The Great Puzzlement: Dissecting The Economy, Markets And Policy

The Great Puzzlements: Economic Realities, Market Misinterpretations and Government Policy By Dave Livingston, Managing Principal, Llinlithgow Associates (www.llinlithgow.com )

Dave is a management consultant primarily focused on improving enterprise performance by coupling strategy with execution thru the design and implementation of workable, integrated management systems. He blogs on this and related issues in Economics, Markets & Investments and specific industries and companies at www.llinlithwo.com/bizzx, his BizzXceleration blog. Over the last two years we’ve all been puzzled, even frightened, by the behavior of the economy and how the markets have reacted to them. We’ve also faced the biggest public policy challenges and actions since the Great Depression and World War 2. However, our argument is that the economy is not quite as hard to understand as most think if you have the right toolkit. Nor is market behavior, for similar reasons. And the two are directly linked, though often in incomprehensible ways. This essay collection is a survey of the economic situation, how the markets interpreted the data (or mis-interpreted it as the case likely is) and government policy on the credit markets, monetary policy and public spending – and how they not only influenced the last year but saved us from falling into the abyss of Great Depression 2.0. Which still leaves us with the Great Recession and a wildly distorted Market as well as public policy actions that leave many apprehensive and confused. In this collection you’ll find a running series of blog postings presenting economic data straightforwardly using some easy to grasp graphical tools that make it possible for everyone to be their own economist to some extent. They cover the period May through August 2009 and ground our current circumstances with a lot of reusable machinery and still applicable data. Inter-mixed are posts on the state of the markets, now they are behaving and their linkages, or not, to the economic data. Finally there are posts on fiscal and monetary policy as well as some discussions of the structure of the stimulus package and the prospects and sources of deficits and debts. You’ll find our analysis is vastly different from the headlines, the talking heads of the commentariats and the political partisans who are selling their positions and not necessarily what helps the country or your position. You’ll also find discussions of investment strategy and why the old simple rules no longer hold and you need to dramatically re-think your own investing. Taken all together the collection of data, tools and machinery, analysis and interpretations and conceptual graphics and explanations provide a comprehensive survey that we don’t think is duplicated elsewhere. And a fairly complete toolkit for you to use to your own advantage. As always with our essays they are largely drawn from an inventory of blog postings built up over three years. For each essay the URL is listed and each post generally contains a very extensive list of

background reading excerpts. These not only document the issues and companies but provide a library of resources for you in your own investigations.

Table of Contents 1. Real Data Interlude I: Econ-ecostructure (GDP to Trade)

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2. Real Data Interlude II: QtQ vs YoY and Economic

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3. What's It All Mean: Economic Landscape

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4. From Economy to Markets: More Bubble Busting Due?

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5. The Long Dark Veil: Economy, Markets, Business

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6. They See What We See: Weak Recovery, De-Leveraging, Strategic Change

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7. What the Markets See: Yellow Weeds Thru Rosy Coke Bottles

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8. The Vast, Ignored Difference: Economic Bottoming vs Recovery

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9. Time to Fold 'em: Market Outlook vs Investment Strategies

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10. Drugged Wallabies, Crop Circles and World Economies

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11. Brown Shoots, Weak Markets, Resilient Business?

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12. Beyond the CRE "Bombshell": Real Stress Testing for Finance

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13. Realities vs Rhetorics: Economy, Policy, Real Data

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14. About Llinlithgow Associates

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May 07, 2009

Real Data Interlude I: Econ-ecostructure (GDP to Trade) http://llinlithgow.com/bizzX/2009/05/real_data_interlude_i_econecos.html Now even Schwab has called March 9 as a market bottom (we'll revisit that) and suggested buying the dips; all based on the hypothesis that we've seen so many green shoots that the worst is over. As we keep saying there's at least two huge problems with telling the difference between them and yellow weeds. First off is what does the data really say and second what's the long-term outlook. When everybody from Bernanke to the CBO to the acronymics (OECD, IMF,World Bank) tells us that the long-term outlook is very week for years somethings wrong. We visited this point in a prior post on deconstructing GDP (Will The Real Economy Stand Up? : GDP, Consumption, Investment) but thought we'd take another detour into the real data and try and offer up some foundations. Just for the record YoY GDP dropped much worse in Q1 than in Q4, as you can see from the table below.At this point in case you're wondering why do I care - we'll let the cartoon composite speak for us and our arguments subliminally. Judging from friends, neighbors and acquaintances it pretty well captures the general response. The sad fact is that much of this was avoidable but that's a long-term structural statement so never mind. The sadder fact is that most of it was dodgable if you'd paid attention to the warning signs. And that didn't require major national policy changes - just a good dashboard of properly filtered and structured indicators.

ADP Private Employment: Real Trends Also just for the record everybody got all excited about ADP's private employment report but the reality is that, again YoY, it went down -2.4, -2.9, 3.4, -4.0 and -4.3% YoY in the last five months. Not only wasn't that good news from last month to this but that looks like an accelerating downtrend to us.The key problem is quick hit headlines and sounds bites that report on the MtM instead of the YoY changes. To try and show you what the reporting covers vs. what we think you should be looking at we've built this chart of the MtM changes annualized vs. the YoY% changes. Take a moment and see how warm and fuzzy you feel about all that; us, we go back to the cartoon as capturing the spirit of the moment. The Zeitgeist is shock and awe but we're probably all too burned out by adrenaline surges to panic anymore. So we thought we'd dig thru the real data and trying and frame the situation a little better in a couple of posts. This one will give you some background on the structure and components of the economy and we'll follow it up for each of these components with a post comparing QtQ vs YoY as soon as tomorrow's employment numbers come in.

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Surveying the Real Data But before doing the graphics thing for the components let's at least start with this summary table of the major elements to be watching. Pretty dry and boring right - just a table of meaningless numbers ? Maybe, but look around you, talk to your neighbors, ask yourself about your job and your kids futures and the meaing may get clarified and more important. We jokingly said one time that economics was the largest experimental science in the world...and we're all the lab rats. Some of the key things to watch (think of them as the scientists anal thermometers if you like) are red-highlighted and reinforce points we've been making for a long....g time. The only slightly bright spot is Real Wages which is up because Inflation has dropped so far and fast. We expect the continuing decline in Employment, which went down -3.1%, to reverse that trend. Employment is yellow highlighted because it was one of two early warning signs of the slowmotion slowdown (try a search on that term here to see how many times for how long it's been showing up) and the beginnings of a downturn. The other being the obvious Residential Investment, which leads the cycle, has been bad going to worse since early '06 and got worse this last quarter - despite the headlines. Take a look at the last column where, except for Wages, every single number got much worse than in the prior quarters. Real GDP dropped -2.6% vs .9%, Capex and Industrial Production went in the tank and so on.

The Economic Ecology: Structure and Components Before we get to the YoY vs QtQ debate de-construction let's put some foundations in place. So much of what you hear not only misses the real trends but isn't set in any kind of context, let alone an accurate one. The top subchart shows each major component as a % of the economy with Consumption on the r.h. scale, for about three decades. Notice that it ran about 67% until the investment boom of the Tech Bubble but actually went up to about 73% after the crash on the back of the Housing ATM. Talk about a House of Cards or building on sand the economy tanks and you spend more by borrowing? Notice the evil twin that resulted - Net Exports were about 0% as Imports balanced Exports until the Consumption Borrowing Bubble led to a huge surge in imported consumer goods. The bottom sub-chart zooms in a little to a shorter timeframe and breaks out some of the detail. After the break we'll break down each of these components yet again and you might want to pay attention because some of the results could surprise you. For example Gov't spending is a big chunk but it's not the welfare queens. The other little item of interest to note is that it went down during the '90s which led the reduced deficits and boom times of the Clinton Era. What was behind that?

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Breaking Down Consumption Starting with the big kahuna, Consumption, let's break it down into it's major pieces of Durables (things like cars, TVs, washing machines, lawnmowers, etc.), Non-Durables (gas, towels, laundry soap, food, etc.) and Services (Healthcare, insurance, fedex shipments, movies and so on). Services are 40% of the economy and about 70% of Consumption while Non-durables are about 20% and Durables are about 10%. When you look just at the later two in separate detail the patterns get more interesting. Durables were at 6% but climbed to 10% - now how much of that tells the story of the decline of manufactured things over the post-war period and the impact of globalization and huge price drops during the '90s ? Who did that benefit the most ? There's some real indicators here if you stop to think about which industries and companies go into which of these major components too. With Services so high that points you to looking at Healthcare, Technomediatainment, etc. for example. Put on your investor and employee or job-hunter hat when you look at these charts. What's P&G make and what kind of secular trend is it selling into ? During the '50s it was a steller growth company as people got washing machines and bought soap for them. Now ?

The Accelerator: Investment If Consumption is the engine that drives the economy then the governor that speeds up or slows down the trend is Investment which consists of three major pieces. Capital spending on software and equipment - interestingly enough up until the '90s that was just Equipment but now Software is the dominant capex component. Structures are commercial real estate - plants, warehouses, ports, off-shore drilling equipment, etc. You know the thing that all the headlines tell us is cliff-diving and we're all surprised (despite for example Calculated Risk's multi-year warnings). And then there's Residential Real Estate. During the '90s Investment climbed from 12% to 18% of the economy, first on the back of Tech investment during the late '90s. But instead of falling back as it should have with the bust it fell and then climbed back on the back of real estate speculation, which climbed from 4% to 6% of the economy. Seems like such a small gain for such a ginormous problem. It took us about 10 years to work down the excess capacity that resulted from over-investment in Technology. How long will real estate have to run BELOW 4% to get us back to a natural level of Housing? Let's hope it's not ten years but it sure could be. Those Homebuilder stocks might not be such a good

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investment idea after all - nor anybody who's selling into those markets, Lowe's or HD for example, or home furnishings, appliances, etc. Closer to home what might that say about Housing values and prices ?

The Little Engine That Did: Trade Trade has become an increasingly important part of the US economy. Back in the '50s and '60s it was 4-6% of GDP yet made up the largest piece of world trade flows. Over the next three decades it slowly climbed until it was about 10% of the US economy. Then, all of a sudden, it zoomed to about 14%. But up until the late '90s the trade balance was about 0% until all of a sudden it started a rapid deterioration. Trade is everywhere and always beneficial to everybody, even the companies and people who are displaced, as long as they can find a better use for their efforts. And we do it every day - you don't make your own shoes or cars, cut your own hair and grow your own food. Being able to swamp the value of something you do well and can focus on for things other folks specialize in and can do better makes us all better off, at least in the long-run. When you take the deficit apart into it's two pieces (Services and Goods) it turns out that we've enjoyed a surplus in Services for a long time and that the sole source of the overall deficit is the goods deficit. Which in turn is largely two things - Oil and Consumer goods (remember those durables) that we borrowed on the artificially inflated values of hour houses to buy. As consumer demand has tanked so has the overall deficit. Now here's an interesting conundrum - in the last 10 years we've seen the largest improvement in worldwide Poverty in human history but that was built on the backs of export oriented economies by folks like Japan, Taiwan and China. What happens to the Developing world and all those Emerging Markets investments if/when the American consumer shifts back to being a saver ? Now there's a fascinating question.

Consumer Behavior Shifts Consider this chart that compares GDP growth rates to the proportion of Consumption in the economy to start seeing some answers. It turns out that the proportion of the economy going to Consumption has been steadily shifting upward for almost five decades, but accelerated post-2000 during the downturn. Now there's another conundrum for you. Simply fascinating. The other question this raises is the role of Consumption vs Investment in long-term economic growth, prosperity and social well-being. The more you consume then obviously the less you invest and the less you invest then the less you grow. For the US to get back to a prosperous society we're going to have to shift to a nation of savers that puts it's savings into productive investments. People have noticed that income distribution become more and more unequal in the '80s, '90s' and the '00s and that the bulk of the gains thruout that period flowed to the

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upper income groups. We don't exactly recall the statistic but something like 70% of the gain went to the top earners. If we'd like to get back to a healthier society....well the possible implications are obvious aren't they ?

