From Chaos to Turbulence:

Myths vs. Realities in the Economy, Markets and 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.
Where you can keep current on the state of the Economy, the implications for Markets and read
explorations into business performance for Industries and specific companies.

This collection of blog essays covers the period from August to November, 2009 as the Chaos in
the first half of the year gave way to Turbulence. That’s a critically important distinction as Chaos is
when nothing is predictable and where you end up could be disastrous depending on minor
differences in where you started. In contrast turbulence is still a very disturbed environment,
technically a collection of smaller-scale chaotic behaviors, but subject to overall patterns and flows.
In other words what we experienced in this period was the re-emergence of more predictable
behaviors in the economy, largely as the result of effective and successful monetary and fiscal
policy.

In the process of laying out this evolution we dig into the structure and patterns of GDP and
business cycles, where the economy was at and is likely to go, the interactions between markets
and the economy as well as multiple delusions about the future that set into market outlooks and
tackle multiple numbers of mythologies that were floated during this period as to what was going on
and the implications for the future.

While you might think this look back is dated in fact the machinery and long timespans detailed
here will determine the course of the economy for years to come. In particular the explorations of
Debt, Savings and Growth, the role of debt and the future of de-leveraging and the impacts of
Trade, Exchange Rates and trade balances will be things we wrestle with for the next decade.

We also spent considerable time exploring the role and impact of government fiscal policy and the
strategic outlook for the US economy. It was government intervention, thru fiscal and monetary
policy, that kept what could have been a disaster as we fell into an abyss from being much worse
than it could have been. An important point to learn is that the health of the economy is still utterly
dependent on government support though we can look ahead to a tricky transition. The key to that
transition will be whether or not the economy reaches takeoff velocity and establishes a level of
self-sustaining growth, or whether it remains weak and vulnerable. It will, in any case, remain
fragile and we’re facing a weak recovery with very poor job growth for years.

In other words we lay out the groundwork behind the New Normal using machinery that you can,
we hope, readily understand and re-apply.
 Table of Contents
1. Interrupting Your Reported Data Distortions: More Darkside for the Economy 3
2. Same 'Ol, Same 'Ol: Economic Cliff-bottoms vs. Cliff-diving 6
3. Between Stalingrad and Kursk: Real Economy, Policy and Outlook 8
4. Where's the Money: Markets, Outlooks & Re-Thinks 12
5. Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness 15
6. Refreshing the Economic Outlook: Fundamentals to Business Outlook 19
7. Moscow, Stalingrad, Kursk: Edge of the Abyss to "Recovery"? 22
8. From Mythologies to Realities: Economy, Employment, Credit & Trade 26
9. Markets Away: Run Baby Run? Or Stumble? Or What? 31
10. More De-mythologizing: a Little Markets, Some Economics, Lots of Policy 33
11. Really Different This Time: Liquidity, Rates, Markets & Risks 37
12. Surprise, Surprise: Not a Rally and It's Still Different 39
13. It's Still Different: Refreshing Policy and Market Info 42
14. Cuspiness, Collisions & Conundrums: Market Carry, Employment & Euphorillusions 43

Page 2 of 50
August 01, 2009

Interrupting Your Reported Data Distortions: More Darkside for the Economy
http://llinlithgow.com/bizzX/2009/08/interrupting_your_reported_dat.html

We' re interrupting your regularly scheduled data dumps of economic data, and our
planned posting schedule, to bring you this special bulletin about what yesterday's
GDP numbers really said. First off there were not just huge revisions but a complete
re-factoring of the data. This is not, and for the record, some nefarious government
plot (though it will again be taken that way) which resulted in better data and
revisions stretching back decades. Which made, among other things, the ' 01
downturn much milder and this one must worse. More importantly our recurrent
theme of needing to really look into things needs re-emphasizing because the
reported headlines are based on QtQ data instead of YoY and when you look at
properly are much worse than anybody is telling you.

The fact that mis-interpretations and resulting distortions are beyond widespread,
beyond endemic and would appear to be innate is another critical factor.

This morning' s WSJ put it all very nicely in historical context though by comparing
the decline in GDP to previous downturns since the end of WW2 with this nice
chartporn. We' ll dig into all this graphically because it'
s critically important but what
you need to know is the headlines reported QtQ changes over the last three
quarters in real GDP of -5.4, -6.4 and -1.0%. Which gives great weight to the
fantasies of a V-shaped recovery.

In actual fact, on a YoY basis, the last three quarters were -1.9, -3.3 and -3.9%. Let
me repeat that - REAL GDP WAS DOWN IN Q209 BY ABOUT -4% !!! If you take
out the effects of trade (exports were down -15.7% while imports dropped further by
-18.6% and net exports as a whole were -28.7% YoY. That last number is a slight
improvement over the previous -29.8%) GDP x-Trade was down the last four
quarters by -1.1, -2.5, -4.4 and -4.7%. Let' s try that again too...DOMESTIC GDP
WAS DOWN ALMOST -5% !!!!!.

No way, shape or form that one can read those as good numbers. Nor can one
argue that they show much flattening of the rate of decline, or bottoming out. The
QtQ numbers do tell us that we' re in the process of crossing that cusp point though and we'd expect to see better
numbers in the next few quarters, at least in the sense that the rate of declines drops. Positive GDP improvements are
a ways off, significant positive GDP improvements farther, growth in employment and investment and the return of a
naturally growing economy is much...much...much farther off. In fact the Fed expects that after a bump up the long-
term outlook is for an average growth rate of 2.4% - that' s barely breakeven on required new job creation and means
we're going to have an organically weak economy - thru 2015 and beyond.

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Letting the Real Economy Stand Up

Let' s put all that in context with this graphic so you can
what the data really says and how it looks in comparison
to the last two decades plus (we' d go back farther but the
structural revisions of the data are a work in progress and
it'
ll be some time before it' s completed and we can rebuild
all our spreadsheets). There' s a pernicious meme in wide
circulation, mostly driven by deliberate distortions for
political purposes, that the stimulus program isn' t working.

In actual fact about $300B of tax cuts and transfer

payments have already gone out the door and have been
what' s kept state and local disasters from turning into
catastrophes. A very rough cut of GDP, with and without Federal spending, shows the downturn would have been
significantly worse. NB: that initial $300B is about all that could be shoved out the door and actually work. NB2: and the
pace, timing and structure of the program thru the rest of this year and thruout next, on which continuing to keep the
wolves at bay depends, is beyond what the operational capabilities of the federal departments can handle; in other
words about all that can be done is being done. (Realities vs Rhetorics: Economy, Policy, Real Data).
Understanding the real data is critically important but it would appear that understanding how it's being mis-reported
and deliberately mis-represented is even more so. Without Federal spending YoY GDP growth would have been -0.6, -
2.7, -4.0 and -4.7% the last four quarters. In other words the economy was almost a full percentage better than it would
have been otherwise in Q2.

The Real Outlook: Consumption, Investment and Implications

Current consumption tells you how the engine of the

economy is doing, investment (real estate and
business) tells you how it' s likely to be doing and the
combination of wages and employment tell you how the
future is likely to evolve. The second chart above shows
us that Consumption is still bad but it leveled off
somewhat, instead of following over the cliff with GDP as it
usually does. For the last four quarters real
Consumtion was -0.7, -1.8, -1.5 and -1.8%, so it' s
bumping along a bottom for now. That is its not getting better
but it'
s stopped getting worse - in some significant part
because of stimulus. Employment on the other hand is
dropping like cliff-diving lemming, along with GDP.

Consumption drives future business expectations which

in turn drive hiring and investment decisions; which, in turn,
feedback on consumption decisions. With consumption still very weak and employment dropping we' ll be lucky if
demand holds up which means investment and hiring will be constrained for a long time. Take a careful look at
investment in this second composite - it sharply peaked in early ' 04 and began declining immediately. The first thing
that tells you is one of the major reasons we had a very weak and jobless recovery - the organic feedback loop never
caught and the engine was just sputtering along with poor capex spending and hiring. Then it started falling rapidly until
it went cliff-diving very early in '
08. The last four quarters were -8.1, -12.5, -25.2 and -27.4% YoY!

Investment dropped by almost 30% in Q2!! Residential investment generally leads the business cycle and this last time
housing price bubbles led to sustaining Consumption on the back of the Housing ATM. That' s created a long-term
structural problem where excess inventory will have to be worked off, where Housing won'
t recover as it normally does

Page 4 of 50
and where the ATM is never coming back. Business spending fell -6.0, -17.4 and -19.6% the last three quarters. Again
the start of a bottoming process but -20% is a LONG way down in our book.

Investment and Future Demand

In this third composite the top part breaks down

Investment into its two major components so you can
see the RI and Business pieces separately.
(Again the revisions to the reported data and the on-
going updates make the earlier data a little
squirrely, technically speaking, but the recent data
appears reliable.). In the top of this graphic you can
see how the cliff-diving real estate drop preceded the
overall downturn and then how business
spending has followed it off a cliff. With all this in mind
(the worst downturn, preceded by a jobless
"recovery", VERY poor business spending
prospects) we can probably say that getting back to
2.4% growth would be an optimistic outcome.

The next question is how is the Consumer going to react, now and in the future. Remember no more stock market or
housing bubbles to subsidize consumption. Then there' s the re-balancing and de-leveraging of consumer balance
sheets - the fuel that drove the engine the consumption engine for three decades is being taken away. Now at this
moment in time consumption depends, and will depend, on incomes and nothing else. The best indicator of that is the
combination of real wages and employment. In the second sub-graphic here you can see where real wages have
jumped up as inflation has dropped. But you can also see where job market pressures are beginning to impact wages.
Meanwhile of course Employment is in terrible shape, and given normal business cycle behaviors in combination with
terrible job creation prospects, will worsen significantly (at least 10% Unemployment and likely worse) and will be
followed by a really terribly jobless non-recovery. At 2.4% growth businesses will NOT be hiring nor investing much.

What's Really Going On

This rather large and complex composite puts

together four different graphics we' ve put up
several times and like to re-use because they tell
the complete story. One of the advantages of
ideographic languages like Chinese is that the
characters also tell a story because they are
pictures. Think of this graphic as four
ideograms that also form a fifth, master, picture of
how the major currents are playing out all
together inter-actively.

First you have the business cycle where

Consumption drives business spending and hiring
but both Consumers and Business decide
based on income, prospects and
funding/borrowing. As we cycle around this
feedback loop, which can be either virtuous or
vicious (and we're in a vicious one indeed), the
economy oscillates like a wave pattern.

But we have some deep-seated structural feedback problems where Credit Markets sustain or constrain how the
economy does. They are self-repairing in the sense that collapse is no long immanent (make no mistake last Fall and
this Winter that was NOT a given - Bernanke, Paulson and Geithner saved Western Civilization). So Credit and

Page 5 of 50
Housing are still in trouble but the US Economy is, as we've just been pounding away at, in deeper trouble. As it
happens, no matter what you here in the headlines, the International Economy is much worse. Partly because Japan
and Europe are in the deepest dodo but also because China' s reported growth is still not good enough to breakeven on
job creation requirements. It's not an accident that so many serious civil disturbances have been breaking out, getting
bigger, more serious and widespread. And also because China acted fast and well but has created terrible problems for
the future by pumping too much money that moved out of their credit system into bad loans.

The bottom left-hand chart pulls all this together and tells you where we think we' re at in the cycle and what the
alternative paths were and are. A shallow V-recovery is out of the question. Depression 2.0 has been avoided, so far!
Judging by GDP one could estimate we' re at the beginnings of a bottoming process. But, especially with poor future
growth prospects, the continued deterioration and poor future prospects for Employment - which is IOHO the best
gauge of overall economic health - has not begun that process yet.

There's a log of pain to come and our long-term condition will be chronically poor for a longer-time, even
if we manage to start putting together positive growth on a sustainable basis.

August 14, 2009

Same 'Ol, Same 'Ol: Economic Cliff-bottoms vs. Cliff-diving

http://llinlithgow.com/bizzX/2009/08/same_ol_same_ol_economic_cliff.html

The immediate prior post actually covered the ground we' re going to re-cover with this one. The difference then is that
we pivoted around the new and revised GDP numbers to hang everything else on while this time we' ll focus a bit on
employment and retail sales. While we put up this longish posts that cover some ground and attach excerpted readings
to go with them this time we' ve outdone ourselves on the readings. In fact normal blog practice would have had almost
20 separate posts on just the first item - the hot, recent econ news, alone. This way though you don' t get machine-
gunned with a bunch of data that doesn' t fit into a larger picture. Instead we're going to drop a round of artillery with
many big guns to try and link it all together. We start with the recent economic news (employment, output &
consumption and real estate) then we hop to some big picture topics on the longer-term consequences of the new new
thing...FRUGALITY! Then we segue to the international consequences with particular attention to China, move on to
talking about oil and the dollar and conclude with a few readings on policy. Which, btw, was extensively covered in the
last post (Interrupting Your Reported Data Distortions: More Darkside
for the Economy).

Employment and Outlook

Amazingly enough a loss of only 270K jobs had everybody

dancing in the streets, completely unjustifiably so in our opinion. The
basic chart on YoY Employment is shuttled off to the readings. The
only number that showed any "improvement" was unemployment,
which was down "only" -60% instead of the prior ' -80%! Jobs and
hours continued to deteriorate. Consumer spending is NOT going to
come back until we see significant long-term job creation, which will
be a long time coming. Based on this prior chart of job re-creation (HT
CalculatedRisk of course and not the NYT, et.al. who ripped
him off w/o attribution) this is already longer and deeper with more to
come; ioho we' re not going to see significant job creation for a long
time indeed. To breakeven we need to create 150K jobs/month, otherwise it' s the Red Queen falling farther behind. We
entered this recession ~3million in the hole and are now about 12 million jobs in the hole. It'll take a long period (five
years?) to make that up and requires that we hit 4-5% GDP growth (3%+ real growth?). The Fed' s looking for 2.5%
growth in real GDP at best !

Page 6 of 50
Consumer Behavior

Some folks outlook is pretty sanguine but some have a

more realistic view, as you can see in this chart on
consumer spending recovery. More importantly we
funded the growth in consumption in the ' 90s on the
wealth effects of the Tech Bubble and during this
decade by leveraging the housing ATM.

Those are both going away, consumer are converting to

savers, faced with years of having to re-build their
balance sheets AND we' re seeing some fundamental re-
thinkings about what we actually need. So for many
years at least credit availability restrictions will constrain
spending, followed by balance sheet constraints and then
we might reach a new normal. But that new normal will be
at a lower set point. The best depiction of all that we' ve seen
is (HT!) from our buddy Jake over at Econpic where he looks at 10yr annualized change vs. net worth.

Read a certain way the last four decades of consumer wealth creation has just been destroyed. And people are pricing
the market for a quick-hit V-shaped recovery? We don't think so.

