INCOMING...Or not, to be quite honest. A few quarters after the US economy has printed positive GDP numbers, the debate continues to rage as to whether we're facing a "normal" economic recovery. As we have discussed really over the last year, in many senses financial market rhythm of the past year, especially as seen in equities, has very much replicated that of what we have come to know as a traditional recovery cycle. Of course this is occurring amidst unprecedented monetary and fiscal policy being applied to the economy and the financial market, so normal seems a bit of a stretch in terms of characterization. But as we've discussed the "institutional playbook" concept over the last year, the script has been followed virtually to a tee. Initial market cyclical liftoff periods have been characterized by high beta leadership. Tech, discretionary and materials led the charge over the last year and many in the discretionary sector in recent months (in good part due to short squeeze activity) have lit up like bottle rockets. The financial markets have acted as if a normal economic recovery is well underway relative to historical equity market patterns. But as we all know, the financial markets and the real economy are two different animals. Without question, unprecedented monetary policy has certainly influenced the financial markets, but we see this to a lesser extent when we look across the broad economy. As we mentioned a while back, at least as we see life, the dichotomous theme of recovery on Wall Street versus Main Street remains alive and well right up to the present. All one has to do is check in with the NFIB. The recovery on Wall Street that is driven by anticipation, perceptions, liquidity and often a dose of reality has galloped far out in front of that of the real economy again viewed very broadly to include small business. As we all know, small businesses which are a very important part of the real economy are still in good part struggling. Since they represent 50% of the private sector and a very large employer base, it's meaningful.

Be all this as it may, we want to focus in a bit on the current character of personal income and have a quick look back at prior cycle experience in a bit of compare and contrast. Important why? First, the obvious. Broad consumption/demand is the driver of the US economy plain and simple. And as we look back over historical experience the trends are clear in terms of rising income in post recession environments. Income that supports consumption (and in turn production). Although it's our individual opinion, the character of personal income is the hallmark fingerprint of the health of the US private sector. In the absence of asset based lending (which is not coming back) income is the support to any credit cycle...or potential credit cycle. Second issue deals with the deleveraging still occurring and needing to occur in the economy at large, but very importantly at the household level. We saw in the recent 4Q Fed Flow of Funds report, nominal dollar private sector deleveraging in the final quarter of last year was the largest number on record. In aggregate deleveraging is accelerating, not decelerating. So what's the tone and rhythm of the broad economic income being generated to allow this process to continue? Moreover, just what does it tell us about how this process of deleveraging will one way or another be accomplished - debt paydown or debt default? At least so far in the current cycle, it has predominantly been the latter, not the former. And this absolutely speaks to the ability of the economy to commence fresh credit acceleration, the veritable and longer term life blood of the US economy.

Let's get to it and start with a look at one of the data points we believe to be most important in the current cycle. In the chart below we're having a quick peek at the year over year rate of change in personal income excluding government transfer payments. In essence, we view this as reflecting organic economic stability and growth. Can we characterize it as "core" income? We think so. You know that the Street is expecting payroll growth very soon. We know the census hiring will spike the headline payroll numbers in the months directly ahead. We'll already start to see it with the March number. The household survey is improving and it leads the headline numbers. Moreover the initial and continued unemployment claims data have been trending down, but emergency unemployment benefits rolls remain substantial. Therefore, we believe looking at personal income stripped of government benefit payments tells a relatively pure story about what's occurring in the labor markets. And this is what we see both currently and over the last half century.

Even as of recent data, the year over year change in income is below anything seen in any prior cycle with the exception of the mid-1970's. And remember, we're now comping against labor market Armageddon in the early part of 2009. And even against that we can't print a positive comparison yet.

We believe the following table is pretty important stuff from the standpoint of comparing the change in the US economy and labor markets over the last half century. It's a bit convoluted, but here's what we've done. Again, all the data is personal income numbers stripped of government benefits. We're marking each recession end and then rolling the tape ahead nine months. Why? Well, theoretically the most recent US recession ended in the June 2009 quarter. The second column in the table shows us the percentage growth in personal income excluding government transfer payments nine months after each official recession conclusion. And the final column to the right documents the percentage gain in the income numbers we are using relative to the prior cycle peak in personal income less transfer payments. As you would imagine, at all official recession conclusions income still remains depressed to a point. Have a look.

