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Children Of The Bull Market


“Are we there yet?”



Most of us have taken at least one long drive with our kids. Some of these drives may have been part of a well orchestrated vacation designed to familiarize our young ones with the scope and beauty of this great land. In the days of my youth these adventures took the family through the heart of the Catskill Mountains in central New York . I loved the majestic rolling hills, the spires of West Point perched high overlooking the Hudson River, the monumental spans of the Whitestone and Tappan Zee bridges. Rip Van Winkle and the ghosts of Henry Hudson’s crew rolling a game of nine-pins seemed so very possible in the autumn mist and brilliant colors of the Catskills.


The Hudson River Valley was created by the intrusion and withdrawal of a glacier millions of years ago, the Catskills are largely the remnants of erosion and the deposits dredged by the massive sheet of ice; the bare geology of the region is a glimpse at the guts of the earth. These trips stimulated my mind and produced a curiosity I would more than satisfy in a freshman geology class. My younger brother Jim was my traveling companion on the bench-like rear seat of the family sedan. We rumbled along in the days before we realized or remedied the perils of jetting down the highway (sans seatbelts) with only tenuous gravity holding our little butts in place. Jim dreaded these winding trips along ribbons of undulating highway carved into the mountainsides. These drives left him hugging a bucket in the back seat. It goes without saying that Jim’s constitution was not well suited to the drops and curves of the mountain roads.


When Jim began to turn green I would huddle close to our baby sister Linda at the far side of the back seat. Linda liked to sleep her way through the Catskills. She would wake only briefly to urge me to “MOVE OVER!” or to remind me of the necessity of brushing one’s teeth before breathing on ANYONE!


I was fascinated by each and every aspect of the Catskills adventure; Jim couldn’t stomach the ride and missed the grandeur of nature. Linda was content to ignore the entire outing in blissful slumber unless events out of her control spilled over to her side of the back seat. Jim, Linda and I are as different today as we were in ancient times. Our perceptions influence our experiences and observations.


When will we get there?” “Are we almost there?” “Are we there yet?


For many ours was a generation of auto-tourism, seeing the world through a car window at highway speed. Today, as parents we expect to hear these questions from bored kids in the back seat. We are also the generation of the great bull market. And as investors we are asking the same questions about the end of this deep recession. We have been conditioned to buy on the dips, some even say when there “is blood in the streets”. We have been trained as investors to believe that riches await those with the courage to wade in the murky water ignoring the unseen risks. And why not heed the lessons of the bulls? The Dow Industrial Average is up over 1600% in the past 35 years.  A hearty few make the biggest killing anticipating the turn from recession to expansion. With this history lesson in mind investors often act out of fear of being left behind. In the equity markets this leads investors to buy stocks even as the economy contracts. Fixed income investors “stay short” keeping powder dry for the inevitable economic recovery and higher yields, despite near 10% unemployment. And so the questions above take on great significance for investors and your favorite money manager.


Success Is a Journey Not a Destination


We have all heard these pearls of wisdom. These words hold great value for investors today. It is through a clear understanding of the journey that we can answer the variety of questions asking when we will get there (sustainable economic recovery) and perhaps more importantly, what will it look like when we do. Minsky’s Financial Instability Hypothesis has done the heavy lifting for us on this subject and we have relied on his work in many previous musings. (Quarter 4 commentary for 2007 and 2008)  Minsky has laid out the course that has taken America from the “great moderation” or Goldilocks economy to the brink of financial ruin. Suffice it to say that we have exhausted all the financial sleight of hand Wall Street, bankers, mortgage lenders and the magicians at the Fed had up their collective sleeves. The western world is left with a badly compromised banking system (Bank of America lost $2.2 Billion in Q3) , a Humpty Dumpty housing market (1 in 136 homes in America is in default) and an uncertain place in the evolving global economy. Consumers buried under mountains of debt and experiencing unprecedented job insecurity balance the urge to splurge with the need to save. Our guess is that sanity will prevail and saving for a rainy day will become a rediscovered priority for many prudent Americans.


To varying degrees the Global economy has been immersed in the Keynesian lab of theoretical economics. In this lab the state takes up where the free markets fail. The experiment has moved through stage one. In stage one the governments and central bankers around the world have acted in unison and propped up the global economy. The actions have arrested both the financial panic and economic free fall that threatened a deflation driven global depression. In the eyes of many this early success is cause enough to go long stocks and short duration in bond portfolios.


But it is stage two of the Keynesian experiment will be the most telling when considering questions like “Are we almost there?”  Stage two of this grand experiment is where the 28 or so Keynesian programs that have supported commercial banks, corporations masquerading as commercial banks, investment banks masquerading as commercial banks, Wall Street masquerading as something other than a rigged casino, the housing market, the securitized debt market and the economy in general, are withdrawn. Even the most dedicated devotes of Lord Keynes know we have scant evidence that economies devastated by financial collapse and debt deflation can readily transition from government life support to some form of free markets without war and a rebalancing of the world financial order.