The China Syndrome and Consequences

China's performance so far has been miraculous while India and Brazil' s have
been excellent. But Russia is sliding over the lip of a black hole. We want to talk
about China mostly but a few words on the others as well.

First off, China'

s recovery has resulted from massive public spending and
money injections. But unlike in the states where the new money disappeared
into the banks balance sheets China' s sloshed on thru to spending. The
question is how much of that went to productive investments that will pay off in
the long-run. Not a lot. Aside from severe data reporting problems where their
kumquats are not either our apples or oranges (cf. the Jim Jubak URL in the
readings on China' s realities) the real problem is their continued dependence
on exporting.

If the US and the other developed countries become net savers and reduce
consumption the demand for Chinese exports will drop dramatically. That in
turn will lower the demand for commodities over what the speculative fantasists
are currently imagining. When you look at the long-term prospects China has to
keep running faster and faster to stay ahead of its population'
s needs for jobs
but is facing some major barriers.

So, of the BRICS, we' d have to say that Russia is a basket case headed for
worse, India will face many challenges and China is storing up serious
problems for the not to far future. On the whole the best of the four is Brazil,
which has pursued careful monetary and fiscal policies, has a more robust and
balanced economy and has a shot at growing domestic consumption enough to
be self-sustaining.
China may eventually get there (certainly they are aware of the problem) but it
won't be easy, will take longer than expected and be at a lower growth rate than we'
ve seen. So for everybody
expecting commodities and gold to shoot off think again.

Page 7 of 50
The one major caveat, which we' ve discussed before, is that folks like Russia, Mexico, Venezuela and Nigeria have
been over-exploiting their existing oil fields and not investing in new ones. So, even with reduced Chinese growth,
we're likely to be back at a D>S imbalance.(Oil Industry II(Analysis): LT Supply-Demand, Outlook and Disruptions)

Note: this will also impact the dollar. The dollar rose in the last several months as a flight to quality play when
everybody was piling into US Treasuries (so much for the "replace the $" theory) and is since dropping as people are
becoming more comfortable that worldwide Armageddon has been averted. What drove it down secularly, over a
period of years, was that we were exporting borrowed dollars to buy oil, goods and other stuff from China and the ME.
As we shift to a Savings > Investment world net exports will tend to get more positive. And fewer dollars will be flowing
abroad; the net result will be the reduction, if not elimination, of the structural down pressures.

Welcome to the Brave New World of the New Normal.

But bear in mind lots of folks think we'
re kidding so you may want to play them!

September 4, 2009

Between Stalingrad and Kursk: Real Economy, Policy and Outlook

http://llinlithgow.com/bizzX/2009/09/between_stalingrad_and_kursk_r.html

Stalingrad was not just a terrible battle but an

extended, multi-month campaign that was part of a
larger operation, but it was the end of the
beginning. Since we like military metaphors,
especially ones that work this well, compare last Fall
to the Battle of Moscow where Russia almost died and
Zhukov' s troops were marched from the trains
directly to the Front. The real point is that we are
wrapping up our Stalingrad in that we' ve stopped cliff-
diving but we' re lying at the bottom, broken and
bleeding with a long and painful crawl across the other
side and a cliff waiting us there. Kursk was in front of
the Russians in 1942 and a lot of war after that. NB:
if you think we're kidding about all this check out
Timeline of the Eastern Front of World War II.

The really scary metaphor that' s so close it'

sa
model is how deep in trouble Stalin got by ignoring the
intelligence from Richard Sorge that told him the
Germans were going to attack. Stalin didn' t want to hear
it and Russia almost died. We trust the comparison to
the willful denials that got us here are clear but the real problem, in all the sturm und drang, is that people are
substituting ideology for analysis and are about to repeat the mistakes. The accompanying graphic, used before,
explains where we' re at and what the outlook is, and we intend to prove our points as best we can.

Page 8 of 50
Current Economic Situation

Sorry if this is a little to much data

crammed into to small a space but we
wanted to cover lots of ground AND
present it all as one gestalt, in the same
way a pictographic language like Chinese
(subliminal hint) convey background ideas
by using pictures of real things while its
saying something directly.

All charts are YoY% changes of real data

and the UL chart shows GDP,
Consumption & Employment. GDP was
down -3.9% vs. last quarter' s -3.1% while
Consumption was down -1.8% vs. -1.5%,
though on the charts you can see it
flattening; that'
s all despite the huge
stimulus effects.
Two prior posts spend more time on the shorter-term data if you want to see that flattening more clearly (Interrupting
Your Reported Data Distortions: More Darkside for the Economy, Same ' Ol, Same ' Ol: Economic Cliff-bottoms vs Cliff-
diving).

BtW - responsible, non-ideological analysts put the impact of the first round as adding up to +4% to GDP and saving
our bacon. Sorry to tell the ideologues, it worked. Employment though is down -1.6, -3.1 and -3.8% over the last three
quarters, which explains why we have two your are here lines on the cycle conceptual chart. Output wise we' re
flattening but Employment wise we' ve not hit bottom yet!!!

Strategic Outlook

We re-visited our estimates of job creation and

cumulative growth by directly pulling the
employment and labor force growth, estimating
productivity impacts from historical data and
calculating aggregate job creation. It turns out we need
about 147K/month, or 440K/quarter instead of the 150K
we were using to breakeven. Breakeven also
requires at least 2.5% real GDP growth and
preferably 3%. Without that level of growth we dig the
hole deeper and we' re now about -10 million jobs in the
hole, as shown in the LL sub-chart above.

The UR and LR charts compare changes in

Consumption and GDP to changes in national
income real wages plus employment (our old
indicator was changes in real weakly (deliberate
Freudianism) wages but deflation is badly
distorting that for the first time in decades. As long as
jobs keep disappearing, people keep dropping out of the
labor force and incomes are under pressure
demand will have a tough time growing. Especially now that asset-backed borrowing (the Housing ATM) is history. That
means the ugly recovery we should have had after 2001 but were saved from is back and it' s really PO'
d.
The OBM just published its Mid Session Outlook and gave us its long-term prognostication to 2019.

Page 9 of 50
Before you upchuck because it' s the government we' ll mention that there projections are consistent with the major
international agencies (IMF, World Bank, OECD,...), major players (Roubini, Feldstein, Krugman, et.al.) and
private/street forecasters (GS/Hartzius,...). If anything they all converge, roughly, but are a little optimistic. We'
ve piled
up a whole bunch of readings and John Mauldin in particular has an excellent series (the Statistical Recovery).
Unemployment peaks out near 10% and takes a long.....g time to get back to 5%, GDP peaks up about 4.3% in 2012
but tails off to 2.5%.

This is going to be the Mother of painful, extended and jobless recoveries we' re sorry to say. BtW: for all the gold bugs
buying food and ammo the OMB' s interest rates are pretty sanguine for a long-time. Again we' re looking at the triumph
of ideology and not data or analysis. But that's a really important point - you don't just play the game, you compete with
the player. And if that many people are insisting on using funhouse glasses colored red, by all means, prepare to take
advantage.

Politics, Policy and Salvation

Speaking of using your forebrain to rationalize what is

into what you want to see we might mention what's
been going on the policy front. Which we
discussed extensively in a prior post with looks at
spending, the structure of the package and the real
history and outlooks for the deficits. (Realities vs
Rhetorics: Economy, Policy, Real Data) The really
fascinating thing to us is that no single member of our
network has given any credence to our analysis,
bothered to look at the numbers or taken a
position that they didn't go in with.

Menzie Chin has a very straightforward estimate of the

impact of the stimulus so far, and came up with 4%,
which he then chopped in half to keep the trolls off his
back. (For an interesting dissection of public
intellectual disputes and bad math click here.) The
package was very carefully constructed to get tax cuts,
transfers and rebates out the door fast and then gate
more effective and directed programs that are at the
limits of what can be implemented. Other than the Administration itself there are no commentators who have clearly put
the economics, the impacts, the mechanics or the politics together into a holistic assessment. We' ve done our best with
this graphic, which relates the various alternative paths forward to the structure of the package and the cusp points
where we are at risk of mission abort.

Right now we' re in for a U-shaped recovery that'll be drawn out as balance sheets are re-built and people turn from
spendthrift borrowing grasshoppers to frugal and saving ants. If the political pressures for killing the remaining
programs mounts far enough the risks of a W-shaped recovery increase exponentially. Worse, that recovery will be
non-organic and have high likelihood of stalling us in a long-term malaise where we don' t succeed in re-basing the
economy.

We won' t go into the package structure or deficits, which were covered previously with charts on the Stimulus Structure
and Deficit History but each is not what you' ve been told. For recent updates by Menzies on the nature of the
deficit/sources and on the budget deficit outlook click on the highlights. What he highlights is that the higher the
economic growth rate the lower the deficits, the faster the debt paydown and the lower the burden. But we all know that
from our private lives right - when we borrow to spend we dig a hole and when we borrow to invest we get future
returns? Right? Right? Oh, never mind.

Page 10 of 50
Seeing the World As It Is...Are You Kidding?

Let's pick up on that point, starting with this graphic from a recent
Money/CNN online survey which tells us what the man in the
street thinks (sorta), instead of us bloggers, the pundits or the
pontificators. Based on what we' ve just been saying the
people seem to be more realistic than the pundits; or
paying less attention to the so-called "statistical recovery" and
feeling the pain of real job losses, income shortfalls and poor
prospects. In some ways, looking out to 2019 with the OMB,
they're too optimistic. Compared to the folks who just ran the
markets up they' re paragons of pessimism and/or realism of
course.

The LT corner sub-chart in the very first graphic might have been a puzzlement, though the reason we shaded certain
indicator dials should be clearer. And if you read the excerpts after the break, e.g. on Housing, even more so. But why
did we indicate that the international economy is worse off the US domestic economy? That' s a key question and one
we dove into deeply in an earlier post (Same ' Ol, Same 'Ol: Economic Cliff-bottoms vs Cliff-diving), triggering off of
Mike Pettis'"China Financial Markets" observations, which again in the readings, you' ll find is now in wide circulation.

Basically it'
s this: yes indeed, China has held up well with rapid, forceful and large stimulus actions. Unfortunately it
needs 6% growth to stay ahead of the riots. That would be yellow all by itself but for one thing their accounting is kinda
funny (not necessarily deceptive) in that intermediate output is counted in the stats so they look much better than they
probably will. For another all that sloshing cash injections went into loans that are likely to turn bad. That all taken
together at least turns China pinkish, to be technical. But they, along with the rest of rapidly developing Asia, face a
major structural conundrum. They need to shift from export oriented economies to domestically driven ones and that' s
not happening. As US consumers save more they will import less and we will need enormously less in terms of foreign
financing. That' s why they and the rest of the international economy, and for similar reasons in the aggregate, are
shown as bright red. But, as usual, none of this is reflected in the headlines or most analysts thinking...yet.

Page 11 of 50
September 8, 2009

Where's the Money: Markets, Outlooks & Re-Thinks

http://llinlithgow.com/bizzX/2009/09/wheres_the_money_markets_outlo.html

This is going to be another longish post, focused on the current market situation, the outlook, special cases and the
emergence of new approaches to investing. The last is the most important, deserves careful consideration and lots of
investigation and will be our capstone. But the bottomline is that the old shibboleths are beginning to go into their death
throws and new paradigms are emerging. We' ll be following that line of thinking but the old 60/40 equities/bonds asset
allocation based on the Efficient Markets Hypothesis, buy-n-hold and ride the trends are going away. We have some
thoughts on what replaces them but it' s going to be a very different world for a long time to come.

Markets, Earnings(?) and Euphorillusion

Let's start with the current market situation. The top sub-chart
shows the SP500 YtD and shows some of the technical signals that
called for turning points. Some of which panned out and many (the
yellow warnings) that didn' t. Reviewing the bidding we started the year
sliding until the real economic data led to fears of Armageddon and
panic. When it appeared the banks weren' t going to all die (say
thank you Timmy) we got a major bear market relief rally that' s
almost died again several times but each time found hope in green
shoots and earnings.

There are several huge problems there: the earnings aren' t really good
but based on cost-cutting and expectations management, much of the
volume has been concentrated in very few stocks, i.e. the
Financials, and is even less grounded in reality and what we' ve
really been experiencing is a sentiment driven market. The bottom sub-
chart brings back a little reality...the downtrend is intact.

Re-visiting some key charts we' ve concatenated from previous

discussion might put things back in their proper context. The top chart
shows cumulative growth since 1950 in real GDP, Corporate Profits and
the SP500. Notice we got two market bubbles, a profit bubble this
decade and that the markets barely kissed the long-term trend of real
growth before taking off again. Where' s the reality in that?

Two other major things to notice though - before delusional thinking took
over everything followed coincident structural trends AND the
markets had long secular cycles (uptrends and downtrends) along that
deeper path. There are two possible futures implied here.

One, we return to sanity and enter a decade of the doldrums. Or

we sustain the fantasy based on who knows what. IN EITHER
CASE the old "stocks for the long-term" shibboleth dies and
active investing based on structural, secular and technical
integrated analysis becomes the new paradigm.

Page 12 of 50
The other thing to notice in the bottom sub-chart is that the profits were a combination of structural sub-par
performance in the real world and leveraged risk-taking in the financial. Now do you think the Finance Industry'
s
going to be able to replicate that? And at what cost to the rest of the world?

PE's, Valuations & Returns: Where's the Money?

The question then becomes where' s the money? Equity

returns are composed of earnings and prices, that is, PE
Ratios. In fact the finance community talks about betas and
alphas. Beta is the weighting factor based on expected
market returns, preferably adjusted for risk. It tells you what
return you should expect if you got a normal return over the
long-run. In fact much of the bubble returns, before they
were destroyed, were betting on leveraged Beta.

Alpha is the return you get that was unexpected, i.e. that
resulted from insight, analysis, luck or skill. Beta is going
to be low for a long time, leveraged Beta (trend-
following) could kill you so if you want something
besides the lowest common denominator it' s going to take
work to go seeking alpha.

We' ve used Bob Shiller' s work several times on long- term

PEs so we' re taking a different data set from S&P in these
charts which show PE' s based on 12Mo Trailing
Earnings from 1936. The average PE from 1936-1990 was
14.4 and from then until 1995 or so the PE' s cycled
naturally around that average. Then they went to the moon
and never came back.

That' s a really critical point - PE's have never

corrected back to the average in the last 15 years or so!
The bottom sub-chart looks at the difference between
average and current PEs and reinforces that point. It' s
critically important to remember that exceptional returns don' t result from buying at the highest price. We'
ve used
Graham-Dodd' s framework to chart the relationships between PE' s, growth rates and interest many times so we won' t
revisit that chart but suggest you review it. Then ask yourself, at these prices, where' s the return?

Assessing the Markets

Taken all together our experience is that at any given time there are four factors weighing on the markets.

