Subtract Apple’s earnings and the bounced back earnings from the ‘hated’ AIG & the earnings growth from the remaining S&P 500 stocks was only 1.1%.

Observing its momentum, it’s hard to see anything stopping Apple’s stock from taking out $525/share or even $550 before it’s anticipated announcement of the iPod 3 (just guessing & if things play out as usual, we’d have a temporary selloff after everyone has bought ahead of the announcement).

Despite Steve Jobs’ passing, Apple still has:

-the most popular products (with a cult following),

-the best management,

-approx $100 Billion in cash,

-extremely high gross margins

-the most profitable retail outlets with unheard of sales per square foot, and

-explosive new growth opportunities in the enterprise space (with some in business & government beginning to move away from Blackberry toward iPhones).

Other than that and only a modest P/E multiple in the face of a 100% last-year earnings growth rate, there may be few other reasons to buy their stock (or so someone might be tempted to say)! Of course, they depend on new product development and the law of large numbers could eventually catch up to them. Predictions that they’ll double to a trillion dollar company will obviously not happen overnight but its fun to watch a semi-parabolic move in the stock of the most valuable firm in the world. (FWIW, I’m personally no less bullish on Apple than when Steve Jobs was alive but recognize that a huge firm can face limits to growth. ).

Wayne

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PS: Apple just cleared $500 share & seems unlikely to look back any time soon. According to advisor analyst:

• If Apple had Microsoft’s Price-Earnings Ratio, it would be worth $483/share
• If Apple had Oracle’s Price earnings ratio, it would be worth $514/share.
• If Apple had Amazon’s Price Earnings Ratio, it would be $3,347 a share.
• If Apple had Netflix’s Price Earnings ratio, it would be worth $17,948 per share (which would give it a market capitalization of $17 Trillion)

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PPS: Our Super Mario Brother in Europe will be doubling down on even more Long Term Financing Operation (LTRO). Facing a second Great Depression, Mario Draghi is arguably even more Super than “Easy” Al (Greenspan) or “Helicopter” Ben (Bernanke). The Piper may have to be paid in a few years, but for now let’s continue to eat drink and be merry … so long as we remain on Super Mario Brother’s chosen EZ Money Path (with more than a little help from the good ole USA)!

The market’s direction remains path dependent. For now, we remain on the path easy money financed in part by Helicopter Ben who is helping to shower Europe with fresh, electronically produced dollars exchanged for Super Mario’s Euros and available to bail out European Banks with 3 year, 1% loans courtesy of the LTRO! Helicopter Ben may not be far behind with more easy money while Obama promises another $1.3 Trillion deficit for 2012. Remember Marty Zweig’s old adage: “Don’t Fight the Fed.” Throw in the ECB & virtually all central banks around the world that are printing money like there’s no tomorrow!

What do we get for our unprecedented money printing, and huge deficits: 1.5% growth! What happens when we take away the sugar, caffeine & speed? We’ll find out after the election!

In all seriousness, we all have to hope that attempts to buy time allow players 2 insulate themselves from the effects of a Greek default. What we do during the respite may make all the difference in the world!

I agree that we are at “risk” of seeing the Post World War II “Great Debt Super Cycle” come to an end. Just as this long term post-WW2 credit expansion has boosted GDP growth rates enjoyed in this Post War Era, a gradual reduction in such credit would tend to depress GDP growth, (hence the reason for my belief that we are mired in an economic depression that is qualitatively different from the previous Postwar recessions).

Although this depression scenario has been a long held view, I see some prospect that this Great Debt Super Cycle could eventually gain a second wind due both to (1) short term government stimulus and (2) depression fatigue (aka Euro Fatigue) on the part of U.S. consumers. With pent up demand to replace aging autos and effect long-deferred household formation, such “second wind” seems less fanciful when viewed in the context of the many mini-recoveries enjoyed in Japan during their two lost decades of the 1990s and 2000s.^[ii]

Like the Japanese, we have mitigated our depression with massive fiscal stimulus (although our Debt to GDP ratio has risen to “only” 100%, a level half that of the approximately 200% Japanese Debt to GDP ratio created by two decades of their proverbial “bridges to nowhere” and business bailouts.) The Japanese are sadly finding that their more shame-based culture may have less resilience^[iii] (i.e. display greater fragility in the language of complexity theory) in shame-based cultures that recoil from facing failure absent a face saving utter defeat.^[iv] While they may feel partly protected by their high savings rates, such protection is weakened by the “security” of questionable investments in Japanese and other sovereign bonds^[v] (aka “paper” & “electronic” IOUs that some fear are ultimately not going to be worth the paper they are not printed on!)

While the Japanese may be running our of time, we “fortunately” have the theoretical ability to grow our destructive debt snowball as a result of our reserve currency status and heretofore greater economic dynamism, innovation, and protection found in the rule of law. The U.S. also faces far less dire demographic trends than Japan or even Europe.

Given all the relative advantages we enjoy as Americans, it seems likely that this recession, which was “knocking at our door” in the summer and fall can be delayed for a while longer. If this happens, the second recession within what I am still characterizing as a depression might be delayed long enough to give us time to turn our Ship of State toward a more sustainable course.

My hope is that we use any respite to get our fiscal house in order. My fear is any success in holding off this depression’s second recession will give our society apparent license to edge back toward its more profligate ways and allow debt problems to fester to a point sparking a new crisis that will require even more sacrifice to deal with. If history is any guide, elected politicians will opt for the easy solutions to continue to their Faustian Bargain until we reach the Keynesian Endpoint. The good news is that pain can be delayed. The bad news is that our condition worsens so long as we allow the cancer to grow.

