Executive Summary

• This is not a normal recession, and it will not follow predictable patterns.
• Tax data does not support the assertion that consumer spending has essentially remained unchanged.
• Housing market recovery is being delayed by government programs.
• Households and small businesses are shedding debt, and big businesses are only adding a little, leaving government responsible for most of the new debt.
• We need to become serious about our real needs and stop frittering away time and capital.

I am going to be peering ahead with my views for 2010 and beyond in a multi-part series, beginning with the big picture before moving into individual ideas and suggestions.

Let's start by pondering a bullish set of views gleaned from the news:

Wall Street closes 2009 with "an expectancy of better times in the air."  While not predicting immediate return to prosperity, general mood was the most optimistic since midyear slump dashed hopes of early business revival.  General belief that "factors of long-range bullish import" are steadily increasing, while vast bulk of necessary deflation has been accomplished.

While the past year was painful, the pain won't necessarily end with the year.  However, there's good reason to believe the country is in a better position than it was a year ago.  The past year has rid the country of illusions, including the theory shortly after the crash that the US had invented the "harmless panic."  It has produced a new realism, where business projects must be sound to proceed. 

The year has also provided an "incalculable amount of ultimate benefit" in eliminating the many "weak spots" that an economic boom always produces. Institutions that "withstood the extraordinary strains of 2009" should be well positioned for the tests of 2010; common sense and experience suggests these will be less severe. Consumption has outpaced production for months; "effective demand for expanded mill and factory production cannot logically lag far behind."

Truth be told, these quotes were gleaned from newspapers published on December 31, 1930.  The only things I changed were the dates, to make my point that these quotes could have been written last week.

Nothing ever really changes, and hope springs eternal.  To read the above quotes in their original form, just replace every "2009" with "1930" and every "2010" with "1931."

I got those quotes from a wonderful website that posts the news from the 1930's, called, appropriately enough, News from 1930.

Just for kicks, since those quotes were published on December 31, 1930, right as the real pressure of the Great Depression was just beginning, let's review how the Dow Jones did afterward:

The Dow proceeded to rally over the next eleven weeks and put in a nearly 11% gain.

But ultimately it worked its way down to a 76% decline from the level at the end of 1930 and took another six years to recover those losses.  Sometimes things seem like green shoots and roses even when they are not.

If you are built like me and detest losses, then you will agree that it would have been better to tune out the bullish prognosticators in 1930 and stay out of the market, waiting for a clear signal that the waters were safe again.

Here are some quotes that are actually from today.  See if you can spot the similarities:

Economy Poised for Surge, Says 'Most Accurate' Forecaster

(Bloomberg) - The U.S. economy next year will turn in its best performance since 2004 as spending perks up and companies increase investment and hiring, says Dean Maki, the most-accurate forecaster in a Bloomberg News survey.

The world's largest economy will expand 3.5 percent in 2010, according to Maki, the chief U.S. economist at Barclays Capital Inc. in New York. The rebound in stocks and rising incomes will prompt Americans to do what they do best-consume, said Maki, a former economist at the Federal Reserve. Faced with dwindling inventories and growing demand, companies will soon become confident the expansion will be sustained, he said. 

N.E. economy poised for recovery, Fed report says

The New England economy is showing signs of improvement, as most businesses surveyed by the Federal Reserve expect a recovery next year.

The survey released by the Fed yesterday, known as the Beige Book, found that some companies are either beginning to hire and reverse pay cuts, or plan to do so next year.

And so forth. 

While it may be true that we are "poised for recovery," a number of very troubling signs remain out there that should give us some pause.

Where are the tax receipts?

State, Local Tax Revenues Decline 7%

State and local tax revenues fell 7% in the third quarter of 2009 from a year ago, the Census Bureau said in a report underscoring how the economic downturn is stressing government collections.

Sales taxes declined 9% to $70 billion in the third quarter compared with the year-ago period, the Census Bureau said. Income taxes plunged 12% to about $58 billion. Together, sales and income taxes make up roughly half of state and local tax revenue.

Once again, I am going to ask how it is possible for the government, via the BEA, to report that consumers are spending essentially the same this year as last year (down -0.2%, Table 8)  if states are reporting 9% lower sales tax receipts.  This is a huge and glaring difference. 