The first is Structural – what are the long-term secular and structural trends, particularly changes, going on in the
economy such as the emergence of the rapidly developing BRICs and the associated impacts on energy and
commodity markets. Next is the Fundamental – by which we mean what are the basic economic fundamentals
associated with the real state of the business cycle. That can be taken to subsume business fundamentals on the
outlook for industries and companies, which build on the first two factors; e.g. the implications for the Energy Industry.

The third are Technical factors – that is how is the Market reacting to its own internal pressures and dynamics and can
we analyze them. Technical analysis is focused more on the short- to intermediate-terms while structural and
fundamental tend to work out over longer timeframes. Moreover the latter two factors tend, as we’ve shown, to
converge on basic economic performance. Going back to our description of Mr. Market’s behavior he tends to settle on
the sober-sided basics eventually but, as we’ve learned to our sorrow, he can also be volatile and giddy in the short-
term. Which means that Technicals are important part of the toolkit but a sense of the very short-term market

Page 13 of 50
psychology, Sentiment, is also critically important. Our judgment is that, right now, Mr. Market is almost entirely under
the sway of sentiment driven fashion.

The accompanying graphic compares our four-factor assessments from Jun08 to Jun09 and, looking back, seems to
have held up reasonably well in both time periods. Our take now is as follows:

1. Structural – C-/C: after the earlier

discussion we think the economy’s
freefall has been arrested but the long-
term prospects are rather poor and
dependent on first crossing over into self-
sustaining growth. The downturn has led
to serious under-investment in energy
development so future supply/demand
imbalances could return as current proven
resources are drawn down. On the other
hand structural shifts in world trade as the
US saves more will reduce long-term
growth rates in China, et.al. and lower the
imbalance pressures.

2. Fundamental – C: the economy is

bumping along the bottom and the
chances of a rapid recovery are poor.
There is also a downside risk that a
recovery will be aborted and we will see a
W-shaped pattern. A bigger risk is
balance sheet re-building, a deferred
Housing recovery, other risks to the
Financial sector and the likelihood of
very poor job creation dampening
demand. We’d also judge the odds of being able to re-base the economy to higher growth as
poor.

3. Technical – C/C+: the bear market rally appears to have run its course and was based on a
combination Armageddon avoided relief rally, misinterpretation of earnings quality and
outlooks. However the market is not particularly oversold or overbought and could have some
upside surprises still in store. The biggest surprise risk is that the longer-term earnings and
valuation realities will finally sink in.

4. Sentiment – B/B- and dropping: our judgment is that this rally was based almost entirely on
sentiment. Probably the best ways to judge sentiment are by a close reading of headlines and
pundits comments as well as by market reactions to news. When the market continues to rally on
“not-worse” news sentiment is strong and positive. When better news gets a yawn, or worse a
drop, then it is shifting. Right now we’re in a very volatile state with regard to sentiment as the
last two weeks show. There is a real and significant risk that sentiment will reverse suddenly for

Page 14 of 50
 the worse. As it did, we should remind you, in mid-February when economic realities visible for
months were finally accepted.

Brave New World, Old World Approaches

It'
s a brave new world, that seems clear enough. What' s not clear
is what rules are going to best for surviving and thriving in it.
There are some huge re-thinkings beginning to go on but the new
approaches haven' t come up with a new playbook just yet. We
think that new playbook is going to be active investing based on
understanding what' s going on and then taking intelligent
decisions while managing risk.

The old blind cookbook approach to riding the Markets and

hoping for "leveraged Beta" should be dying a natural death. The
other two critical lessons we think are there for the hearing, if not
for the listening, are that lots of folks got into lots of trouble by
letting the 'old hindbrain make the decisions. And it doesn' t
appear to us as if many are prepared to put the adult
forebrain in charge. Who knows - maybe finding the lizard- brain
popular delusions and mad crowds is the new trend to figure out
how to take advantage off!?

Vitaliy Katseelson has an interesting, fascinating and useful

piece up on Scribd on Active Value Investing that we
recommend you downloand and memorize. And then apply.
We' ve borrowed a couple of his charts on equities vs bonds
during uptrend and sideways markets to highlight some of our
key points. Notice that the periods he's looking at map
exactly to the secular cycles around the structural trends we
discussed earlier.

One major quibble with his charts though....the apparent

advantage of equities in the first sub-chart was a bubble
effect, not fundamentals. Think about it!

September 27, 2009

Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness

http://llinlithgow.com/bizzX/2009/09/debt_wealth_finance_outlook_si.html

It'
s time to re-visit, update and wrap-up our discussion of the Finance Industry and the chances for regulatory and
legislative reform. On the one hand this is an important part of the domestic policy agenda, and in some senses,
arguably the most important. On the other it' s been back burnered ostensibly by the press of events which has resulted
in all the last few weeks punditry commentary getting it wrong, at least in our '
humble opinion. Analogously to
Healthcare Reform the administration first focused on the necessary emergency measures while trying to build a sense
of cooperative self-interest in the finance community. An attempt that, unlike the HC communities (believe it or not), has
foundered on the rocks of short-term and narrow self-interest. A point we' ve been arguing for a very long time and used
as our central point in the last post which reviewed the state of play. Here we want to concentrate just a bit more on the
stakes, the liklihoods and outcomes and the potential impacts.

Page 15 of 50
In Fed We Trust: Our Near-Death Experience

David Wessel of the WSJ has written an excellent book on the crisis, which
he started before Bear-Stearns went under and which he tracked thru the
entire crisis. While he's appeared on several talk shows, of various sorts, the
talk he gave in a Washington D.C. bookstore was the best because he had
time to cover his findings in some detail and because of the audience' s
pointed and intelligent questions.

Before leaving this topic we highly recommend your watching the CSpan
video clip (http://www.c-
spanarchives.org/library/index.php?main_page=product_video_info&product
s_id=288534-1&showVid=true )

He concludes by making three points:

1) we had a near-death experience and were saved by emergency
heroics, perhaps largely those of Ben Benanke and the Fed,

2) we'
ve survived the worst of it barely but have a long way to go before we'
re restored to health and

3) there'
s been little or no change in the regulatory and legislative framework.

We'll come back to that last point at the end, and it'
s vitally important, but our critical observation is that the
commentariat mis-understands the process the Administration is following. First, put out the fire and start the repair
work while second, attempt to inclusively line up support. Now they are shifting to a full-bore press and we would
suggest that the Industry NOT under-estimate their chances. It wouldn' t take much to fan the smoldering torches into a
conflagration.

A Little History Review: Debt Since WW2

These potential reforms are important only

insofar as we a) mitigate the chances of it
happening again, b) we maintain a healthy,
vibrant and contributory financial sector
while c) doing away with the socionomic
dysfunctions that almost destroyed the
economy.

The root of all this are debates over the

level and role of debt financing in the
economy so we thought we' d review a little
history to put things in context. To address that
we built two sets of composite charts from the
Fed data on money flows and the results
make interesting viewing.

In the UL sub-chart current dollar debt (our

estimates) grew from about $2.5T to about
$31T from 1945-2008; and contrary to
current headline and political mythology
that's not Federal debt that'
s the largest
portion, it'
s Households and Businesses. Our
post-war prosperity was built on a sea of it.

Page 16 of 50
In the LL chart though you can see the structural shifts where relatively speaking Federal debt was shrunk while
Financial sector debt grew enormously. These shifts are highlighted on the right-hand sub-charts as multiples of GDP
where total debt grew from 1.6X GDP to slightly over 3.5X!

More interestingly Household and Business Debt grew steadily until the ' 80s when it jump-shifted, and then did so
again in the '
90s and '00s. Bear in mind who was making that debt available - which leads to the most startling growth.
Financial debt grew 0.01X to 1.18X of GDP, or about 1,163%!!! In addition to pointing out that it was post-deregulation
that we began drowning in debt but in fact, contrary to popular political mythology, Federal debt was steadily paid down
until the Reagan administration when it ballooned again, then was paid down during the Clinton years only to be re-built
during BushII. Not what you normally would think, eh?

Relative Debt Growth

The second chart shows the normalized

relative growth and highlights many of these
points from a different perspective. All these
charts are built around cumulative % growth from
1945 to 2008 and show the relative,
normalized, growth of each of the major
sectors. As you can see in the UL growth in
Finance debt outstanding completely swamps all
other sectors, which is why the other charts
break things out separately. The LL sub-chart
shows the major sectors, excluding Finance, the
UR shows Finance by itself and the LR sub-
charts shows Household debt along with
growth in Credit Cards and Mortgages.

Here's the fundamental questions these

charts raise in our minds:

1) What'
s the appropriate level of debt for a healthy economy? We'
d suggest something more in line with the points
reached around the mid-80' s, except for Finance.

2) If that'
s true what kind of regime will be required to evolve back to that point? How long might it take to get there? Is
it feasible and what happens if it's not?

3) If Banking and Finance need to return to their roots (not say 0.01X of GDP but something on the order of .25-.5X, ala
the 1980' s, what kind of Industry will we have? Is it even possible? Is it politically feasible given the heartfelt opposition
of the Industry to even modest reforms?

Fighter's Go to Your Corners: the Prospects for Reform

Ah, there'
s the rub, as they say. It's not an accident that the President made
a speech directly to Wall St. on this topic nor that Summers, Blair and
Shapiro were addressing the Georgetown University seminar on Financial
Reform about the same time, nor that a whole slew of regulatory changes
were being announced by the Fed, et.al. during the same time period. We' ve
have to say that the agencies, the Administration and Congress are headed
for the mats, as Sonny Corrleone would put it, over this. And should be.

But that kind of warfare does no one any good - it may simply be the best
alternative that we'
re all left with. We'
ll continue to argue that after loosing
(destroying) almost a decade' s worth of funny-money profits it's even in the
Industry's own evident self interest to proactively and constructively

Page 17 of 50
participate in re-shaping the regulatory and legislative framework. Larry Summer' s Georgetown speech (http://www.c-
span.org/Watch/Media/2009/09/18/HP/A/23338/Georgetown+University+Conference+on+Future+of+Global+Finances.
aspx ) laid out the Administration'
s framework pretty clearly, as well as explaining the reasons and intents. Five major
principles were laid out:

1) Capital Adequacy for systemically important institutions (which also implies no more off balance sheet
green curtains)

2) Resolution Authority - in other words the end of TBTF (to big to fail). As Larry put it we don'
t ever want to
find ourselves again where we were with FNM, FRE, LEH, AIG and MER with no institutional recourse.

3) Regulatory Arbitrage - no more shopping among regulatory agencies for the best deal, and that especially
includes international comparison shopping (if you don'
t think that was an important part of the recent G-20
meetings think again).

4) Regulate Systemically - no more regulatory "prudentially" single institution by institution but ask what
impact the collective will have. Think of it as the end of "we will assimilate your distinctiveness and make it
ours".

5) Consumer Protection - need a separate authority to focus on the health and well-being of the consumer
instead of letting those concerns get swamped by concern for the financial health of financial institutions. That
(hopefully of course) means the end of predatory lending practices or exploitative credit card marketing and
management.

And the Alternative?

Summers pursued a great analogy when he compared

changing the regulatory framework to how we deal with
Automotive Safety issues. For many decades the
theory of auto safety was that it was the responsibility of
individual drivers. But as more and more vehicles got on
the roads with higher and higher performance cars we had
an "epidemiological" problem - that is there were more and
more unecessary deaths because cars were changing faster
than humans evolve. By comparison then do we
continue to let the death toll mount or do we do
something?

One thing the Industry is under-estimating outside the

Beltway or NYC is the depth and breadth of public
anger. One could argue we saw similar outrage after the
Tech Bubble burst with Enron, Worldcom, et.al. and the
outrage petered out. The difference though, this time, is
those actions didn'
t threaten society.

Last June we were at a conference on the future of corporate governance and one session, focused on improving
Board decision-making, was taken over by one gray-haired gentleman' s anger at the breeches of fiduciary trust by the
Finance Industry. Bear in mind this was a couple of hundred people all of whom were executives, board members or
consultants with decades of experience. If they were so anger as to loose control what does the rest of the country
think.
We suggest you listen to the accompanying vidclip of Michael Moore being interviewed by Dylan Ratigan on MSNBC
and listen to Ratigan. http://www.msnbc.msn.com/id/32450072/vp/33019751#33019751

Refreshing the Economic Outlook: Fundamentals to Business Outlook

Page 18 of 50
http://llinlithgow.com/bizzX/2009/10/refreshing_the_economic_outloo.html

Welcome to the "New Normal"! One of the most fascinating

things about it is that, like the "old normal" denial seems to
be a fundamental element. We were going to put up a
refresh of the economic data yesterday but delayed to
catch the most recent Employment numbers, which were
about as bad as it gets, not least of which was because the
BLS revisited and revised its numbers and took another
800K+ jobs out of the last two years.

If there's any debate that this is going to be a long, ugly

and jobless recovery that should start disappearing here,
though slowly (that' s the denial part) and we have heard
more and more folks singing from the same hymnal that we
use. Now there' s not many/any radical structural or trend
shifts in the data so, after a "brief" look at the employment
data per se we' re going to take a different perspective on
what that new normal might look like.Though we' ll bet it
looks like this collage to most!

Re-visiting Employment

Starting with the Employment data (& there' s a bunch of excerpts and URL pointers in the readings) let'
s take a scan of
the data. YoY Employment, Private jobs, Hours worked and Unemployment all continued to worsen (Unemp would
have been worse but labor force participation dropped again!). In the LL corner though we highlight the Private Jobs -
the heavy red line makes a point about the 3rd jobless recovery in the last 20 years: no new private jobs have been
created since Q298!

That's not after labor force, population or productivity adjustments - that'

s PERIOD! Speaking of which, we need 440
jobs/quarter to breakeven but net job creation was still negative, though improving slightly. On a cumulative basis
though we' re now about -12 million jobs in the hole. In other words addon whatever we loose over the next 18 months,
the under-employed and that 12 million and we' re just back to breakeven. Think we'll dig out of the hole by 2019? The
OMB doesn' t, as we discussed (Between Stalingrad and Kursk: Real Economy, Policy and Outlook). And just for the
record the LR corner compares the business cycle to Employment for a little schadenfreudische unsinn!

Where Away From Here?

So the fundamental question is, when/how/where do things begin

to come back? And what are the liklihoods? We'
ve tried to
answer that question by looking at key
cycle relationships and seeing what
leads to what, following around the
economic circle of life. The driving
engine is Consumption where there' s an
almost 1-1 link which you can read right
off the first sub-chart in two different
timeframes.

The real question today's news

makes critical is when are jobs
coming back? There the news is less
appealing. We need 2.5% job growth for
breakeven, which would be about 4% GDP
growth. Given that the outlook from the

Page 19 of 50
OMB, et.al. is for 2.5% GDP growth thru 2019 we' d suggest that the chances of reaching that point aren'
t real good. In
fact at 2.5% growth it'
ll take a darn long time just to get back. There is NO investment, business or personal decision
you or anybody you know will make that shouldn' t be hedged against that outlook - maybe for the next decade.

