As discussed in “Paradox of Thrift-Sovereign Style” in the May 2010 letter, every developed country representing more than 65% of world GDP is embarking on a tightening of fiscal policy, with the goal of narrowing the aggregate debt to GDP ratio from 10% to near 3%. This admirable exercise in fiscal frugality will be accomplished by primarily raising taxes, which will reduce consumer’s disposable income simultaneously worldwide. The net result will be slower economic growth, and less tax revenue than any of the bean counters expect. In the U.S., the Congressional Budget Office uses static accounting, which postulates that tax payers will never change their behavior whenever tax rates are either lowered or increased. Before taxes are cut, the tax revenue the CBO estimates the government will ‘lose’ is often overstated, since tax payers will generate more capital gains or receive more income, if the government’s take is less. Conversely, in the face of higher taxes, taxpayers take whatever steps necessary (mostly legal) to shelter income and gains from the bigger tax bite. Invariably, the government rarely receives the amount of tax revenue the CBO estimates it will when tax rates are raised. The combination of higher tax rates and slower economic growth in the U.S. and around the world, virtually guarantees whatever estimate the CBO makes in terms of increased tax revenue will prove widely optimistic. It also means the budget deficit will remain higher than the CBO’s forecast.

Voters should be concerned about the budget deficit, since total federal debt next year is expected to exceed $14 trillion, about $47,000 for every U.S. resident. President Obama has appointed an 18 member National Debt Commission to make recommendations on ways to avoid a debt catastrophe. As I noted in the April letter, “Roughly 88% of the budget is mandated by law, which is great for members of Congress. With spending on autopilot, they can spend most of their time campaigning for their next election. The crew sworn in after the election in November won’t have it as easy.” The Co-Chairmen of the National Debt Commission addressed the National Governors Association on July 11, with a rare display of straight talk. Republican Alan Simpson told the governors that the entirety of the nation’s current discretionary spending is consumed by the Medicare, Medicaid, and Social Security programs. “The rest of the federal government, including fighting two wars, homeland security, education, culture, you name it, veterans, the whole rest of the discretionary budget, is being financed by China and other countries.” Democrat Erskine Bowles was equally blunt. “This debt is like a cancer. It is truly going to destroy the country from within.”

The governors understand the problem better than the 535 members of Congress, since state budgets are even in worse shape, as tax revenues remain weak, and the ‘stimulus’ money coming from Washington runs down. Since 49 states must balance their budgets by law, they really don’t have a choice other than to make the necessary tough choices. States are being forced to balance their budgets by cutting services and spending, including laying off state workers by the thousands. State spending represents 12% of GDP, so the reduction in state spending will represent another significant drag on GDP growth during the next 12 to 24 months.

A recent WSJ/NBC poll shows that 63% of Americans say the President and Congress should worry more about the deficit than the economy. I’m sure members of Congress will be carrying a copy of this poll in their pockets, as they stump around the country, thumping on this theme at every whistle stop. Anti-deficit sentiment has grown so ardent that Congress has refused to extend employment benefits to the 2 million workers whose benefits have run out as of mid July.

The Great Depression of the 1930’s was assisted and deepened by a number of policy mistakes. The Federal Reserve allowed the money supply to shrink by more than 30%. In June 1930, the Smoot-Hawley Tariff Law was passed, igniting a wave of global protectionism that resulted in a 40% decline in world trade within 18 months of its passage. After the economy rebounded in 1936 and 1937, the Fed tightened by raising reserve requirements. Taxes were increased to pay for social security, and the federal government cut spending. In 1938, the economy tanked anew.