Of course the choices are not limited to two extremes but rather include a range of treatments including a gradual withdrawal from our debt addiction in a manner that allows us to safely de-lever. The “fly in the ointment” relates to the difficulty (bordering on impossibility) of happening onto wise, democratically elected politicians able to sustain public support through the short term “air pockets” and mini-crises that inevitably occur during the most difficult part of the treatment! In the end, our best hope may be that we “muddle through.” More likely, we will first need a political crisis to force a response to the Gathering Storm.

Inherent Path Dependency

Which brings us to the economic concept of “Path Dependency,” popularly associated with economics Ph.D.s at least since the time of Harry Truman who famously lamented that he could never find a “one armed economist.” Like all good economists, Truman’s economic advisors were criticized for seeming to temper their forecasts with the caution of what, “on the other hand” would occur if events unfolded in a different direction.

Fasting forward from the 1940s & early 50s, we should better understand how seemingly small events create huge changes in what we now understand to be complex systems (i.e. interconnected and interdependent economic agents that adapt to change based on their differing incentives and circumstances). Throwing in the potential for staggering domino effects, we understand that almost no elected politician would willingly accept an economic catastrophe so long as the consequences can be pushed forward to a future administration or even future generation!^[vi]

Sudden failures are of course sometimes allowed once memories of previous economic tsunamis have faded from memory. This is what happened in 2008 in response to a growing drumbeat of populist opposition to bank bailouts such as that which “saved” Bear Sterns in the Spring of 2008. The growing chorus of calls to avoid “moral hazard” and allow failure was girded with the intellectual framework of Austrian School Classical Economists which ignores sticky labor markets, assumes economic rationality, and assumes full employment and equilibrium ensured by a quick “regression to the mean.” Using the “laws” of economics, these economists with what I like to call “physics envy,” foresee a quick return to equilibrium with a certainty bordering on that associated with Newtonian Physics.

 Once the systemically important Lehman Brothers was allowed to fail, the consequences of letting “the letting the chips fall where they may” became clear. Either we were going to accept the so-called “moral hazard” of a bailout or we were going to face a second Great Depression! Neither Hank Paulson or George Bush (or even Nancy Pelosi) wanted to undertake trillion dollar bailouts. But they understood that failure to bail out the banks would ensure a world wide depression that was orders of magnitude greater than anything ever seen since the founding of this country. Such bailout was soon aided and abetted by Keynesian Economists focused on deficient demand in ordinary business cycles and concerned about containing the short term pain than safely defusing a growing debt time bomb.

 Fast forward three years to the 2011 chapter of the European Crisis and we see the possibility of a cascade of falling dominoes sparked not just by the seemingly limited failure of an investment bank but by the possible failure of an entire country! While first contained to relatively small countries such as Ireland and Greece, the falling dominoes began to undermine confidence in Portugal, Spain, and then Italy. The feared catastrophic consequences of the collapse of Lehman Brothers, as bad as they were, paled in comparison to the prospect for failure of entire countries, including Italy which is the third largest country in Europe!

 The fear of another “Lehman Moment”^[vii] led certain individual countries such as Ireland, the U.K. and Greece to tighten their belts and get their fiscal houses in order. This raised the unfortunate specter of the “fallacy of composition” under which we can sadly find that actions that appear helpful to a single individual (or entity) turn out to worsen the problem when (almost) everyone tightens their belt at the same time!

 To make matters worse, Jean-Claude Trichet began to tighten monetary policy to fight nascent (and largely non-core) inflation precipitated by the massive monetary stimulus in the US (which exported inflation to Europe and China while still failing to sufficiently debase the US dollar to help both stimulate its exports and partially inflate its way out of our excessive national debt). Tight European monetary and fiscal policy left Europe on the edge of a serious depression with a second recession prematurely knocking on the door of the already depressed US Economy.

 Super Mario Brother (at Least Temporarily) Saves the Day

 Facing depression and social unrest from the disorderly collapse of the Euro, the Mario Draghi quickly reversed Jean-Claude Trichet’s contractionary fiscal policy. In his first major move as the new President of the European Central Bank, Draghi helped to orchestrate one of the greatest feats of financial legerdemain in modern history. Absent the monetary authority available to the more independent U.S. Federal Reserve Board, the MIT-educated Draught’s ECB orchestrated a solution in which local governments unable to borrow money at hopefully more reasonable terms from local banks which suddenly found themselves funded with 3 year notes at 1% from the suddenly accommodative ECB!  To restate:

1. the ECB lends 3 year paper to insolvent European banks at 1% (replacing wholesale monies withdrawn by U.S. money market funds and institutions which could not bear the risk of default
2. the suddenly less insolvent European banks now have funds to lend to overly to local business that would otherwise be unable to obtain loans
3. ….unless such businesses are viewed as too risky, in which case bank funds might be “temporarily” parked in bonds issued by the indebted (& effectively insolvent European countries in which they are located
4. enjoying potentially new “investor” demand from their ECB-funded local banks, it is (or was clandestinely) hoped that lower interest rates paid on European sovereign debt might both help fund the local countries and at least partly mitigate European bank losses from the extent of the write down that they will almost certainly need to recognize when they report earnings for the fourth quarter of 2011!

Like two staggering drunks propping each other up, Draghi may have helped Europe buy time to safely and gradually get their fiscal house in order! Before markets fully recognize the financial slight of hand, it would help if the important European banks could raise the additional equity capital that they failed to raise in 2008 when major U.S. banks were effectively forced to raise the new equity capital. Whether European Banks can raise enough new capital is an open question. The extent to which they succeed will go a long way to determine whether they can avoid a major financial accident and avoid turning a deep “Club Med” depression into depression throughout the entire Continent. The U.S. may be able to delay a new recession if Europe can avoid debt contagion and depression. It would also help if India could contain its collapsing currency and China can orchestrate a soft landing! But that’s a subject for another day.

