The U.S. Economy & U.S. Markets

November 13, 2001

Even as the stock market was ascending to undreamed of heights, IAN GORDON warned our subscribers in our June 11, 1999 interview, that we were nearing an end of the greatest bull market in the history of the stock market. This would end, Ian insisted in what would be an economic decline at least as severe as the 1930's - if we are lucky. It may well be far worse Ian said because the excesses are far greater this time than before and because unlike the 1930's when the U.S. was a major creditor nation, it is now the world's largest debtor nation!

Then in the November 9, 1999 we interviewed DAVID TICE manager of the Prudent Bear Fund (BEARX) and the Prudent Safe Harbor Fund (PSAFX). David Tice affirmed his agreement that Ian's Kondratieff Winter or impending depression was totally appropriate for the U.S. economy. In our interview with David, he pointed out how since the 1960's our fiat currency system has been requiring an ever growing creation of new debt to keep the economy growing. For example, "only" $1 to $1.50 in new debt was required in the 1960s to increase GDP by $1. By the mid 1990's $3 of new debt was required to grow GDP by $1. And, when I interviewed David, that number grew to $5.30 of new debt requirement to grow GDP by $1.

What about now? Well, Alan Greenspan has been creating debt at one of the fastest paces in our history and the economy is not growing very little and probably not at all. Accordingly, the ratio of new debt required to increase GDP by $1 is now in the process of reaching infinity! The important thing to note is that the inability to stimulate economic growth by printing money is not all that uncommon at the end of long credit cycles. It happened in the U.S. in the 1930's and it has been happening for the past ten years in Japan. In fact, I would go so far as to say this phenomenon is inevitable at the end of this 60 or 70 year Kondratieff or Long Wave cycle.

ON THE VERGE OF COLLAPSE?

Regarding the issue of whether or not the U.S. is yet pushing on a string, the Prudent Bear's brilliant analyst Doug Noland offered some thoughts this past week at www.prudentbear.com. You should visit this site because there is a wealth of information there not just from Doug but from a number of other analysts like Lance Lewis and London based Marshall Auerback. In his latest post, Doug talked about the stubborn resistance of the American consumer to stop buying things, despite his over indebted balance sheet. He gave this as a reason to believe the ever more frequent analogy of "pushing on a string" to describe the inability of the Fed to generate GDP growth by printing money may be a bit premature. But he acknowledged that sooner or later that analogy will likely become accurate. Here is an excerpt from Doug's work dated November 9th.

"It is now commonplace to read reference to the Fed "pushing on a string" and having lost effectiveness with being caught in the infamous "liquidity trap." While I am sympathetic to these concepts and can imagine both applicable at some point in the future, they remain largely inappropriate today. After all, how can one argue that lower rates are not stimulating borrowing and spending with the key interest rate-sensitive sectors booming? It's worth keeping in mind that household mortgage credit expanded at an 11.4% rate during the second quarter, a torrid pace likely being surpassed with the current refinancing boom. Furthermore, businesses borrowed at a 7.2% rate during the second quarter, while financial sector debt increased at an 8.8% rate and State and Local government debt expanded at 8.4%. The dilemma, as we have addressed for some time now, is not that policy is ineffective in stimulating normal borrowing and spending patterns. The insurmountable problem is that a Bubble economy of such historical proportions requires enormous sustained credit excess - feeding to all the beckoning valleys, cracks and crevasses - to maintain the semblance of a normally functioning system. Clearly, excesses of such magnitude are problematic and increasingly destabilizing for both the economy and financial system. This then explains why the frantic 'terminal stage' of Credit Bubble excess is generally (and fortunately) short lived.

"Nonetheless, the authorities have embarked on a futile and increasingly precarious course of attempting to resuscitate unsustainable boom-time demand. Do they truly believe it is advisable to stimulate a wild burst of vehicle sales, unprecedented mortgage credit creation, and such extreme money supply growth? While these actions are indeed forestalling a severe downturn, they are significantly increasing the probabilities for much worse down the road. The U.S. economy's greatest ills are structural, the unavoidable consequences of previous gross borrowing, speculating, and spending excesses. It is our view that these types of deficiencies and imbalances are only growing more dangerous. The patient has been poisoned by credit and speculative excess, has suffered severe damage to internal organs, and is in critical need of extended bed rest and carefully guarded recuperation. The Fed is injecting steroids and prescribing an aggressive exercise program. This will be a regrettable case of the Federal Reserve being forced to learn the hard way that there is no shortcut for a necessary healing process/adjustment period.

"It does not today take a wild imagination to come up with a scenario where collapsing demand in the overheated auto and residential real estate markets lead the economy into a very deep and protracted downturn. Indeed, objective analysis would today have to consider such a circumstance as a reasonably high probability scenario. These are, after all, markets that have been operating at a feverish, credit-induced, pace for some time now. It is, similarly, disconcerting to ponder how the U.S. credit system will operate in the event of faltering auto and home lending. Developing over many years, auto and particularly real estate finance have become keys drivers within the U.S. credit system. They have generated huge credit expansion that is paramount to fueling spending throughout the economy, as well as sustaining financial market liquidity. Perhaps the Japanese could provide valuable insights as to the keen difficulty in generating systemic monetary expansion in a post asset Bubble environment. They have certainly witnessed first hand how monetary processes become exceedingly more difficult to manipulate when the key asset class (real estate) responsible for previous systemic lending excess begins depreciating in value. But that's why feeding asset inflation is a dangerous game, and why we fault the Fed for playing it so recklessly. It also explains why "pushing on a string" will surely be applicable to the U.S. credit system at some point in the future. I hate to be the unrelenting curmudgeon, but the Fed's seething travails to forestall recession are laying the financial and economic groundwork for depression."

