Q4 ’04:   What, Me Worry?

The current theme among investors seems to be “what, me worry?” The stock market rallied nicely after the election, closing the year on its highs; the Dow up 3.1% and the S&P up 9%. The bond market has continued to defy gravity — ten year Treasuries are at 4.15% as of this writing and corporate spreads are at historic tights. Housing sales continue to make history as October sales set a new record, and then fell off sharply in November to a still high level. Market cheerleaders are predicting clear sailing for the foreseeable future. Bullish consensus is at multi-year highs; volatility at 10 year lows.

And judging from the overwhelming consensus of the sycophants at the recent “economic summit” in Washington, who fell all over themselves for an opportunity to kiss George Bush’s hindquarters, we have entered into a golden era with, in the words of AP reporter Tom Raum, “an economy of blue skies, happy workers and prosperity for all…just around the corner.”

From the viewpoint of a contrarian, to which I confess, all the above is ominous.

Fiscal Madness Phase II

On the fiscal front, the White House is planning to slash domestic spending in an attempt to execute the second half of the “starve the beast” strategy. The President has promised to halve the deficit, but this does not necessarily mean a real reduction in spending or borrowing. An increasingly fractious Republican caucus, drunk from four years of unrestrained spending, represents a substantial obstacle to spending restraint, so the deficit reduction will be accomplished primarily by using accounting procedures that would make Ken Lay blush.

Real spending cuts would have the effect of cutting off much of the juice to our stimulus dependent economy. But not to worry. Real cuts will only be felt by those without a Republican sponsor, such as the environment and the indigent. More importantly, creative accounting is in vogue at 1600 Pennsylvania Ave. First up on the agenda is Social Security “reform,” a Trojan Horse designed to undermine Social Security while running up another $2 trillion or so in debt — off budget of course, as is Iraq and lord-knows-what-else. We book the cuts and borrow off budget. Now why didn’t I think of that? More tax cuts are also planned.

If successful in this shell game, Republicans may squeeze enough juice out of the economy to keep the wheels turning for two more years while claiming the moral high ground of fiscal responsibility. I give the Bush folk an overall fiscal grade of C: an F for responsibility, a C for creativity and an A for audacity.

Consumption Frenzy

Our debt-driven economy, powered by the insatiable American consumer, is the locomotive of the world economy. But U.S. consumers have been taking on debt for 20 years, and are nearing the end of their run. Noteworthy — consumer borrowing dropped 5% in November, the largest monthly drop on record.

America is currently sucking up over 80% of global savings to finance our consumption, and U.S. net savings hover just above zero. This bad behavior has not gone unnoticed by the currency markets. The dollar is down over 30% in the past three years (matching the decline in positive attitudes toward America ). Even so the trade deficit continues to set new records month after month…$60 billion in November alone!

The big question for macro economists is whether China and the rest of the world will be able to rev up their consumers in time to take up the slack when Americans start to deal with their debt burden. One question no-one seems to ask, publicly at least, is whether this kind of debt-driven consumer economy on a global scale is healthy or sustainable to begin with.

The following chart is a good visual aid for realizing the consequences of our unbridled consumption combined with faith based economics.

U.S. External Debt and Primary Trade Deficit (share of GDP)

This mountain of debt will have to be retired one way or another. Dollar devaluation is one way to reduce the size of the mountain. Despite the 30% devaluation to date, there is virtual unanimity in the marketplace that the dollar remains overvalued, and many commentators expect that it will have to drop another 30% to restore balance. A gradual devaluation is in everyone’s best interests, and great efforts will be made to see that it happens that way. So it would seem the outcome is ordained; the path is uncertain. With so much dollar bearishness we could see some dramatic rallies.

For a perspective on what could happen if things don’t unfold according to plan, or if the plan becomes even more divorced from reality than it already is, check out “Episodes of Hyperinflation ,”a website maintained by Thayer Watkins of the San Jose State Economics department. This site is a study of many cases of hyperinflation from Rome forward. Interestingly, all cases lasted for a short time, from 1-3 years, coming on the heels of many years of escalating imbalances.

Showdown in the Senate

The President has announced that he is going to re-nominate the judicial nominees filibustered by Democrats in his first term. In support, Senate Majority Leader Frist has announced that he plans to invoke the “nuclear” option to limit filibuster on judicial nominees. This will usher in a period of virtual hand to hand combat in the Senate and make it difficult to generate bi-partisan support for anything over the next two years.

The dustup over judicial nominees will be the first major battle in the renewal of all out political warfare. The Republican leadership, not content with victory but pushing for total domination, is teeing up an aggressive agenda of controversial issues with Karl Rove style PR campaigns in support. The impending retirement of Chief Justice Renquist, seriously ill with cancer, will release a torrent of partisan flak attacks. See “The Coming Firestorm ” in the January 1st Economist. The way things are shaping up, we may soon find ourselves yearning for the relative civility of the ’04 campaign.

There are signs that the Republican juggernaut is stalling. The normal pattern is that the party in power loses seats in the mid-term election. All indications are that the Republicans are going to overplay their hand and that it will cost them in ’06. Numerous scandals, the plague of second-termers, are brewing. Abuses of power will hurt also. House leaders in particular, acting more like a crime family than a political party, seem especially intent on shooting themselves in the foot on this score.