The $64 Trillion Question: Will the First Installment of Super Mario’s Bailout Be the Last?

While the Super Mario’s $638 Billion Dollars of Loans remains far too small to meet all of Europe’s needs, it does provide a first step toward providing breathing room for governments to facilitate some path to safely reducing leverage. Once it is understood that Euro was widely believed to have been within only days of collapse, one can better appreciate the importance placed by certain politicians on offering additional financing sufficient to stem the flight of Euros  before it morphs into panic. Assuming that this large but limited monetary leash provides a first installment of an effective monetary bailout, Europe may be able to avoid the deflationary debt trap that would otherwise come from sapping real resources that would crowd out other spending. And to help mitigate the liquidity drain that could crowd out excessive amounts of European resources, the World’s “Uncle Ben” (aka Helicopter Ben) Bernanke also stands ready to provide “Euro-Dollar Swaps.” If the ECB is a little short of dollars, they can simply exchange some Euro-denominated debt for newly created U.S. Dollars! All courtesy of Uncle Sam! Let’s just hope everyone appreciates how nice it is to have such friendly uncles!

The result is that we possibly forestall a European collapse and debt contagion that would otherwise spark a new U.S. recession and create even worse consequences in Emerging Markets dependent on strong consumer demand from the so-called developed Western World. With memories of Lehman Brothers fresh in everyone’s mind and elections looming in the U.S. and Europe, politicians have a strong incentive to go down this path^[viii] of kicking the can down this long and winding road.

Possible Near Term Paths For US Consumption and GDP

Assuming Europe takes the path of this bailout and complacency sets in, it is possible that the recession weary US consumer spending might continue on a path of new borrowing over the past few months, as evidenced by a drop in savings from 5% to 3.5% of income. If this continues, the economy may remain on its sugar high for a number of months or years^[ix] before facing the painful steps of financial deleveraging.

Of course the longer they wait, the greater the cost. But the near term course of the economy critically depends on the path that is chosen. My hope is that we move toward a relatively safe and orderly deleveraging. My fear is that it will take a much bigger crisis to motivate myopic politicians to make the tough choices to nudge us toward a more sustainable path. Considering all known facts and circumstances, the path of least resistance is to palliate the pain while stretching out or even delaying attempts to get control of excessive debt.^[x]

In fairness to the US consumers, one should recognize that reduced savings may be at least partly explained by the loss of jobs in certain relatively high paying jobs in finance and government in favor of new employment opportunities for lower paying jobs such as those who’ve helped us with our annual Christmas shopping and our friendly Wal Mart. To maintain living standards, laid off government workers and employees working lower paying jobs inevitably display a higher Marginal Propensity to Consume. In addition to (a) reduced savings, the economy has been goosed by (b) new energy developments, (c) lower gas prices, (d) the payroll tax holiday and (e) accelerated capital spending due to special tax breaks that expiring December 31, 2011.

Payroll tax holiday. 

To maintain this stimulus, we are extending the payroll tax holiday and hopefully encouraging a further drop in energy prices that could happen if domestic energy resources continue to explode, Europe, India, China, and Brazil continue to weaken, and/or contagion extends to our shores.  The payroll tax will eventually need to be restored (or more likely a “soak the rich,” “progressive” tax is initiated) and the Bush Tax Cuts may someday expire, something that is especially likely to occur if President Obama is re-elected. If savings also renormalizes, we could easily find that our recent 2.5% growth in GDP again slips perilously close to recession. If we can skirt recession in the first half of this year, the pent up demand for automobiles and gradual bottoming of the housing market could set the stage for modest growth. But in the end, the future is path dependent, regardless if one argues from the left the Left or the Right. George Soros made billions from understanding reflected in his theory of reflexivity which profits from bubbles that Neoclassical Economics said could not exist (and which the Nobel-Laureate laden Chicago School economists ignore to their peril based on what Talib might label their Procrustean Theory of Economics which lops off the limbs of important detail in an attempt to force their reality to fit with the skeleton of mathematical models. I’d call it an exercise in futility at best and the cause of both the 1998 Long Term Capital Management catastrophe and the 2008 Financial Panic.^[xi]

Rays of Hope From Innovation and Change

Despite stifling new regulations that delay recovery in a manner reminiscent of FDR’s counterproductive populism of the 1930s, I continue to pound the table for the new rays of hope that could mitigate the depths of this depression and set the stage for solid growth by the 2020s. At least partly offsetting many aspects of our dysfunctional education system, we have virtually unlimited potential for better educated immigrants who seek a land of opportunity made possible by our greater respect for human rights and the rule of law.

Along with an arguably fewer number of U.S. educated students (the population of which could be expanded with more enlightened educational policies), we have the potential for continued technological innovation and cheap, abundant and cleaner energy.

The revolution in fracking and our abundance of Natural Gas is already allowing for significant U.S. energy exports.  It is hard to think of a group of private investments that will create more stimulus and do more to strengthen national security than new energy investments that help to free us from Middle East oil. The Keystone Pipeline, fracking, and renewed energy developments in Alaska and the Gulf of Mexico will take us a long way toward energy independence. While this must arguably be balanced with enlightened environmental protection, the economic and worldwide environmental benefits of cleaner (albeit not perfectly clean) energy offers a way forward that seems almost impossible to stop. While debt and demographic issues create important headwinds, the tailwinds of innovation and creativity of (relatively) free people offer a strong basis for hope of a much better tomorrow!

Comparison With Your Bridgewater Claims

While gold would correct further if a Fisherian-style debt deflation were to emanate from Europe, a mild deflation contained by Central Bank easing would continue to support precious metals even if base metals such as Dr. Copper remain weak after its strong 2 to 3 year bounce. If we take the path of monetary debasement, an eventual inflation would come near the end of a possible bubble in gold which started to become evident earlier in the year.