Rules of the Road: Government Have you ever stopped to think how much fun it would be if every morning you woke up and the rules for driving changed. Or worse had to be made up on the fly with every car you met on the street or highway ? Sort of like the fun it is in a giant mall parking lot where your risk of being run over by some blind and oblivious person is pretty high - speaking from experience. The larger and more complex a society the more it needs mechanisms and institutions for organizing things as well as providing public services. People forget, or never learned, that government investment in Transportation for example made this economy what it is, from the early canals to the railroads to the interstate and airways systems. Did you know for example that most of the major airlines built their initial route structures around the early airmail routes? Or that Trucking moves about 70% of the intercity freight traffic in this country? How productive would our economy be without railroads and long-haul trucking? Not very. To take another example thruout human history cities were always deathbeds because the population concentrations encouraged diseases. The Romans got around this problem with good plumbing and water engineering but the West didn't get back to that happy status until the late 19th century and the development of massive public health programs. To satisfy those demands, no matter who was in office or what the zeitgeist was, the US has spent about 20-22% of GDP on Defense, State and Local government and Non-Defense government activities. Of that State spending has been 12% or so of the economy or about 60% of the total. No matter what the mythologies of the Reagan revolution it's your local schools, libraries, snow-plowing, cops and traffic lights that absorb the bulk of the spending. As it should be given what we think government ought to be doing. As for Federal spending about 60% of that was Defense at the beginning of the '90s. In fact overall Federal spending saw a massive drawdown in Clinton's years on the backs of the so-called Peace Dividend, as it turns out from looking at this chart, cutting nondefense spending like he was a die-hard Republican. Interestingly enough both started to surge in Bush's early years as the War on Terror led to increased defense spending. Even more interestingly non-defense spending surged as well! Now what was that all about we wonder?

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May 08, 2009

Real Data Interlude II: QtQ vs YoY and Economic http://llinlithgow.com/bizzX/2009/05/real_data_interlude_ii_qtq_vs.html The headlines over the last six weeks or so have been that green shoots are breaking out all over. That's wrong and badly so for at least two reasons, if not three. A typical headline would be this one from the AP: U.S. sheds fewest jobs in 6 months. Compare it this chart which compares private job losses between ADP and the BLS on a MtM vs YoY basis, where MtM is annualized and the YoY is on the r.h. scale. Over the last three months the MtM change for BLS where -7.1%, -7.2 and -6.4 and for ADP they were -7.0%, -7.4 and -5.2. That indeed shows some improvement in that the rate of decline is slowing but still terrible. BUT.....BUT on a YoY basis they are -3.8%, -4.3 and -4.7% for BLS and -3.4, -4.0 and -4.3%. In fact looked at properly with the seasonal noise filtered so you can see the structural pattern emerge more clearly the downturn continues to accelerate. The gap between the headlines and the realities would appear to be widening and about as far apart as this time last year when de-coupling was all the rage and a V-shaped recovery would begin at the end of '08 ! The problem is, even if they are green shoots, that's not a harvestable field. The other problem, as this data makes clear we hope, is that they aren't very green nor big. Finally there's serious risk of them turning out, or into, yellow weeds. In this rest of this post, boring as it may be, we want to lay down some more stuff building on yesterday's foundation that walks thru the major components of the economy and compares the QtQ to the YoY numbers (or the MtM where appropriate).

An Overview of the Economic Situation: GDP, Consumption & Investment In this next chart GDP, real PCE and Investment are shown on the two basis in what we hope are nice clean, simple charts that make our fundamental points. The last post had a pretty complete data table of the real data so we'll try not to bore you will repetition of the numbers. The top sub-chart here shows real GDP which went down -6.3 and -6.1% QtQ, which hardly strikes us as green shoots, other than the rate of decline has stopped increasing. And doesn't represent much of a difference IOHO. BUT (again) on a YoY basis the actual numbers to pay attention to are the drops of -0.9 and 2.6% in Q408 and Q109, respectively. If anything the economy went farther in the tank faster! The second sub-chart shows real Consumption (PCE) which went down QtQ by -4.2% in Q4 but went up 2.2% in Q1. On

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the surface that's great news which we'll come back to shortly. The real "shocker" was investment which, in the third sub-chart, went down -23 and -53%. OMG - that's terrible, ain't it? It also explains why GDP continues to deteriorate - back to normal business cycle structure, where Investment lags changes in Consumption and GDP (as we explained yesterday). We'll need to break down Investment into it's components since the behavior of real estate investment and corporate capital spending are driven by such different things and behave differently as a result. In particular real estate investment has always led the cycles where business capex is the lagging variable.

Breaking Down Consumption Before we get too excited about Consumption we need to tunnel down for a more granular view, though the data is only available thru March. When you do that the underlying realities get a lot clearer. On a MtM basis real PCE increased 0.6% in Feb but dropped -2.6% in March. Now THAT hardly seems like cause for celebration or green shoot harvesting. Again, it looks to us, as if the news is abysmal but you wouldn't know it from the headlines. But MtM can be pretty noisy so what happened on a YoY monthly basis - which is also a compare and contrast to the quarterly charts above. Well, it turns out both months went down by -1.0 and 1.5% respectively. Again the rate of decline accelerated, and again that hardly seems to justify the headlines or the market's reactions. The thing we'd urge you to do is think thru the consequences for revenues, profits, earnings, PEs and stock prices for the consumer-related sectors, industries and companies. There is NOTHING in these charts to indicate that good news is on the horizon for anybody.

Breaking Down Investment Now let's look at Investment which is Residential Real Estate, Commercial Real Estate (Structures) and business spending on Equipment and Software. The news on either a QtQ or YoY basis is a lot less open to ambiguity or misinterpretations but hasn't received any coverage whatsoever that we've seen. In fact Cisco just announced it's earnings this week and was guardedly optimistic though declining to look ahead very far because of a lack of "visibility". Well let's try and give them some and repeat our two key warnings. Investment is a lagging indicator and Capex spending will drive the Tech, equipment and commercial real estate sectors. Let's do that by just eye-balling the charts (which as usual if you click they should enlarge). Starting with real estate it looks, par for the course, as if things got a lot worse. QtQ RE investment looks to have dropped almost 12% but to be down almost -23% YoY. Worse, on both measures, the rate of decline doesn't appear to be slowing. The second sub-chart looks at capital spending and there's NO ambiguities there at all. Again eyeballing the QtQ drop looks to be -40% while the YoY looks like -15% to us. That sorta explains why the GDP number was so terrible. Let's hope that the rate of decline slows down in the next couple of

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quarters. Tunneling down specifically on equipment and software (which we've labeled Tech) in the third subchart the QtQ number looks like -40% and the YoY number looks to be worse than -20% ! Taken all together real estate is still getting worse and capital spending is cliff-diving now along with it. The first means that Homebuilders and housing related industries and retailers are going to continue to take it in the neck. The latter means that the Tech and equipment industries as well as commercial real estate are also. In fact our friend CalculatedRisk guestimates that now that the collapse of Commercial real estate has begun it will go on for the next two years. May 09, 2009

What's It All Mean: Economic Landscape Having done two major uber-nerd posts, and you wouldn't believe the time to write 'em let alone build the charts, required :)! But we thought it was a necessary and vitally important foundation. We're seeing too many headlines like this one from the AP: Evidence piling up that worst of recession is over Hopefully nobody reading this blog is prepared to casually go along with that story. If you disagree with all our data-crunching and chart-churning so be it, at least it's not casual. Just to reiterate our main point though, green shoots are NOT a crop. They're few, young and sparse right now and the chance that they'll turn into yellow weeds is not that small. In some ways the real economic news this week was the results of the stress test - which despite all the criticism is turning out to have been a truly brilliant policy move because it's announcement calmed the credit and financial markets and let them keep self-repairing, which they are. Unfortunately the headlines told us more about the capital shortfalls, not the losses still to come. We're going to put a point on things by starting with the stress tests, briefly since there's so much coverage, then segue to the continuing saga of the Credit Death Spiral that's on-going and future prospects for the economy.

Stress Test and Consequences Where do we start - we're going to defer detailed discussions to all the mainstream media which is doing a fine job; and plan on picking up some detail in the future when we wrap up our on-going series on the health and strategic outlook for the Finance Industry. There was a lot of criticism of the tests as a political maneuver, which wasn't very serious. It's turned out to be a brilliant policy ploy that calmed down the markets, bought time for the rest of the economic policy package components to be rolled out and start implementation and for TimmyG to flesh out his plans in particular. The sad fact is that the test were a tad optimistic - as you know we expect a longer downturn, a more sustained period of low growth which will further strain the banks and years of below potential growth. Nonetheless "mild" as it was the test restored some measures of confidence but also showed a need, depending on reports for $65-75B in additional capital. The part that should have gotten more headline coverage though is that another $600-700B or so of losses are anticipated. If you want to see some of the details the WSJ interactive

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graphic (click to start) is one of the best. Surprise, surprise Lewis' BAC is by far the worst off on every measure with Citi not far behind. Just out of curiosity what was Kenny-boy thinking ? And why is he still there ? For reference: Leaders, Leadership & Culture: Crisis, Values and Perfomance (Updates).

The Rolling, Rocking, Rampaging Credit Crisis We've seen this graphic before - it lays out all the detailed vicious feedback loops in various markets and instruments. Briefly what we saw was poor quality housing loans turned into synthetic debt instruments that were leveraged and re-leveraged.As Housing went into the tank the losses in these instruments were multiplied many times leading to huge loses, write-downs and balance sheet damage. That resulted in a near freeze of credit last year and the damage percolated from the financial markets and housing over into the core real economy. Which was headed for a downturn anyway. Now that we're in the midst of this crisis people forget that we're hear of what's going to happen as the economy stays in the tank. All the other "normal" business like credit cards, consumer loans, auto finance, business financing, etc. etc. are beginning to go thru their own vicious cycle. We don't think that was reflected in the stress tests, nor in the way investors are treating banks so far.

The Consumer Debt Conundrums During the '80s and the '90s but most especially in this decade everybody took on greater and greater loads of debt from financial institutions to businesses to consumers as they got more confident that a stable and growing economy meant "it was different this time" and asset values would keep rising forever. The end result was a huge consumer debt, paid by the Housing ATM largely, and a nation of borrowers not savers. If/when/we hope the economy begins to arrest, stabilize and recover there will still be two tremendous problems facing us in the long-term. First, all of that debt will have to be paid down. And second, consumers are very unlikely to return to their old spending patterns. And boy, does that have implications for the long-term economic outlook.In the top sub-chart the YoY changes in consumer debt shows the biggest drop, a startling one, during the entire data series. So big in fact that it dwarfs all others. The bottom sub-chart shows an abrupt shift to consumers being savers. We consider all too possible that consumers will evaluate the levels of uncertainty in the economic outlook and slowly re-build their positions to where it was prior to the 1980s. Even returning to the '90s would be a major shift. If borrowing is truncated that much AND consumers move to being savers in-line with history consumer demand will be very low for a long....long time. In other words the driving engine of the economy will be turning over a lot more slowly. If you recall the prior charts where Consumption peaked at ~73% of GDP what happens when they return to being 67% ? Or 65% Or, as is both possible and sensible, a more historic 63%?