The inflation adjusted Federal funds rate is already negative, so the Federal Reserve is impotent, as far as using interest rates as a policy tool. In the last few months, the Fed has ended its buying of $300 billion of Treasury bonds and $1.25 trillion of mortgages. This action represents a tightening of monetary policy, even if it is from a position of extraordinary accommodation. The global drive to cut debt as a percent of GDP may not be comparable to the protectionism that followed the passage of Smoot-Hawley, but its dampening effect on global growth will mirror the lurch toward the protectionism of the 1930’s. Since the fiscal year for most states begins on July 1, most states have already enacted spending reductions and increases in taxes and fees to balance their 2010 budgets. These tax increases will be followed by a large increase in federal taxes on January 1, and a modest lowering in the growth of federal spending. Since members of both parties will be running on the need and virtue of raising taxes to reduce our awful budget deficit, Congress won’t be satisfied with just allowing Bush’s tax cuts to expire. They will want to prove their budget deficit mettle by finding even more ways to increase government revenues.

Collectively, these actions represent a colossal policy mistake. As a result, the risk of a real second dip in the economy is rising, as is the risk of deflation and a subsequent massive liquidation of debt. It must be noted that as debt is liquidated through default, money evaporates, and money supply contracts, despite the size of the Fed’s balance sheet. Most of the policy makers in this country have no idea what they are dealing with, as they have proven in recent years. Is there another course of action we could take? Yes. Will we do it? Not a chance.

A rising tide lifts all ships, including tax revenues. Over time, economic growth generates more tax revenue than a tax increase. The best way to increase tax revenue is to adopt policies which encourage risk taking, and encourages investment, since small businesses create 70% of all new jobs. We need to shift the balance of demand from government stimulus to private demand.  Raising taxes so workers have less disposable income will only dampen private demand and weaken the economy, which will lead to calls for more government spending. Instead, we need to cut taxes so the average worker can save a bit more and spend more. We need to lower corporate taxes and encourage business investment. We need to build nuclear power plants, so jobs are created now, and ensure we will have the electricity to power the battery cars of the future. And in order to make progress on the budget deficit, we need to freeze government spending at a minimum, and make cuts where ever possible. However, more than anything, we need our leaders to be honest with the American people about the challenges we are facing, and admit that the government cannot make good on all of its promises. There is simply not enough money to meet the unfunded liabilities of Medicare and Social Security. Will this happen? Not voluntarily, and only after a bigger crisis.


The failure of Lehman Brothers in September 2008 brought the global financial system to the edge of the abyss. To prevent a complete implosion, the Federal Reserve and Treasury Department implemented a series of extraordinary measures to stabilize the financial system. As a sense of equilibrium was restored, the Federal Reserve and Congress initiated a number of programs to stimulate demand. The Federal Reserve’s purchase of $1.25 trillion of mortgages, not only helped keep mortgage rates low, but also provided the funding for new mortgage lending. The Cash for Clunkers program and first time home buyers tax credit gave industrial production and housing a lift. And the $787 billion “American Recovery and Reinvestment Act” passed in February 2009 helped many states close their budget gaps and fund many pet Congressional projects. The goal of all these programs and stimulus spending was to buy time, and as the economy healed, ideally provide enough forward momentum to launch a self sustaining recovery. During the last year, I have been skeptical that a self sustaining recovery was likely and have cited a number of secular headwinds that are likely to take three to five years or longer to address. However there are also a number of cyclical headwinds that are going to dampen growth over the next 12 to 18 months. Unfortunately, slower growth in the intermediate term will also stretch out the time needed to repair the secular imbalances that have built up over decades.

In response to the financial crisis, the Federal Reserve expanded its balance sheet from $900 billion to more than $2.2 trillion. This statistic is often cited by those who interpret the ballooning of the Fed’s balance sheet as proof the Fed has flooded the economy with liquidity. Invariably their conclusion is that inflation is virtually inevitable, with some warning of hyperinflation within a few years. Their analysis reveals a lack of understanding of how credit creation works in the real world, and why I continue to believe that deflation poses the greater threat in the near term. When a gardener wants to water the flowers and plants in their backyard, the spigot on the house is opened, and water flows into the hose. Until the nozzle at the end of the hose is opened, no water comes out. The Federal Reserve has opened the spigot, but the banking system and securitization markets, acting as the nozzle at the end of the hose, are not allowing much of the liquidity provided by the Fed to flow into the economy.