At ICM we are less confident in the V-Shaped Recovery scenario that is driving equities to gains of nearly 60% since the frightening days of early spring. We see a crippled economy leaning on the crutch of government financing, guarantees and direct ownership totaling $11 Trillion. We read the tea leaves that declare the recession over this quarter a tad differently than many in the V camp. While GDP will likely show a slight quarter on quarter improvement it is the year on year view that tells us how far we yet have to go to recover what we have squandered. Hopes for the big V were fanned by the second quarter GDP figures that showed better than expected results, namely a marked slowing in the rate of economic contraction. Third quarter figures for GDP are expected to show a quarter on quarter gain. But when we change the metric to a more meaningful peek at where we were on June 30, 2009 versus a year ago we see a very different snapshot. In this picture US economic output was 3.9% slower than the second quarter 2008. Some may not be too alarmed by this figure until we search for an historic parallel. Not even the double dip recession of the 1980s with 20% borrowing costs showed so large a decline in year on year economic output. Few among us need reminding that today the Fed’s official rate is zero and that we have printed, borrowed and spent $trillions to push market driven  borrowing costs ever lower and to assure liquidity in short term debt markets that supply life to corporations.


What we have learned so far is that global capitalism has found its legs when helped to its feet by central banks, credit support mechanisms, printing presses and direct taxpayer ownership while insulated from the rigors of free markets. When the props are removed and the weight of competition and market driven borrowing costs pile on will the domestic economy respond with renewed vigor or crumble under the weight of uncertainty and illiquidity? Before we can begin to answer the question “Are we there yet?” we must know if there is a self sustaining expansion behind the Keynesian Experiment. This question cannot be answered in the lab. The answer will reveal itself in the years, yes years, to come. So no kids, we aren’t there yet.


In the interest of honest communication we are lost, traveling a new road for which there is no map. This road will likely be constructed of sharp turns, sudden drops and glorious climbs. This journey will not be for the faint of heart with weak constitutions. Keep your buckets at the ready. Those who choose to sleep through the ride until forced awake by what economists call “externalities” may find themselves in unrecognizable territory. Our advice is to remain alert and observe the landscape carefully, keeping an eye on the horizon for signs of changing conditions.


The Financial System Veered Off Course


The financial infrastructure is entrusted with the most sacred tasks in a capitalist system. It was our faith in the “invisible hand”, “efficient market theory”, innovation and “self regulation” that encouraged us to entrust the financial well being of our nation to a small group of wealthy private citizens. We trusted the titans that run our banks and brokerages to rise above the conflicts of interest, compromised regulatory and ratings institutions and misguided compensation packages and to work in the best interests of our nation. Their critical role provides for the efficient allocation of capital to its best use, prudent risk management and low transaction costs. While many resent most accept the compensation these captains of industry command as a cost of capitalism. This extraordinary pay was rationalized as the cost of propelling financial innovation. What we have hopefully learned is that our trust has been misplaced and our treasure squandered. Innovation served the innovators and few others. The financial sector needs guidance so that it may return to the best course for America rather than the best course for Wall Street. The powerful Securities Industry and Financial Markets Association, (read lobby) SIFMA, is chipping away at efforts to bring its clients back in tow. Regulations to rein in the lucrative and dangerous $600 TRILLION derivatives markets are facing a tough slog. The top five US Commercial Banks are on track to make $35 Billion trading unregulated derivatives in 2009. Wall Street profits are at the heart of this struggle and congress is being swayed. Children of the bull market apparently have either obliterated their short term memories in the haze of their youth or have unbridled loyalty to a system and its pilots gone astray. It was but a handful of months ago that the world feared for its future.


Where Are Rates Headed?




When Will They Get There?


Answering these two questions requires that we enter the murky water but with the risk clearly in mind. It is difficult to envision a global economy where the value of the World’s reserve currency, the U S Dollar, continues a multi-decade decline and where short term interest rates remain near zero. This is especially true when the issuer of said currency is also the globe’s largest debtor. But even our largest creditors recognize that the driving force of global consumption resides in America and that without American consumer dollars their export driven economies would spiral into deep recession. There is an undeniable codependence between our nation’s overconsumption and mountain of debt and their “miraculous” story of growth. Exporters must not only be patient with America and the Dollar they must be supportive until they have developed a sustainable middle class to replace American demand.


The global economy must rebalance with debtors repairing balance sheets and creditors expanding services and promoting spending versus savings. The devaluation of the Dollar will help exports but at the cost of weakening American purchasing power. This rebalancing will take years if not decades. Pressure to raise rates and choke off a nascent U S recovery seem unlikely to bear fruit at present.


The myriad of Keynesian programs that support the economy will likely be unwound to some degree before any dramatic changes in monetary policy occur. It would seem self-defeating for the Fed to raise financing costs in the face of a bailout of this magnitude.


Finally the lessons of the “Great Depression” and Japan ’s debt deflation and unrelenting recession speak to the perils of removing or blunting stimulus before a self-sustaining recovery is at hand.


Only in a relapse of global financial uncertainty do we see a disorderly jump in U S interest rates. We see monetary policy on hold for the remainder of this year and well into 2010. The unknown impact of removing credit and housing market supports will force a slow hand. The employment picture must improve to provide political cover for a move to tighter credit.




The Leaves Have Turned


Fall has arrived. It is a time of epic battles for supremacy and for planting the seeds of the next generation. Fall is at once the precursor of nature’s harshest season and yet holds the promise of new life. I’ll close this Quarterly Commentary with the words of former Fed Chairman and current presidential advisor, Paul Volker. “The financial crisis has been itself a clanging alarm bell. I trust it is understood as such. The country can’t be dependent on financial acrobatics to paper over the real imbalances with ever greater leverage, to count on endlessly complex hedging strategies to obliterate risks and to trade in derivatives that have no intrinsic value, no matter how well compensated those activities have been.”