The numbers pretty much speak for themselves, no? You bet they do. First, we've never experienced a decline in personal income stripped of government transfers nine months after an official recession conclusion until now. Even the prior two cycles characterized as "jobless recoveries" witnessed income growth without government assistance. Not this time. But of course it's the final column that is the eye-catcher. The prior cycle peak in personal income less transfer payments occurred in September of 2007. Of course in the clarity of hindsight that coincided with the prior cycle peak in equities with near perfection. Yet still today two and one half years later, this measure of absolute dollar personal income stands 7% below that level. What does that translate to in dollars and cents? Personal income less government transfers today remains $700 billion below the prior cycle peak two and one half years ago. Never have we experienced anything like this. Now do you know why we've seen extension after extension in unemployment benefits? Of course you do. This is about as far away from "normal" economic cycle experience as we can imagine.

The next little table is really more an FYI than not in that it recounts the fact that over this same period the general cost of living for households has continued to move in one direction - higher, with clear variability in specific costs.

This clearly begs the question as to how households allocate income in the current environment and looking forward. The government has been the plug factor for households in terms of total income availability over the last few years. This has allowed households to cope with higher costs of living. But the deleveraging issue still looms large as the household deleveraging cycle remains perhaps mid journey at best. This also raises the question of household discretionary spending strength in the potential absence of government benefits. Anecdotal evidence tells us the recent "surprising" rise in retail/consumption has been driven more by the high end demographic than not. Why? The high end is more levered to improving equity prices than any other wealth demographic.

The following chart and table will be our guides as we move ahead. The chart looks at the year over year change in government social benefits. Here's the key issue. We've marked each official recession with red bars. As is self obvious, the year over year rate of change in government social benefits has peaked right at the end of each recession virtually like clockwork.

We try to quantitatively represent this historical rhythm in the table below as we look at each recession conclusion and the quarter in which the rate of change in government benefits peaks. As you can see, most are simultaneous. Not this time. Not yet, anyway.

The only two standouts are the post 1991 recession and the current period. But again from the data above, personal income was growing in the post 1991 recession and was very near the prior cycle peak nine months after that recession officially breathed its last. That's not true in the current cycle at all. Not even close.

The next two charts we'll roll through in brief. Total personal income in the US is primarily driven by wages and salaries, certainly government benefits on a cyclical basis, and by interest income and employer "supplements" (think benefits). A very quick look at the current character of the interest income portion of personal income. The fact that we are still in the land of year over year negative territory should be a surprise to absolutely no one given the rhythm of interest rate movements over the last year. And of course from an historical standpoint we'd expect nothing less in a generational low interest rate environment.

Would the Fed nudging rates up a bit actually help personal income circumstances Stateside? From a very narrow perspective, yes. But of course nudging rates would tamper with the almighty carry trade and hurt badly the exact highly levered players the Fed and Treasury have acted so ferociously to save over the past few years. As we have mentioned in the past and believe this set of circumstances exemplifies, increasingly monetary policy choices are narrowing and fast.

Finally, the component of personal income that is employer "supplements". We've chronicled this before. We're looking at near generation lows in the rate of change in employer benefit costs. We do not expect this to change voluntarily any time soon, although the healthcare bill will ultimately raise the deficit, and there is no need for this to happen from an employer perspective given true unemployment/underemployment conditions of the moment.

In a bit of short summation, without question wages and salaries are the singularly largest component of personal income, as is seen below. Proprietors income is really driven by small businesses and supplements are clearly part of greater household "income" defined broadly. For now, the government has been the plug factor in the greater household income gap since the third quarter of 2007. Direct government transfer payments are up close to $500 billion over this period.

Monitoring personal income is simply a must do exercise in terms of taking the ongoing "temperature" of the real US private sector. Personal income is the key to consumption and the key to the deleveraging process. Finally, you probably saw the relatively dramatic Employee Benefit Research Institute retirement poll that was released a few weeks back stating that 47% of the folks polled had saved less than $10,000 for retirement. No worries, 27% had less than $1,000. Again, a good bit of headline melodrama. As you know, we have not even brought up the term savings in the entire discussion. But we will just ahead. Again, the character, tone and rhythm of changes in personal income circumstances is critical as we move ahead. Critical to the real economy. For now, Wall Street is still gorging on the Fed sponsored liquidity feast of a lifetime. It simply is what it is. And there is nothing wrong participating in that as long as we are able to identify the reality of what is driving the real economy and financial asset prices at any point in time. We hope that as long as we can see this reality, we can all the better manage risk in investment decision making. As Matt Damon, as Jason Bourne, remarked in one of the Bourne series of movies, the first thing he did when entering a room was to become immediately aware of the location of all of the exits. Absolutely applicable to the risk management process in the here and now.