Of course whether or not the implications will sink in and be strategically and effectively responded to are other
questions entirely.

For Example: the Investment Outlook

What we' d like to get back to is organic, self-sustaining growth

where increased jobs lead to increased consumption lead to
increased investment, which leads to more jobs, higher wages
and so on around the "Great Circle".

When it works that' s called a virtuous cycle - when it runs in

reverse it's a vicious one. From the top sub-chart (note how much
steeper it is) Investment is responsive to growth beyond a certain
point. If we get to 3%+ growth it looks like we' ll get a big jump in
Capex. On the other hand Tech spending is even more sensitive
(the curve is much steeper). As long as the economy stays in the
doldrums the outlook for Tech ain' t very good.

And clearly the days of 9-16% surges have gone the way of the
Dodo. Just as a bit of a test - how much of that do you think is
reflected in Tech sector earnings outlooks and PE valuations?
We' d hazard that the inverse is true - that is people are still locked
into a mindset from the ' 90s and aren' t adjusting their thinking at
all; and won' t until the smoke signals on the horizon are fires at
their feet. Which does present some interesting trading
opportunities but not very good investing ones, in general.
RE Investment is the other interesting conundrum. Now as our
friend CalculatedRisk has taught us all RI leads the business cycle and helps to drive it. As he also taught us it was
Housing floating on a see of bad debt and decisions that was the ATM machine the held up consumer spending this
last decade. Does anyone think that ATM is coming back? Anytime soon? Anyone, anyone...Ferris? To get a significant
lift from RI it'
d need to grow at 10% and IOHO we' ll be lucky to see years of 3% growth, hopefully followed by some five
percenters. In other words, by the charts, expect no help from RI and take what comes as a pleasant surprise.

Comes Round Goes Round: Employment &

Wages

The economy is a cycle - like we keep hammering on. Future output

and investment growth, such at is and/or might be, will
stimulate hiring and wage growth. Now the (temporary?) death
of Inflation has driven up real wages short term and helped hold
up spending, of course enormously helped by government
spending. So in the next chart we' ve taken a shot at looking at our
key future indicators of consumer demand, the YoY change in the
sum of real wages and employment, and used Personal
Income (PI) as alternative proxy just to calibrate things a little.

Zero % growth in the first basically gets us back to that

aforementioned 2% consumption growth but it' s worse looking at PI,
more like 1.5-1.75%. To get future growth of, say, 4% in
Consumption we need the sum of wages and employment to grow

Page 20 of 50
at 4%. If it'
s PI plus employment it'
s more like 7%+! Now what in anybody'
s outlook makes growing real wages and
growing employment a strong likelihood!

Welcome to the New Normal Indeed: Where's My

Mommy?

We wish we could send you off this weekend with better news but
couldn' t figure out how to do that without blowing a lot of
sunshine up your skirts, so-to-speak. The key for this new
environment is going to be how well businesses and
consumers adapt their behavior. It' s not a question of the new
normal being supported by the new frugalities, but the "New
Frugality" being forced by it. At the end of the day this is going to be
an economy for a tough-minded Scotsman, a Buffett-economy in
other words, that will reward insights, analysis, preparation,
discipline, patience and persistence. As well as having the
courage to change. Now speaking for ourselves we always prefer
cowering in terror but we' re hoping very sincerely that the same
t true of our leaderships. URL: http://llinlithgow.com/bizzX/pics/ClimbingFall.jpg
ain'

Back in the day when we used to do a little rock climbing there always came a moment when it dawned on the climber
that that tiny little thing bracketed by their boots was the six acre parkging lot they' d left a few hours ago. It wasn't
unusual (ahem) for the next step to be clinging tightly to the rock whimpering for Mommy to come make it better. The
best response we ever saw was the instructor who shook loose the safety rope and leaned into a loud stage whisper as
they rope fell down slack, "you' re gonna die"! A little harsh but the student did survive to finish the climb and go on the
next one.

Consider this our "stage whisper" and add to your shoppinglist two key readings, one from Mohammed El-Arian: A
CEO’s guide to reenergizing the senior team and Return of the old ways of thinking threatens recovery.
Good luck...or as the German guy said in the Eiger Sanction...may we continue to climb with style!

October 8, 2009

Moscow, Stalingrad, Kursk: Edge of the Abyss to "Recovery"?

http://llinlithgow.com/bizzX/2009/10/moscow_stalingrad_kursk_edge_o.html

We could title this post a lot of things but wanted to focus on a

metaphor we' ve been using because it' s powerful and accurate.
The Battle of Moscow in 1941 was when the Russians were
saved, after letting themselves be surprised thru wishful thinking
and ideological self-delusion (our term has been and is
euphorillusion) by last minute miracles (Zhukov' s Mongolian
divisions were marched thru the streets of Moscow in a "parade"
straight to the front). That was followed by many things but a
central one was the extended Stalingrad Campaign (as part of the
larger Uranus) in 1942 which was only the end of the beginning.
URL:
http://www.msnbc.msn.com/id/3036789/vp/33175376#33175376

The beginning of the "middle game" was the giant battle of Kursk
in 1943, where the Russians entrapped the Germans into the
world's largest tank battle and defeated them, partly thru better

Page 21 of 50
intelligence and decision-making, partly thru luck but mostly thru a lot of darn hard work. Last Fall, as is now becoming
all too clear, was our Moscow. We' ve been saying that for a while but how close we came to the edge of a worldwide
collapse in the financial markets is becoming clearer and clearer. This last Winter and Spring was, and is, our
Stalingrad. So, consider this post an addendum to the last as well as its own thing. We' re going to largely let some key
excerpts speak for themselves with a little judicious commentary but will also point to a selected set of excerpts to back
up many of the points after the break.

Fall in Moscow: Near-Death Experiences

Don't let anybody kid you, it was as the Iron Duke said in
another context, a "near-run thing, a damn near-run thing".
Not only did LEH, FNM and FRE die but MER disappeared
but we were within a hairsbreadth of seeing Citi, MS and
GS go as well, despite the denials at the time and,
especially on the part of GS, since. NB: we have no
problem with the artful dodging of Paulson and other policy
makers - tell the idiot horses that the fire was out of control
would have triggered the panics they were trying to stop.

Let us let an excerpt from Andrew Ross Sorkin' s just out

book tell the story, but we'll draw your attention to the stock
charts....even might Goldman almost died in those few
days and hours. And below we' ll also point to the charts on
credit....which we' ve talked about before. Just in case the
point's not clear - the financial system is still broke and
credit is shrinking....without continued Fed support the whole thing will blow away. We'
re a long way from fixed
and from starting to fight Kursk.

Wall Street’s Near-Death Experience With the implosion of Lehman Brothers, in September 2008, the realization
dawned: Morgan Stanley and Goldman Sachs could be next. In an excerpt from his new book, the author reveals the
incredible scramble that took place—desperate phone calls, seat-of-the-pants merger proposals, flaring tempers—as
Washington got tough and Wall Street titans Lloyd Blankfein and John Mack fought for survival.‘This is an economic
9/11!” There was chilling silence in Treasury Secretary Hank Paulson’s office as he spoke. Nearly two dozen Treasury
staffers had assembled there Wednesday morning, sitting on windowsills, on the arms of sofas, or on the edge of
Paulson’s desk, scribbling on legal pads. Paulson was seated in a chair in the corner, slouching, nervously tapping his
stomach. He had a pained look on his face as he explained to his inner circle at Treasury that in just the past four hours
the crisis had reached a new height, one he could compare only to the World Trade Center attacks, seven years
earlier, almost to the week. While this time no lives may have been
at stake, companies with century-long histories and hundreds of
thousands of jobs lay in the balance.
The entire economy, he said, was on the verge of
collapsing. Paulson was no longer worried about just
investment banks; he was worried about General
Electric, the world’s largest company and an icon of
American innovation. Jeffrey Immelt, G.E.’s C.E.O., had
told him that the conglomerate’s commercial paper, used to
fund its day-to-day operations, could stop rolling. Paulson
had also heard murmurs that JPMorgan Chase had stopped
lending to Citigroup; that Bank of America had stopped
making loans to McDonald’s franchisees; that Treasury bills
were trading for less than 1 percent interest, as if they were
no better than cash, as if the full faith of the government had
suddenly become meaningless.
Paulson knew this was his financial panic. The night before,
chairman of the Federal Reserve Ben Bernanke had agreed

Page 22 of 50
it was time for a systemic solution; deciding the fate of each financial firm one at a time wasn’t working.

It had been six months between the implosions of Bear Stearns and Lehman, but if Morgan
Stanley went down, probably no more than six hours would pass before Goldman did, too. The
big banks would follow, and God only knew what might happen after that. And so Paulson stood
in front of his staff in search of a holistic solution, a solution that would require intervention. He still
hated the idea of bailouts, but now he knew he needed to succumb to the reality of the moment. “The
only way to stop this thing may be to come up with a fiscal response,” he said. Paulson, who had been
living on barely three hours of sleep a night for a week, was beginning to feel nauseated. Watching the
financial industry crumble in front of his eyes—the world he had inhabited his entire career—was
getting to him. For a moment, he felt light-headed. From outside his office, his staff could hear him
vomit.

Page 23 of 50
Stalingrad - the Stimulus Package & Sausage-Making

Another thing we need to be very clear about is the next time we

were dancing on the edge of the abyss and how close run a thing
it was and still is, as well as how much cleanup and ripple
effect we' re going to be dealing with for a long time. Now
we' ve taken some really deep dives into fiscal policy, the
stimulus package and the effects it' s had as well (Between
Stalingrad and Kursk: Real Economy, Policy and Outlook) so we
won' t re-review those in any detail.

But despite all the ideological arm-waving it' s been the early tax
cuts and transfer payments that saved us from much...much
worse (and yes we' re talking GD 2.0 here), in conjunction with the
Fed' s unusual actions. It's also going to be Federal spending that
keeps the wheels on the wagon for the next two years while we
hope a more natural organic recovery begins to emerge from the
bombed out rubble. The accompanying chart on job losses
hopefully brings home the point of deep the chasm is as well as
how far we' ve got to go to get to the other side. But the
excerpt below should make clear the human dimensions of the
policy-making and sausage-grinding that went on.

Inside the Crisis:Larry Summers and the White House

economic team The most important question facing Obama that
day was how large the stimulus should be. Since the election, as
the economy continued to worsen, the consensus among
economists kept rising. A hundred-billion-dollar stimulus had
seemed prudent earlier in the year. Congress now appeared
receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion.
Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight
hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009
and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but
Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be
more than $1.2 trillion.
There were sound arguments why the $1.2-trillion figure was too high. First, Emanuel and the
legislative-affairs team thought that it would be impossible to move legislation of that size, and
dismissed the idea out of hand. Congress was “a big constraint,” Axelrod said. “If we asked for $1.2
trillion, it probably would have created such a case of sticker shock that the system would have locked
up there.” He pointed east, toward Capitol Hill. “And the world was watching us, the market was
watching us. If we failed to produce a stimulus bill, that in and of itself could have had deleterious
effects.” There was also a mechanical argument against a stimulus of that size. Peter Orszag, who was
celebrating his fortieth birthday that day, said that, while the argument for a bigger stimulus was sound
theoretically, there were limits to how much money the government could practically spend in the near
future. Summers brought a third argument to the debate, one that echoed his advice to Bill Clinton
sixteen years earlier, when his Administration was facing persistent budget deficits that Summers
believed were suppressing economic growth. He, like Romer, was guided by an understanding that in
financial crises the risk of doing too little is greater than doing too much. He believed that filling the
output gap through deficit spending was important, but that a package that was too large could
potentially shift fears from the current crisis to the long-term budget deficit, which would have an
unwelcome effect on the bond market. In the end, Summers made the case for the eight-hundred-and-
ninety-billion-dollar option. “A lot of my research has been figuring out what policymakers did,
why they did it,” Romer told me. “I have a whole new level of sympathy. Until you’ve
experienced it, you don’t realize how hard it is. It’s humbling.”

Page 24 of 50
 Geithner proposed an alphabet soup of programs to entice the private sector to take bad loans off the
balance sheets of struggling banks. The crux of his plan was the stress tests. The Federal Reserve
and other regulators would examine the nineteen biggest banks to reveal how much capital they would
require if the economy worsened, and the results would be publicly released in May. The idea was that
the process would restore confidence in the banks and reassure investors. But throughout the spring
the plan was attacked by a growing number of economists and members of Congress as a pale
alternative to nationalizing the weakest banks. In February and March, Paul Krugman alone wrote
seven columns in the Times deriding the plan and calling for nationalization. What was more troubling
for Geithner was that the White House seemed to be losing confidence. The political advisers dreaded
the bailouts. In the end, though, Summers acknowledged that there were no better options, and
Geithner’s plan survived intact. On March 31st, Summers sent the President a page-and-a-half memo
outlining the reasoning behind the decision not to nationalize any banks. Obama was on his way to the
G-20 meeting in London, and he wanted to be prepared with the best case against it.

Getting Ready for Kursk: Economic Repair plus

Regulatory Reform

The final section of the readings is a set of video clip addresses that we highly
recommend you make the time to watch, though the accompanying CNBC
short interview should set the stage. In it some key players from both sides
of the House discuss the state of things and their outlooks. One
observation by Barney Frank we found especially interesting is that he
expects a House Bill to be brought to the floor this Fall - and further that
they've been working on it since the Spring of 2008, when it was kicked off
based on Sec. Paulson' s suggestions! Think about the implications of all that
for a minute.

Now this is a topic we' ve spent considerable time and horsepower on, to the
point of post after post. (Ask Not For Whom the Siren Shrieks: Let the Finance Wars Begin, Refreshing the Economic
Outlook: Fundamentals to Business Outlook) So we won' t re-visit that
ground but you might want to refresh yourselves a bit. URL:
http://www.cnbc.com/id/15840232?video=1287062674&play=1

Planning for the Future

But there are several bottom lines here that need to be considered.

1. Regulatory reform is coming and it'

ll be significant.

2. The Finance Industry as we know it will, or at least should, not be the same.
Not just because of changes in the regulatory framework but even more so
becasue a) the debt-driven, leverage-based financial engineering of the last
three decades didn' t work and b) because the business models of the major
lines of business are broken.

3. The US economy has floated on a sea of debt, triggered by de-

regulation, and balance sheets will be re-built and de-leverage will be the order
of the day. That'll reduce demand in the intermediate term and make the
jobless recovery even more jobless but result in a healthier foundation.
4. This structural evolution is likely to take a decade to work out.

5. Right now, nobody is paying attention to these factors or preparing for them.
The "New Normal" is being met with the "Old Normal" rules of thumb, behaviors and strategies.

Page 25 of 50
6. So, not only do you need to re-think your own strategies, e.g. for investment, job and business development, etc. but
you need to re-think them in a world of mal-adjusting laggards.