One assumption I would carefully question is the near-universal assumption that the Chinese RMB will continue to appreciate against the dollar. Helicopter Ben Bernanke’s Quantitative Easing many not have succeeded in creating inflation in the U.S. but it has succeeded in exporting inflation to China and other emerging markets. Higher food and energy costs represent a larger portion of the Chinese budget and represent a source of labor unrest. Higher Chinese labor costs make it more difficult for them to compete in manufacturing low value added products that have begun to move to areas of even lower labor costs. Any inability to sustain their breakneck growth runs the risk of painful retrenchment which could lower the Yuan’s value when combined with inflation and loosened controls.

Like Bridgewater, I also remain bullish on U.S. Treasury Bonds which were by far the best investment of 2011. Whether Treasury yields shoot up after mid year depends on whether money continues to flee to the relatively safe haven of the U.S. Dollar or whether new stimulus sparks more rapid growth from a another sugar high from the drug of new debt creation. As I’ve argued throughout this discussion, our economic outlook remains unusually sensitive path dependence.

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^[i] This is consistent with the view I’ve held since my premature expectation of a nasty downturn by 2006 which was did not begin to kick in until 2007 & did not fully materialize until 2008. One thing I’ve learned from this premature call is that the economy can remain resilient for much longer than a presumed rational analysis might otherwise suggest.

 ^[ii]  FWIW, I recall seeing references by John Mauldin to oral statements made by Martin Barnes to the effect that he sees this Great Debt Super Cycle extending at least several more years as governments do everything in their power to delay facing the consequences of decades of our imprudence. His characterization of this Super Cycle has of course evolved over the years since his predecessor Tony Boeckh first coined & popularized this term. This great postwar credit expansion should also be seen in the context of our demographic time bomb and the “need” to placate civil unrest from rising wealth and income disparity that has reached extremes not seen since the late 1920s.

 ^[iii] Using the language of complexity theory, we might say that a shame-based culture tends to have greater fragility.  The more fragilized the economy or society, the greater the potential for that proverbial last snowflake to create a landslide. If history is any guide, it will not be until after cataclysmic landside that the politicians will lead the mobs to jail whoever happens to represent that unhappy last snowflake or snowflakes that touched off the landslide. In the end, the voters will demand someone be sent to jail (so long as it’s someone other than the next crisis’s Barney Frank, Chris Dodd, or Franklin Raines who will have turned out to be most responsible for creating the systemic fragility and then (in the case of Raines)raking in the ill-gotten gains.

 ^[iv]  The Atomic Bomb of 1945 and the Tsunami and nuclear meltdowns of 2011 are two possible examples of overwhelming power that permits a face-saving defeat. If so, widespread business failures in the wake of the Tsunami could prove to have the silver lining of allowing for the Schumpeterian Creative Destruction to set the stage for some form of renewal from redeployment of capital previously trapped in failing enterprises that up to now have not been allowed to die.

 ^[v]  The Japanese sovereign bonds held as security for retiring Japanese could have just as easily been dubbed “paper” IOUs that some fear are ultimately not going to be worth the paper they are not printed on!  Germans in the Weimar Republic at least had paper to burn. Holders of today’s currencies seem content with electronic impulses!

 ^[vi] The devastating economic catastrophe resulting from cascading bank and sovereign failures are simply too great a cost to allow them to pull their metaphorical fingers from weakening dykes. Unless all other options were exhausted, it is reasonable to presume that they will at least attempt to alleviate the symptoms. Perhaps the best that can be hoped for is that some pain is accepted during a period of gradual deleveraging in an attempt to safely let the proverbial “air” out of the economic balloon. Before dismissing this as too pessimistic, consider Churchill’s comment that democracy is the worst form of government. Except for all others!

 ^[vii]  This “Lehman Moment” point of crisis has also been dubbed the “Minsky Moment” by Paul McCauley for the now famous economist Hyman Minsky. Minsky’s insight was that economic stability breeds complacency that fragilizes systems and temps people to take more and more risks. Such fragility was unwittingly aided and abetted by economists who measured risk based on historical experience that was limited to the expansion phase of the Great Debt Super Cycle. As still waters and the Greenspan Put bread growing complacency, “too big to fail” financial institutions took greater and greater risk with more and more leverage and counterparty risk from derivatives dubbed many years ago by Warren Buffet as Financial Weapons of Mass Destruction. Unhappily, Buffet was proved right. Even more unhappily are the even greater destructive consequences we could face if we don’t adopt strategies allowing us to safely delever. The apparent decisions of Bank of America and JP Morgan to shift a combined $154 Trillion of derivative exposures to the FDIC and the taxpayers could be said to be a giant step in the wrong direction! For anyone making the counterargument of a more moderate ‘net’ exposure, I would point to the counterparty risk shouldered by AIG which was unable to make good on its Credit Default Swaps counted on by other parties to neutralize risk. Absent the US Government’s bailout of AIG, many “too big to fail” U.S. financial institutions (including Goldman Sachs) would have almost certainly been bankrupted.

Policy Makers’ Attempt to Stave off European Depression Reminiscent of Fall, 2008 Stimulus

Widely Credited with Staving off US Depression

November 30, 2011

1.             In a move reminiscent of the Fed’s contribution to the 2008 U.S. Bailout, dollars are being printed to provide emergency funds via the ECB to major European Banks. This, combined with this morning’s 50 basis point reduction in Chinese reserve requirements, is the Fed’s answer to weeks of fund outflows from major European banks capped by last night’s S&P downgrade of 15 major banks.