Doug makes a great point that the American consumer, which has become "drunk" with prosperity continues to leverage his balance sheet way beyond the bounds of insolvency in order to keep on enjoying the good life. But I do not blame the consumer so much as our leaders who, rather than facing the reality of our depraved economy, keep administering greater doses of money. Referring again to the ever increasing amount of debt (money) that has to be created to realize the same amount of GDP growth, I think it is safe to say that in effect what Greenspan and all the elitist policy makers are doing is no different than if a doctor continued to succumb to the demands of a dying heroin patient in the terminal moments of life. Issuing more money, like issuing more heroin may make the patient feel better, but it ensures the patient's (economy) ultimate death at an accelerating rate of speed.

WALL STREET IS SLOWLY CATCHING ON

Thanks to the excellent service of Richard Russell, editor of the "Dow Theory Letter," I was made aware yesterday that some of Wall Street's top name analysts are now starting to buy into the views of the likes of Ravi Batra, David Tice and Ian Gordon, which were presented to you back in 1999. I would strongly encourage you to visit www.dowtheoryletters.com for additional information on Richard Russell's excellent work.

Here is an excerpt from "Richard's Remarks" posted on November 9th, which passed along some of the candid views of some of Wall Street's more credible, honest and accomplished analysts such as Morgan Stanley's Barton Biggs and Stephen Roach.

"The strategists at Morgan Stanley 'tell it like it is.' Morgan Stanley let's them do that? Answer -- surprisingly, yes. Two of Morgan's top strategists below.

"Writes BARTON BIGGS in a piece entitled, 'Not a Pretty Picture.' I have been in Europe all week, and the revelation is how weak the economies here are; how far below expectations earnings are going to be, both this year and next and how complacent most investors and central banks are. Absolutely no reputable strategist or economist is forecasting a recession, but then, of course, no one ever does. However, the combination of weak activity, whiffs of deflation, and corporate structural rigidities almost guarantees a severe profits recession in quarters to come. I expect a test of the September lows."

"This from Stephen Roach: "After my most recent visit to Asia, I must confess to a serious loss of faith. Not only is the region in terrible shape from a cyclical point of view, but its structural problems loom more formidable than ever. The unhappy state of Japan's economy is no secret -- a fourth recession in eleven years speaks for itself.

"The data flow is terrible and getting worse by the day. With industrial production plunging by 2.9% month-on-month in September and the unemployment rate surging to a record 5.3%, this downturn is easily on par with that of the 1970s."

"Meanwhile, Merrill Lynch's Richard Bernstein (their chief quantitative strategist) runs what he calls his most reliable indicator. This is his "sell side indicator," which is a survey of Wall Street strategists' equity allocation (what percentage of assets should be held in stocks). In late September this indicator stood at 71%, its highest level ever. When this indicator was below 50% (its a contrary indicator) the following 12 months has never been negative for equities. When the indicator was above 60% half the time forthcoming equity returns were positive only half the time. When above 61% equities never outperformed cash in the coming 12 months. The current 71% reading calls for a drop of 25% in equities in the coming 12 months. Should be interesting.

"Standard & Poor's weekly publication, "The Outlook," is headlined (Nov. 7) "Looking Across the Valley." The Outlook starts, "The recent dismal economic reports can be taken as a sign that the recession is near its nadir and doesn't have much further to go."

"And that seems to be the widespread sentiment today.

"How do they know that "the recession is near its nadir and doesn't have much further to go"? I'll be damned if I know. They don't really say. I think it has something to do with what the Fed has been doing. Well, if optimism is a blessing, Standard & Poor's analysts are blessed. Me, I'm from San Diego (a province of Missouri). So c'mon, show me.

"Here's how the International Herald Tribune's reporters see the situation: 'With the United States reeling from the terrorists attacks and Japan mired in a decade-long slump, Europe was supposed to steer the global economy through the storm. Instead, it is stalling too -- held back, economists say, but a high-stakes game of brinksmanship among European policy makers.

"While US leaders slash borrowing costs and seek to spend tens of billions of dollars to try to rev up their economy, Europe is paralyzed, constrained on the one hand by a stubborn central bank and on the other hand by budgetary restrictions that have been called a corset, a straitjacket -- even a medieval torture chamber. Instead of taking action, European policymakers are pointing fingers at each other.'

"While I'm on a quoting binge, I want to quote from the Levy Institute that is now situated at Bard College. The Levy group was one of the favorite forecasters of the late, great Bob Bleiberg, former Editor of Barron's. Here's what the Levy Institute is saying: "The United States should now be preparing for one of the deepest and most intractable recessions of the post World War II period, with no natural process of recovery in prospect unless a large and complex reorientation of policy occurs both here and in the rest of the world. The grounds for reaching this somber conclusion are that very large structural imbalances, with unique characteristics, have been allowed to develop. These imbalances were always bound to unravel at some stage, it now looks as the unraveling is well under way."

If ever there was a time NOT to buy stocks it is now! The S&P became even more expensive this past week with the Earnings yield going down to 3.28% of which only 1.39% was comprised of cash. As Richard Russell has pointed out time and time again, as we approach a major economic decline INCOME PRODUCING INVESTMENTS are going to be what everyone longs for. Unfortunately, companies paying out dividends are already far and few between - even at this early stage of the decline. And already the need for cash flow on the part of investors is beginning to push the yields down on both debt and equity investments. Clearly, investors who sold out of equities and purchased bonds have done exceptionally well compared to those who believed the Wall Street arguments that it makes more sense to seek capital gains than dividend or bond yields.

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