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Long-term Consequences and Economic Policy That means the US must find other engines of demand to generate sound, sustainable growth of face an L-shaped Japanese recovery. Which is not an impossible outcome, though hopefully an unlikely one. Right now the only source of demand is government spending which either continues until the economy returns to a self-sustaining, organic growth path or fails and aborts. There are at least three major risks of that happening to...do we fail to arrest the downturn? Do we fail to keep on stimulating the economy? Do we fail to reach the cutover to selfsustaining growth? Even if we manage to navigate thru all those challenges we're still faced with a low and slow economy for years. The only hope for paying down debt, having consumers put a new emphasis on thrift AND return the economy to sustainable, higher growth is if we put the economy on a new footing. In other words all out hopes for the future rest on whether or not we can invest in Education, Healthcare and Energy and get industries, jobs and growth out of it. Put differently - our lives are in the hands of the policy-makers and will be there for a long...long tme.

Coming Full Circle: Future Demand As we explained yesterday in the great circle of life that is the economy Consumption => GDP => Investment + Hiring => future consumption. A feedback loop that can be virtuous or vicious depending on how it's running. When the Housing ATM was holding up consumer spending, on debt admittedly, it helped us all out. Now it's running in the other direction. Consumers make their current consumption decision on the basis of future expectations and resources, which depend on the job outlook, real wages, assets and borrowing conditions - or expectations and experiences thereof. We've found that a good way to judge, proxy if you will, these expectations for future demand are to look at changes in real wages and employment and add them up. We dove into employment a bit above, and it's continuing to get worse. In the top sub-chart QtQ Employment looks to have continued dropping on an annualized basis and be about -6% while YoY it appears to have about -3%. Worse, on both measures, the rate of decline is accelerating. That's actually the normal response since Employment is another major lagging variable. Like Investment it too is likely to get worse in the months ahead. The spot of good news, in the second sub-chart, is real wages, which jumped up on both a QtQ and YoY basis. Now here we're back to a bit of a puzzlement. On a YoY basis the increase is unambiguously positive but the rate of increase QtQ dropped considerably. This results from two opposing forces. The increase was the result of a huge drop in inflation beginning in Q3 last year and accelerating in Q4. That resulted in the big Q4 jump in real wages. But as employment continues to be bad,

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and possibly continues to worsen as we expect, the pressures on wages will mount and it's likely that they too will start dropping. WHICH MEANS THAT FUTURE DEMAND WILL START DROPPING !

There's one other thing you need to factor into your thinking on the real data, it's interpretation and it's application to investment, business and personal decisions: NONE OF THIS UNDERLYING REALITY IS REFLECTED IN THE GENERAL AWARENESS.

In other words most folks are still flying along dumb and blind and could easily get side-swiped by something they don't see coming. Think about...eventually they will too. May 10, 2009

From Economy to Markets: More Bubble Busting Due? http://llinlithgow.com/bizzX/2009/05/from_economy_to_markets_more_b.html I had occasion to be chatting to my Schwab guy this last week and asked him what he was seeing, or better, what Schwab was seeing. The answer was that after getting hammered they're seeing a bunch of business flow back in. And their CIO just "called" a bottom sort of - in their typically cautious way at least and suggested it's time to start dollar-averaging back into the market. Now Schwab is a class act who runs a good show and has displayed a lot more integrity than most over the last decade. Nonetheless, despite my guy's caution hemming and hawing, it strikes me they're getting suckered along with the rest. In fact what we think is going on is that a lot of money managers are jumping back in because everybody's doing it and now retail investors are getting sucked in as well. The problem. is if you buy into any of the last several posts on the real state of the economy, is that this ain't grounded in the data. Our bottomline - now doesn't look like the time to be getting back in despite what the gurus and charts might be telling us. Let's explore why we're getting nervous and would suggest that, at minimum, now would be a very good time to be on the sidelines. Take a look at this YtD chart of the SP500. Right now we're still roaring up the up-channel, but as you may recall that's largely been on the back of all the "good" news on the banks from the Pandit Put to TimmyG's Plan to Thursday's Stress Test - which was actually a lot worse news than anybody let on. Not to mention our points in the prior post on the other tsunamis still to come.

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Market Dynamics: Jan08-May09 Let's pop up a level and take a look at what's been going on in the bigger picture. In this weekly SPX chart from Jan08 to now the really important indicator is the moving average, which captures the dynamics. From Jan thru Sep08 which had a nice, tidy and optimistic bear market until the fecal matter hit the impeller with Lehman's collapse and the breakdown of the credit markets (btw TimmyG was on Rose Thur. night and admitted that they all thought Western Civilization was ending, at least in so many words). Let's call that the meteor strike of the disequilibrium event. Or the dinosaur extinction event. When you pop up to this timeframe you can see where the new equilibrium that appeared at the beginning of this year disappeared in March and what we've been doing is repairing the damages of that panic attack. Other than this last week or so's surge all we've really done is get back inside the trading range that we were in from Oct/Nov to Feb. When you look at the Slow Stochastic you can see that it's still roaring ahead. So there's still a lot of momentum in the market. In fact a huge amount, judging from the massive runup in the SlowSto. Until it and the MACD turn over you can still try playing for the upturn and then we'll see. But depending on whether you're an investor, a trend trader or a scalper you'll want to think hard about how to play all this. Again the steer clear advice seems well grounded to us.

Linking Markets and Economy Let's really pop up a level and re-visit an old and familiar meme here. That, to wit, the economy drives profits which drive earnings which drive the markets. We'll try and make those points off this busy little composite chart - sorry for the noisy top part. We're trying to say too many things at once. In the top the faint lines are the YoY% changes of GDP, Profits and the SP500 on an annual basis. The only really important point for now to take away is that the relationship appears to hold. The heavy lines are non-linear trends which make it clearer. Notice how closely Profits follow GDP and, in turn, that the SP500 follows both but tends to amplify the cyclic patterns. Until recently when it ran ahead. The bottom sub-chart is the cumulative change in all three from 1950 to now which, IOHO, really makes the key relationships clear. Notice that they basically cohered up until 1995 when the "this time it's different" delusion took over the markets. Interestingly about the time that bubble was being drained it re-inflated in this Housing ATM driven fantasy over the last several years. Even more fascinatingly, at least to us, Profits followed GDP until 2004 without exception or major variance. Think about that - FOR FIFTY-FOUR YEARS PROFITS MARCHED WITH GDP!

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Then, in the weakest "recovery" in post-war experience they started their own bubble and carried the market back with them. Now we know that a lot of those so-called profits were a) delusions from Wall St. idiocies and b) in the real economy the lack of hiring and capital expenditures of the folks who actually ran real companies. Judging by this chart we've got a lot of bubble deflating to go. Unless of course you'd care to argue that the fifty-four years of experience, of the forty-five up until 1995, were the screwy anomaly and the last decade the real deal ?

Analysts vs Realities Let's borrow an interesting little chart from John Mauldin and take a look at the analysts collective guesstimates on where away for earnings. It shows the estimates for 2008 and 2009. For 2008 they started at $92 and dropped to an abysmal $15. The really interesting thing is that they "only" dropped to $60 by Sept. when the floor caved in with the market collapse and all of a sudden they flopped over the cliff. We'd say went diving but that implies deliberation and skill, at least according to the guys in Acapulco. Then the estimates for 2009 started at $81 and went to $29 and again display an inverse J-curve with a lot of that re-thinking happening at the end. So much for visibility. Now if you think $28 or so is reasonable and you also accept a "conservative" PE Ratio for a seriously recessionary environment is 10-12 then we're in a pretty funny space for the SP outlook. 28 X 12 = 336 after all so let's say 400. Or better if you think Shiller's longterm estimate of 15 is accurate we get a little better. But at the end of the day it comes down to what earnings are likely and what they'll be worth. If we get an economy that may, but is unlikely, to start growing at the end of this year but stays below potential for a long time PEs certainly won't be coming back above 15 for a long time. Or at least they shouldn't.

Graham-Dodd Valuation and the Outlook We've pounded away at the G-D formula a bunch of times as well as looked at other alternative approaches so we'll content ourselves with simply pointing to this chart which shows the relationships graphically so you can read them off from either the tables or the graph. Now if we're anticipating highgrade bond yields of, say, 6% for a long time (out investment horizon whatever that might be) and 6% growth in earnings (which on the evidence we've been presenting on the economic long-term outlook is wildly optimistic) a PE of 15 is perfectly justifiable. 6% interest rates seems reasonable to start with though if you're in the hyper-inflation camp you'll want to to you value analyis with something considerably higher of course. But 6% earnings growth would require major continued cost cutting, because it's sure not going to come from organic growth. Or, admittedly, re-leveraging the balance sheet (ahem). But let's say on the basis of all the long-term economic outlooks that 2-4% is more conservative, grounded in facts and analysis and therefore more defensible. That leaves us with PEs in the 9-12 range. Looks like we've come

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full-circle. Bottomline here is that a 10 PE and $20-40 earnings looks pretty defensible which puts the floor on the SP500 back at 400. Which guess what...would take out all that remaining residual market bubble over long-term growth. You have to wonder if coming to the same conclusions form five to six ways doesn't tell you something, right? In any case if you want to keep on reading there's a bunch of interesting columns and stories with a bunch more food for thought, tools and suggestions that we think is worth your while in the readings after the break. Click on thru by all means.

UPDATES: It's always gratifying when after you throw something out in the blogoether that a slew of stuff comes rolling across the transom confirming your arguments. Now either a bunch of us are smoking the same stuff and not seeing the immaculate recovery or the punditocracy is self-deluding again (conjur up images of mental masturbation to make it graphically clear). There was just a bunch of stuff over the weekend and so far today that you ought to go read that reiterates a bunch of our themes about 1) mis-reading the data, 2) a prolonged and painful recovery with low job creation, 3) continued business performance pressures and 4) an over-valued market that's a sucker's rally in drag. Take a look and if something catches your eye go read it (the Jeremy Grantham newsletter is critical reading IOHO). May 15, 2009

The Long Dark Veil: Economy, Markets, Business http://llinlithgow.com/bizzX/2009/05/the_long_dark_veil_economy_mar.html We're in the interesting situation where the real economic data - as it was at this time last year - is different from the headlines, where the future appears murky, where fragile green shoots are mistaken for the promise of a large and healthy crop and the markets, largely on the back of banking earnings surprises and the well-conducted stress test exercises have had a spectacular runup. For the record the 40%+ run since Mar9th would have been a fair return over three normal years! Unfortunately we didn't believe it was real until it was, in our judgment too late to jump in. Now the interesting question is where do we go from here. In the readings section we start with some short-term data, segue to the strategic economic outlook, the international, including oil. The reading on the structural causes of China's poor product quality is worth the price of admission - on of three must reads. Then we pick up the market readings where the key findings are a) Merrill's Rosenberg in his swan song of "yes, it's a sucker's rally" and backs it up and b) earnings may have surprised by not being as bad as expected but it was the result of cost cutting. Revenues fell badly. Which naturally sets up the Business section readings which by and large provide empirical evidence for the topic of our last post....which on the day that GM is announcing a 25% reduction in it's dealer network should hardly be necessary but there you are. The real must-reads are the ones on the WSJ survey where the vast majority of respondees warn we're in for a long-tough slog along with the Economist's and (especially) El-Erian's discussions of a poor longer-term outlook. We're in the midst of an inflection point in consumer behavior and economic growth that will be with us for a long time. The graphic btw is extracted from the WSJ survey both because it makes the point and because who'd have thought the Journal had a sense of humor?! If you want to see the serious results click away.

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Short-term Data: Retail Sales, Oh MY ! Short-term, so-to-speak, since it was this week and should have been a wake-up call but obviously hasn't been. Judging from this composite which shows nominal and real retail sales along with auto sales the word cliff-diving is in order and this week continues the event. We find it rather odd that before this crisis short-term meant back a few years, now to get some context we have to run our monthly charts back to '92 ! For a serious long-term view where you can actually compare last week's results in a big enough picture to understand the implications try this clicking on this chart that goes back to 1960, and also looks at Consumption and GDP. This recent cliff-dive puts real and nominal sales in the biggest drops they've ever been in. In fact nominal (non inflation-adjusted) is far worse than every year except '67, when it's only much worse. So much for the "second derivative" meme, in other words that the rate of decrease has gone to zero. It does appears to be slowing but....