While we averted a Double Dip Recession in 2010 with our remaining fiscal stimulus and the Fed’s Q/E-2, we now have a Fed that is out of major policy bullets, only limited room for fiscal stimulus and Gathering Storms on the International Stage. Crises affecting both European Banks and Sovereign Credits threatens a disorderly crisis in the Euro that makes it much more difficult to accelerate the economy out of its present “stall speed.” To add to the challenges, we now find that China’s attempt to contain their property bubble is beginning to take hold. “Dr. Copper” is warning of a serious Asian slowdown that is further confirmed by collapsing prices for cement and other commodities. Domestic Metallurgical Coal producers are further confirming a softness in steel, another telltale sign of a soft patch that will prove to be the start of a new recession UNLESS policy makers can pull some kind of rabbit out of the proverbial hat!

Real GDP apparently fell in January and February, followed by a weak bounce and renewed weakness this summer. While it has not yet persisted long enough to qualify as a recession, any bounce this quarter will need to be followed by additional growth to avoid the next leg down. The sad thing is that this next recession, whenever it starts, will start from a high level of unemployment that will seriously challenge our own deficit and make it difficult to stimulate out of. An economy that does not respond to 0 to 1% interest rates and does not respond to multi-trillion dollar deficit spending in the face of deflationary excess capacity is an economy that is in a Depression. The exact start of the next recession is academic. Unless the word “depression” is purged from our vocabulary, a three year liquidity trap is depression. Even if we get by with another near miss, the fact that we’ve had two near misses in two years after what is called the Great Recession tells me we are in a Depression, albeit still a Contained Depression. (As in all depressions, some segments of the economy are still doing fine. For example, retail technology as exemplified by Apple Computer which is in the process of trading places with Exxon as the most valuable company in the world). I do find it interesting that fewer people get mad at me when I say we are in a depression than when I said we were entering a depression three to four years ago! This tells me that a psychological depression is beginning to set in which gives me hope that we are moving from the 2nd to the 3rd inning of this slump. Attitudes toward debt will eventually change as it did after the Great Depression***.

While Q/E-1 led to a massive bounce comparable to the recovery in late 1929 to 1930 and Q/E-2 at least helped forestall a Double Dip Recession, Operation Twist may actually do more harm than good as it dampens the rebuilding of bank capital by pressuring banks’ Net Interest Margins while further depletes the income of savers. Meanwhile, reducing mortgage rates by 15 to 25 basis points will do little or nothing to stimulate housing demand that was not already stimulated by 30 year interest rates around 4%. In the words of David Rosenberg, “ the Fed has moved from cannons to shotguns to water pistols.” It will be very interesting to see the next data point on the ECRI Weekly Leading Index tomorrow.

Facing a crisis, the World is retreating to the US Dollar, a store of value that still retains a lingering reputation as a risk free asset. This temporarily stronger dollar will exacerbate weakness in commodities and even exacerbate a temporary weakness in precious metals. But in the end, I’ll bet that the temptation to depress interest rates will lead to further purchases of overvalued bonds and further debase currencies in a worldwide competitive devaluation (i.e. a race to the bottom). To make matters worse, Brazil has just imposed a 30% Tariff on China, a move reminiscent of the infamous Smoot-Hawley tariff imposed by the Emerging USA in 1930. Meanwhile, Europe’s decision to tighten monetary policy as it did just before the 2008 recession has dried up demand for European Sovereign Debt and forced the U.S. Fed to swap Dollars for Euros so that the European Central Bank can funnel dollars to insolvent European Banks and Governments.

From what I can see, this does not end well.****

For now, look at the message from “Dr. Copper” as seen in the stock price of Freeport McMoran (the largest copper producer). In many ways, it looks very much like the ECRI Leading Index. We may bounce here in the short term, but we’ll punch through to new lows UNLESS POLICY MAKERS CAN BREAK THE VICIOUS CYCLE. So far, I don’t see the political will in either Europe or the U.S. “Everyone” says that this is “no Lehman.” My only questions are: what is bigger Greece or Lehman Brothers?…Portugal or Lehman Brothers?…. Spain or Lehman Brothers? …Italy or Lehman Brothers? …European Money Center Banks or Lehman Brothers? …Bank of America or Lehman Brothers?

Just thinking about these rhetorical questions tells me that policy makers will be forced to act; otherwise our post-Lehman Brothers panic will look like a walk in the park. We know the identity of the 2011-vintage Lehman Brothers. We don’t know who the AIG-like counterparties are.

Governments will not allow a cataclysm until all other options have been exhausted. So Germany and the U.S. will eventually have to do the right thing….but not until they’ve exhausted every other alternative (to again use this overused Churchillian phrase)

*** A similar phenomenon also occurred after the Panics of 1837, 1873, and 1893. This may have been especially evident after 1893 when inflation brought by the mass coinage of silver (i.e. 19th Century Money Printing) turned the 1870′s deflation to inflation in the 1880′s and eventual crash in 1893 which President Cleveland blamed on the money printing of silver. The Deflation of the 1870s arose out of the post Civil War Railroad build out and Excess Capacity analogous to the Worldwide Excess Capacity we face today. While the frontier opened up by the railroads brought surpluses of goods in the 1800′s, trade, emerging markets and technology provide the transmission of Excess Capacity today.