7. This too is advice and observation that will likely be ignored and so on around the circle until denial is no longer
credible, new rules of behavior emerge and adaptations are forced.

David Wessel covered some of these bases in a Capital column story from last week from which this graphic is drawn,
which is excerpted in the readings. BtW any resemblence between that column and our previous post (Debt, Wealth,
Finance & Outlook: Sixty Years of Bubbliciousness) on the topic is purely coincidental. Put it down to great minds
converging on the same set of worries when examining the same realities.

October 12, 2009

From Mythologies to Realities: Economy,

Employment, Credit & Trade

http://llinlithgow.com/bizzX/2009/10/from_mythologies_to_realities.html

We didn' t really want to circle back to pure economics so quickly but there' s so much mythologizing going on, without
looking at the underlying structure and trends, that it seems necessary. Plus of course we had all this nifty
accumulation of information and readings to point to! :) But with stuff like Brian Wesbury writing in the WSJ things like
The Economic Recovery Is Well Underway it seemed necessary. BtW if you don' t have a sub to be able to read it, don'
t
bother (as my blogging buddy Barry put it- not worth the time). This is after all the guy who has yet to get anything right.
Instead, for deep insight into the realties, we' ll point you to The Daily Show, which cuts closer to the quick in the
accompanying vidclip. URL: http://ccinsider.comedycentral.com/2009/10/09/the-daily-show-and-slim-thugs-music-
video-still-a-boss/ . You have to admit it' s not very often that you hear the greatest economist of the 20thC being cited
in a hip-hop video, now is it? And, all seriousness aside, the point of the video is actually fairly accurate...it certainly
captures the situation that most people are finding themselves in.

Page 26 of 50
Current State of the Economy

For something a little more straight-

forward we' ll point you to this extract from
the latest Northen Trust economic
outlook update. The graphic is a
composite taken from Paul Kasriel' s most
recent road show and if you click on it it'
ll
pull up a Powerpoint presentation with some
selected excerpts.

On the other hand the entire

presentation is well worth your time so if you'll
click on thru on the highlight you' ll get the
entire presentation in PDF format and can
download - we highly recommend it since
you' ll be able to see the entire pitch and read
Paul' s words that're wrapped around the
charts.

We' ll ask a little patience as well since we're

going to cover a lot of composite and
complex pictures that deserve their own
extended discussions but aren' t going to get it.
That' s because when you put them all together a large-scale picture emerges that' s at the heart of the points we want
to focus on. In this case the pictures are pretty clear - the worldwide economies appear to be turning back up but be
careful to notice that the UL chart is a YoY chart and the rest QtQ changes annualized. On the whole the key take
away is identical, except worldwide, to our last major econ post (Between Stalingrad and Kursk: Real Economy, Policy
and Outlook).

Employment: Structure Outlook & Surprises

Which brings us to something else we' ve waxed on about but want to

highlight as it'
s central, and that'
s the strategic and structural outlook for
employment as well as the current situation. The last Payroll report
surprised by showing Unemployment was nearing 10% and indicating that it
soon would be as well as implying that job recovery would take a terrible long
time. The jobs picture has surprised everybody to some extent though all the
expectations were for a bad result it's worse than anticipated though it IS
following the standard patterns. The top sub-chart is drawn from Greg
Mankiw and shows the expected pattern with and without the stimulus
package. As you can it was worse earlier in the year, got much worse
recently and is beginning to level off at a higher than anticipated rate.

The stimulus package and monetary policy did their job and the situation is
much better than it would have been BUT that' s not saying much. A major
part of the problem is continuing credit rationing, another is the beginning of
large-scale structural shifts between sectors and another is business
uncertainty about the duration of weak demand and business decisions about
hiring. The structural shift part is important, messy and complicated.
Normally as the economy cycles up and down the allocation of people and
resources between sectors isn' t changed much but with the over-
investment in housing and other sectors those resources are being
displaced. That takes time and is subject to a lot of friction. On the

Page 27 of 50
bottom when you add in the under-employed there are 10 openings for every job - which tells you how serious the
situation is, how weak the economy is and how long it'
s going to take to get out of this.

Credit, Debt and Secular Changes

The next chart highlights some other aspects of the deeper changes that
will take the rest of this decade to work out. The bottom shows the
current state of Consumer Credit, as well as history. A topic we've
invested some time and effort on exploring in earlier posts (even
triggering a WSJ story on the subject!).

As we found earlier credit didn' t grow appreciably until de-regulation and

then accelerated in the '90s and bubbled this decade when it fell off a cliff.
Given the condition of the banks with bad balance sheets, more loan
losses, toxic assets to be written down, etc. etc. none of this should be a
surprise. Nonetheless it tells us that for the short- and intermediate- term
there will be NO debt-driven surge in consumer demand; as if we
didn't already know that from the jobs indicators.

Then we get to the Net Worth problem. People were more badly hurt by
this collapse than have been since the Great Depression. It' s also
unlikely that the majority of the population will ever recover. What
made people comfortable with those huge surges in debt was that their
apparent net worths would support the debt (or so they thought). Now
consumers will be focusing on repairing their balance sheets as much or
more than the banks. Or, put another way, we' re going to be forced to re-
discover frugality which means that we' re going to become more of a
nation of savers, not spenders. Another drag on demand growth!

The Trade Equations: S-I-NX

There' s an interesting identity in international

economics trade, and when we say identity we mean
that it'
s a definition, not open to interpretative
debates and that it governs the economy and trade as
much as gravity governs the orbits of the planets and
in the same way. It' s also grossly mis-understood but
it'
s also felt in every way by everybody every day.

The basic identity starts with the basic economic

equation that Output (Y) = Consumption +
Government spending + Investment + Exports -
Imports. Or in h.s. algebra Y=C+G+I+X-M. Since X- M=
Net Exports (NX) and Savings = Y-C-G that means that
S=I+NX, or S-I=NX.

In words that' s Net Savings equals Net Exports. When

we import more than we export (NX<0) then Savings is
less than Investment (S<I). In other words all that excess spending had to be financed from inflows of foreign money.
Turn it around though - if we shift to S>I then NX>0 and we won' t be importing Arab oil money or Chinese savings to
support our spendthrift ways anymore! This represents a huge...huge...huge structural shift in the world economy,
which few are prepared for (if any) and fewer are preparing for as yet.
All of which is captured in the accompanying graphic where the UL sub-chart shows the collapse in trade brought about
by the Recession and the UR nets out the impact of oil imports (boy, if we ever wean ourselves!). The bottom two sub-
charts trace that history back to 1980. Notice that things were largely in-balance until the mid-90s and didn'
t really get

Page 28 of 50
out of whack until this decade. What that really tells us is that this wasn' t some vast conspiracy but the natural,
algebraic outcome of our debt-fueled over-consumption. As we continue to maintain a more frugal posture that' ll lower
the trade deficits and take a lot of the structural pressures off the dollar. BtW - it'
s also important to note that almost
nobody is talking about these things, even though they' re as natural as the tides (also the result of gravity!).

Structural Changes in Other Countries

The American consumer has been the driving engine of world

economic growth for close to three decades now and Japan, Taiwan, South
Korea and the Asian Tigers based their economies on an export- driven
model of development. As has Germany and especially China. When you
hear folks talking about a re-balancing of the world economy they' re talking
about two things. Those countries will have to either shift toward a more
domestically-based and consumer-led economic structure or they will face
severe and dramatic downshifts in their economic growth. That, in turn,
implies huge structural shifts in their economies.

If we can take the case of China this graphic illustrates the situation and
challenges pretty well. While Chinese consumption has been growing very
rapidly it'
s a small part of their economy - the smallest part of any of the
large economies. For them to continue to grow that' ll have to change. Or,
looking at the bottom sub-chart, what we' re implying is that Chinese
consumption will have to evolve from being 4% of growth to perhaps 6%, or
more. Actually it'
s more strigent than that - it will evolve the real
question is what will be the adjustment mechanism. Will it be a drop in
overall Chinese economic growth or will it be a major structural shift to
emphasize domestic production for domestic consumption?

On the answer to that question depends the economic outlook for the world
economy over the next ten years and beyond. A failure to cross that barrier
will result in political instability that would threaten the viability of the
Chinese state. The good news is that they' re well aware of the fact and
are beginning to move in that direction. The bad news is that it will be
difficult and take some time.

Debt, Government Spending and Finance

Another shibboleth (an icon that people use to recognize

membership in the in group but really meaning an old way of
thinking that people uncritically worship without recognizing how
the world has changed) is all the sturm und drang you hear about
long-term deficits and the crowding out of private
investment. As well as the associated one of the
inflationary impacts of huge reservoirs of liquidity and the
inflation outlook. Let'
s take that a piece at a time.

In the UL you see the "credit liabilities" of private vs federal

borrowing. Consistent with our earlier points private
borrowing skyrocketed until it collapsed while Federal
borrowing gradually went down in the ' 90s. Now they' ve
displaced one another. Federal borrowing is, right now and for
the next several years, the only thing holding the economy together and is NOT displacing private borrowing. And with
the slow growth and a shift to savings the demand won' t grow as it might have in the past, plus there'
ll be more
domestic savings to provide funding. That' ll be offset somewhat by decreased inflows of funds from abroad of course.
In the UR chart you see the surge in Fed liquidity flows but, bearing in mind excess reserves are what the banks hold

Page 29 of 50
on the Fed' s books and don' t put in circulation, those flows aren'
t getting into the economy. If they do and aren'
t sopped
up there might be a problem but, again, a problem which the Fed is well aware of, is not a problem now and won' t be
for quite a while and one which they are preparing to deal with. Another shibboleth bites the dust. Which is directly
reflected in the LR sub-chart where the stock of money is actually shrinking!

The final shibbolethic worry is the "huge" federal deficits that are going to destroy the future of the country. As a side
note the biggest problem is Medicare, which would (one would think) lead to a massive surge in conservative support
for Healthcare reform but...anyway. The LL sub-chart shows the Federal deficit back to 1950 and ahead to 2020.
There' s clearly a surge right now and the questions would be what' s the alternatives and how bad would it be
otherwise? The other interesting thing to note is that the prior biggest surges were under Reagan and BushII, while it
was actually paid down to a surplus under Clinton. The final de-shibbolething should be to notice that the going forward
projections after we get thru the Recession aren' t that far out of line with the Reagan spending. Though admittedly
they're projected to stay relatively level and that'
s not a good thing, but it' s also not unaffordable or intolerable. We
covered the other side of that coin in discussing fiscal policy btw (Realities vs Rhetorics: Economy, Policy, Real Data).
On the whole we' re in pretty good shape and NOT facing the kind of really deep adjustments that ALL the rest of the
world is facing. Secular changes, yes. Not a complete re-engineering of the fundamental structure of the economy!

Kipling's Friends and the Outlook

The good news is that the awareness of our needing to

wrestle with these issues is growing. Ultimately, as we
discussed several times previously (Debt, Wealth,
Finance & Outlook: Sixty Years of Bubbliciousness), as the
US shifts from a dis-saving to a savings economy we will
free up more funding for investment in productivity and
economic growth. The process will not be easy, short or
painless of course. But it should be some small
consolation that the periods of highest growth in the US were
pre-deregulation when savings and investment were at their
highest.

There was an interesting discussion on Morning Joe that shows the awareness of these issues beginning to creep into
the wider consciousness, which is all to the good in our '
umble opinions. URL:
http://www.msnbc.msn.com/id/3036789/vp/33290333#33290333%20

We' ll close with two sets of thoughts, the first from our I keep six honest serving men
favorite poet, Rudyard Kipling: (They taught me all I knew);
Or put another way, be sure when you' re reading the
next headline, listening to the next talking head and
Their names are What and Why and When
preparing to sacrifice the burnt offerings of your And How and Where and Who.
savings to some of their shibboleths that you' ve asked
your six serving-men to take more than a simple look I send them over land and sea,
at the realities behind those mythologies and ask for I send them east and west;
proof. You don' t have to like, or agree, with our
answers. But the ones you' re getting cheap and easy
are going to be more expensive than you think in the But after they have worked for me,
long-run. I give them all a rest.

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October 21, 2009

Markets Away: Run Baby Run? Or Stumble? Or What?

http://llinlithgow.com/bizzX/2009/10/markets_away_run_baby_run_or_s.html

Like a couple of famous bunnies the Market just keeps on running and running - the question we' ve had for quite a
while is why and how? The short answer, ioho anyway, is that' s running on momentum. Otherwise known as sentiment
or psychology, or in our coined word, euphorillusion! Strangely a recent survey of Wall St. strategists has the market
ending the year at the same level they forecast at the beginning and about where it' s at now. Now we' ve recently spent
a lot of time, both in gathering, posting and leaving those posts up for you to read, on the Wall St. bonus issue.
Strangely enough that' s coordinated in multiple ways.

What got all this going was when, after the stress test we remind you, financial earnings stopped dying. On the other
hand they sure haven' t been very good - the market died a small death today when Dick Bove downgraded Wells
Fargo. A little while ago Whitney put GS on hold/neutral because it' s more than fully valued. If you'
ve been paying
attention there' s a lot of problems lurking on the banks books and the only lines of business making money have been
proprietary trading. To the extent that the Financials have been driving things we think that's a foundation of quicksand.

The other thing is earnings surprises, which were based on cost cuts although some companies have recently been
surprising on the top line, after lowering expectations. Our bottomline is twofold - as long as its running let it run and
ride along with it. But start prepping and decide what you're going to do; and we' d repeat it still might be time to take
profits off the table if you'
re the least bit ancy.

Current Market Situation

Let'
s take another overly complex look at the
market situation with a four-part composite
chart. The reason we combine these, aside from
compression, is that it forces you to
consider four time frames simultaneously,
which we think is revealing and important.

We' ll come back 'round but let' s start in the LR

corner with the key point. After the ' world is
ending'collapse in March and the "no it' s not
rally" what we see is that the market is just
reaching back into the downtrend channel
that' s been going on since Oct07. In other
words we were in a normal recession bear
market that collapsed twice. Once when the
sandpile of leveraged debt (remember those
financials) in Sep/Oct08 and again this last
Spring. Now we' re still in that downtrend.

As you can see in the UL corner we' ve been

running up ever since. The only other
observation we' ll add is that three separate times it looked like the runup was done for (in fact Doug Kass called a top
in Aug09 - and since he' s the guy who called the absolute bottom to date in March, well...). The UR chart takes Fib
limits from the March low to the range-bound May-early July market and moves them up and over to see what might
still be going on. Again notice that the rally hit the 1030 resistance line and started to stop then broke out but looks like
it'
s struggling to get to the 1096. If we finish the year at 1100 we' d be surprised; and not to surprised if sometime as the
new realities (read employment reports) sink in if we don' t see 877 again. But not just yet. Which gets us to the LL

Page 31 of 50
corner - the longest term sub-chart. There we' ve taken a straight-forward Fib chart from the '
03 bottom to the '
07 top
and guess what - the market is struggling to reach and breach resistance at 1088. Wow, deja vu'all over again as they
say.