Have people figured out how to buy things without paying sales tax?  Are a lot of businesses risking jail by holding onto sales tax receipts instead of turning them in?  Or is this merely a case where the sales tax data is correct and there's something badly wrong with the BEA methods and results?

Given everything I've seen and read over the past year, it is a near certainty that the BEA is fudging the numbers for political gain and sales tax receipts are telling the accurate story.  If we believe the tax receipts, then we believe that the economy is far weaker than advertised.

The Mortgage Mess is Still With Us

The relative lull in mortgage foreclosures is not yet a sign of health returning to the housing market.  It is partly a sign of the impact of a government program, which goes by some name or another, but which I call the "Delay and Pray" program.  Here's how the New York Times recently characterized criticism of the program:

Some experts argue the program has impeded economic recovery by delaying a wrenching yet cleansing process through which borrowers give up unaffordable homes and banks fully reckon with their disastrous bets on real estate, enabling money to flow more freely through the financial system.

"The choice we appear to be making is trying to modify our way out of this, which has the effect of lengthening the crisis," said Kevin Katari, managing member of Watershed Asset Management, a San Francisco-based hedge fund. "We have simply slowed the foreclosure pipeline, with people staying in houses they are ultimately not going to be able to afford anyway."

I thoroughly agree with this assessment. Instead of pulling the Band-Aid off quickly, this program is allowing us to peel it off as slowly and painfully as possible.  While this may be good politics, it is bad economics.  The truth of the matter is that houses are still overpriced and need to fall until they are again affordable.  The sooner we get to that new bottom in prices, the sooner we can actually begin to recover.

All we've done so far is delay the inevitable, while praying that this time the laws of economics will somehow not apply.

The other reason I remain sour on the housing market as a whole concerns the fact that our recent lull in mortgage foreclosures is also a function of where we are in the mortgage reset cycle.  The vast proportion of all our difficulties in the housing market stems from a class of mortgages that "reset" after a period of time to either a new rate of interest (always higher), a higher principal payment component, or both.

This picture tells it all (and is the same one I've had taped over my desk for 2 years):

During the first wave of resets, some really bad things happened in our economy and financial system.  2009 was a lull year, and in 2010 the resets ramp back up to hit a peak in 2011.

That's right around the time a big wave of CRE notes come due as well, so I think we've still got some rough sailing in front of us here.  At the very least, it is entirely too early to be doing victory laps around the stock market.

Why This Isn't a Normal Recession

I was recently at a gathering with a very large presence of mega-money managers (hedge fund managers, pension trustees, etc).  The question was repeatedly asked, "Will this be a V-shaped recovery, or a W, or an L?"

I think the error was in asking the question itself, because the assumption that underlies this thinking is that this recession will behave like prior recessions.  If it were that simple, all we would need to know is which type the current recession will most emulate.

But, in fact, there is plenty of evidence that this recession is fundamentally unique in some very important ways, with none more so than in the levels of debt that we have carried into this downturn.

I wrote about this in an article entitled The Crisis Explained in One Chart: Debt-to-GDP, which was posted almost exactly one year ago on January 13, 2008.  I sincerely think that if you could only hold one argument for why this time will be different, then you would be well served by simply focusing on debt-to-GDP.

Let's update the debt-to-GDP chart and take another look at it:

As you've already noticed, I had to "break the box" in order to accommodate the Q3 2009 data.  We ran out of chart box.  The amazing thing to me is that the debt-to-GDP ratio is not in sharp retreat at this time.  I realize that GDP itself is in retreat, but I would have thought, given the immense retreat in consumer borrowing via credit cards and the housing ATM, that debt would have been falling faster.

Nope.  Not so much.

You'd think that perhaps a crisis like this one would be a perfect time to reexamine one's position and reverse the accumulation of debt. 

We now stand at 369% (and climbing).  As I've noted previously, this is due to the fact that government borrowing (primarily) is running at a faster pace than consumer retrenchment.

Should GDP fall like it did during the Great Depression, we could expect the current reading to vault upwards as it did in the 1930's, perhaps to 500%, 600%, or more.

