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Precariously Balanced Bull
by Mark M. Rostenko
Editor, The Sovereign Strategist
November 17, 2004

In light of last week’s explosive stock market gains, it would seem rather spoil-sportish to harp on the factors which threaten to derail our progress. The election went off without a hitch, nobody bombed anything, etc. and the stock market was happy.

But regardless of how many negatives the market has ignored, the imbalances are creating an increasingly unstable situation with every passing month. Whether or not this will translate into stock market losses remains to be seen, but the informed investor should be aware of economic reality. It’s a bit like driving. The odds of having an accident are relatively slim, but that doesn’t mean that a driver shouldn’t remain alert to dangers on the road.

Yet it would seem that with all there is to worry about, apparently there’s nothing to worry about at all. Many of the negatives and imbalances have been with us for some time, yet the economy seems to be muddling along and the S&P 500 surged to a 2-1/2 year high last week. Official Minister of Economic Cheerleading Alan Greenspan isn’t worried about anything, so why should we?

According to Uncle Al, crude oil at $40 per barrel was nothing to worry about because that price level wouldn’t be sustained. When it breached $55, Uncle Al said the world would adjust to higher oil prices. The housing bubble and surging mortgage debt are “manageable.” In fact the bubble doesn’t even exist because, by some twisted logic I don’t quite understand, the “size” of the U.S. housing market apparently shields it from bubble-like prices. Consumers maxing out on credit cards to make ends meet are “handling their debt well.” Whatever worries the market, Greenspan explains away with a fistful of $4 words. Don’t worry, be happy.

So far, nothing particularly horrible has happened. But does that mean the dangers have passed? If you hear a nasty rattling under your hood but your car makes it home alright today, tomorrow and two days from now, does that mean the car’s running fine and will continue to do indefinitely? Probably not. Our economic engine continues to rattle under the hood, but with every passing quarter that nothing especially dreadful occurs, we grow immune to the rattling. Yet the rattling continues and if it’s not fixed, eventually something will give and the engine will stall.

Might we be headed for another recession? Corporate profits have begun to slow. The most recent retail sales and employment data have been better, but the gains don’t reverse the downward trend established in previous months. Stephen Roach of Morgan Stanley pins the odds for a 2005 recession at 40%. (Recessions, by the way, bring about stock declines on the order of 43%, on average.) In his words:

Each quarter that we escape a problem, the greater the comfort level as to what lies ahead. Such myopic risk assessment misses the forest for the trees. In my view, the US economy is an accident waiting to happen. That’s the message to be taken from a record shortfall in national saving, a record current-account deficit, record levels of household indebtedness, a record deficiency of personal saving, and outsize government budget deficits. The emphasis is on the word record. Never before has the United States pushed the envelope to this degree on such a wide array of economic imbalances.

To Mr. Roach’s list add another imbalance that isn’t much discussed: the burgeoning levels of subprime debt. Anybody with a pulse gets a credit card these days. If your name is on the mailbox, you qualify for a 110% mortgage simply by nodding your head “yes.” There’s a lot of very risky debt being issued and it wouldn’t take much to push some of these issuers over the edge. Financial “services” are a huge part of our economy today. (GM loses money on cars, but turns a profit on lending.) Were this segment to run into trouble, the repercussions could be astounding. Think in terms of the savings & loans debacle of the 1980s.

Surprisingly enough (ha ha!) fearless Uncle Al doesn’t see this as a problem either. “Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.” In other words “folks without two nickels to rub together can now partake of the great American debt bubble.”

To be sure, we’ve done very well in light of the potential fallout of a huge stock market bubble collapse. The result (thus far) was one of the mildest recessions on record. (You hear that a lot, but you don’t often hear that the following recovery has been the worst on record since the Great Depression.) Slashing interest rates and cutting income taxes appear to have done the trick. After all, things aren’t that bad, economically speaking. Hence the market’s faith in the economically-almighty Greenspan, whose utter refusal to acknowledge ANY imbalance as problematic continues to soothe market investors to the point of ignoring any and all potential negatives.