Snipe Hunting: Where's the Markets ? The question then becomes where's the Markets in all this. And in an interesting place is the answer. Given that the Market is still holding up it doesn't seem like time to go poking at the big picture, long-term charts so we're going to focus on the short-term and compress way to many technical geekicators (that's technical indicators for wannabe stock market geeks like myself) to try and make a bunch of points that are important. We think the fundamental context here is a very week economy that will be weak for a long-time to come, even if we get a modest late-year upturn, and one where none of that is being priced. So notice the up-channel lines are still basically intact - or just breached but the lines of resistance from the Jan/Feb trading box are still in place about 875 and 825. Then notice the turning point indicators that worked earlier (the Slow STO and MACD) which gave off three clear signals Down (1), Down (2), Up (3) and are now a little fuzzy to warnish (4). This is a market that can't make up its mind. Now a real technician would have the courage of his tools and, without getting into the stress test of day-trader and scalping, would have ridden this recent rally. We couldn't believe it was real for 2-3 weeks. And in fact it wasn't - notice the "false" downturn signals around March 30th and April 15th. Other than the green shoot delusion this has been a market that rode to the sky on the backs of earnings in general and banking earnings and government actions in particular. For a chart comparing

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the Finance ETF (XLF) with the Sp500 and noting some of the major "surprises" that sustained this rally when it shouldn't have been based on the real data click on thru. You might be surprised to learn that the XLF channel is very much intact but also that each of the aborted failover points we mentioned was associated with things like the Pandit Put.

Alea Iacta Est: Crossing the Inflection Point Alea Iact Est is what Julius Caeser reportedly said as he took his provincial legions across the river Rubicon and began the Civil War which turned the Republic into the Empire. Having put together the shorter-term data and the markets let's focus on our Rubicon, actually the second we consider structurally significant. A set of socionomic Rubicons. The first we discussed yesterday in taking apart the history of corporate profits and argued we'll not see those days again. Now let's focus on changes in consumer behavior and the implications for the long-term economic outlook. The top subchart shows the cumulative growth in GDP, Consumption, Investment and Savings from 1948 to now, about as long we care to get. Notice that they were roughly in sync until 1995 or so; in fact Savings ran ahead of (and funded) growth and investment. That cusp point where the Tech fantasy boomed Investment has now almost completely corrected but the wealth (I'm rich, I'm rich) effect of first stocks and then houses sent savings into the tank. There's actually an earlier point where cumulative growth leveled off. That's reflected in the second sub-chart which shows the trends in YoY growth of Consumer Debt (r.h.s.) and Personal Savings. The former inflected into a climb from 4 to 6% in 1974 and then shot up to 7.5% this decade. The latter crossed its Rubicon around 1984 or so and it's 2nd derivative was definitely negative. The long-term structural and strategic consequences are shown in the third sub-chart which compares the YoY trends in GDP, Investment (r.h.s) and Savings (red line). Under the impact of the '70s the long-run economic growth rate dropped and hasn't recovered; recently of course it's gone in the tank as well. The lesson is very clear - in the long-run increased Savings fund Investment, which increases productivity and growth. The question we're facing right now and for the next several decades is whether we return to being a nation of values-centered savers and investors and restore our economy to a higher potential growth path. Or settle for third best where l.t. potential growth is likely to be around 2.5%, far below the 3.3-3.5% rate that's the previous norm. One of the other l.t. measures we like to look at is cumulative job creation, for that chart click on thru, which we've looked at several times before. We're now about -10 million jobs in the hole, i.e. below what's required to breakeven on labor force and productivity growth. It's no accident whatsoever that job creation has been poor and poorer since 1980 when the growth weakness set in and we became increasingly a nation of Grasshoppers. So what're the chances for our re-crossing the Rubicon and restoring frugality, sobriety and performance? That IS the question isn't it?

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May 25, 2009

They See What We See: Weak Recovery, De-Leveraging, Strategic Change http://llinlithgow.com/bizzX/2009/05/they_see_what_we_see_weak_reco.html The major recent economic news was the abysmal Housing data (which the readings link to the goto guy, CalculatedRisk for a thorough dissection) plus increasing pressures on debt, defaults and the finance sector (ditto). What we found really interesting last week on the economic front is the realization from many quarters that things look pretty much as we've been warning they are and will be: a weak, prolonged recovery back to a new abi-normal, a world of continued deleveraging and fundamental changes. The other interesting points are that the rest of the world is in far worse shape than the US, a trend who's implications is not widely grasped as yet, and the structural consequences of forced frugality on the US Consumer. All of these issues taken up in graphics form below and iterated thru in selected readings after the break. Starting with the San Francisco Fed's recent FedView update. As we found the biggest impact on GDP was a huge drop in Investment last quarter but the Fed, no surprise given their locale, translates that into consequences for the Tech Industry, which is now being hurt as bad or worse than any other. Something the Industry is struggling to come to grips with. Take a look at their assessment and you'll notice that things aren't as bad, yet, as in '01 but are still headed down. No surprise when you realize the Capex investment is a lagging indicator and, with an economy still likely to weaken further, one which will be worse before it gets better. Something the Tech Industry and investors have yet to come to grips with.

Weak Recovery The Fed chart pair we like, in the sense of conveying crucial information that aligns with our findings and views not in the sense of liking the news, is this pair which looks at the outlook and then compares the "recovery" to past ones. The mothership Fed has also released it's outlook and basically concurs. That is they see "hopeful signs" but lowered their outlook. Translation - that means that there's still drops to come but the unmitigated freefall is likely over as long as credit markets continue to repair themselves but growth will be lower for longer than they were publicly admitting in previous outlooks. In fact if you were to extrapolate along the second sub-chart here envision a world in which the economy only slowly bumps along the 100-index line for many quarters before gradually and grudgingly climbing

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back to say 101-102. You need to bear in mind CalculatedRisk and the Fed's finding that it was the Housing ATM that kept the last downturn from being a disaster. That source of consumer spending is gone forever. You also need to bear two other strategic factors in mind - things we've learned the hard way to think about. 1) While the logic is clear most are and will continue to ignore it and 2) the resulting investment and business decisions will be based on the old, not the new abi-normal. Btw the SFO's FedView chart pack is one of the better short and succinct presentations of what's going on. If you click on the highlighting you'll find yourselves with a dloadable PDF file which we recommend to you.

The New Abi-Normal: a De-Leveraged World Earlier (The Long Dark Veil: Economy, Markets, Business) we spent some time on the outlook for savings, debt, investment and leverage and the McKinsey Global Institute turns out to have taken a similar look at the situation. You'll find an interesting assessment in the readings excerpts that's worth your time. We find these charts fascinating, for their own sake, and because they look like and come to identical implications as ours using slightly different approaches. The top sub-chart shows how aberrational and above trend consumer borrowing got since 2000; and how far it has to go to correct. The middle sub-chart shows you why and how that happened; a lesson in the truth meaning of the wealth effect. You can see the bad impacts of the previous bad times in the '70s, the re-building in the Great Moderation in the '80s and '90s and the leveraged bubbles in the Tech and Housing Booms. Those ARE NEVER COMING BACK - voila' Forced Frugality whether we want to or not. Like we said a weak, slow recovery with a very different world on the other side of it. Circle back to the implications for hiring and capital spending and ask yourselves whether you think those will be very robust in the new regime? No surprise in all that that net new borrowing went in the tank and is likely to stay there for some time to come. Now we've still got a lot of hangover debt write-offs to go - the consumer and credit problems are just beginning and will get worse as employment worsens. But what's it mean for the future of the Finance Industry, for example, that we'll be forced back to being a nation of savers? Again something about which the Industry as a whole is in denial.

World Economic Situation As everybody has now noticed debt-financed consumption, especially that of the US consumer but also including many Europeans, was THE engine of economic growth for most of this decade. As consumption has been cut back those economies that were and are dependent on export growth to grow their economies have been much...much worse hurt by the downturn than those that were based on domestic, organic growth. Germany and Japan for example are going thru their worst downturns since WW2 with no

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prospect for improvement. China is experiencing major strains which means that the folks who sell to China, i.e. Australia and Brazil, are also facing challenges and will continue to do so. Now China is a long-way from being a domestically driven economy though it's moving in that direction. IF the US consumption engine doesn't come back, ever, to what it was what are the implications for Chinese economic growth? What does that mean for the rest of the BRICS? How about the implications for Oil and Emerging Markets? The meme running around the financial community is that we're back to where we were but we don't think the implications of a de-leveraged and lower growth world have been worked thru very well as yet. In fact not at all.

Public Policy and Strategic Consequences McKinsey makes another telling point - as US consumers re-build their balance sheets, which they must do, it makes an enormous difference whether they do so with growing incomes or stagnant ones. As they point out a 1% rise in the savings rate means about $100B in decreased consumer spending. If we return to the world of modest savings with a 5% rate that's $500B...but if we go back to what it was in the halcyon days of the '60s with a 10% rate....well you do the math. Turn that around and ask what decisions they are likely to make. Or, in other words, if a 5% rate would re-build balance sheets well enough if incomes were growing? The different answers make all the difference in the world. They also mean that re-factoring the US economy back to a higher growth path based on real gains in productivity, investment, new industries and new jobs is a matter of vital concern. Not just to the US btw but to the rest of the world. We tried to put it all in context wit this conceptual chart which shows some of the strategic alternative we are facing. The first big danger is that we fail to get the economy back on a selfsustaining footing where organic growth leads to a virtous cycle of employment growth driving increased consumption leading to increased investment. That is, to be honest, problematic for the reasons we just reviewed. The second big challenge is raising the long-term speed limit from the low growth 2.5% that is the "new normal" back to what it was in the prior decades of 3.2-3.5%. That's partly dependent on population and labor force growth, i.e. immigration. But it's mostly dependent on creating new innovations, new products and industries and re-discovering the '50s. You might want to consult these related posts: Re-building On A Rock: Policy, Economy & Values, Existential Crisis in the Agora I: Economy, Policy and US Strategic Outlook (Addons). May 28, 2009

What the Markets See: Yellow Weeds Thru Rosy Coke Bottles http://llinlithgow.com/bizzX/2009/05/what_the_markets_see_yellow_we.html We started to answer that titular question two mornings ago and have 90+ min. of writing our post blew-up. Given that we were going to take a rather pessimistic view (surprise) view and the markets rallied enormously on Tu. perhaps it was for the best. Yesterday's drops brings us full circle though - what do the market see ? The runup on Tu. was, in theory, on the back of the Consumer Confidence numbers and ignored the Housing data that came out at the same time and/or any other economic data. On the other hand Treasury auctions yielded a surge in yield yesterday, which allegedly drove down the markets as "inflationary" threats to the recovery made traders

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more wary. Sheesh....that's as bad a mis-judgment as the first, if not worse. We're so far from inflation being a problem that we don't know where to start. So we're going to come full-circle back to our original thesii and walk thru three different views of the SP500 to try and get some perspectives, albeit largely technical. We'll refer you to the prior post for the worldwide economic situation and the extent of the green shoot situation. Just for the record though consider House Prices On Track to Fall Another 10%-15%backed up with Nouriel's latest take on the worldwide economic outlook - Still more yellow weeds than green shoots as the global economy has not bottomed out yet. You'll also find two more detailed dives from CalculatedRisk on the realities of Housing in the beginnings of the readings section. That's immediately followed with a highly unusual interview with David Swensen, the Wizard of Yale, on Wealth-Track which we recommend you listen to, take notes, think about and memorize.