More debt!

These next charts come from the Federal Reserve Z.1 report, and everything in them is current through Q3 2009. 

Total credit market debt stands at $52.6 trillion, down less than 0.5% from its peak in Q1 2009.

However, this retreat in credit, minor as it seems, is really quite a shocking development for a system tuned for continuous exponential expansion.  The Fed knows this, and it is why they have partnered with the government and other central banks around the world to keep shoveling more and more debt into the system.  The unfortunate part of this story is that anybody with reasonable elemental awareness can determine that there's a problem with a system that requires continuous growth.  Sooner or later it will "go vertical" and completely run away and destroy itself (and everything else).

Nonetheless, this is the system we have, so we must analyze it for clues as to what the future may hold. 

As I've noted before, the really interesting part of the story in the credit markets is not that credit has barely fallen from its all-time highs, but that it managed to remain flat at all.

Financial sector debt (belonging to banks, REITs, finance and insurance and mortgage companies, etc.) has declined by slightly more than a trillion dollars from its peak.  So this sector isn't responsible for holding up the debt pyramid.

The answer must lie in the other big bucket, "non-financial sector debt," and it does.  The debt here has been climbing uninterrupted before and during the crisis.

The non-financial sector mainly consists of households, non-financial corporations, and government (state, federal and local), and we can see that this sector has been growing its debt steadily and consistently throughout the entire crisis.

How about big businesses?  Have they been adding debt?  It turns out they have been adding some, which only make sense, given the ultra-low interest rates being offered by the Federal Reserve.

But the amounts are not nearly enough to account for the losses we've already seen in the charts above.  So what about small businesses?  Have they been adding debt?

No, it would seem that small businesses have been shedding debt, as well, which makes sense, given the collapse in lending by banks.

Well then, what about households?  Are they adding debt?  The answer is "no."

So if households and small businesses are shedding debt, and big businesses are only adding a little, the answer to our riddle of who is adding debt must rest with government, and indeed it does.

State and local governments have been piling on the debt mainly to cover up vast budgetary shortfalls caused by the recession/crisis. 

But the amounts here are relatively small (note the scale on the left axis).  The real winner, hands down, is the federal government.

Yes, our credit market debt has been prevented from going into a free fall, but at an enormous and unsustainable cost to our national treasury.  It is my contention that there is a limit to how much the federal government can really borrow, and I suspect we'll hit that limit in 2010.

My outlook for the future rests heavily on these charts and what they imply.

The Future

My primary analytical angle rests on a foundation of skepticism.  I am deeply skeptical that a crisis rooted in debt can be solved with more debt.  Specifically, I am quite convinced that transferring the role of debt accumulator from the private sector to the government sector will not work.

I understand the Keynesian logic on display here.  The idea is that the government steps in during down times to provide support to the economy until the private sector dusts itself off and takes off again.

However, the fundamental issue still remains:  We've got a system that needs to continuously compound its debts in order to function passably well.  That's a long-term predicament that will not end well. 

More immediately, the scope of the interventions now representing a very large portion of the overall economy are well beyond anything we've tried before and are therefore worthy of a healthy dose of skepticism.  Maybe they'll work out as planned; maybe not.  So it's probably best to not bet the ranch on a healthy recovery being the outcome of this historical experiment.  We might get something unexpected instead.

This Spring

My next target for a date where something interesting might occur is the end of March. 

Two things happen then.  The first is that the Federal Reserve's mortgage purchase program ends.  Unless they extend it, or initiate something like it, this will represent $15-$20 billion in freshly printed (thin air) money that will not be hitting the streets each week.  I think this money has been finding its way into stocks, bonds, and commodities.  That's what hot money does - it goes out and finds things to do.  When it goes away (assuming it does) then what will the various markets use for fuel?

The second thing happening right around the end of March is that the impact from first bolus of federal stimulus money runs out.  Unless another round is ordered up and tossed into the economy, we'll have two major sources of market-stimulating money running out at roughly the same time.  I am sure the plan has always been for the economy to have gotten itself back up and running by then, but I strongly suspect that this will not be the case.