A Foreign Perspective: Exchange-

rate Market Adjustments

Via BigPicture we found the Financial Times

had an interesting perspective on things by
looking at the US markets from a foreign
perspective, i.e. by adjusting the SPX for the
drop in the Dollar. We took that idea and spun
it some more by looking at the inflation-
adjusted and the inflation- and exchange-rate
adjusted SPX.

The inflation-adjusted (blue) SPX has yet, if

you' ll please note, to return to the BOTTOM of
the '03 low! So much for this rally, fading or
not, as we suspect. And it' s not as if inflation
has been all that much of a problem. The quick
lesson here is that if you' re in this market you' re automatically TRADING, not investing. We show two exchange rate
adjustments - one for the major currencies and the other for our broad trading partners but both trade-weighted.
Fascinatingly the three indices roughly track each other, though the broad rate-adjusted performance shows some
much wider swings. Let' s try that again - for thirty years from 1973 to 2003 the major currency adjusted and the
inflation-adjusted SP500 tracked each other almost identically. From 2003 forward there' s been a wide swing! And, in
fact, not only has performance been abysmal but the
recent highs are FAR below the ' 03 lows!

Trading in a Range-bound Market

Or, put another way, the death of buy-n-hold! Now that'

sa
point we' ve made before. But everybody' s still locked
into the views that got ingrained as religious icons from
1980 to 2000. Markets always go up. Lots of folks,
including us, started to suspect that was no longer true and
that we were in a secular, range-bound market as far back
as the early noughts. Now most of the brighter and better
analysts and strategist have reached similar
conclusions.

In the readings below you' ll find a large collection divided

into three categories: current state of the market with
some very interesting vidclips (we particularly
recommend the BNN clip with David Rosenberg), some
interesting stuff on strategies and particularly cases
and concluding with a section on some of the best advice
on strategic positioning and managing your
investments in a range-bound market we' ve ever read. All
of it is at least worth skimming but, if we had to pick,
the single must read article is Jim Jubak' s that looks at
key major factors and how they' re likely to play out, the title
starts with "Know What to worry about..."

Page 32 of 50
Barry had another great chart of his own devising, which we' ve combined with the exchange-adjusted chart to link the
points. He and his firm, FusionIQ, took a look at previous range-bound markets and created a composite of what
happens in range-bound, secular bear markets. BtW - where the loop closes is that if you' ve paid any attention
whatsoever to what we' ve had to say about the longer-term economic outlook we' re not going to see decent economic
growth for years and this will be a weak and jobless recovery. Which means consumer demand aint'coming back and
on and on. Again review the discussions but ultimately it indicts all of the current shibbolethic thesis that are running
around, from China to commodities to gold.

So three points on the bottome-line:

1) You can't be playing buy-n-hold anymore. You need to be prepared to adjust your market
position as the market fluctuates.

2) This market is running on nothing much whatsoever and the fumes are thinning out.

3) Ride it for however long your comfortable but start thinking about moving toward high-
quality bonds and on the shorter end of the curve. Not just yet but start prepping.

There are two keys to this energizer market (both id'd and discussed by Doug Kass among others). The first is that this
is a momentum largely driven by liquidity (really wow, deja vu'all over again!). The second is that anticipation of a
continuation is ostensibly based on earnings expectations beats but, underneath that, is that the folks speculating
merrily away see a V-shaped recovery as likely. Despite the fact that a) all the grounded outlooks are based on a weak
recovery AND b) supposedly this is widely recognized and internalized. It is, as Jim Jubak points out, NOT! To that end
these are two stories you should really read: (…). Both are excerpted more fully at the end of the readings after the
jump.

October 23, 2009

More De-mythologizing: a Little Markets, Some Economics, Lots of Policy

http://llinlithgow.com/bizzX/2009/10/more_demythologizing_a_little.html

Well today's market might be taken as confirmation, a tad, of our red-flag waving twer it not we've been here before.
Instead of Bove on Wells Fargo as on Tu. we had some reality from the transportation companies, not to mention that
earnings have been beating "expectations" but, as usual, not very well on revenue, mostly on continued cost cutting
and careful management by the Investor Relations departments. We so remind ourselves of the broken records we
were playing thruout 2007 on this but at least it'
s a song we know by heart. Recall that we started the last post (Markets
Away: Run Baby Run? Or Stumble? Or What?) re-warning about fumes and euphorillusion. Now we' re going to run
ahead and visit some more economic realities but just for the record we start the readings after the jump with some
excerpts that could have been added to that post (Stocks Slide as Railroads, Oil Lose Ground, Andrew Ross
Sorkin: Banks Look Stable But "There's Got to Be Another Leg Down", Roubini: A Big Crash Is Coming, But I
Don't Believe in Gold) just to close the loop and set the table, so to speak. Let'
s shift gears now and pick up some
more economic de-mythologizing, in the spirit of our last post on the economy.

Page 33 of 50
Current State of the Economy

Fortune has done a nice little job creating an interesting and

straight-forward index of the state of the economy which we
recommend you look at. Fortunately there wasn' t a lot of
major/surprising econ news this week so we don' t need to dig
into that.

The early warning indicators may be telling the techno-

wizards that a recovery is in the offing (which it is by the way)
but they also reinforce how weak it' s going to be. For the
mostly coincident indicators that Fortune works with we' re still
at the bottom of a trough.

(http://money.cnn.com/magazines/fortune/storysupplement/recovery_index/index.html )

In the readings you' ll find some more current economic information on retail outlooks, employment and housing. None
of which are looking particular good. There, that said, we can shift to the some more neglected and deeper structural
factors. BtW - this post is intended as a complement to an earlier one looking at some other realities: From Mythologies
to Realities: Economy, Employment, Credit & Trade . We really.....really suggest you re-read and review those
arguments there because they' ll start showing up over the next several months as well.

Let's Put Inflation to Bed

In terms of slaying another mythology let' s start with the risks of

a huge surge in inflation which is being used as one
justification for all the frenzy in gold. The Atlanta Fed did us the
favor of looking at some interesting inflation data by looking
at core inflation. Instead of the standard sans food and energy
they trimmed the statistical outliers in the top chart. On top
(red) we have inflation basically stable and at a
comfortable level early in the year then dropping abruptly to a
very low, deflationary level (green) and then dropping even
lower (blue) in Sep. Our take, and the ATL Fed' s as well as
CalculatedRisk' s, is that in the short- to intermediate-term we' re
facing deflation more than anything else.

In the longer-term and beyond if all the injected money starts

moving into the economy there might be some danger of
inflation but the Fed is already preparing for that. NB: right
now it' s only the Fed's money plus things like TALF and their
purchases of Mortgage Backed Securities that are
keeping the credit markets open at all.
The bottom sub-chart compares official Fed Funds rates to a
couple of flavors of real interest rates. Now tell us what does it
mean when the gap between near-zero(or lower) Fed rates
are showing a huge gape with market rates? It tells us the
credit markets may not be broken but nothing is flowing thru

Page 34 of 50
the system'
s piping to get that credit to consumers and businesses!

Banks, Deposits and Credit

Well if you take a look at the accompanying

chart you can see what happens when the Fed
injects and the banks sit on that money. As you can
see deposit growth is a far bit higher in 2009 than
loan growth. And to top it all off the biggest
banks are getting bigger and more dominant.
The top five banks grew their deposits
considering in 2009 over 2008, which when you
think about it, is kind of surprising considering the
state of the economy. Meanewhle their share of
deposits grew considerably in 2009 over the
previous several years.

In other words that money is just sitting there, like we've been saying for a lot of other reasons. Or put another way, it'
s
not an accident that small businesses can' t get loans nor that your credit card statements are showing more fees, credit
limit cuts or being shut down entirely.

In the readings you' ll find some more discussions on all that, and again we suggest you pay attention, particularly to the
discussions of the Fed policy outlook. The general consensus is that the Fed might start raising rates, at best, in the
latter half of 2010. But if our assessment of the state of the economy is correct then they may keep rates low until well
into 2011, if not 2012. At least they should. One of the most hawkish governors (Bullard of STL) has come out and said
they need to be wary but also that raising rates shouldn' t happen until unemployment starts going down. From previous
discussions you know that won' t happen for a long time. In fact the OMB doesn't expect Unemployment to return to 5%
until about 2019!!!

More on Trade, the Dollar and Re-

balancing

The other mythology that' s running around is about

the death of the dollar (on which topic you' ll find
several excerpts in the last post and which we' ll take
up in horrific detail in a future post). Two things
though. If rates are kept low you' ll see continued down
pressure on the dollar but you should bear in mind
that the runup last Fall in the dollar was a flight to
safety and the flight away from it recently a "risk- on"
trade. The major counter-vailing pressure that will
build up is the coming gradual evolution of re-
balanced world trade. If the US consumer
moves to a more savings oriented posture then we'
ll
buy less, import less and there will be less US$
flowing out and coming back as loans from the
Chinese. So let' s re-visit trade a bit and see how folks
adjusted and are adjusting.

Fortunately Uncle Ben gave a recent speech

tracing out the impacts though his real sub-text was
that the world we knew is not coming back and you need to start adjusting. Both are traced out in his charts, the first
directly and the second by implication. Reading the charts clockwise starting in the UL you can where world trade fell

Page 35 of 50
off a cliff and is only starting to crawl back up. We'
d have to say despite rumors of a recovery it too is proving slow and
reluctant.

The next chart tests who was the most impacted by looking at below trend GDP growth vs openness to trade while the
third chart compares GDP to financial openness. Not surprising the most heavily trade-dependent nations who were
the most open (the two aren't independent btw) suffered the most. It' s the fourth chart that'
s really interesting when you
compare industrial production to exports vs pre-crisis levels. China held up the best on IndProd but not particularly well
on exports.

The question you should ask is how does one get production to hold up better than exports if you're an export-driven
country? Well we could all have been wrong and a country might be more driven by domestic production and
consumption than we thought. OR...OR... government policy could have stimulated production by stimulating
investment thru fiscal stimulus and loose money. Now the real question, particularly in China'
s case, is for a country
already in danger of igniting inflation and badly over-capacitated what happens when those chickens come home to
roost?

Keeping the Wheels on the Wagon and Policy

Speaking of policy the Council of Economic Advisors estimated that

the stimulus program added 2-3% to GDP in Q2 and 3%+ this
quarter. NB: independent and trustworthy (i.e. non-ideological)
analysts concur. Now there' s more to come but that stimulus starts
fading out in the second half of the year. So what happens then?
Well if we're lucky the pump priming kept the wheels on the wagon
and will get the economy back on a path of self-sustaining, organic
growth. On the other hand the employment data makes that, shall
we say, highly problematic at best. Which is why even the optimistic
forecasters are anticipating growth slowing, though not a return to a
recession per se. Go draw yourself a square root sign and reverse
it. That'
s the optimistic outlook for now.

We' ve covered the whole issue before(Between Stalingrad and Kursk: Real Economy, Policy and Outlook) so we won'
t
re-visit the subject in detail but we'
ll make three key points.

1) Right now things are being held together by public policy not by anything innate in the
economy. Don't let the folks substituting ideology for analysis trick you into believing anything
different.

2) That means that we're going to be dependent on monetary and fiscal policy for a few years to
come. For example the minute the Fed quits buying MBS's the Housing market dies.

3) As a corollary that means that the other government programs, oddly enough for our normal
thinking about business cycles and the economic outlook, will be critical.

On that last point we' ll simply point to the chart on wages vs total benefits costs. This last decade wages went nowhere
while total benefits went to the mooney. Gee....what do you think caused that? Well a small hint: healthcare costs have
been going up around 7%/year for almost two decades. (A Taught/Taut/Taunt Moment: Healthcare Speech, Policy,
Politics & Realities) Getting those under control might be as important for incomes and consumer demand and the
overall health of the economy as anything else that' s likely to go on; particularly now that borrowing against your house
or tech stocks is gone forever!

Page 36 of 50
October 28, 2009

Really Different This Time: Liquidity, Rates, Markets & Risks

http://llinlithgow.com/bizzX/2009/10/really_different_this_time_liq.html

After the last three days in the market our prior post on the Markets outlook might be looking a tad prescient, but who
knows? Two other previous posts focused on longer and deeper structural issues (From Mythologies to Realities:
Economy, Employment, Credit & Trade, More De-mythologizing: a Little Markets, Some Economics, Lots of Policy) and
tried to debunk a lot of the ideological shibboleths (including a definition of shibboleth!) that'
s influencing too much of
people' s thinking. If you'
ve been reading along we' ve hammered several themes repeatedly: a weak economic outlook,
a jobless/loss recovery, a market that' s widely and wildly over-valued based on any of the fundamentals and a
deep...deep...deep need to re-think investment strategies (more on that we hope in a subsequent post). Between
aberrant behaviors and poorly grounded shibboleths the really central question is WTF is going on? We think we' ve
finally arrived at a fundamental answer - or at least the
beginnings of one.

To summarize the rest of this post, somewhat, we think what

we' re seeing is a shift from a Risk Off (fear and loathing on
Lombard Street) to a Risk On set of speculative trading
where vitally necessary policy steps that kept and are
keeping the economy from collapsing are also both restoring
confidence but are also putting to much liquidity back in the
markets and lowering the risks of screwball trading while
simultaneously re-assuring folks that the risks of catastrophe
are reduced. Which, as a bottomline consequence, means
that all the running up markets are built on foundations of
sand! Which means that our advice to start preparing your
storm shelter should be taken to heart - think back to BSC
as an early warning sign. Or, in some ways, the March
Market Madness which resulted from economic realities
finally sinking in. It looks to us as if sentiment is shifting so we'
re going to have one
hexx of a fight between sentiment and sense.

Reviewing the Bidding: Current Valuations

We won' t review the bidding on earnings, profits, the economy and valuations in any
great detail since we'
ve run off quite a bit about it. But we will point to this chart
drawn from a BNN interview with David Rosenberg of Glushkin-Sheff, a gentleman
whom we' ve cited several times before.

Frankly we don' t think there could be any worse news, particularly when you look at
the realities of earnings. NB: despite what the MSM is telling you earnings are NOT
coming in that good. In fact, despite 75% of companies beating estimates, they are
beating those estimates because they managed expectations down so low.
Something that happened beginning the Tech Bubble and has, if anything, continued
to get worse. When you check the readings excerpts after the jump you' ll find a
couple of key sources on that and several other topics.

Operating earnings are before minor details like interest, depreciation and taxes
while reported earnings are after those adjustments have been made. You actually
need to look at both, and implied in our prior comment, put them thru a very fine-
tooth examination. Which the sell-side analysts are NOT doing for you!