Rosy-colored Puzzlements Let's start with the shorter-term market situation, starting with this 7-month daily chart of the SPX (click to enlarge). The two technical indicators are now telling us slightly different things. The SlowSto - mostly useful for overbought and over-sold as well as turning points and the MACD - mostly useful for trend, momentum and turning point confirmation - gave very clear and reinforcing signals earlier. The two abrupt downturns and the upturn were clearly signaled (red lines and green line) by the SS and confirmed by the MACD. For several weeks now the SS has been fluctuating in over-sold territory and throwing off confusing signals but recently has started heading down; but the MACD is NOT confirming that. Instead we see the market oscillating back and forth (actually jumping) in a fairly narrow trading range. We've outlined the three trading range rectangles we think have been at play since Nov. The red is the bigger picture and sets aside the OMG the economy's broke panic in Feb. and some/most of the banks are fixed fantasy in Mar. The blue is, IOHO, the more realistic one until we get some more clarity and the yellow is where we think we're going to be, or should be. Notice that the top of the yellow rectangle is serving as resistance right now.

Pop UP a Level for Clarity One of the tricks we've learned from our trading friends is that when we suspect a trend or turning point at one timeframe is being signaled pop up a level and see what's being confirmed or not. In this case that means moving from a daily to a weekly time-period though in the same 7-month timeframe. When you do that we really do think things become simpler, clearer and easier to analyze. The fundamental trading range, highlighted by the yellow rectangle, seems to us to emerge fairly clearly. Again discounting the panic/euphoria swings in Feb/Mar (why are we reminded of George Carlin's line about the '60s - "chemicals were good to me"?). The major turning points that were tradeable were very clear, as is the downturn in the SlowSto.

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However the MACD also clearly is still showing upward momentum, albeit a momentum that would appear to be fading. Our bottomline so far would be that the market can't make up it's mind and lacks a clear consensus on future economic trends but wants to believe the best while fearing worse. Put other ways - now is NOT the time to get back into the market unless you're prepared to stay on hold for a long....long time. This looks like a fully valued market, particularly given our recurrent investigations of earnings, PE valuations and the economic outlook. If you're in now might be a very good time to take your winnings and head for the sidelines.

Widening the Aperture Let's stay with the same period (weekly) and widen the timeframe aperture to get a better idea of the big picture by running the weekly chart back to the beginning of 2008. We've kept the same technical indicators only now we've highlighted what we think are the major trends that went on. From Jan08 to the credit market collapse, when the fundamental structural flaws in an over-leveraged fantasy were taken beyond deniability, we had a relatively slowly emerging bear market. Offset from time-to-time by various short-term fantasies (decoupling, China will save us, "V"-shaped recovery) all of which have no been established as false to fact. Stop us when you think any of those are being rereplicated in contradiction of the data again btw. Then we got a punctuated equilibrium in Sep/Oct after the asteroid landed and market-life as we know it was (literally) brought to the brink of extinction. Then a new steady-state emerged and survived from Nov-early Feb., when a new, factually much smaller asteroid, emerged which led to another abrupt downfall. This time instead of the markets being the leading cause it was the realization of how truly weak the US and world economies were. Followed by the banks are fixed recovery...BACK to the SAME STEADY-STATE RANGE. One should also note that the banks are fixed meme that drove that culminate in a stress test that actually told us what bad shape many are truly in. While admittedly telling us which are well-run. But the vicious cycle between a week economy, debt and banking write-offs has a long way to go. All we've really done is avoid Armageddon. There's still a long way to go to get to a real recovery with organic growth.

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Re-thinking Your Investing Strategy Dave Swensen manages the endowment at Yale and has truly been a revolutionary innovator. He's written two books, one for his fellow professionals on his strategies and techniques and the other on his trying to adapt them for individuals. His primary thesis was diversifying into alternative investments but with judgment and homework. In the readings you'll find the link to the interview he just did, which we really think you should listen to. The top component of the graphic gives you a sense of how truly drastically he changed investing strategy during his tenure. As he says in the interview though the private investor hasn't got access to many of the tools that endowments do (and by that he means competent, active managers for alternative investments) so the individual has the choice of either putting in the time and effort or going passive. But DON'T chase performance and listen to the talking heads. Some of his other points: 1. In a long-term perspective entering a period where equities should outperform. 2. In a crisis, which we are still in, MUST take a top-down macro approach and understand how policy, structural trends, etc. are going to influence investment performance. 3. Diversification doesn't work in a crisis ('87, '98, now) where the only factors are risk and safety. 4. Principles are the same for institutional investors as for individuals. The difference is in access to resources and tools. 5. Can't find good active management. Quality of management in mutual funds for example is poor - they trade to much and run up transactions costs and tax exposures because they don't think about the customer. On the other hand customers chase last period's performance so one hand washes the other. Be either very active or very passive but don't compromise. 6. It's more than time to re-think your portfolio strategies - be willing to take more risk for a given timeframe (the second part of the graphic is a recommend allocation but you need to understand how and why he arrives at it). Manage risk by combining core low/no-risk positions, e.g. cash, with the edge positions as sketched. Also in the readings, along with many other excerpts, is a recent Bloomberg interview with David Rosenberg, who just left BAC/MER who expects the Mar lows to be re-tested as the realities sink back in. As much as Swensen, listen to that interview. He has a lot to say that doesn't make it into the story. A final key reading is the one that points out that almost universally investment advisors for high net-worth investors are drastically re-considering their strategies and beginning to move away from the old shibboleths of buy-n-hold. We strongly suggest you do the same because, if our economic assessments and strategic outlooks are correct, the old free ride is dead and in the process of being buried. TANSTAFFL ! There Ain't No Such Thing As A Free Lunch .

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June 05, 2009

The Vast, Ignored Difference: Economic Bottoming vs Recovery http://llinlithgow.com/bizzX/2009/06/the_vast_ignored_difference_ec.html The readings contain sections on the current situation and purported outlook, largely from Paul Kasriel of Northern Trust, recent Consumption and Employment data, the outlook for recovery in the US and worldwide (with an illustrative reading on Germany) plus Krugman's most recent take on the non-V recovery and a potential lost decade and the credit and policy situation with Janet Yellen of the SFO Fed's assessment that the "Great Moderation" of the last two/three decades is likely gone forever. Brave New World indeed! There are several bottomlines here that are incredibly important, not least for the fact that they are being completely ignored. 1. There is a vast difference between a bottoming process and the beginnings of recovery. The economy is stabilizing in that a panicked cliff-dive has stopped (Western Civilization is saved) but recovery won't begin until we start creating jobs again and won't be sustainable until both employment and investment begin growing significantly, if ever. 2. Consumption data on a YoY basis as well as Employment data continued to drop. Worse, the decline in job losses, is more due to really dangerous structural factors than moderation; the Employment:Population Ratio is cliff-diving as badly as it has done in three decades, indicating huge downward employment pressures, reflected in Hours Worked and the beginnings of Real Wage declines. 3. The commentariat, punditocracy, allegedly responsible economic forecasters, the investment community and business leadership (to some extent) is reacting month-to-month to the headlines, missing the vast difference, ignoring the underlying realities on trends and patterns and generally setting itself and us up for some serious disappointments. For which, worse, nobody will be prepared again. The chart is a snapshot of some of Kasriel's latest key outlook assessment showing the Leading Indicators are bottoming, that New Orders are not shrinking anywhere near as fast, that Monetary policy is apparently very stimulative and the credit markets are self-repairing. Paul is one of only two economists in the forecasting business who's largely gotten it right (the other being Roubini), which is not to ignore Summers, Feldstein or Krugman who comment more than regularly publish assessments (and not to neglect CalculatedRisk nor ourselves who have been accurate as well). That said we think his outlook for a Q4 upturn is optimistic but in any case, as he admits, will see a drawn-out and very weak recovery that will feel more like a recession.

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Employment Let's show you why by considering the Employment situation now that we have today's latest figures which, as the top sub-chart shows, is still cliff-diving on a YoY basis having dropped in the last four quarters -0.4,-1.6, -3.1 and 3.8%. That latter number certainly doesn't indicate much of an improving situation being that much larger than Q1 though admittedly Employment is a lagging indicator. In the second sub-chart though you can see where the pressures are really showing up with an over 6% drop in Hours Worked and the YoY change in Unemployment nearing -70% !!! That's not a typo - the YoY% change for the last four quarters in Unemployment is 30,44, 63 and 70% ! Doesn't get any worse than that - well actually it might. Our e-friend and blogging colleague CalculatedRisk dives into the Employment:Population Ratio to look at the worst consequence - the number of folks being driven out of the Labor Force. His set of posts are linked in the readings are as his charts. Read 'em and weep but start paying attention. Our approach to the long-term structural consequences is to look at New Jobs, Net New Jobs (> 150K/month breakeven) and the cumulative creation of jobs. In the third sub-chart the redline tracks the latter and there are two points. The one we've made and keep making - how incredibly weak a job-creating "recovery" this was - and a new one that's really scary. New job creation has gone as badly in the tank as it has since we can apply this approach, and not be a little big either. In the last four quarters we went from being -5.2 to -6.9 to -9.4 to, now, -11.2 million jobs in the hole. 11.2 million jobs in the hole, we repeat; what do you say? OMG seems grossly insufficient, doesn't it? What kind of recovery is going to create 11.2 million jobs just to get back to breakeven? And how long will it take? And what will growth look like while we struggle with just getting back to that point? Oh, btw, if the US consumer was the engine of worldwide growth over the last three decades and is going to go in retreat for the next decade to repair the damages what replaces them? Where does demand for the BRICS come from?

A High-Frequency Snapshot Let's dial up the granularity and dive into our collection of monthly data that serves as our dashboard of the detailed current situation, starting with current Consumption and Investment. In the top sub-chart YoY Personal Consumption and Retail Sales continue to decrease though the rate of decline is leveling off (remember our first key finding !) with Consumption down about -2.0% and Sales down over -10%. Key thing to note - both dropped these last couple of months! Investment wise new capital goods orders are truly cliffdiving, being down almost -25% YoY, Industrial Production (which is more coincident than lagging) following though the scale reduces the drop and

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Residential real estate improving only if you consider a change from -40% to -33% a vast positive sign. Good luck on that. The two things that drive a recovery in more normal circumstances are Consumption and Residential Investment. The former is going to be incredibly weak for a long time while the latter has enormous accumulated damage to repair. We'd say a long, drawn-out and very weak recovery is the best we can hope for. Shifting gears what about that possible growth in future demand? Well that's where we come full-circle. What drives Consumption is consumer’s ability to spend which depends on wages and employment plus their ability to borrow against their assets. At this point we hope everybody is clear that the late '90s stock bubble is never coming back and the Housing ATM that sustained spending, and the US and world economies, is likewise one with the Dodo. In fact given the state of bio-genetic research we consider it more likely that historical recovery and cloning of Dodo DNA is more likely to see the birth of new Dodos than seeing serious jumps in consumer spending for a long time. THE KEY INDICATOR is the YoY change in Real Wages plus Employment. That showed a steady drop as both weakened until Fall08 when the sudden drop in commodity-driven inflation drove up wages. Now W+E is dropping again and rather seriously. Part of that's due to the Employment pressures, which will worsen significantly over the next 18 months or so and continue to pressure spending. Worse the bad Employment situation, really coming full-circle now, is beginning to drive down Real Wages. So now we've linked the macro-outlook to the long-term structural and secular trend picture and then to the immediate high-frequency indicators. We're in for a weak, U-shaped, recovery at best with the problems in Employment keeping the risk of an L-shaped recovery very real. And NONE of this is being factored into any outlook or market advisories that we can see ! June 16, 2009

Time to Fold 'em: Market Outlook vs Investment Strategies http://llinlithgow.com/bizzX/2009/06/time_to_fold_em_mark et_outlook.html Well in the course of normal sequencing it is, and was, time to look at the markets and relate them to our prior take on the economy (The Vast, Ignored Difference: Economic Bottoming vs Recovery). Believe it or not we were all set to go over a week ago but when the god of timing fried our connectivity and we just got it fixed yesterday. And trying to blog, upload and link in graphics is a painful experience over the SBUX WiFi network for some reason. But, as my ex-girlfriends tried to tell me, timing is everything. What we have to say is what we were going to say and what we've been saying for about six weeks or so: this market is more

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than fully valued, it may run up on pure sentiment but its got nowhere to go from here. In fact based on our economic outlook its got nowhere to go for at least the next two years if not longer. That being the case if you have any profits it's time to take 'em off the table and get a drink. It's also time to re-think your investment strategies. But the involuntary delay works to our collective benefit since the markets might seem to confirm our argument so far this week, the commentariat is beginning to sound like us and today's econ data is more confirmation of sparse and wither prone green shoots. Just for the record Industrial Production was down YoY by -13.4% compared to last months -12.7%; in fact the rate of decline is still severe if slowing.