****But I of course want to pay heed to Art Cashin’s famous advice to be careful about predicting the end of the world since the end of the world only happens once! In the end, policy makers will be forced to make tough decisions or at least “kick the can down the road” to buy time to get our fiscal houses in order. Debt can grow a few percentage points a year if GDP eventually grows by a few percentage points plus 1%! What can’t continue won’t. I just don’t believe it’s going to stop before we slip into another recession! This Contained Depression will include at least two (and I’ll bet at least three) recessions punctuated by short recoveries. But in the end, new technologies will lead to the dawn of a New Era, again proving Malthus wrong and proving Schumpeter right! So I remain a long term optimist…

A question arises as to whether asset values are “cheap.” With analysts’ earnings forecasts around $95 to $100 on the S&P, an S&P Index of 1125 is “only” 11 to 12 times earnings. While this should be inexpensive in the face of low so-called risk free rates, the advent of recessions tend to go hand-in-hand with a fall in earnings which could easily be at least 25% to 30%. This gives rise to a critical question of whether or not we are falling back into recession. If recession is avoided, the S&P could easily rally to test its recent highs near 1300. If recession is at the door, the S&P could easily slip below 1000. So long as the recession remains contained, S&P weakness should be contained between 900 and 1000. All bets are off if parts of the Euro Zone collapse in a debt-deflation catastrophe. Ongoing signs of resistance to bailout of the GIPSI countries bears watching. Exploration of that possibility is deferred to a later communiqué.

Let’s look at a sample of indicators to assess whether or not we are slipping back into recession.

1. First is the shocking number from the Philadelphia Fed which fell below minus 30. NEVER has the “Philly Fed” index fallen below minus 30 when we were not in a recession. While the Philly Fed index only measures regional manufacturing, it could be a canary in the coal mine

2. The New York Fed’s Empire State Index produced a negative print for the 3rd month in a row, falling from negative 3.8 in July to negative 7.7 in August. Bottom Line: this is often a harbinger of recession

3. The Chicago Fed National Activity Index (CFNAI) Reported August 22nd actually rose based on July Data from a minus 0.38 to only a minus 0.06. While it is a national rather than regional study that includes both services and manufacturing, it uses data points that somewhat lag the Philly Fed and the Empire State Index. Hence, next month’s CFNAI report will be important to watch

4. Challenger, Gray & Christmas reported August 3rd that employers plan to increase layoffs by over 60%

5. The Economic Cycle Research Institute’s Weekly Leading Index (WLI) turned negative for the week ending August 20th. While this negative print would need to persist before the ECRI predicts a recession, the Index’s recent persistent weakness and breakdown into negative territory bears watching

6. Unemployment Claims rose back above 400,000

7. First Quarter US Real GDP was revised downward on July 29th to only 0.4%, with first Half GDP only 0.85%.

 a. The economy is dangerously close to stall speed once Real GDP growth falls below 2% (now below 1%)

 b. One more major adverse shock and this expansion is history

 c. Talk could even emerge as to whether the recession ever really ended if we get a negative GDP print for Q3. A downturn in Q1 of 2012 would still qualify in many minds as a double dip

 d. Q4 is likely to be “goosed” by Capital Expenditures ahead of the expiration of the 100% CAPEX tax write-offs that will likely “steal” CAPEX from Q1 of 2012 (unless Obama is able to kick the can past his re-election bid by delaying the expiration of the tax break until year end 2012).

 e. A downturn any time in the next 12 months may finally give rise to widespread recognition that we remain mired in the first Depression since the 1930s.

 f. Analysts who continue to quote statistics surrounding a “normal” post WW2 recession are reading from the wrong playbook. This is a Balance Sheet Recession (aka a Depression), the likes of which we have not had since the 1930s. But for approximately $2 Trillion of government stimulus on borrowed funds, the unemployment would be higher.

 g. Whenever it starts, the next recession will start from an unacceptably high unemployment rate (an unemployment rate that suggests economic slack that would not presage a normal garden-variety recession following a temporarily overheated economy). This will lead to government deficits that are much larger than those now predicted by the Congressional Budget Office!

 8. Commodity Prices are weakening, suggesting a slippage of demand (Oil prices Also weakening)

9. I also smell what I’ll call the “political barometer” that I’m picking up from Obama’s new finger pointing in which he is blaming the Tea Party for creating this recession. If we don’t fall into recession, the president appears to fear that the voters will find it difficult to tell the difference between slow growth and an outright downturn

10. Until recently, almost every market analyst seemed to be predicting a second half rebound, bringing to mind one of the legendary Bob Ferrell’s 10 Market Rules to Remember: “When all experts and forecasts agree, something else is going to happen.”

11. The Unemployment Report a week from Friday will be Important to Watch

12. Recall that GDP = Consumption + Investment + Government + Net EXports (or C+I+G+X)

 a. Consumption must fall to rebuild savings

b. Government Deficits are contracting due to political pressure & reduced Subsidies to States

c. Net EXports remain Negative, albeit less negative

 d. Investment from Capital Expenditures Are Unlikely to be enough to offset falling C+G

 e. High Unemployment Hurts Both Consumption and Investment

 f. Contracting Credit (Exacerbated by Dodd-Frank consumer protection laws)

 g. State & Local Government is Contracting

 h. Pension Funds have become woefully underfunded due to low investment returns and low expected returns/discount rates that increase the present value of liabilities just as baby boomers begin to approach retirement

 i. Employment to Population Ratio is at a 28 Year Low

 j. CAPEX is Dampened by

 i.  Unknown and unknowable shifts in public policy as Regulators implement new ill-timed laws that handcuff private business.

 ii. Excess Real Estate Capacity in both Residential and Commercial Structures

 iii. Neglect of Aging Infrastructure

 k. Temporary inflation in food and energy crowd out other expenditures, creating deflationary pressures

 i. Roughly half of our corn is used for inefficient ethanol (which takes almost as much fuel as produced by corn that could be better used to feed the poor in the face of worldwide food riots)!

 ii. The Government is pulling 20% of the Coal Fired Utility Plants out of Service, Which Promise to Raise Utility Bills and sap purchasing power

 l. Economic Activity Boosted in Normal Times by a Rise in the Monetary Base is retarded by a “Velocity Shock” in a Keynesian Liquidity Trap.

