of taking back at least one house if they can pull themselves out of their stupor. They could improve their prospects dramatically if they actually offered some alternatives to Republican policies that most Americans are clearly disenchanted with.


Pressure is building for an exit from Iraq. Public sentiment is now almost 2-1 against the war. Many conservatives, including former war hawks, are acknowledging that the Iraq war is a distraction from the war on terror and our failures there are in fact undermining our security. There is also growing concern that the Iraq war is damaging the military from within. The problem with enlistments is well reported but a much more serious problem is that a high percentage of junior officers are now considering leaving the military. See “The Not So Long Gray Line ” by Lucian Truscott IV, grandson of the famous WWII Army general.

The grandiose scheme to democratize the Mid-East and remake the world in our image has been extremely damaging to our standing in the world. I confess that I too believe in America’s special place in the world, and in its leadership role. What we have witnessed over the past five years, however, is the dark side of that vision: the arrogant belief that we can violate the laws of man and nature with impunity and impose our values and our system on the world at the end of a cruise missile.

For those caught up on the receiving end of our campaign to democratize the world our actions don’t look much different than previous efforts to impose utopian systems “at the end of a bayonet.” A dead wife or child or brother is simply dead. A life ruined is a life ruined. It doesn’t matter that your initial intent was noble. Like they say, the road to hell is paved with good intentions.

Retired General George Odom, Vietnam veteran and former head of the NSA, recently said “The invasion of Iraq, I believe, will turn out to be the greatest strategic disaster in U.S. history.”

For an excellent history of the bi-partisan development of this neo-con fantasy, read “The New American Militarism: How Americans Are Seduced by War ” by Andrew Bacevich, professor of international relations at Boston University and Army War College graduate.

We all know about the chaos in Iraq, the Iranian nuclear program, China’s military buildup, the Taliban resurgence in Afghanistan, North Korea’s nukes and the bombings around the world. But the situation flying under the radar most likely to threaten global stability is in Russia.

Russia possesses more than half of the world’s nuclear weapons — some 22,000 of them — many of them poorly guarded. Russia is crumbling economically and politically, and we are piling on, pressuring them from all sides. If we push Russia into collapse, it will be very difficult to prevent the emergence of a black market in nuclear weapons. As they get closer to the brink, they may also re-assert themselves militarily, laying claim, and waste if necessary, to Georgia and Ukraine. Needless to say, this would raise global tensions considerably. If you like horror stories, you might want to read “Failed Crusade: America and the Tragedy of Post Communist Russia ” by Stephen Cohen, Professor of Russian studies and history at NYU.

It all adds up to a rather gloomy outlook on the global scene, but just when one starts to feel like all hope is lost, something good pops up.

For a surprising and very encouraging read, see “The End of War” by Greg Easterbrook, and also “Peace is Spreading ” by Niall Ferguson. According to Easterbrook and Ferguson, citing research from the Center for International Development and Conflict Management at the University of Maryland, despite the war on terror, the rise of militarism in the U.S. and outbreaks of religiously inspired violence around the world, global violence has in fact been in decline for the past 15 years, down over 60% in fact, and the average human today may well be the least likely in history to be the victim of war. Given the daily media barrage we are subjected to concerning wars and mayhem around the world, this information is rather counterintuitive, but it’s nice to be surprised to the upside sometimes.


Keep in mind that the global housing and commodity boom is not just a demand phenomenon, but also a reflection of the general debasement of currency by the world’s central banks. With the U.S. running massive trade and budget deficits, other countries are printing currency to buy our dollars and keep the global economy afloat. Hence the world is awash in liquidity. This money has to go somewhere and it has been going into assets…housing and commodities, as well as into U.S. Treasury securities. We are involved in a de-facto competitive currency devaluation rather than a straightforward asset bubble, and it is quite possible that we have not begun to see the froth in the housing bubble.

The best opportunity these days is…defense…defense…defense. Also, know your banker, broker and/or customer. Liquidity is valuable, but quality trumps liquidity. Uncertainty reigns, but by the middle of next year we should have a better sense of where things are headed.


We have entered the bearish stage of the presidential cycle. The March high, which I expected to be the cyclical top, was slightly bettered in July, and tested again in September. I expect this expanded top be the high for at least the next two years. Given the tremendous debt that the next administration will inherit, this could well be the top for the next 6 years, 10 years or longer.

The bottom line is that instability and uncertainty are the ground state of global affairs, and the list of potential triggers for an economic accident remains long. At the same time the corruption and the obsession of our leaders in Washington with their ongoing tribal warfare denies us the leadership we need at this critical time. Our leaders, with our consent and support, have been doing the things that have historically brought great nations to their knees — running up enormous debt, allowing epic scale corruption and engaging in foreign wars.

Hubris is the defining characteristic of our current government. The result is that we have made a shambles of our balance sheet, created growing doubt, division and confusion at home, and lost the respect of the world. If you have not seen the movie Ran, I suggest that you rent it.

Hubris is not manifest only among politicians, but is widely evident in our society. U.S. corporate chieftains are still up to their sleazy ways, SEC scrutiny notwithstanding. Failed Morgan Stanley CEO Philip Purcell left in disgrace after only nine months on the job with a $32 million paycheck. $25 million is now average compensation for CEO’s, regardless of their performance. In the world of science, the bio-tech industry is bringing the Frankenstein myth to life. Human cloning is moving full steam ahead in South Korea. American scientists are injecting human genes into plants and animals, and recently celebrated the creation of the first mice-humans. The talk these days among technophiles is about the merging of man and machines to create a super race with Godlike power and virtual immortality. (See “The Singularity is Near ” by Ray Kurzweil.) We are definitely due for an attitude adjustment.

All of the smartest people I am aware of seem to be on the same page these days. Yes, we have created big problems with our profligate ways, and yes, the imbalances we have created must sooner or later come into balance. In fact, they are waiting for some trigger event to send them cascading to their new equilibrium. But when, how and over what time period no-one is prepared to offer. Could it be a disaster? Yes, it certainly could. Can we save ourselves from disaster? With some real leadership, yes we can, even now. It seems that the thing everyone is in agreement on is that the dollar will fall further, probably much further. Of course just to spite everyone, the dollar has rallied 10% over the last several months. So there you have it. No-one knows anything. Did they ever?

I think that the defining principle of our current situation is that the fruit of hubris is beginning to come home to roost and the risk to all sectors is high. Think defense. Think new paradigm…that will be a good topic for the Q4 letter.