Market Assessment Starting with the current market situation take a look at this chart composite. In the long-term (since 1990) chart you'll notice that we got two bubbles but the market has essentially gone nowhere for over a decade. It did bounce off the lower Fib level in '03 but busted it and climbed back up in the March Madness but would appear, on this scale to be failing at the next level of resistance. We're probably lucky it didn't bust the lowest level around 450. BtW S&P estimated as of early April that 2009 earnings would be $44.10 and $44.78. At a 10 PE, well you do the math...also notice that S&P is implying a zero growth in earnings as well! The lower chart looks at the SPX since Jan08. In the first ten months we had a "normal" bear market followed by the panic in the Fall and a near total rout in March as it dawned on folks that various warnings about a very weak economic situation were indeed true. Nothing like a dose of reality to have the Bears come of their caves and the Bulls to run for cover. Thru last week we'd bubbled up a bit but so far this week that bubble has been largely erased. At best we're in a trading range. But valuations are pretty high and built on a recovery in corporate profits which is NOT in the offing at all. Like we keep saying this is going to be a long, drawn-out recovery that's a long way from getting started. The end of cliff-diving is NOT the beginnings of growth.

GDP vs Profits vs SPX Earlier we dissected (Beyond Specifics to Principles: Business Performance Principles & Outlooks) the relationship between aggregate/cumulative growth in the economy and corporate profits since 1950 and broke it down by Finance vs Non-Finance. The key finding was that there was a highly aberrational bubble in profits this decade, which drove apparent profits, but was due mostly to constrained hiring and investment. MUCH worse the aberrations turned out to be concentrated in Finance and had been far...far above trend since the mid-'80s (deregulation anyone?). The bottom half of this composite reproduces the key chart on Profits vs GDP with Finance vs Non-finance broken

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out. The top half is the interesting one here. Interestingly, or strangely enough, we can see the two bubbles in the stock market we saw in the technical chart reproduced in this comparison of cumulative growth since 1950. Really stop and think about that for a minute....from 1950 to about 1995 GDP, Profits and the markets all grew synchronously until an investment-driven bubble pushed the markets (twice !) way over long-term trend. The markets are beginning to come back to trend but you have to wonder how far the excesses will lead to a corrective over-shoot. With a weak and jobless recovery likely to drag out over the next five years profits certainly won't be growing though they have yet to return to trend.

Long-term Valuations We've pointed at Robert Shiller's work on longterm PE Ratios before as being the exemplar of a data-driven approach to looking at valuations. He found that PEs averaged 15.3 from about 1870 to now; and if you take his figures and net out the bubbles the average is about 14.9. By any measure the market is indeed fully valued. The last time we visited Prof. Shiller (Markets Manias: Thinking About the Year Ahead) we coupled that discussion with our favorite Graham-Dodd PE valuation formula of PE = (8.5 + 2*G) X 4.4/Y, where G is the earnings growth rate and Y the AAA corporate bond rate. That prior post reproduces our G-D tables where you'll find a 5% growth rate and a 6% interest rate yields a PE of 13.6; right in line with the other paths to enlightenment. BUT....but...but a 0-3% growth rate, which is reasonable given the economic outlook, and an 8% interest rate, which is reasonable given the downside risk factors to be properly priced, yields PEs in the range of 5-10, depending. Now look back at Shiller's chart and notice that a) we've had a tremendous bubble in PE Ratios as well as ALL the other indicators and b) every other time that's happened we've had a major corrective overshoot. Lots and lots of different approaches seem to converge in roughly the same region, don't they?

Re-Thinking Investment Strategies The mantras that everybody has followed for the last three decades are buy-n-hold combined with asset allocation and those have been based on the "efficient markets hypothesis". In the readings you'll find several selections on the current market situation that (finally) raise exactly the questions you can find us raising about the markets about twice/month since at least January. MUCH more importantly are a key set of readings on the long-term strategic re-thinkings that are beginning to go on. These include two pieces from Mohammad El-Arrian of PIMCO plus another one from Bill Gross and a piece from Joe Nocera of the NYT pointing toward a growing set of challenges to the efficient markets concept. Markets may in fact be efficient if a) they're not distorted and b) all the information about them is available. When those assumptions fail so does the EMT (that's Efficient Markets Theory not emergency medical technician but one wonders). The accompanying graphic is our most recently

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updated assessment of the markets situation for the four fundamental factors we like to look at: Structure, Fundamentals, Technicals and Sentiment. Each category shows the immediate prior assessment compared to this one. For the record the immediate prior assessment was from Jun08 since the disequilibriums of the Fall and Winter swamped our concerns with updating them. If you'll click on the graphic what you'll actually pull up will be a downloadable PDF copy, which we suggest you do dload, read AND think about. The two prior assessment summaries are here and here.

Alternative Strategies So what does that mean for your investing strategies ? We think several critical things that are going to be painful and a lot of hard work but less painful than continuing to worship dead shibboleths. For well over five years we've been suggesting that Buy-n-Hold was a dead strategy because we were in a low-return world and one where markets were, being polite, generating a lot of anomalies. Our 2004 take on re-thinking portfolio and asset class strategies against timeframes is, IOHO, worth revisting for several reasons. (Portfolio Strategy:Mar04). Among those are the structure, timeframes and asset classes. Also among them are the things we got right and wrong, in retrospect, though we'd argue that there was more right than badly wrong and they were good guesses at the time. We took another pass at re-thinking strategies in Jan08 and dedicated a whole post to it. The resulting re-vamped portfolio strategy put a lot of emphasis on ETFs, particularly leveraged and inverse ETFs. (Portfolio Strategy:Jan08). We discussed the reasons and rationales extensively in this post:This One's for Jay: Investing Strategies for a Dicey Market. Our bottomline is that you need to re-think and re-structure, be more active and look for anomalies and trends. Anybody who followed our Jan08 recommendations made a lot of money last year, and would still be making money. If we'd been all that smart way back when we'd have done better as well. This last decade was dominated by key trends: foreign markets, commodities and real estate to name some key ones. Now the question is what will they be in the future? A question for future investigation though right now with everybody wallowing in the same ditches nothing comes to mind. BUT repeating the same tactics that worked for the last set of inefficient anomolies won't work again. For example banking on emerging markets to be the great opportunity is, IOHO, a done and exhausted investment idea. The re-factoring of the BRICs is fully captured, with the disappearance of the US consumer the export-led growth model won't come back and that will decrease worldwide demand for commodities. All large and complex subjects. Made more so because there may be short-term opportunities to exploit everybody else's worshiping of the old shibboleths.

UPDATES: Merrill Fund Managers Survey BNN talks to Gary Baker, co-head, international investment strategy, Banc of America Securities-Merrill Lynch. STREET CRITIQUE - Todd Harrison TODD HARRISON, founder and CEO of Minyanville.com. Paul asks Todd about Wall Street's response to the Obama Administration's planned overhaul of the financial regulatory system. Todd also offers perspective on the current market environment. White Paper No. 46: Is It Different This Time? During extraordinary market conditions of all kinds – good and bad – it is usual to hear people say, “It’s different this time.” Of course, every market environment is different from

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every other market environment, but what these people are saying is that market conditions today are so exceptional, so completely unprecedented, that investors will need to reassess everything they thought they knew about the investment process – or face serious consequences. June 28, 2009

Drugged Wallabies, Crop Circles and World Economies http://llinlithgow.com/bizzX/2009/06/drugged_wallabies_crop_circles.html It's been quite a week for the data that was and the data that was reported, starting with a much more pessimistic World Bank Report leading, allegedly, to a major market drop that was entirely recovered by a slightly more optimistic OECD report that saw a "full" recovery along with some US domestic data, e.g. consumer income, spending and savings. For the record when you actually read what was written and dig into the headlines as usual were almost completely distortionate. We sound like, and are, a broken record on this topic but will keep replaying the old songs as long as no one else is despite a desire to moving on. The chart is a short-term look at only two data indicators - real personal consumption and real retail sales and makes one of our major, critical points: the rate of decline has stopped accelerating but is still about as bad as it's ever been. Abysmal to put a word on it that's both accurate and revealing, and ignored apparently. Rather than spend this whole post on digging thru the other data and re-repeating ourselves we'll point you to this downloadable PDF file of all the recent data on both a short- and long-term basis so you can see that ever series confirms this and how bad they all are in historical context: Recent Economic Data.

The Real World Economic Outlook In the readings you'll find addresses and excerpts for both the World Bank and OECD reports as well as some news stories. In the Markets section you'll also find discussions on BNN regarding each of the BRICs specifically. This chart encapsulates what the OECD really said and shows maps of the '09 and '10 outlook as well as graphics for the BRICs and the major developed economies. What they really said was "weak recovery in sight but damage will be long-lasting". In fact if you do some more digging around the have an associated part of the report that ALSO says that long-term economic potential has been badly damaged and will result in anemic "growth" for a long-time to come. NOT what appeared in the headlines - adjusting for differences in weighting factors their outlook is identical to the Bank's as well as that of private

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forecasters (another one of the BNN vidclips). The sad fact is that this not what most are reporting, seeing or acting on. You'll find graphics with more details in the readings BTW.

Structural Changes: Reversing the Virtuous Cycle to a Vicious Cycle The World Economy has undergone tremendous structural evolution, even abrupt re-structuring, in the last decade with the BRICs as a whole crossing thresholds into entirely new economies. Those changes will remain but they are both one time events that set the stage for new secular evolutions and will proceed at slower rates in the future. If everybody's ignoring the real data the implications of these shifts are even more neglected; that is they are not reflected in investors or business executives planning. A primary driver that's going to shift is that US consumers have been the driving engine of worldwide economic demand and they are shifting from dissavers to savers as they re-build their balance sheets. They are not the only ones that will be de-leveraging and re-building their balance sheets either - the entire worldwide financial system will as well. The devil's bargain that is unraveling in front of your eyes is that the developed economies borrowed from the rapidly developing ones who, in turn, built export based economies based on that demand and exported their "excess" savings as loans to finance the excess consumption of the world's grasshoppers (puns intended). Now that set of feedback loops will be running in reverse which means that Chinese growth, for example, will be lower in the future. By some estimates as much as 2-3% or more. That means that demand for commodities won't grow like it did, impacting countries like Brazil and Australia, nor will demand for the tools and equipment that made it workable, impacting Germany and Japan for another. One of the lessons of the last lost decade is that the markets went nowhere per se but certain anomalies did well for a time, e.g. real estate, emerging markets or commodities. If the point isn't clear the under-pinnings of those anomalies just got knocked out and will stay knocked out for a long time. But, because the "common wisdom" is looking for a return to old patterns we'll likely see a short-run effort to speculate on those patterns. Which explains the recent runups in emerging markets, oil and commodities. We won't repeat an earlier NYT chart on the implosion in world trade but here's the link so you can re-examine it as statistical evidence for how these cycles have reversed: World Trade Implosion.