Page 37 of 50
From all our prior postings on various takes on long-term earnings and PE valuations you might recall that we think a
15 PE is optimistic and a 20 PE indicates somebody under the influences of massive hallucinogenic optimism. What
can we say though about a PE of 120? We' ll let that case rest there but will also point you in particular to the first
reading (again from Jim Jubak) discussing the relationship between stocks and the dollar.

Let the Real Valuations

Standup

Martin Wolf of the FT has an excellent

discussion of this whole topic where
he's channeling an economist and
market analysts named Andrew Smithers,
who' s recently come out with a new
book. You might note that his previous
book was published at the height of the
Tech Bubble and issued the same
warnings about over-valuations based on
euphorillusions that he's issuing this time.
Only now he' s suggest a couple of metrics that are well worth paying attention to, as well as being entirely consistent
with our previous posts on long-term valuations where we channeled Shiller and our own work. His bottomline
conclusions - the SP500 is over-valued by 40%. Which means, btw, that back at the trough in March when we were
arguing that the market was much more fairly valued, even accurately valued based on economic fundamentals, we
might have been on to something.

Smithers introduces two fundamental metrics of valuation. The first, Q, compares market valuations to a company' s net
worth. If you stop and think about it for a minute it makes perfect sense, and in fact, resonates strongly with Graham-
Dodd and Buffet' s long-term approach to equity valuation. His second metric is Cyclically Adjusted PE, which looks
back at the 10 year average of real earnings. (Wow, shades of Shiller indeed). Not surprisingly his conclusions are both
stark and congruent with Shiller's and ours. Almost as interesting Jeremy Grantham, a notorious and very well
respected analyst and investor, comes to similar conclusions in his latest newsletter, though he sees the market as
"only" being under-valued by 25%.

Bill Gross on the Big Picture

Mr. Bill brings it home for us by both returning to

economic fundamentals and relating profits to GDP
growth, a topic we' ve explored as well. He also points at
the total universe of asset valuations. His basic
conclusion (more in the final reading excerpt) is that you
can' t reasonably expect profits to grow faster than
nominal GDP and earnings should grow with them, as
should stock prices. That they haven' t for the last three
decades he attributes to financial leverage and
engineering! Which seems to be our basic theme here,
doesn' t it?

We borrowed both these charts from his latest

newsletter and, not surprisingly his top chart on Profits vs
GDP looks a lot like ours. Which we find encouraging
though he uses nominal GDP and not real; but then
again we used deflated profits as well.
It'
s his second chart we find really...really interesting. It
compares the trailing five-year growth rate in assets vs
GDP growth. Notice that the two most recent major

Page 38 of 50
bubbles stand out rather starkly indeed, at least IOHO. And just as another reminder this is precisely consitent with our
look at long-run cumulative growth rates in real GDP, Profits, Earnings and the SP500.

So now you' ve got at least four of us who are coming to identical conclusions, showing roughly equivalent results and
arriving at these end points by very different, on the surface anyway, methodologies. Yet coming to the SAME
endpoints! We don' t think the conclusions could be any starker - Mr. Gross goes on to point out that as savings
increase and de-leveraging becomes necessarily widespread that future valuations and returns are going to have to
return to a new normal which is in actual fact the Old Normal. Which has all sorts of implications for investment strategy
BtW!

NB: in other words the markets are running up on all the new liquidity sloshing around, which means that not only is the
last three decades of aberrant market behavior and recurrent bubbles due to financial engineering and de-regulation.
Which also means that reforming Financial regulation is a sine qua non of getting back to a stable new/old normal.
Rather than point back at previous discussions we'll instead point you at two key posts on another blog:
The Chinese Goldsmith, Finance and the Next Big Fight
http://llinlithgow.com/PtW/2009/10/the_chinese_goldsmith_finance.html

Banks Hate Banks, Voters Hate Banks: Hear the People Singing!
http://llinlithgow.com/PtW/2009/10/banks_hate_banks_voters_hate_b.html

October 31, 2009

Surprise, Surprise: Not a Rally and It's Still Different

http://llinlithgow.com/bizzX/2009/10/surprise_surprisenot_a_rally_a.html

Surprise, surprise is the start of the punchline to a terrible junior H.S. joke about Gomer Pyle and the neighbor girl told
when you' re to young to know better and still puzzled by life' s mysteries. Now that we' re all older the supply of
mysteries seems to keep going and it' s one damn surprise after another. In fact there were so many that instead of a
couple of updated additions to the prior post we ended up with a huge inventory that calls for a separate one, driven by
the two big surprises: Th. GDP number and Fr. market shock. What they have in common, other than surprise, is that
they're tied together by a mystery. That mystery is the mythologies we' ve been working our way thru, doing our best to
debunk and de-mystify, and look for the structure and relationships.

A Quick Look at the Market

That we' re completely being bombarded

shouldn' t be a surprise - we are after all dealing with
the after-shocks of the biggest disruption in the
economy and markets since the 1930s where all the
old structural relationships got shaken up. One thing
that happens in complex systems subject to
shocks is that it takes them a long time to return to
stability and normal operation. When the shock is
severe enough the linkages and parameters get
changed so that the old system is not the new one.
That' s exactly the case here. Let' s take a quick look
at the markets to start with.
You should read this chart composite clockwise
starting with the UL corner and working round.

Page 39 of 50
The point there being that March saw the world is ending as economic reality sank in and as fears of bank failures
exponentiated. When that got fixed by the stress tests we got back to some measure of sanity but followed it with ill-
grounded optimism bordering on illusion and went for a liquidity and leverage driven mini-bubble not based on realism
about economic growth, earnings and profits or valuations. All of which led immediately to the UR chart - the real
question is will fantasy return triumphant or will self-delusion be reduced enough to return to reasonable estimates and
valuations? In the readings BtW Prieur du Pleiss has one of the best summaries we' ve read (Stocks and risky assets
stumble ) on the subject. The bottom two charts tell us something, technically speaking, about where things might end
up if reality wins. That reality is defined by whether or not the continuing turbulence of a fragile system continues to see
the Central Banks trying to pump money in and what the Financial System does with it.

And a Look at GDP

One way to sort out the pattern from the

noise is to find a set of instruments and filters, and
we like YoY% changes, which makes
economic patterns about as crystal clear as they
get. The bottom chart here shows us GDP,
Consumption and Employment and, on the
surface, it'
s nothing but good news. We' ll
make it official - the Recession is indeed over as
measured by GDP.

Of course there are several catches which

we' ve yaddayaddad about forever. The
recovery is not just highly but utterly
dependent on government policy (Fed rates,
quantitative easing, tax cuts & transfers,
stimulus spending) which are going to be
vitally necessary for a long time. The real key is how fast, when and if the economy transitions from a dependency on
policy to internal, self-sustaining and organic growth. Which really means when does it start creating jobs and beyond
that when does it make up for all the lost ones.

There's a second deep and vitally important idea to note here. Normally in our four factor model (Structure,
Fundamentals, Technicals, Psychology) Structure is the factor with the longest time-horizon - measured in years and
decades and heavily dependent on the socio-political environment. Which means that it doesn' t change very often.
Now with policy having to respond monthly or weekly structural factors are changing as if they were a high-
frequency variable. In this turbulent environment where we' re clearly crossing a turning point it pays to look at YoY vs
QtQ changes which the top two charts do. At least on the surface the QtQ changes indicate a positive direction.

Page 40 of 50
Consumption, Outlook and Markets
So what happened Fr. in the markets and what' s the relationship
with the economic data? We start to answer that by taking a more
granular look at Consumption in the top chart comparing monthly
YoY changes to MtM changes for Consumption. Guess what -
monthly consumption dropped almost -2.0% after booming from
Cash for Clunkers! Oops...welcome to Reality Land.

As you know we like to look at the future outlook for demand by

looking at the changes in Real Wages and Employment. Wages are
continuing to show strong positive improvement while Employment
continues to deteriorate so the net effect is still negative. In other
words demand growth will be weak at best. But there' s a catch -
real wages are going up because of declining inflation, not
increasing labor demand.

The bottom sub-chart compares Consumption to

Wages+Employment to Real Personal Income+Employment. And
the latter is definitely in the strongly negative camp. Remember the
argument that relationships get changed by strong shocks and
turbulence so you have to re-think the rules-of-thumb you' ve been
depending on? Well, there you go.

Readings Guide

As usual there's a fairly extensive collection of readings excerpts and links (btw - the highlighted title takes you to the
original source, is our way of giving credit where due and letting you read the whole thing). Aside from Prieur' s very
nice summary you' ll find a bunch on the state of the economy but one in particular is worth paying close attention to.
The IMF has found that after severe shocks like we' re working our way thru that long-term growth rates take a while to
recover and, when/if they do, we' re at a much lower base. Now we were already facing an outlook where the new
normal was projected to be 2.5% growth. What if it' s lower than that? At 2.5% growth we don' t create enough jobs to
breakeven, let alone recover all the lost jobs.

At the end of the readings you'll find the links to some recent TechTicker interviews with Martin Wolf of the Financial
Times. We STRONGLY recommend that you listen, take notes and even listen more than once.
Oh, by-the-way, on the top economic chart you' ll notice that long-term employment hadn' t turned up yet. At this point
nobody expects it to do so until late next year. They also expect it to take years to painfully work our way back to 5%
Unemployment (the OMB estimates 2019!). That' s the new reality. Whether it is truly incorporated in people' s thinking is
another question, verses whether everybody gives it intellectual lip service but keeps trading as if the new normal
would return to the old normal. And that explains why the markets tanked on Friday. They' re beginning to get it on a gut
level that the New Normal is really New.

Page 41 of 50
November 3, 2009

It's Still Different: Refreshing Policy and Market Info

http://llinlithgow.com/bizzX/2009/11/its_still_different_refreshing.html

We were going to add a few links with some interesting stories that came out since our last post on the Markets.
Interestingly there were so many that adding a couple, or a mere few, to that post seemed in appropriate. Nonetheless
if you'
d consider this as at least partly an extension it might be a good idea.
The basic themes we struck, and have been striking, are:

1. We could never justify the rally on the basis of fundamentals, economic outlook or valuations and have been viewing
it as a relief rally. The continued triumph of optimism over experience, otherwise euphorillusion.

2. The central fact that we think explains about everything is the world's Central Banks have been pouring liquidity into
the world's banks who have largely been sitting on. In that process they' ve in turn made their returns, where they made
them, in the last two quarters thru proprietary trading of one form or another.

3. Generally we' ve taken to calling this the RiskOn trade where the saving of the financial system combined with all that
surge in homeless cash led to money pouring into risky assets. If you checklist your way thru all the markets and asset
classes it explains about everything from China to Gold to the rise and fall of the dollar. For example when Risk is on
money flows out of the US, thereby dropping the dollar, and visa versa.

4. As the recovery gets underway several Central Banks are beginning to tighten up their policies and are preparing to
withdraw liquidity. That will tend to reduce the liquidity pools.

5. At the same time it is slowly and reluctantly beginning to dawn on folk that the economy is not going to see a V-
Recovery. Which shows up, for example, in last Friday' s debacle when consumer spending was so much worse than
expected. Or, as we put it, supwise, supwise (in the immortal words of Gomer Pyle, FRB).

A Glance at the Markets

Given that the markets are all moving together we can

continue to look at the SP500 as the proxy for just
about everything else, suitably adjusted for
differences in liquidty, risk preferences and
illusions. So here's a little market snapshot we took
yesterday that highlights the situation as we see it.

What we see is a technical pattern called a "fallling

wedge" where the market is very shortly going to
have to make up its mind about which way to
break. On the last several months history having it
break yet again to the upside wouldn' t be a great
surprise. Having it break to the downside would be
merely rationale and on any number of grounds
(earnings, profits, economic outlook, valuations).
Barry Ritholz put up a couple of David Singer
annotated charts on Head & Shoulders patterns
today that are linked in the readings you ought to look
at as well, though they are a bit more complicated.
Notice as well that volatility is increasing. Prior to the
sandpile collapse last Fall when the VIX got to 30 it

Page 42 of 50
meant a major drop in the market. Now we' ll see, won't we? Notice that the MACD indicator is beginning to tip over on
the bottom of the weekly chart as well. Since everybody' s expecting a correction it ought not to exceed 15-20%. It'
ll be
when the real economic realities sink in next year that fundamental re-thinkings set in on valuations.
In the meantime we suggest you at least skim the readings on Central Bank policy as well as several others on the
market situation and outlook.

November 5, 2009

Cuspiness, Collisions & Conundrums: Market Carry, Employment & Euphorillusions

http://llinlithgow.com/bizzX/2009/11/cuspiness_collisions_conundrum.html

An amusingly alliterative title, don'

t you think? With just that touch of the common with the hattip to what' s his name the
comedian..John Stewart was it? :) An alternative might be it' s still not any different but the delusions are rampant. We
also find ourselves in the familiar position of having to much to add to let it go with just an update, especially since the
mythologies and delusions continue to run rampant. Specifically we' re in a trading market being pushed along by
speculative momentum and sentiment and based on the US Fed interest rates funding an all market carry trade. That' s
one major delusion. A deeper one is that, despite all the claims to the contrary, most of these folks think that it really
was going to be a V-recovery and it' s dawning on them that' s not true, though they haven' t adjusted their positions. The
third is that the number of ungrounded and ideological shibboleths driving investment and trading decisions is
monumental, including mis-understandings of rate outlooks, employment, debt and deficits, inflation and the dollar.

Our next major scheduled post was going to be on the dollar and further de-mythologizing in fact. Instead we' re going
with the flow and putting up our fourth major post on the markets, three in a row in fact, to try and keep trying to correct
some of the euphorillusions. Actually this whole set of market discussions are really one long giant post that fits into our
series on de-mythologizing so we start the readings off with the complete inventory of Market and Mythologies history
and will hope to get back on track sometime in the future. The net result of substituting ideology for analysis is two
colliding mis-understandings that are on major tipping points. The first is the obvious carry trade and asset bubbles.
The second is employment and the implications for rate policy. We won' t re-visit all the mythologies but will concentrate
on two: Rates vs Employment and the Bubble(s), but we' ll also spend a little time looking at Emerging Markets and
Illusions.

Rates, Employment and Inflation

The first thing to understand about Fed rates is that

they don' t raise rates until employment is growing
again. That' s one of the primary purposes in life, a
strategic goal and explains why Greenspan' s Fed left
rates so low for so long (Employment didn' t begin a
"recovery" until '03 btw). The other thing to
understand is the other key factor is Inflation. Now
we' ve discussed both of those repeatedly and
some of those discussions are listed in the
readings for your review. As it happens almost all of
the standard thinking has got it wrong - which
means almost all of the headlines and investment
decisions floating around are ill-founded, to say the least
and being very polite.

Employment is going to be very weak for a very long time (it takes 5%+ real GDP growth to start making a dent and
we'
re going to have 2.5%). Inflation is likewise not a danger for the foreseeable future because banks poor position
means that all that excess liquidity is going to stay on their books and not in the economy - technically that'
s called
money velocity and it's a measure of how fast the supply of money turnsovers in the economy (cf. the readings). What

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ties it all together is a modified Taylor Rule that links Employment and Inflation to rates. A version that works very well
is:
Rates = 2.07+1.28*Inflation-1.95*Excess Unemployment.