If not, you can be fairly certain that our fiscal and monetary authorities will engage in another round or two of stimulating.  And that's where something interesting could happen.  Either the world lets us do it again, or it doesn't. 

If not, then we could easily see problems in the US bond markets, with the dollar and all the other various markets gyrating in sympathy with the bond market.  A betting person would wager that nothing will likely happen at the end of March.  The prudent person will take out some insurance in case it does.

During the first three months of the new year, I am expecting a continued wall of liquidity, something I have been harping on for quite some time now, to continue to exert its effects on all markets (stocks, bonds, and commodities).  Where others have been calling for a deflationary result (if not depression), I have been marveling at and remarking on the clear evidence of a massive flood of liquidity.  I happen to think that liquidity alone is no magic bullet and that its seemingly magical benefits will wear off someday, but these things take time.  For now, it looks like we're surrounded by the very best market conditions that thin-air money can buy.

The Dollar

Shortly after the stimulus wears off, I think it will be revealed that the consumer really is tapped out and will not come roaring back into the economy.  General recognition will finally dawn in the dark recesses of DC that shoveling money into the black holes of Wall Street doesn't actually do Main Street any good.  Ways will be sought to put money more directly in the hands of the people. 

While I am fully cognizant of the troubles that exist with the Euro and the Yen, I do not ascribe to the view that the world "must" have a reserve currency.  I can easily envision everyone switching to a basket of currencies that make sense for their respective countries.  This would really be just a continuation, perhaps even an acceleration, of a trend that began a while ago.  So arguments that there's no logical replacement for the dollar as the world's reserve currency can be considered something of a red herring.  Suppose we don't really need a reserve currency?  Then what?

I am expecting the dollar to bounce along for a while, until things resolve themselves into sharper focus, but I don't expect it to move much to the upside, as some are expecting.  A bounce, yes; a strong bounce, no.  I think that it is the Fed's policy to foster a weaker dollar, and I know our exporters want one.  Couple that with the fiscal and trade deficits, and there will be some serious headwinds against any possible sustained dollar rally.  If it wants to really rally, the dollar will need more help than simply being "less worse" than the alternatives.

Once the dollar begins its next big wave down, however, I am expecting some major seismic activity in all of the major financial markets.  Those ideas will require an entire report all on their own.

Conclusion

Hope springs eternal and, just like in 1930, we find ourselves surrounded by bullish pronouncements on how bright the future is.  As was true then, there are lots of reasons to be cautious today. 

The gap between government reports of economic recovery/health and declining sales tax revenues is troubling.  The most likely explanation for the gap is that the economy is weaker than advertised and the BEA is churning out some very bad information.  It's possible that the opposite is true, but not very probable.  The most likely explanation is that the sales tax revenue is telling the true story and the BEA is not.

One of the main drivers of this whole mess has been the aftereffects of the bursting housing bubble.  The recent lull in mortgage foreclosures is an artifact of the reset schedule combined with an aggressive government program designed to postpone the pain to another day.  Both of those mitigating factors wear off in 2010, signaling a return to higher levels of foreclosure activity and a return of bank stress.

Of course, the main thing that underlies the entire mess is the fact that our collective load of debt spiraled far away from our underlying productive economy.  We lived beyond our means for awhile, and now we need to live below our means for awhile (or risk destroying the dollar).

This is both natural and good, but it is being fought tooth and nail by a determined government that is doing everything it can to keep the debt bubble expanding.  Perhaps they fear it bursting, or perhaps they simply lack the imagination to try anything other than preserving the status quo.  Either way, they've set a course, and it had better work.  If it does not, the dollar itself could be destroyed as a useful currency.

I see 2010 as something potentially far more interesting than a "year of slow or low growth" (as it is being described by most mainstream economists).  I see it as a potential watershed year, where the true reality of our predicament will settle in for a long stay. 

We've got too much debt, and it needs to be reduced, not expanded.  We need to become serious about our real needs and stop frittering away time and capital trying to preserve something that never should have been.  If we don't, our future will be badly diminished. 

In the meantime, I stand by all of my past recommendations.  Portfolios need to be insulated against a dollar decline and the resulting inflation that will be kicked off.  Each person should tighten up their own ship for some potentially rough sailing.