Structural Changes and Strains Which is not to say that the structural shifts in the world economy won't be continuing in some form, albeit at a lower level. Bridging back to the last post on the strategic outlook for the Auto Industry we borrow this chart from one of the reports we pointed to in our update on the industry outlook in the Rapidly Emerging Economies (REE). Our friends at Booz & Co also provide this more detailed prognostication: World Auto Demand Outlook. We think those outlooks are reasonable,

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fact-based and are representative of the huge shifts facing every industry. Shifts it's NOT at all clear they are preparing for or able to adapt to. At the same time we think that the actual levels will be reduced and the numbers will take longer to reach. That's on the assumption that the reductions in worldwide growth and the shift in demand don't strain the socio-political institutions of the BRICs to far. On that topic we'll point you to these discussions (G-20 Persepctives: How Well Do Bears Dance ?, Brave New World: the Emerging Balance, Pluralities, & Non-zero Sums, Existential Crisis Around the Agora II: New World Stories). The fundamental points here are that the development of the BRICs (or REEs) is fragile and dependent on the institutional framework. When Chinese growth drops to 8% they are under strain, if they drop to 5-6% that's more threatening to them than a sustained -6% would be for US.

Trade, Growth and Innovation: Choices About the Future What's enabled and sustained all this change and growth is world trade. Trade is, on the whole, unambiguously beneficial to all participants though certain sectors of the economy and segments of the population suffer serious adjustment impacts and costs. For example in the '90s everybody was afraid of the Four Tigers after been afraid of Japan during the '80s. They missed the fact that what was going on was the shift of 15thC economies to 20thC ones with labor shifting from agriculture to manufacturing. China is playing out that adjustment on a ginormous scale. As a result they shifts will continue, if they are sustained for a long...long time. When you compare China's coastal areas to their interior you are in effect making a comparison across those years. The coast is a REE and the interior is just the opposite. We are faced with several alternative paths forward, which depend on maintainingg stability, the continuation of trade and economic growth and renewed innovation on the part of all parties. These chart tries to capture (too many) things but shows how the gains from trade effect wealth at a point in time, how each economy changes and what might happen depending on the paths we end up on. Almost needless to say the red and yellow lines are colored for a reason - on those paths like the possibilities of severe disruption. Even the blue path, a muddling thru, will see severe strains. It's the green path we need for things to all hold together. And that requires large-scale innovation. Meanwhile the readings excerpts below contain a number of vidclip excerpts from BNN, the only financial news network aside from PBS' Nightly Business Report, worth listening to IOHO. The discussions on the world outlook and the investment climate are extended and worthwhile. The sections on each of the BRICs highlight the differences, though occasionally you need to watch out for someone talking their book, e.g. Russia. Also included in that section are some grahpic summaries of world markets worth looking at. By the way the "drugged wallabies" story is also in that section. It turns out they make the crop circles but also, at least to our mind, characterize how most observers are looking at the economic, investing and geo-political situations. For the record we stand by our own last two posts on the Economy (The Vast, Ignored Difference: Economic Bottoming vs Recovery) and the Markets (Time to Fold 'em (Updates): Market Outlook vs Investment Strategies), as well as our assessment of business performance (Beyond Specifics to Principles: Business Performance Principles & Outlooks). Each component is critical in its own right but what really drives things is the interaction between the three!

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July 08, 2009

Brown Shoots, Weak Markets, Resilient Business? http://llinlithgow.com/bizzX/2009/07/brown_shoots_weak_markets_resi.html We're going to take a quick pass thru the economic situation, markets and - picking up on last post's theme's - talk a bit about business resilience or not, as the cases may be, with examples. Last week's payroll employment data seems to have convinced folks that what we've been saying for months about non-existent green shoots, a weak outlook, a drawn-out recovery and a de-leveraged jobless future is in fact what's the outlook. Interestingly you need to tear yourself away from the US and major foreign business and financial news and listen to BNN; in the readings you'll find some selected vidclip URL's that are NOT there by accident and we highly recommend them all, but especially the two *** ones. The market has bounced on PEs not on earnings and that's the story of the moment with the longer-term implications of all this still being struggled with. As we've tried to make clear this is a matter of responsive adaptation in the shorter run and adoptive innovation in the long. Also in the readings you'll find some specific cases on how well that's working and the brave new world we're all facing. The NYT did provide a superb graphic slideshow (http://www.nytimes.com/interactive/2009/07/02/business/economy/2 0090705-cycles-graphic.html?ref=business ) illustrating how a business cycle works which, if you'll click thru on the graphic, you'll be taken to. Watch it and think about it. We've talked about business cycles a lot and even provided a tutorial earlier so were particularly happy to see this; a superb use of new technology that gets the story right (NB: we've also notice that the YoY meme is really getting much wider spread use as well !).

Back to the Future: Employment & Consequences This little gem of three composited charts tells multiple inter-locking stories with the top part showing the YoY% changes in Employment and Unemployment since 1998 monthly. Like we've been saying, a leveling off in the rate of decline is NOT a recovery, and you can see both the steepness and depth of the decline as well as the slight leveling - though Unemployment continues to worsen. Folks are starting to pick up on the differences between unemployment in folks actively looking for work and those pushed out of the labor force (Many Left Uncounted in Nation's Official Jobless Rate). That rate of unemployment is 16.3%. Those points are reinforced in a longerterm context in the 2nd sub-chart which shows Employment dropping -4%, Hours Worked -6% and Unemployment increasing by 70% !!! If you think the consumer is coming back any time soon think again. Worse yet the 3rd sub-chart gets back to our long-running theme about how weak job creation was during the recent "recovery" (reaching almost -4 million jobs in the hole) and how disastrous it's become. We're now about -12 million jobs in the hole. REALLY think about that - how long will it take to even get back to breakeven? Bearing mind that unemployment will keep increasing for some time - perhaps thru all of next year? What can we say except OMG X 2. First time for the numbers and second because almost nobody gets it.

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Market Realities Return The green shoots and China will save us theories led to a major bear rally between March and May though we've gone nowhere since then. In the last few days (largely on BNN again admittedly) we've heard pundit after pundit talk about the same things we've been jabbering away at. And in the last week we've seen a bunch of market analysis on the likely breakdowns in the market, for which you'll find another bunch of URL addresses to reinforce that point. If there's one must watch please watch the online vidclip presentation of MarketClub's tool demo assessing the SP500. Wonderful. Here's two SPX charts compounded to make our points, which are nearly identical. As you can in the top chart the critical level is about 880, which we busted yesterday on weak volume. If that keeps up, depending on how earnings run, then we can expect things to run down. But where ? In the lower sub-chart we look for some natural limits using Fibonacci limits. A first bottomline here is that you should be on the sidelines - as we said last major market post - take your money off the table! The next stopping point is ~840, which we consider likely. If that's breeched the downward momentum will build and running down to 780-790 is highly likely. Depending on how things look, the news is running and what the sentiment is that might be breech as well. If that happens then we're back in the where's the bottom in a long-run sense. A question extensively previously considered but if you want to look at an updated long-term chart click thru. Which we recommend and you can't say you haven't been warned ! :)

Business Reactions and Performance Recent earnings estimates have been extensively revised downward, which you can see by consulting the S&P Earnings Estimates. They're calling for earnings of $55.54 and $74.02 in '09 and '10 with PEs of 16.55 and 12.42, which leads to estimates for the SP500 of 919. In other words a flat market at best, though if you use our Graham-Dodd approach lower PEs, like 10 or less, are appropriate. But even so that's telling us two major strategic things, actually three. 1) There's a lot of risk in valuations, 2) the recent runup was the limit for two years (and possibly more if you go with our pessimistic outlook) and 3) real earnings in a terrible economy are going to be the critical determining factor. Gee, somehow or another we've circled back to business performance, short- and long-run. Our recurrent mantra is understand the strategic context (Economy and Geo-Politics), understand how each Industry is trending and then understand how each company is dealing with the things it cannot control and the things it can, now and for the future. There's a vidclip in the readings of Ivan Seidenberg being interviewed on Rose which is as perfect an exemplar of this sort of balanced thinking. The take on the current secular trends and how Verizon is being positioned is outstanding but the look ahead to the worldwide future of the Telecom Industry is worth the time.

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In the readings there are some specific examples for your skimming pleasure. The section starts with some examples like a Greek Shipping company as well as Apple, talks about the Finance Industry which is the exact opposite of an industry adapting well. They're still locked into the way things were, not the way they are or will be. The lack of effective response and thinking ahead can only be described as stunning. Then we have Rio Tinto, the Australian mining company who road the commodity boom into worldwide acquisitions sprees starting to spin off pieces as the result of the downturn. Talk about foresight and mis-readings ! NOT !! We spent a whole long post taking apart the Auto Industry but the outlook for sales is abysmal but the triple tsunami is the growing capabilities of the rapidly developing world, e.g. China's acquisition of Opel and the fact that India has turned out a great car in the Nano. Sadly it would appear that the kind of innovative adoptiveness required is more on display outside the developed world than in it. A theme enormously reinforce by Saab's moving to migrate production of the Grippen to Brazil really.....really....really think about what that says not just about opportunity but about capabilities. Aircraft are among the most complex and demanding products in the world - advanced fighter aircraft are another order of magnitude. Meanwhile pharma sales are going to decline in the developed world so Big Pharma is looking outside the US, which has been its development base since it's founding. Now the Rapidly Developing Economies are very exposed because they are so export oriented to the downturn and future weakness. But in the long run.... ? Well...we'll leave it at that because we think the implications are both obvious and taken apart in depth and detail in the last post. July 10, 2009

Beyond the CRE "Bombshell": Real Stress Testing for Finance http://llinlithgow.com/bizzX/2009/07/beyond_the_cre_bombshell_real.html One of the big announcements today was a member of Congress telling us that Commercial Real Estate was a major bombshell about to burst. This was actually kind of funny since CalculatedRisk has been laying down the law, graphically, on the CRE bust for almost two years now and calling it exactly. And he's done it by simple informed and competent analysis. Of course he also prognosticated the real estate bust early (very) in 2005 (which was just about the time that Merrill, et.al were piling on, taking more risk and creating special business units to get into the business!). There are NO surprises here - the good news is that this will be bad but not as bad as residential real estate and there's not as much leverage involved. We ourselves introduced this simple conceptual graphic well over a year ago to try and illustrate the various feedback loops that were at play (the immediately preceeding version is here - click on thru to note the changes). Credit markets are repairing but not in great shape and credit is still restricted. In the meantime the economy turned bright red but has since stabilized, as we've been saying, at a terrible level. Ditto on the stock market. Despite the headlines and talking heads the International Economy is worse - you think it's an accident that Iran and China have been beset by riots? Despite China's headline growth they need 8% to

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stay ahead of the alligator of population and at 6% are in deep, deep trouble. Unfortuantely they're really storing up worse problems in the future when they have to deal with this credit bubble they are creating.

Credit Contagions Even earlier in the game when we were all trying to decode the alphabet soup of CDS, CDOs, MBS, etc. etc. we came up with this little gem to illustrate the basic problem on of leverage, balance sheet blowups and cross-linked markets. This chart is close to two years old now (to the best of our recollection, anyway). We think it's fair to assert that, conceptual as it is and naive to boot, that it's held up pretty well. Even very well. The contagion that started in sub-prime saw boulder after boulder crash into the various debt and credit markets and sequentially take them all down. If you think it's an accident that nobody can get a mortgage or that the PE guys can't get financing or that the credit card companies are screwing us all...well look at this chart. Though admittedly we didn't spell out all the ramifications at the time since we didn't see them.