Saving Grace?...Boy, we'll see. As mentioned above, yes, personal income in the current cycle is important in terms of gauging the rhythm of both consumption and balance sheet deleveraging, as well as attempting to "save" for boomer retirement purposes. A last set of relationships to quickly ponder tied to what we discussed above that we believe are crucial to real economic outcomes ahead, but of course will have little to zero impact on financial market outcomes near term. The short term is certainly important, but our feeling is that the macro in the current cycle is crucial to investment survival.

As we tried to explain last month, we are absolutely convinced that there is little to no chance the Fed can stop printing money and/or the government stop borrowing and spending until private sector credit turns positive and accelerates. Either the private sector borrows or the government does. Either the private sector borrows and effects money supply expansion, or the Fed carries the load. We believe it really is as simple as that. We know that up to this point monetary and fiscal policy has been unequivocally aimed at trying to restart the credit cycle and inflate household assets. Cash for clunkers and the home buying tax credit were framed to get folks to borrow for homes and cars. Great while it lasted, right? But what about an encore? We believe this restarting of the credit cycle is key to real economic recovery or otherwise near term, unless of course monetary and fiscal stimulus is limitless, which we all know it's not and increasingly comes with very meaningful longer term consequences with each passing day. So far, the Fed has failed at restarting private sector credit expansion and getting the money supply to grow, but has been very successful at inflating financial asset prices.

The first chart below shows us what we believe is the very important linkage between household asset values, household income (that we discussed above) and the greater household credit cycle. Right to the bottom line, we believe this relationship shows us that when household assets are inflating faster than household income, households are much more likely to leverage up than is the case otherwise. This is exactly why the Fed is hell bent on reflation - it's the only way to restart the credit cycle! And if that means stocks since real estate is turning out to be the immovable object, then so be it. The blue bars we marked in the chart depict those periods where household net worth (asset values) were not growing in excess of income and low and behold these were also the exact periods where household debt relative to GDP laid flat. Moreover, as we see the numbers and interpret the chart, it's the asset inflation relative to income that leads the leverage expansion. This is the key point. And this is exactly why the Fed is trying to reflate stocks because they already know real estate is a non-starter and will be a further drag.

Of course the early part of the last decade watched the household net worth to income ratio decline, but leverage was just starting to skyrocket as cheap mortgage credit laid the seeds for the next asset and leverage bubble. So fast forward to the present where net worth to income has descended to average levels of the last three to four decades (as we showed you last week) and personal income is under pressure exclusive of government transfer payments. Unless the Fed can massively inflate household assets from here, the chances of starting another household credit cycle of meaning appear slim at best. Attempts to reflate housing have been a failure and will continue to be until the leverage is cleared, which is a long way off. That leaves equities as the inflation object of choice, as if you didn't know.

Finally, a look at the relationship between household asset inflation and personal savings. Important why? As a choice with available personal income, saving is clearly one alternative in addition to consumption and debt repayment. Healthy competition, no? We believe the chart below reveals the historical truism that the savings rate has increased during periods where household net worth relative to income has declined, and vice versa. This is exactly the directional relationship shown.

The net worth to income ratio is now back to the area that has seen average activity over the last half century. Gone are the twin net worth to income bubbles of the 1994-2008 period. And with this the saving rate has turned up with relative vigor. We're back in an area of net worth to income where at least pre-1994 we have seen the US savings rate in the 8%+ range. Is this where we are headed in the current cycle? Stay tuned. The bottom line is that this relationship tells us savings will be in serious competition with consumption and deleveraging for the household income dollar. A competitor that has really not been in the running for close to a few decades now. Maybe the 27% of the folks in the EBRI survey will double their retirement savings to $2,000. It would be funny if it was not so sad.

Enough. We know you get the picture. What the reality of personal income and household asset values tells us is that the current cycle is very different than anything we have seen in quite some time. Really in our lifetimes. Organic income growth has not yet been seen. We have a $700 billion personal income (excluding government transfer payments) chasm between current levels and 2007 prior cycle highs, not that it is preordained in the heavens that this gap must close. We also have a Fed and Administration fighting to the death to restart a household credit and asset inflation cycle using unprecedented means. We do not think they will stop voluntarily anytime soon. As a result asset distortions are a reality and again, it's ultimately the unintended consequences of these circumstances and actions that will be most important to longer term investment decision making. Watch out for incoming, okay?