 13. Post-credit bubble collapses tend to be followed by less powerful upturns and more frequent downturns (notwithstanding quibbles to the contrary by Paul Krugman)

14. We’re also seeing issues of yield curve inversion in certain emerging markets suffering inflation as a side effect of the U.S. monetary policy

Offsetting recessionary tendencies, we have:

1. We see a significant increase in insider buying that gives bears pause

2. International Policy Coordination in the Face of Crisis

3. Germany’s need to save the Euro to prevent

 a. damaging deflation from an appreciating German Mark

 b. Insolvency of their banks (i.e. the Need to Bail Out Their Banks With Taxpayer

 4. The Seemingly Never-Failing “Chinese Fiscal Policy Put” in which They Construct More Empty Buildings and Roads to sustain their Growth rate (something they should be able to pull off for a number of more years).

5. The Seemingly Never-Failing “Bernanke-Greenspan Put” that brings the hope of more monetary stimulus from the Fed to bail out an ailing economy. The Fed told us that they were going to maintain their Zero Interest Rate Policy (ZIRP) until mid 2013. (For discussion purposes, set aside the observation that Monetary Policy is impotent in the environment of a “Liquidity Trap” following a Balance Sheet Recession.)

 a. A. In telling us that interest rates will remain low, they are essentially telling us that the economy will be in the tank for the next two years (fueling asset prices & helping Gold prices go vertical).

 b. I’ll stick my neck out and call this “Unlimited Stealth QE” because the only way they can promise to keep interest rates near zero is to stand ready to buy whatever Treasury securities prove necessary to keep short term interest rates near zero.

 c. This is essentially the same strategy that the Japanese Central Bank has used over the past 20+ years to contain their depression and which has resulted in would could prove to be a disastrous 200%+ Debt to GDP ratio that could give rise to hyperinflation once the World loses faith in the Japanese Yen or when the aging Japanese population starts to draw down their liquidity (whichever comes first)

 As the United States is stronger and has far more assets than Japan, Japanese-style Quantitative Easing would likely take considerably more than two decades to totally destroy the US currency. But the younger people on this mailing list may well live to see it! Japan, however, remains an accident waiting to happen.

For now, the US still has more flexibility than most of the developed world and is not yet in danger of a U.S.-initiated Debt Crisis. So long as the U.S. can still issue debt in its own currency, sell Federal Assets, and/or raise taxes, it can avoid default. While tax hikes would likely stifle the economy, erode living standards, and hasten eventual insolvency, such an unhappy ending would be the problem of a future President and a future Congress and therefore possibly downplayed by a myopic and apparently clueless political class! (Tax hikes would be less damaging if done alongside a drop in marginal tax rates such as that done in the 1980s. In the end, these may be necessary so long as polls continue to tell us that voters (a) want no increase in their taxes and (b) want no decrease in their increasingly unaffordable government benefits. For now, politicians willing to engage the electorate in an adult conversation of realistic tradeoffs appear few and far between).

Enough said for now except that my take is that renewed recession is far more likely than not within a year. And unless quickly reversed by aggressive policies, there’s a better than even chance that the NBER may officially date the recession beginning in the current quarter. If so, this new stock market bounce will fail at a lower high and eventually drift below S&P 1000. While we’re at it, we can all get out our Dow 10,000 Celebration Hats so we can “celebrate” Dow 10,000 for at least the third time! If recession does not happen, we would likely get a 15% to 20% rally that is typical of false scares. For what it’s worth, I would still view rallies as short lived.

Hang on to Your Hats!

Wayne

Facing immense domestic pressure, I wouldn’t want to bet on Merkel’s ability to convince German people to bail out the GIPSIs. Word is now coming out that they will not even broach the critical subject of Euro Bonds! (See http://www.bloomberg.com/news/2011-08-16/on-euro-bonds-europe-s-politicians-lag-behind-the-market-view.html). 

If Germany and France end their summit with only platitudes and half measures, the world economy is in deep, deep trouble. We may need a crisis to get them to act. But if a crisis hits, we could find that we are almost out of bullets to head off a new downturn which would carry serious if not disastrous social consequences. After this rally, it may in short be time to think in terms of “Risk Off.”  It’s normally problematic to look at short term swings; riding this out may require the nerves of a Warren Buffet!

Money center banks are especially vulnerable. Bank America may have been saved from an Irish default but they have another bullet to dodge in the event of a European Bank default. In the end, it’s hard to imagine that a major European bank would be allowed to default despite their apparent insolvency. The ECB has been weakened by purchasing bonds from certain GIPSI countries.

The “Barbell” strategy of balancing risk assets with Treasury bonds has worked well to date, the fall in treasury yields (until their rise over the last few days) makes it difficult for many to stay comfortable with. For those people cash may be king. I would only caution that money market funds exposed to European banks are not the same as cash!  (But perhaps no need to worry so long as European politicians can be counted on to bail out insolvent banks…. which they’ll continue to do as long as possible). Gold is still cash & may again strengthen until the next increase in margin requirements! Central Banks are buying gold; but caution that the IMF could conceivably sell gold holdings to fund short term financial fix.

One more body blow and we will almost certainly find ourselves back into a serious recession. The one hope or saving grace is that the politicians have to understand that a collapse of Lehman Brothers would be child’s play compared to the collapse of a European Bank. In the end, Germany will probably do the right thing for short term Euro survival….but, like Churchill said of the U.S., not until they exhaust every other alternative. Hang on to your seat belts!

While market valuations appear to be cheap if we remain in recovery, they are not cheap if we fall into a new recession which could easily lead to a 25% to 35% drop in profits. In fact, it strikes me that prices now reflect a high probability of another recession within the next year. Even if it’s not a full recession (which usually does not occur when an economy is already bumping along the bottom), it may feel like one to most people. As you know, I still look at this as a Contained Depression. Pray that it stays contained! Historic Ibbotson Rates of Return are totally irrelevant in this climate!