The Next Set of Credit Tsunami's What we did suggest however is that Housing and the related financial markets were just the beginning. As credit problems metastasized into the real economy a vicious feedback loop was set up between a weakening economy, growing joblessness and increasing bad debt across the reach and range of debt. Including consumer, business and financial. Which led to this much more analytical chart. This one in particular we really meant, and mean, for you to trace the paths and think about them. The ONLY linkage path that's pretty well worked its way thru its doomsday scenario is Housing. Yet banks still haven't cleaned up their balance sheets and are both figting the government repair programs and refusing to come clean. Now as we continue in weak economic circumstances leveraged debt, for example for buyouts (CLOs) are headed say with rising corporate bankruptcies while credit card and consumer bad debt is growing exponentially. Similarly business defaults are growing rapidly. The level of balance sheet exposure and synthetic, leveraged debt instruments is somewhat less in these markets but they've got a long way to.

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Repair My Sainted Aunt's Left Butt... You figure out the rest. We've been harping in every market and financial post that the market was being driven by a surge in expectations built on the shaky finance repair and recovery. Courtesey of BigPicture we get this top chart which shows how the various sectors did from the Mar trough to the Jun peak and since then. Guess what - the unrealist of the unreal did the best far and away. Starting with the Pandit put and the "managed" earnings reports for Q1 we got this surge. yet all the bad news is hardly factored in. (NB: stay away from finance stocks unless you're a trader!) So what did that mean for the market as a whole? Well the bottom sub-chart compares the SP500 to the Finance Sector ETF along with the one for Industrials (XLI) and Consumer Discretionary (XLP). Take a careful look and the best performer by far was XLF closely followed by SPX; in other words Finance drove the market as we've been saying. Meanwhile Industrials didn't do anywhere near as well and Consumer stocks ran up with the trend but are since deteriorating badly. If this was a real recovery in sight just the opposite would be try, to some extent anyway.

Pound Away At Finance Off and on we've been devoting major posts to the status of the Finance industry or key players within it. So much so that we found ourselves having to create a whole separte Finance Archive to collect the various posts where you could see them. Skimming back over the last two years it makes for interesting reading. The bottomline here is that we couldn't find any line of business in the Industry that was even in fair to so-so shape. Most are bad or worse. Now we're facing a world where: 1) things are going to keep getting worse for the banks but 2) they need to start do some fundamental re-thinking. The result? They're still in denial. In fact the whole thesis of the Industry being capable of self-supervision has proven false to fact; nobody else has come so close to bringing down Western Civilization all by themselves. Yet not only are they in denail but they are fighting reform of the regulatory regime tooth and toe nail while also insisting that just as soon as things "get a little better" it'll be back to business as it was. If you'll recall our discussions of the aberrational profit pictures that metastasized in the '80s, '90s and oughts for Finance that these is dead as a doornail. The real bottomline is that the Industry is facing a major structural shift that will be as momentous as the impact of de-regulation initially was. And that's going to eventually provoke a backlash of monumental proportions. In the readings section you'll find a sampling of stories from the last couple of months or more that illustrate, as a whole and sector by sector, how the industry is fairing. We suggest you skim them for their own sake but keep all

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these points in mind ! And then think about the sector both as an investor, as a customer and as a participant in the larger economic picture. July 22, 2009

Realities vs Rhetorics: Economy, Policy, Real Data http://llinlithgow.com/bizzX/2009/07/realities_vs_rhetorics_economy.html Long past time for another post and, as things cycle around, it probably should be on the state of the economy. But we've hammered that a whole bunch and nothing has changed our conclusions (The Vast, Ignored Difference: Economic Bottoming vs Recovery, Drugged Wallabies, Crop Circles and World Economies (Refreshes). We did keep repeating that the slowing of decline was not either green shoots or a harbinger of recovery (our constant theme for months now!) so the good news is that we're hearing that reflected all over now. Alleluia! So we're going to spend less time on pure economics and focus more on the conundrums and policy dilemmas we find ourselves in. The level of mis-understanding about the state of the economy, the outlook and the role of government policy is just astounding; and it rests on a fundamental misunderstanding of how cycles and stimulus work. That will be our focus. But just to hattip last week's economic data take a look at the chart set, which shows monthly data back to Jan00 and Jan93 and quarterly back to Q160 on a YoY% basis. Despite the "it's better, it's better" meme running around in fact it's flattened off around approx. -10% ! The real thing to note is this: every single data series in the last few weeks has looked exactly like this (including revenues being reported in the earnings announcements !). Like we said the only ray of light is that the fact that things are NOT good and this is going to be a very weak and drawn out recovery has dawned among a wide group of observers.

Current Cycle and Strategic Outlook When consumer demand drops as badly as this businesses will also cut their spending. In fact increases in hiring and investing happen ONLY after a recovery begins as companies don't need to add to capacity until demand uses up existing capacity. That's why employment and capex are lagging indicators. In normal times the economy naturally follows a cycle where rising consumer demand leads to more business spending which generates new hiring which in turn leads to more spending. The Fed can help mitigate the worst extremes of this as long as we're in a normal environment thru interest rate management. But we're in a once in multiple generation state where things are anything but normal. THE ONLY SOURCE OF DEMAND IS GOVERNMENT SPENDING. Without it we'd be in much worse circumstances, with some serious

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risk of Depression 2.0. If the Fed and Treasury had screwed up last Fall we'd have had one anyway. This 4-panel composite tries to convey all that and link it to our strategic alternatives. We've likely avoided GD 2.0 but are now trying for a weak recovery instead of a long L-shaped malaise. There are a bunch of "abort" points we need to navigate until we get back to the self-priming normal cycle of organic growth. But even if that works everybody from the Fed to Roubini is seeing poor long-term growth prospects (2% or so), far below potential, for years. To restore long-term growth we've got to invest in things like infrastructure, energy, healthcare and education to rebase the economy.

Stimulus Package Structure A couple of weeks ago I sat thru an online presentation by GE Healthcare discussing it's electronic medical records and physicians practice software solutions. As the result of a sliver of a sliver of a sliver in the stimulus package they are offering low-cost financing to the 95% of doctors who haven't yet even begun to think about the problem. That sliver was pretty well-crafted. When you look at the breakdown of the stimulus package it was pretty well constructed. There was a big chunk that was in tax cuts and transfer payments, e.g. extending unemployment benefits. That was and is a big help in mitigating some of the downturn and employment impacts. But 2/3 of the package will hit later on this year and thru next. The other thing that the package does is start laying the groundwork for not only getting us past the abort point but also in jump-starting a structural evolution to a rebased economy. Now there's no denying that the process of rushing thru the package saw some pork loaded in but the extent has been enormously exaggerated. Some reasonable and responsible estimates put it somewhere between infinitesimal and ~3%, a minor political price to pay for getting something that large out that fast and that reasonably well-crafted. When people criticize the package they have no clue as the real challenges. First off the package was about as large as could have been passed given the political situation. Second, when you examine the graphic and think about my anecdote, it's wellcrafted. It's not like folks haven't been examining much of this for decades, e.g. infrastructure spending requirements. ANOTHER key thing to keep in mind is that the package is the down payment and tabs into follow-on legislation on the budget, education, energy and healthcare. Taken all together and in conjunction with what the Fed and Treasury are doing to restore the credit markets and reregulate the Finance Industry this is comprehensive and integrated a system of initiatives as we've seen in almost four decades. Finally, and this speaks to the call for a 2nd stimulus, what's authorized is about as much or more as the current mechanisms of the various Federal departments can handle. Or beyond. To make this work we're going to need a revolution in government operations that's one of the major hidden challenges. And if we end up needing a second stimulus we'll need it on the state and local levels, as the CA. nightmare tells us. The bottomline here is that people are doing the best they know how, it all hangs together and it's all at the limits of what we can manage. In many senses!

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The Deficit Bogeyman A really key thing, setting aside the partisan political posturing that's done to try and exploit old shibboleths that are unworkable and discredited, is that most folks are judging things thru ideological blinders. If we've learned anything in the last couple of years is that the simple common wisdom is no substitute for actually knowing what you're doing. Faced with a problem of this scope and magnitude and complexity what you want is a set of approaches that are as complex as necessary and understand the feedback loops built into a system. Simple answers just won't do it. One of the key bogeymen is the fear of excess deficits so let's take a look at that and try to make it a little clearer. If you're with us this far we hope it's crystal clear that we have NO choice but to spend or face a decade+ long period of 1% growth or less; and hope it doesn't turn over into a depression which is still a possibility. This little composite collection we've accumulated over several years might help. Despite supply-side idolatry what Reagan actually did to restore the economy was create the most massive deficits in post-WW2 history. In other words he pursued as Democratic like a policy as anybody had in decades. The good news is that it worked and got the economy back on a growth path. The bad news is that the resulting deficits were massive. Clinton, bless his pointy little head(s), not only eliminated the deficit but briefly put us in surplus thru a combination of fiscal discipline and taking advantage of reduced military spending. Unfortunately BushII, returning to idolatrous worship, chose to both cut taxes AND enormously expand spending. Some of which was unavoidable. But the net result is that we came to the end of a mini-boom and entered the worst recession extremely far in the hole. When you look at the sources of the current and projected deficit about $200B of $1.3T is due to the current administration. The other thing to keep in mind is the odd thing that if we get back on a higher growth path tax collections will increase and we'll have less of a deficit burden and pay it down faster. In the long-run it really matters what you spend your money on - invest it for future growth or chew it up in frivolous short-term spending. So far we're more on the former path than the latter. When you combine that with the even deeper structural shift of the public from over-borrowing consumers to folks who will be forced to be savers this isn't going to be hard to finance; nor will it crowd out private investment. Initially because there's no demand for private investment and then because a growing economy where Savings > Investment throws off lots of cash. In fact if we can keep this all together for the next decade we're going to be in a far...far better place then we're in now or would have been otherwise. BtW - there's a whole slew of readings and some more charts after the break that span current economic data, the long term outlook, oil/commodities, the mounting problems in China with Rio Tinto that will make sustaining their growth more difficult, a bunch on the policy issues and some more on re-thinking the relationship between markets, policy and institutions.You might want to pay particular attention to the collection to the second China collection if you want to understand a) the long-term problems they ARE creating, b) what a dangerous stimulus program looks like and c) whether we can count on them to pull us out of this (otherwise HA !). Bon Appetit' !

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About Llinlithgow Associates Llinlithgow Assoc. is a management consultancy focused on evaluating businesses to reduce risk, leverage under-developed opportunities in operations and increase overall enterprise performance to improve investment return. Our approach is based on BizzXceleration, a proprietary framework with 25 years of development, to review and analyze Business Models and Strategy, key operating functions and supporting infrastructure and management systems. From there we develop comprehensive, integrated operating plans that tie all the components of the business into a high-performance enterprise.

Customer Problem • Value Proposition • Business Model • Strategy

Management System •Budgeting system •Management Controls •Operating Plans •Resource Development

Marketing, Sales & Service • Customer value focus • Process Discipline • Business-driven

Core Operating Functions • Functional Efficiency • Inter-function Integration •Value Alignment

Several years ago Michael Lewis published an interesting book on how the Oakland A’s took a systematic look at how the game really works, and what investments in players, strategies and tactics were most likely to result in the most wins for the lowest cost. Our approaches are similar in taking a systematic look at the whole business, each of the major components and the best way to tie everything together into a high-performance system. We start by looking at the basic core value proposition and it’s translation into the Business Model and Strategy. Typically we next examine Marketing and Sales operations, where it is possible to reduce operating costs by 30%, shorten the sales cycle by 30% and increase the closure rate by 30%. This is primarily the result of establishing good processes and discipline. BizzXceleration is comprehensive but integrated across the total reach and range of business activities and issues. And emphasizes a pragmatic, workable approach that results in a stepwise path to performance improvement. We believe that our approach mitigates business risks, improves operational performance and can lay the groundwork for 10-30% EBITDA improvements in post-deal execution. If you would be interested in further discussions, more detailed descriptions or the review and testing of specific opportunities we would enjoy hearing from you. We can be reached at [email protected] .

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