The U.S Monetary Policy Forum’s Financial Conditions Index tracks 45 variables, including bank lending, asset-backed security issuance, credit and yield spreads, and stock market data. This broad based index of credit conditions dropped to -1.82 in the second quarter, down from -1.29 in the first quarter. Since 1970, it has been under -1.00 only 5 times, 1974, 1980-1982, 2001, 2008, and now. All the prior instances were coincident with periods of recession, not sustainable recoveries. The fact it weakened, rather than improving in the second quarter, does not bode well for the second half of 2010.

Although banks are no longer raising lending standards, they aren’t lending either. The annual rate of change in lending plunged in the fourth quarter of 2009, and has shown absolutely no improvement. Since the October 2008 peak, loans outstanding have declined 19 consecutive months by a total of 24%.

A review of two measures of money supply illustrates just how little money is flowing into the economy. Historically, annual growth in M2 of 5% has provided support for real economic growth of 3%. M2 actually contracted in the first quarter. M2 includes cash, bank deposits and money market funds. M3 is a broader measure of money supply and it paints an even more negative picture. Over the last twelve months it has shrunk by 5.3%. Since 1960, this broad measure of money supply has consistently registered year over year growth of 5.0%, with only one brief instance when it dropped below 0%. Like a garden without water, the economy is going to wilt without an increased flow of credit.

The level of under employment and unemployment is becoming chronic. Of the 14.6 million people out of work, 6.8 million have been out of work for more than six months, and 4.3 million have been unemployed for more than a year. In June, the average duration rose to 35.2 weeks, 14 weeks longer than the prior all-time peak set in 1982. Since 1948, there have been 11 recessions. In 8 of the 11 recessions, job losses as a percent of total employment did not exceed 3.4%. All the job losses were recovered within 12 months 8 times. During the recent recession, job losses totaled more than 6% of total employment, and six months after the trough in employment are still 5.6% of the labor market. These figures would be worse if companies had eliminated more jobs, rather than cutting hours worked. It has been estimated that another 3 million jobs would have been lost had employers not reduced hours worked so aggressively. The underemployment rate, which includes both those who are unemployed and those working part time instead of full time, is 16.5%.

In June, just 83,000 private sector jobs were created. Although the June figure was up from the 33,000 positions created in May, both months failed to add the 110,000 jobs needed each month to absorb new entrants into the labor market. The unemployment rate dipped to 9.5% from 9.7%, but only because 652,000 job seekers stopped looking for work. Had they remained hopeful enough to keep searching, the unemployment rate would have risen to 10%. Average hourly hours worked slipped to 34.1 from 34.2, and average hourly earnings are up a paltry 1.7% from a year ago.

Small businesses create almost 70% of all new jobs. With bank credit tight and credit card lines of credit slashed by $1.5 trillion in the past year, most small businesses are surviving on their cash flow. In this environment, most small business owners will continue to be cautious and reluctant to add employees. This means job growth will remain insufficient to boost consumer spending to support a healthy self sustaining recovery.

With weak income growth and scant job creation, it is no wonder that consumer’s appetite for additional credit has diminished. In 2009, the year over year change in consumer credit turned negative as some consumers voluntarily chose to cut spending and save more. After dropping $9.1 billion in May, consumer borrowing has declined in 15 of the past 16 months. Credit card borrowing has dropped for 20 straight months. As I suggested in the January 2009 letter, consumers are adopting the less is more spending philosophy. Some of the contraction in borrowing is involuntary, as banks have cut home equity lines and credit card lines of credit have been slashed by $1.5 trillion.