 Indicators & Risks of Recession                                                                      Mitigating Factors, If Any

Other Factors that may Weaken Immunity To Any Attack From a Euro Virus

   Fragilizing Factors                                                 Mitigating Factors, If Any

The key to watch is the extent of movement toward any fiscal union and whether the Europeans. If the Europeans can stop the contagion, an immediate recession might still be avoided. If the ECB follows with a series of baby steps, the recession spreads from Europe to the US. Whenever the recession hits, we will not be ready (due to too much debt, too high of structural unemployment and a 1937 mentality that almost ensures a downturn by 2013 if not 2012. We need high-multiplier infrastructure spending to replace proliferating bureaucracies. The rest of the country will be held back by oppressive regulation so long as Washington DC remains a boom town.

Gold has finally gone parabolic & is finally beginning to take on characteristics of a true bubble. (While I think it’s going much, much higher, today’s announcement of a higher margin requirement suggests near price term weakness in gold). Money coming out of GLD & other gold names is funneling into equities.

Unless we suddenly get some grown-ups in Washington, expect further weakness down the road. I see no political will for sane infrastructure spending to absorb 2 million unemployed construction workers. Meanwhile, the government is handcuffing the private sector with restraints from the NLRB, EPA, and bureaucrats licking their chops over Dodd-Frank and ObamaCare. And with PayGo, the possibility of repatriation of oversees profits is virtually non-existent (the pols will have the “pay for” the $80 billion it would cost to allow Microsoft, Apple and others to bring home their cash to invest in the USA. With Obama determined to double-tax repatriated profits, the new investment will be in Vancouver, China, Singapore.

Before acting on my advice, let me first offer a caveat that markets imperfectly reflect interdependent economies, each of which are complex adaptive systems that dynamically interact with other complex adaptive economies in a highly interconnected and diverse adaptive worldwide economy under conditions of uncertainty and imperfect knowledge leading to emergent outcomes that are inherently path dependent. Ability to adapt portfolios through the dance of history become critical to success!

 As things now stand, I’ll offer a brief historical perspective along with guideposts to help identify key milestones likely to unfold in the wake of the recent Balance Sheet Recession which I suspect is the first act in what is likely to prove to be a decade of weakness. My strong hunch is that the next generation will look back on this decade as one of Contained Depression rather than a series of recessions.

 My base case scenario is that governments will do everything in their power to delay an Austrian-style depression. But this “Great Debt Supercycle” (as identified by BCA Research) will not end well.

Unless hastened by dominoes of interlocking debt, my bet is that the U.S. can kick the can down the road for at least another decade (and possibly two decades due in part to massive assets that the U.S. could sell if forced into a Greek-style austerity). I am also confident that the U.S. will somehow deal with its debt ceiling whether through short term measures or a claim by Obama that the debt ceiling is unconstitutional under the Fourteenth Amendment (a position that Bill Clinton publicly stated that he would take were he now in Obama’s shoes).

Europe has less time and the European PIG countries (Portugal, Ireland, and Greece) are facing immediate default unless bailed out by EU, the IMF, China. The ECB has already poisoned its balance sheet with Greek debt and will itself need to be supported by the core European countries.  The contagion must (and at least for now probably will) stop with Portugal which ostensibly suffers from private sector debt but could suddenly find an explosion of public sector debt if its banks fail due to ownership of Greek bonds and large numbers of variable-rate mortgages secured by depreciating real assets. If the contagion moves to Italy and Spain, the EU’s future will be seriously in doubt. In the end, I wouldn’t be surprised to find that China plays a big role in any solution (putting them in a much stronger bargaining position on a going forward basis).

I strongly suspect that we will temporarily resolve the debt crises on both sides of the Atlantic. Politicians around the world are still haunted by the memories of Lehman Brothers and understand they are playing a game of chicken in the context of Mutually Assured Economic Destruction.  From this perspective, it makes sense for risk-takers to bet on a temporary resolution of debt crises in the developed world. But because the downside is so great and because we are facing a second soft patch in this cycles (as predicted by the ECRI’s Weekly Leading Index which has happily stabilized in the past two weeks but which nevertheless remains concerning due to the unusual circumstance  of two soft patches in the first two years of recovery).

My guess is that debt crises will be “solved” by more debt & debt restructuring which will ultimately add further steam to a debt snowball that could eventually bring down increasingly fragilized economic and social structures and further support prices of precious metals in world of rapidly sinking faith in fiat currencies. Under a worst-case selloff, everything including precious metals would fall in a cascading avalanche. Happily, I suspect that this Armageddon scenario can be postponed for much longer than most believe. If we are lucky, technology may help to cover our multitude of sins. My guess is that much more pain will first have to be faced sometime in the next  decade (which I might call “2020 or 2025 for short).

Where We’ve Been

1.                  60 to 80 year credit cycle in which expanding credit fueled asset prices to unsustainably high levels in relation to income (a peak intellectually typified by the book, Dow 30,000)

My Guess is that they put another finger in the dike for now, eventually allowing one more surge higher in the equity markets.  However, risks of equities now strike me as too high relative to rewards.  

Risks are Also Too High in Money Market Fundswith ALMOST 1 TRILLION invested in European Securities. A catastrophe waiting to happen…  http://www.foxbusiness.com/industries/2011/06/23/regulators-worry-about-us-money-market-funds-exposure-to-european-debt/

Congress will likely put lipstick on the Debt Pig & allow debt problems to snowball for a bit longer.

Having more fun watching from the sidelines!

Italy & Spain Must Pray For a Miracle