In many ways all the above is politics as usual, although incrementally more depraved with each new campaign. But probably the most significant development of the 2004 campaign is that the Big Lie is now unchallenged as the dominant mode of public policy discourse. The old Soviet commissars would be in awe at the sophistication of the machinery of deception. We call it spin these days, and good spinners are held in high regard by our political class. But like a bad case of termites, this spinning business is degrading the foundations of our society. Ironically, those who champion morality and values have become the best spinners.

Spinning now permeates our society. In the words of Jonathan Alford in a recent Salon article, “We have all become implicit spinners. No one likes it and no one knows how to stop it. We look simultaneously at content and predicted effect, at what actually happened and how it will play. If it doesn’t play, it never happened. Conversely, even blatant lies, if they play, become true.”

The War on Terror

Global instability and the terror threat remain at high levels and continue to present one of the most likely sources of crisis for the markets and the economy, although if this threat manifests it will most likely do so in a completely unexpected way.

According to Stratfor, a global intelligence service dubbed “the shadow CIA” by Barrons, the aggressive U.S. strategy in Iraq and elsewhere has brought about considerable moderation in Muslim regimes regarding the jihadis, and the latter’s strategy of creating a global conflict has stalled. In the view of Stratfor, despite the fact that Iraq has turned into a huge and unexpected headache, the U.S. is winning the battle at present.

Other terrorism experts have a different view. Michael Scheur, the ex-CIA bin Laden expert, formerly known as Anonymous, author of “Imperial Hubris,” and Yossef Bodansky, former director of the U.S Congressional Task Force on Terrorism and Unconventional Warfare and author of “Bin Laden: The Man Who Declared War on America ,” both state unequivocally that we are losing the war against terror and that a terror attack against the U.S. using unconventional weapons is virtually inevitable.

A third view is that the entire global terror threat is an invention. A BBC documentary “The Power of Nightmares: The Rise of the Politics of Fear” makes the case that ambitious politicians and an eager press have taken the terror threat to the bank based on the singular spectacular events of 9/11. Producer Alan Curtis puts forth some compelling arguments for this view. See the Guardian review entitled “The Making of the Terror Myth .”

In the Orwellian world of 21st century public discourse, it is difficult if not impossible for the average citizen to know the real truth of the matter. However, regardless of whether we are winning or losing, or if the entire sad story has been an exercise in group paranoia, the management of the war on terror, according to a Pentagon panel, has been an unmitigated disaster. For details see “The New Pentagon Paper ” by Salon columnist Sidney Blumenthal.

I have repeatedly pointed out the obvious: that the continued arrogance and brutality of U.S. foreign policy is hardening anti-American attitudes globally. This has many unfortunate consequences, one of which is that many who did otherwise after 9/11 are now turning a blind eye toward the activities of terrorists and their supporters. The result may or may not come in the form of a major terrorist attack, but if it should the world will not rally to us as they did after 9/11.

Meanwhile, realignment is moving full speed ahead. China in particular has been moving steadily and intently to supplant U.S. hegemony in South Asia, expanding its military capabilities and moving globally to secure the inflow of raw materials. Russia and China recently announced their first ever joint military exercises. (Can we envision a Sino-Russian mutual defense pact?) The recent ASEAN meeting saw the creation of a tariff free Asian trading zone to vie with Europe and the U.S. Many younger people in the region are abandoning their English studies to learn Mandarin. See the NY Times article, “Chinese Move to Eclipse U.S. Appeal in Southeast Asia ” by Jane Perlez.

Elsewhere on the global scene there have been some positive developments. The high point over the last few months certainly was the election in Afghanistan, an act of national courage. See the LA Times Op-ed piece, “Afghanistan ‘s Minor Miracle “byRajan Menon.

Also, the passing of Arafat offers new hope in the Middle East, and China and Taiwan have taken a breather from their saber rattling. It’s too soon to know if any of these developments mean anything for the long term, but one can take note of what it feels like when the pressure recedes rather than increases.


“I object to violence because when it appears to do good, the good is only temporary; the evil it does is permanent.” Mahatma Gandhi

This quote from Gandhi is especially pertinent to the situation in Iraq. The apparent good of removing Saddam from power has resulted in the creation of a terror vortex where there was none before, the destruction of tens if not hundreds of thousands of lives, the vast majority of them innocents as in all wars, and irreparable harm to America’s honor and standing in the world.

Iraq is unraveling day by day, increasingly reminiscent of Vietnam. A recent report by the CIA’s Baghdad chief stated that the situation there is out of control and there is little hope of improvement any time in the foreseeable future. Even the President, the election now in the bag, has finally acknowledged that things there are not going well.

Those who want the real skinny on the reasons for the Iraq invasion should read Stratfor founder George Friedman’s book, “America ‘s Secret War.” Hint: it wasn’t about the phantom WMDs.