For years, homeowners used their appreciating home values as a piggy bank. In 2005, home equity extraction exceeded the annual increase in disposable income, an extraordinary statistic. The first time home buyers tax credit boosted home buying and some took this mirage of demand as evidence of a more lasting turn in the housing market. As noted previously, I think housing prices are likely to fall further, especially at the high end. In May, new home sales plunged to an annual rate of 300,000, the lowest since records began in 1963, after the tax credit expired on April 30. The first time home buyers tax credit is a clear example of how government intervention can and does distort market dynamics. Although targeted programs have helped jump start activity in the past, the overall underlying economic fundamentals are simply too weak, and the foundation of demand underpinning the housing market is unstable. According to the Conference Board, only 1.9% of consumers plan to buy a home in the next six months. The overhang of new and existing homes for sale is 8.5 months, comfortably above the six month supply deemed normal, especially in the face of the very weak demand expected in the next six months.

The intermediate term fundamentals for the housing markets aren’t too hot either. According to RealTrac, almost 900,000 bank owned homes have yet to be sold, with 1.2 million more homes in some stage of the foreclosure process, and another 5.5 million loans more than 60 days past due. Default notices were 96,462 in May and bank repossessions hit a record of 93,777, so the pipeline of bank sales is still climbing. This overhang of foreclosure supply will certainly keep a lid on prices, and will likely cause additional price declines. Although prices may only fall another 5% to 10%, the additional depreciation could prove particularly destabilizing. Of the 57 million homeowners with mortgages, almost 30% carry mortgages that are more than 95% of their home’s value. If home prices do fall another 5% to 10%, some of the 15 million home owners on the edge will be pushed into the foreclosure pipeline. It is estimated that 1 in 8 foreclosures are the result of homeowners who could afford their monthly mortgage payment, and have voluntarily chosen to stop making payments since their home value is so underwater. With home prices remaining under pressure for at least another year, the negative wealth affect felt by most homeowners will not encourage trips to the shopping mall.

According to Reis, Inc, the shopping mall vacancy rate has climbed steadily for nearly four years, and reached 9% in the second quarter for large malls in the top 80 U.S markets. The vacancy rate for strip malls rose to 10.7%, the highest rate since Reis began tracking it in 1991. Reis forecasts that the vacancy rate won’t begin to decline until 2012, and won’t reach 2008 levels until 2016. Lease rates have fallen for seven consecutive quarters. In 82 metropolitan office space markets it tracks, Reis, Inc. says the office vacancy rate rose to 17.4%, the highest since 1993. Since early 2008, occupied office space has declined by 133 million square feet, about the size of 2300 football fields.

With lease rates and rents down, commercial real estate values have fallen almost 42% since their October 2007 peak. This is a problem for banks, who lent money like sailors on leave during 2006 and the first half of 2007, generating billions of covenant-lite loans that were every bit as sub-prime as sub-prime housing loans. Most of those underwater loans will need to be rolled between 2011 and 2014, which might prove difficult with property values down so much. According to Foresight Analytics, about 65% of bank commercial real estate loans coming due between now and 2014 are under water. In the first quarter, 9.1% were delinquent, compared with 7% a year ago, and just 1.5% in the first quarter of 2007. Banks are meeting this problem head on by adopting an ‘extend and pretend’ lending philosophy that will only delay the inevitable day of reckoning. In the first quarter, $23.9 billion of past due loans were restructured, by either extending the maturity of the loan or lowering the interest rate to below market levels. So far their game plan is working almost as well as the administrations program to help under water homeowners. At the end of the first quarter, 44.5% of commercial debt restructurings were 30 days or more delinquent, up from 28% a year earlier.

Bankers are hoping that commercial real estate values will rebound, and borrowers will be in a better position down the road. More importantly, extend and pretend allows banks to avoid the hit to their capital base if they were to write off the losses now, or if they were forced to mark these loans to their present market value. As you may recall, the Federal Accounting Standards Board loosened the ‘mark to market’ accounting rules, after Congress threatened to rewrite the laws if FASB didn’t. After receiving Congress’s ‘encouragement’, and in an admirable show of independence, FASB waited 3 weeks to modify the rules in April 2009. Although some praised this action (the stock market certainly did), we are about to experience the dark side of FASB’s Congressional cave in. Any bank sitting on a pile of underwater commercial real estate loans is not likely to expand its rate of lending, while they wait for commercial real estate values to rebound. This won’t be good for the economy, but bank shareholders would prefer avoiding the dilution that would result from taking the losses now. Didn’t Japanese banks already prove that ‘extend and pretend’ is a poor strategy? No need to worry through. Financial regulatory reform is on the way and it will address everything – except any of the important stuff.