With low inflation and high unemployment the Fed should be setting rates at -5.6% and keeping them there for well into
2011 or beyond. That may lead to future problems but it also means that the only thing keeping the wheels on the
wagon is stimulus spending plus quantitative easing where the Fed buys various debt instruments to try and lower
rates directly. That means that fuel could be added to the carry trade fire for a while and that the dollar could continue
under pressure. It also means that all the surge in asset prices is policy-driven, not based on fundamentals and all the
talk you hear about Gold, Emerging Markets, et.al. is based on very shaky foundations.

Bubbles to the Left, Right & All Around

Let's take another look at that question of widespread and

endemic bubbles. There a a couple of things to notice here.
First, that we are indeed riding into the valley of the Six
Hundred Again and, second, that lots of folks have
noticed. Though we think the first to really point to the
problem are, not surprisingly, Roubini and Simon
Johnson. But this week both the IMF and the World Bank
issued major warnings.

Aside from Gold another really bad example is Emerging

Markets, which have just roared ahead. But it' s not the only
one as the graphs of South Korean and Australian home
prices show. Can you believe it? That might bring us full circle back to China and the now multiple stories about
liquidity injections showing up in stock prices, real estate, and mis-placed investment in infrastructure investment (a
point we won' t dig into since we' ve been hammering away at it so many times before, largely courtsey of Michael Pettis.
NB: the world appears to have picked up on Michael' s warnings and his themes are now widely written about and
accepted but he' s still the original and the deepest IOHO.). Here' s you homework assignment - actually two, and they
ARE for extra-credit. What asset class do you think is NOT part of all this?
What happens when realities set in? Which they will sooner or later.

EM as Representative Futures

Lest you think we' re picking on Emerging Markets too much rather than
treating them as representative let' s take a sideways segue and look at the
Strategic Outlook. Emerging Markets crossed a cusp point at least five
years ago where they' ve moved onto entirely new footings with regards to
stability, security and safety and returns. Many have noticed that
recently but have still not adjusted their investment strategies. A state of
affairs we think is well-captured in this graphic.

In our reading the top chart shows both the double-bubble in EM

stocks, which anticipated the inflow of investment funds surge, and the
continuation of that surge after investors discovered the cusp point
crossing. BUT...the bottom half perfectly well proves the other point -
allocations to EM stocks relfect the old realities not the new ones.
Which calls for major re-structurings of portfolios and investment
strategies. The question is when and based on what information?

Which leads to the really critical point. There is no substitute for actually
understanding what' s going on. Too many folks have substituted "invest in
the BRICs" for actually digging even the slightest into the underlying
realities. Now in several previous posts we' ve tried to apply our Vulcun

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methodology of evidence-based analysis instead of relying on ideological shibboleths by pointing out that Brazil
appears to solidly grounded, then India, then China and way behind, Russia. On a 1-10 scale we' d rate Russia as at
best a 3, China a 4-6, India a 5 and Brazil a 7 from a long-term perspective. Anticipating a burst bubble though we' d
apply a systemic downgrade that would take everybody down several notches. In other words if you' re interested in
protecting your investments it's time to start getting out, or getting prepared to get out and re-position yourself for the
anticipated future.

Warren Is a Vulcun: Lessons From the

Master

One of the interesting, among many, West Wing

episodes is the one in which one sub-theme is
about a bunch of Chinese Christians who fled
persecution and are seeking asylum in the US.
President Bartlett proposes to test their Faith by
testing them for Shibboleths, a label we' ve often
used repeatedly. A shibboleth is, as the Chinese
leader says, an outward sign of an inward Faith. The
catch is that one can't apply evidence and
analysis on this topic but one can and must to
questions of investment strategy or decision-
making in general.
http://www.youtube.com/watch?v=D5RGxE2_G0I

One of the most startling learnings for us over the last year is the extent to which people let their hindbrains entirely
dominate their thinking and really on their forebrains as engines of rationalization to justify the conclusions they' ve
already reached. Warren Buffett is famous for his results, for his folksy wisdom and for his principles. What almost all
the commentators ignore is that Warren DOES NOT make his decisions in 15 minutes of gut-level response. Instead
he invests enormous time and effort, which he doesn' t talk about very often, on acquiring a detailed knowledge of how
things really work. The most difficult of his principles is never invest in anything where the intrinsic value is not far less
than current market value, preferably by at least 25% if not more. The difficulty of course lies in determing that value,
which is where careful investigation is required. If you' re not willing to Pay the Piper then go to the Dance. The other,
among several key lessons, he follows is not to let ideology substitute for thinking. It' s all right to have emotions and
principles. It'
s not all right to let them dictate your decisions - they are ideals and goals.

Right now all the evidence points to almost all assets being vastly over-valued based on reasonable analysis of the
best available data, the Spockian approach. What does that tell you? Especially when so many are are arriving at their
conclusions based on ideology instead of analysis and converting the resulting conclusions into Shibboleths. Your
hindbrain will win if you let it so it'
s up to you to substitute thinking and discipline. Easy to say of course and very hard
to do - and not something we' ve found many (sadly including ourselves) are willing to do in all circumstances (cf.
Cognitive Dissonance, Double-Bind).

But that way lies salvation!

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November 7, 2009

Turbulence Isn't Chaos: Dollar, Rates, Trade and Markets

http://llinlithgow.com/bizzX/2009/11/turbulence_isnt_chaos_dollar_r.html

Recently when the dollar' s been up stocks

have been down, and visa versa. Lying
behind that turbulence is the gyrations
between RiskOn/RiskOff trading based on
liquidity-fueled speculation and the dollar
carry trade. All this turbulence has been with us
in some form for almost two years but
seems to be dampening down. The two
problems with a turbulent environment is that
the risk and uncertainty is higher so
everyone' s looking for the patterns and
explanations to make high-information
signals out of the noisy data. Part of that
filtering is the one we just applied
(RiskOn/RiskOff) but there are layers behind it as
well. A lot of those layers have to do with the
outlook for deficits, trade flows, interest
rates and exchange rates.

And because we' re in a policy-driven

environment where deep structural changes that
are normally predictable and evolve slowly are moving more like high-frequency technical information and subject to
changing policy decisions. In this environment it's hard to decide whether or not turbulence is chaos - unpatterned or
unpredictable - or not. Sometimes in fact it'
s not only hard to tell the differences but there aren'
t many (aerospace
engineers talk about turbulent flow which is best modeled with chaos math for example but can be approximated by
better behaved equations work ably enough).

What makes the chaos more likely is when to many folks substitute simple-minded ideologies based on philosophical
or political preferences for the best available data, analysis and information. In other words when they worship at
certain political shibboleths. We' re going to attempt to keep on de-bunking yet another set of those shibboleths as part
of our continuing efforts to find the patterns and develop the workable, good-enough models for our needs. This time
we' re going to focus on the Dollar and its relationships to Trade and Rates, while trusting you to review the prior
discussions on the economy, deficits, economic policy, inflation, etc. Just to close the loop though the chart is two
analysis of the same 3yr weekly SP500 chart which shows that a) all the downtrends we' ve been talking about are still
intact and b) despite the recent rise it'
s both bumping against the Fib limits from the Oct07 high and churning around
now on shorter timeframes of the recent bear rally. Which way it breaks is going to be a tradeoff between liquidity and
reality.

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Talking About Trade and Rates

To sort the chaos into patterns and make it merely turbulent we' re going to try and present some machinery, admittedly
conceptual, to try and explain how trade flows are linked to exchange rates and how those are linked to interest rates.
The basic relationship is that Net Exports = Savings-Investment, which makes sense when you think about it but also
follows from an accounting identity we've talked about before. Briefly (sorry for the shortness but...) Y=C+I+G+X-I. If
Net Exports NX=X-I then Y-C-I-G = NX. But Y-C-G is savings so S-I=NX and
voila'.

In the long run (at the bottom of this layer cake) you' d like for trade flows to
balance out, that is we buy as much stuff abroad as we sell. That requires
that we either make lots of stuff they want or don' t buy as much from them
as we want or they' d like to sell. NB: we'
ve just explained the last ten years
inter-dependency between China and the US. In this example Europe buys
US goods but needs $ to do that while we need E to buy their stuff. When
we buy too little or they sell to much we end up with fewer E than we' d like
and they have a hoard of $. One way for that to balance out is for the E:$
exchange rate to adjust, in this case since they' ve got to many dollars by a
drop in the E:$ rate, which would then work backward to reduce the demand
for their goods until things are balanced out again.

Another way to re-balance is for that excess hoard of European $ to be

invested in US assets, say stocks, bonds or loans. Which is exactly what' s
been happening between the US and China, or the $ and the Renminbi. We
buy more stuff from them, they end up with too many $ so they loan us the
funds which we use to buy more stuff. Simple right? In our equations NX<0
=> S<I and R:$ should increase to re-balance things. Oops..that didn' t work.
So now the machinery runs backward, so to speak. Since R:$ is to low money keeps flowing to the US and we keep
borrowing to buy things. Before you get to upset about all that let'
s bear in mind both sides are culpable. We kept
playing grasshopper and they got to bring millions and millions of people out of poverty and keep their country from
blowing up. There trade and international relations in one easy two paragraph lesson, right?

SPX vs. Dollar

Or it could make your head hurt, like it does mine but let' s make
it worse by circling back to the markets vs dollar question. A while
back we took a long look at the impact of exchange rates on the
real returns on the stock market using the top part of this chart. It
shows the inflation-adjusted vs exchange-rate adjusted SPX and
up until 2003 there was no practical divergence. (Now there' sa
potential investing lesson!). Since then as trade imbalances have
grown so has the divergence and so has the tendency of the dollar
to drive the markets inversely. The second sub-chart looks at that
directly by comparing the trade-weighted exchange rate for major
currencies ($TWX) to the SPX. Pre-bubble there didn' t appear to be
a lot of relationship but during the bubbles we start to see
more...and more with the recent aberrational environment.

From the machinery you' d expect that there' d be a fairly strong

relationship between business cycles and exchange rates since
during a recovery demand goes up which would increase imports and increase the outflow of $. In the last sub-chart
there' s some relationship but it doesn'
t strike us as very clear-cut or stable. So what'
s going on?

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Dollar Driving Factors

Well that' s kind of complicated and involves multiple relationships all gyrating together. From the top sub-chart and our
trade layer-cake machinery you' d expect one factor would be Net Exports. As NX gets more negative you' d expect the
dollar to start dropping. From the top part there'
s clearly a relationship but it'
s also another one of those it depends
things as well. For example during the ' 90s the dollar was strengthening while the trade imbalance was getting
increasingly worse. Could that have been demand for US equities during the Tech Bubble? Which eventually caught up
with us on both fronts (the bubble burst and the imbalances got "too big")? We think that' s part of it. And from the
middle sub-chart clearly there are business cycle influences, as we noted.

Another major factor though is interest rates. In fact from the bottom sub-chart that seems to be the most clear-cut
driving factor, if not the dominant one. As US rates came down and started their long secular decline the dollar followed
suit with its own long secular decline, interrupted from time-to-time by other factors, e.g. the Tech Bubble or the recent
"Flight to Quality" during the panics last fall. In fact if you look at a shorter-term dollar chart you' ll find that after a rapid
runup during the flight the dollar is basically returning to that trend. You' ll also find that it'
s flattening out around the 75
level.

Wrapping UP: Long-term Secular Implications

There' s a whole bunch of shibbolethic thinking floating around driving Emerging Markets, Dollar depreciation and other
asset bubbles. Briefly it'
s that huge and unaffordable US budget deficits will increase demand for government funding.
Now some of that' s true and there will be some major impacts. But, paraphrasing Mark Twain, the death of the dollar is
greatly exaggerated.

1. A reserve currency must be safe, secure, large and liquid. It' s going to be a long time before any
other currency can match those requirements and best intermediate term candidate is the Euro. But at
the end of the day that will come back to relative growth rates and the long-term prospects of the US
are still much better than Europe' s, or China's for that matter with the latter'
s long-term demographic
and institutional problems as well as their need to re-structure their economy on a more domestic
foundation.
2. As the US saves more it will import less and that will decrease the outflow pressures on the dollar
AND increase the domestic pool of funds available for investing in US assets. That means that deficits
become more financable domestically for one thing. Coupled to that is the fact that while deficits will be
large as the results of previous policy decisions (90% of the deficit problem comes from Bush
administration decisions and the financial crisis not new programs) they will not be historically
excessive. Again that means that the demand to
borrow abroad to finance deficits won' t be what people
are thinking. A third coupling is that as we demand
less and shift to lower energy consumption a similar
dynamic sets in with regard to Oil imports.

3. The world needs to re-balance trade flows which

requires signifiant adjustments in domestic
economies. The US is already making
those adjustments and China knows and
acknowledges that it needs to but will take
time and have political and stability
challenges in making them speedily and
forcefully.

The bottomlines here are that the US will be a

reserve currency for a long time, though perhaps not
the only one and is likely to remain the most
important. Another bottomline is that rates will
adjust back up since they were abnormally low as the

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result of the crisis and policy interventions. But we're not likely to see any many surge in rates for a long time and they
aren't likely to surge out of control. And, over time, as we get the economy growing again, control deficits and start
working them down the doomsayers will find their worries not well-grounded. Which is not to say we aren' t facing a
decade of slow growth, employment problems and difficulties in writing down the debt. It' s what always happens when
you've been partying to hard for to long. The hangovers are terrible.

The bottom bottomline is that all the simple answers on investment and business strategy that you've been hearing in
the headlines or from the talking heads need to be carefully examined. Will Oil and Commodity demand return to their
old levels, speculation included? Unlikely though there are counter-vailing pressures. How about speculating in BRIC
equities? Ditto.

More than at any time in a long time this next decade is going to require understanding how things really work from
trade to rates to business performance. That' s how Warren does it anyway.

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 About Llinlithgow Associates
Llinlithgow Assoc. is a management
Customer Problem
consultancy focused on evaluating
• Value Proposition
businesses to reduce risk, leverage • Business Model
under-developed opportunities in • Strategy
operations and increase overall enterprise
performance to improve investment
return.
Management System
Marketing, Sales &
•Budgeting system Service
Our approach is based on •Management Controls • Customer value focus
BizzXceleration, a proprietary •Operating Plans • Process Discipline
•Resource Development
framework with 25 years of • Business-driven

development, to review and analyze

Business Models and Strategy, key
operating functions and supporting Core Operating
Functions
infrastructure and management systems. • Functional Efficiency
From there we develop comprehensive, • Inter-function
Integration
integrated operating plans that tie all the •Value Alignment
components of the business into a high-
performance enterprise.

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 contact@llinlithgow.com .

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