But while we seem to have averted a large economic slowdown, we’ve done so only by creating massive imbalances, a whole bunch of chickens that will eventually be coming home to roost. We’ve avoided a few quarters of sharper pain likely at the expense of many more years of potentially strong growth. The strength of the recovery thus far should make that quite clear.

While we may applaud the powers that be for their aggressive recession-fighting stance which spared us from dealing with the repercussions of our excessive 90s ways, we may end up vilifying them if another round of weakness arises. Because this time, there’s little left with which to fight. The budget deficit stands at a new record. Can taxes be cut again while billions are burned up in Iraq each month, while baby boomers are about to make huge demands upon the fragile Social Security system? Forget about slashing interest rates. There’s nothing left to slash. Keynesian deficit spending? With what???

Make no mistake: what kept us from plunging into a much deeper recession was the increase of debt engendered by low interest rates. Does anyone really expect that could save us a second time around when debt levels stand at record highs while the savings rate is near a record low? Debt saved us the first time around. I don’t think we have that option if the economy should slip into recession again.

Of course the soothsayers at the Fed tell us not to worry. In that event, “non-conventional” means will be engaged to boost the economy. Be it dropping money out of helicopters or running the printing presses double-time, your friendly Fed is 100% committed to doing whatever it takes to destroy the dollar and increase imbalances to unmanageable degrees, as long as it puts more cash into the consumer’s wallets and keeps the registers ringing at Walmart. Only a fool can’t see that these “non-conventional” measures would serve only to increase the price that must eventually be paid for our economically-profligate ways.

But it may surprise you to know that I’m not quite convinced that gloom and doom and a major bust are in the works. Yes, the imbalances are huge. But to believe that everything must go to hell in hand basket is to overlook the positives and the lessons of history. The world was supposed to end many times over. The rise of industrialism was to make everyone a slave to greedy monopolists. The rise of robots and technology was supposed to put us all out of work. Population growth would lead to mass starvation as we would run out of food in the 70s. Gold would rise forever, the economic system would collapse and the survivors would be holed up in bunkers living on canned food by the mid-80s.

I tend to believe that the desperate and “whatever it takes” efforts of the powers that be combined with American ingenuity will lead neither to collapse nor surging prosperity, but instead what John Mauldin calls the “muddle-through economy.” We won’t see big gains for years to come, but perhaps the imbalances we’ve discussed won’t lead to an economic doomsday either.

I mean, think about it realistically. The United States remains (for the time being) the global superpower. The dollar is still the world’s reserve currency. We are still the primary economic engine driving the world’s growth. We did avert disaster following the implosion of the 90s bubble and today’s global economy combined with the coordination of banks and markets all over the world has created resources and changed domestic economic “rules” in ways that we still don’t quite understand.

Necessity is the mother of invention and nothing lasts forever. Things don’t just keep getting worse, nor getting infinitely better, for that matter. Doomsayers see surging oil prices and declining supplies which lead to war, pestilence and famine as this strategic resource becomes less available. But the reality is that markets reach unsustainable highs at which too many people are priced out. And so alternatives are developed. Sky high oil prices could be a horrible thing. Unless they result in increased efforts to develop alternative, perhaps environmentally-friendly energy sources. I wholeheartedly believe that we will in time run out of oil. But by that time, we won’t be dependent on it.

Humanity has survived countless horrible regimes, unstable financial systems, depressions, slavery, torture, war and pestilence. But can anyone realistically argue that today the world doesn’t offer more opportunity, more comforts, higher standards of living than ever before? Progress, innovation and growth are long-term trends that won’t be derailed by dingbat politicians and unethical central bankers. To be sure, they go a long way to screw things up, but there are a lot of positives in the American business model and in the ingenuity and drive of the American people that will hopefully continue to balance out the ignorance of the powers that be.

I do believe that we still have quite a price to pay for all the current imbalances. I don’t expect another “economic miracle” for a long time, most likely not during this decade. Make no mistake: the imbalances are huge. Record low savings, record high levels of debt, record trade and budget deficits, the dollar approaching a record low. These chickens must and will come home to roost. But we’ll muddle through.

© 2004 Mark M. Rostenko
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