The S&P peaked near 1,220 in late April, and continued to correct until it reached 1,010 on July 1. The initial phase of the decline was sparked by the ‘Flash Crash’ on May 6, and subsequent fundamental concerns about growth in Europe and the sustainability of the recovery in the U.S. Market technicians threw in the towel after the S&P breached important support at 1,040 and the S&P 50 day average dipped below the 200 day average. This technical event is referred to as the ‘Death Cross’. Given the attention it received, one would have thought it was Halloween. Nevertheless, the spike in negativity was real and palpable in various sentiment surveys. The most recent survey by the American Association of Individual Investors found just 20.9% bullish, and a whopping 57.1% bearish. Three weeks ago there were more bulls than bears. In addition, the 210 point decline in the S&P represented an almost perfect 38.2% retracement of the March 2009-April 2010 rally.

As I wrote in the June letter, “Although the Major Trend Index suggests a new bear market has begun, I think the market will hold above 1,040 in the next few weeks, and establish a trading low. The coming rally should push the S&P above 1,100 and its 200 day average, which will trigger some additional buying. This rally could reach 1,135 – 1,150, which was the January high.” Obviously, I was wrong about the S&P holding support at 1,040. But the brief crack below 1,040 did turn more investors bearish, which should enable the current rally to last 3 to 5 weeks. That would make it almost half as long as the decline from April 26 to July 1.

Earnings for the second quarter should be good enough to support higher prices, since the economy entered April with a head of steam. As I’ve detailed in this letter, the real hurdle for the market will come in the second half of this year and first half of 2011 when the economy is likely to slow more than expected. In that context, the current rally makes the market more vulnerable to disappointment. The market will also have to absorb some level of selling pressure from investors choosing to book capital gains in 2010 before tax rates jump in 2011.

So far, the rally has been on very light volume, even after considering that it’s mid-summer. One sign of an impending top will be an increase in trading volume, since it will reflect an increase in optimism. This was one of the ‘tells’ I discussed at the April high.

Just as the market threw investors a head fake by breaking below 1,040, it could briefly spike above 1,150, generating the needed optimism for the next high. If I’m right about the coming economic slowdown, the next high in the market should be followed by a nasty decline. Although the recent break below 1,040 was brief, I believe it was a crack in the market’s foundation. If and when the S&P falls below 1,040, the next stop will be 950 or lower.

This rally is another opportunity for investors to sell into strength and become more defensive. I will do my best to send out a Special Update, if more signs of a high develop. The Flexible Asset Allocation program is 100% in cash.


The yield on the 10-year Treasury bond could rise to 3.2% to 3.3%, as the stock market rallies a bit more. If I’m right about the economy, Treasury yields will be lower by year end. High yield bonds have rallied in conjunction with the stock market. Many of the high yield bond funds appear to be forming the right shoulder of a top. If the economy weakens, high yield bond funds will be vulnerable. A decline below the most recent low will be a negative technical signal, and a sell signal.


The following is from the May 25 letter. “Many analysts have confused the Fed’s increasing its balance sheet from $900 billion to $2.2 trillion as signs that inflation is right around the corner. What these folks have failed to understand is that credit is still contracting, the velocity of money is not expanding, and an overhang of excess labor and production capacity caps any pricing power. The real risk is not inflation, but deflation as debt is liquidated, causing money supply and credit to contract even further. Gold is over loved and misunderstood. I think it is going lower.” A weaker economy should be a negative for commodities in general. Short GLD, the gold ETF at 120.50, with a stop at $123.50.

Jim Welsh

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