Right now it appears that the strategy (which changes often) is to conduct the election no matter what, see the new government installed no matter how illegitimate, and then retreat into a “supportive” role, forcing the ill-prepared Iraqi security forces to the front lines in a bloody civil war with the Baathists while attempting to keep Iran and Turkey from entering the fray — another high-risk strategy from the Bush foreign policy team.

Iraq is having a negative impact on our standing in the global marketplace. While there are no formal boycotts outside the Muslim world at this time, a recent poll in Europe discovered that 20% of Europeans are now avoiding American products. This number will surely grow. This will not be helpful in our efforts to balance the trade deficit.


The best outright long term opportunities remain in the developing world. India, China and the entire South Asia region are growing stronger and are moving toward a solid regional stance with China in the lead. Unfortunately, however, the entire developing world is set up for export to the U.S. When the U.S. finally starts dealing with its debt problems, consumption will plummet, and with it the developing world’s export market. This is a difficult call, because the dollar is also vulnerable to collapse. If you wait too long, you may not have any foreign purchasing power. If you go in too soon, you may have to weather a bone crushing correction. A tough call. Probably the most prudent strategy is to spread (or hedge) assets into five or six currencies including gold and the dollar and wait for the correction.

Gold will move inversely to the dollar, and in case of serious global instability gold will become the choice over any paper currency. Real estate in Canada and Mexico and further South may be worth investigating. Also, as an insurance play it may be a good idea to consider buying leap puts in the S&P’s.

The fiscal agenda involves a continuation of massive borrowing. Much of the borrowing will be off budget – e.g. the social security “fix” and Iraq spending. While the off-budget spending may provide political cover, the markets won’t buy it, which pretty much guarantees that the dollar devaluation will continue. This will continue to be positive for hard assets and commodities as well as for stocks.

Be aware of the hidden tax in the dollar devaluation. Even if you are smart or fortunate enough to have your entire net worth in assets that are appreciating relative to the dollar devaluation, you are going to be taxed on the nominal appreciation, leaving you a net loser. Still better than being in a dollar denominated money market, but less gainful than you think.

The outstanding issue that makes picking strategy so difficult right now is that it is clear that our debt-based economy is overextended and vulnerable. Natural law guarantees that sooner or later, one way or another, it will come into balance, but the way that it will come into balance is unknown. A worrisome sign is that despite the unprecedented stimulus of the past four years we have still seen very little inflation, and the bond market is not anticipating any.

So, on the one hand we could see overhanging deflationary forces take over and force massive defaults. On the other hand, in a debt-based economy policy makers recognize that they must “inflate or die” as Richard Russell is fond of saying. Efforts to counter deflation could get out of hand, causing hyperinflation. Or we could see extended stagflation followed by one of the above. Or we could even see a sudden blossoming of enlightenment and self-sacrifice by our leadership, leading to a global co-operative effort to consciously manage our way to a just and sustainable global economy. I wouldn’t hold my breath waiting for the latter, but then again no-one would have believed that the Berlin wall was going to come down before it happened. The ways to position for these various outcomes are quite different. So the best stance overall remains liquidity, prudence, flexibility and diversification…and patience.


I fully expect that when the borrowing stops, or rather when the lending window is closed, the Bush gamble on faith-based economics is going to end up being a matching bookend for his other big gamble in Iraq . Hubris is not corrected by 20%. Hubris is corrected by disaster.

Economists and other market commentators, mesmerized by each latest set of economic numbers, miss the forest for their laser-like focus on the trees. The fact remains that we are badly overextended fiscally and militarily, and therefore vulnerable to any number of crisis generating breakdowns. With the exception of corporate balance sheets, the excesses of the ’90’s bubble have not been dissipated, and have only been exacerbated by the massive borrowing and relentless stimulus. This is the dominant reality that everyone is trying to ignore. The criminal culture in corporate boardrooms is as bad if not worse than ever, Sarbanes-Oxley notwithstanding. Corruption in government is at epic levels, and extreme political polarization has made it impossible to deal with any national issue in an honest and balanced way. Outsourcing continues to build steam, going upscale as it grows. The disparity in incomes continues to grow; poverty is growing; our health care system is in meltdown and pension programs are almost universally under funded – those that haven’t already defaulted. All of this in the fat part of a “recovery.”

Judging from a convergence of factors: all the points in the previous paragraph; the presidential cycle turning down; the failure of the stock market to make new highs in the bull phase of the current cycle; widespread complacency; soaring bullish consensus; the zero savings rate; the soaring twin deficits; unsustainable consumer debt; the housing bubble, and last but not least, the classic, almost storybook hubris, corruption and casual brutality of our current government, I have to call it like I see it and predict that the time to pay the piper is fast approaching.

I expect the stock market to top out in January or by March at the latest. Given the right catalyst, we could see a sudden and sustained sell-off, but barring a major blowup in one of the many potential economic or geopolitical flashpoints – e.g. Korea, Iran, Saudi Arabia, terrorism, dollar, debt, housing — we are more likely to see a year of continued distribution, sideways to lower with increasing pressure as the year goes on, and with lots of M&A activity. I expect recession by the end of ’05 or early ’06; resurgent deflation and new lows in the bear market by mid-’06. This will be disastrous for some, and present major opportunities for those who are prepared.