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Adam Hamilton

Adam Hamilton

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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Light in the Tunnel?

Have you ever had one of "those" weeks? You know, the ones where exquisite and carefully-laid plans are suddenly depth-charged by the uncontrollable vagaries of business and commerce.

I have to confess our week at Zeal leading up to today was one of those rare gems that help keep us humble and realizing that life and business are not quite as controllable as we wish. We were busy beyond all expectations this week helping consulting clients through critical junctures and working on our private newsletter. Alas, I am ashamed to admit that for the first time since I have been writing these weekly Internet essays that I could not scrape out the time to finish the essay I was crafting for today.

As such, rather than let everyone down who graciously seeks the pain of reading my humble rants week after week, I made the decision, with some trepidation and guilt, to publish a brief excerpt from the shiny new hot-off-the-presses February 2002 issue of our private Zeal Intelligence newsletter that was just sent out to our highly-valued clients this morning (February 1st).

For all of our wonderful Zeal clients, who I love and respect deeply, please accept my personal apologies for stealing a little of the thunder from the newsletter and throwing it on the Web. It was my decision alone and I bear all the blame.

For the legions of folks out there who steadfastly read these Internet essays but don't yet subscribe to our acclaimed monthly Zeal Intelligence newsletter, I sincerely hope you enjoy a brief glimpse into another side of Zeal.

An excerpt from the February 2002 issue of Zeal Intelligence

Light in the Tunnel?
Optimism is a noble human trait. Webster's defines optimism as "a tendency to look on the more favorable side of events or conditions and to expect the most favorable outcome". Who would not want to be an optimist? Not surprisingly, Wall Street remains ragingly optimistic about the US equity markets in 2002. Is it right? Have we really now turned the corner? Is that light up ahead in the tunnel?

The Object of Optimism's Affection
Optimism, like faith, is worthless without an object on which to shower it. Optimism and faith, in order to be real, must have a target. The CNBC crowd takes great pride in exercising its abundant optimism on the object of stock market indices. When the indices march likes bulls on parade, the equity optimists gleefully wax ecstatic. When indices plummet like a commercial airliner mortally pierced by a Stinger missile, equity optimists rationalize that surely it is only a very temporary swoon.

We have reached an exceedingly surreal crossroads of history where optimism, in general, is almost exclusively popularly defined as one's outlook on major equity indices. Amazingly however, there are actually other things in life than equity markets! While this heretical blasphemous statement would no doubt burn the ears of the perma-bulls, its core truth is unassailable. Optimism's warm affections can and should be poured out on other fronts.

We can be optimistic about our families. In the end, money and wealth are ultimately meaningless and all that truly matters in eternity is our relationships with people and with God. We can be optimistic about our own jobs and ventures, boldly moving forward to provide valuable goods and services to make the world a better place. We can be optimistic about the long-term US economy, which relentlessly grows decade after decade with great certainty. We can be optimistic about our country. Even with all its many flaws the United States of America still remains the greatest bastion of freedom and capitalism in the world.

The Branding of the Scarlet-P
Yet, quite paradoxically, if one is unabashedly optimistic about everything that really matters, but happens to be short-term bearish on the stock market at the moment, a noxious stigma is attached not unlike the tragic lepers of old. Like Hester Prynne in Nathaniel Hawthorne's classic "The Scarlet Letter", anyone who does not bow before the Sacred Alter of the Cult of the Perma-Bull today is forced to wear a big blood-red "P" over their heart.

What grievous and heinous crime did the "Scarlet P's" commit? The anathema of Pessimism about US equity indices' prospects in the short-term! Yet as contrarian investors we are psychologically prepared to trod the narrow road, far from the comfort and warmth of the investing masses, the mainstream mobs.

Want to find a real pessimist? Seek out the foolish Communists who somehow believe that capitalism is doomed to spectacularly collapse and never recover!

For those wrongly-branded Scarlet-P's by the fonts of bullish propaganda, popular social acceptance has little allure. The contrarians, virtually every single one of whom I have ever met is a mega-optimist at heart, only need to be right on their investments. The ultimate goal is not as shallow as fitting in at a cocktail party, but preserving and enhancing our scarce capital to build better futures for our families, our companies, our countries, and our world. To embark upon this mission, we need to analyze the economy and markets not through the potentially biased eyes of optimists or pessimists-falsely-so-called, but as unemotional realists.

The State of the Economy? Just the Facts Ma'am.
Recessions are no fun for anyone. Like all other investors, businessmen, and proud citizens of America, we eagerly scoured the horizons in January looking for tentative signs that perhaps the worst is behind us. Unfortunately, even outfitted with state-of-the-art night-vision goggles we could not discern the fabled Light at the End of the Tunnel that is so relentlessly heralded in the financial media today.

In a capitalist nation like America, the economy is ultimately driven by the insatiable quest for profits. The only way that US corporations can hope to earn money is by selling their wares, either goods or services. In addition, in a pearl of timeless wisdom carelessly cast to the swine in the fraud of the latest fleeting "New Era", companies not only have to make sales, but they need to sell their offerings at a profit. It doesn't take a rocket-scientist to realize that companies can't sell their "stuff" unless there is a willing buyer on the other side of every single transaction. The highly sought-after path out of the valley of recession can only be paved by spending.

From a macro-perspective, there are only three large candidates available to potentially open their wallets to spend money buying corporate wares to enable the economy to begin growing once again. In order of relative importance they are US consumers, US businesses, and foreigners. Without serious marginal spending from one of these groups, preferably consumers, the recession will languish and fester, blighting the American economy.

Et Tu, American Consumers?
As is oft-quoted, American consumers ultimately drive 2/3 of the overall US economy directly and indirectly. The hordes of American consumers constitute the largest single market on planet earth. Consumer spending is dependent on the job markets, consumer income, consumer debt levels, and the general emotional fabric undergirding a particular era, whether optimistic or pessimistic for the US economy.

With the December unemployment report kicking-off January with an official number rising to 5.8%, the jobs market doesn't look too hopeful. 2001 saw official job losses of 1.1m, the largest since 1982's 2.2m job rout twenty years ago. Economists are predicting that the unemployment rate will continue climbing to 6.1% in 2002, which would be the highest since July 1994, but that is probably a bit overly optimistic. In the 1992 recession, for instance, unemployment in the US reached 7.8%. In the recession before that, unemployment officially exceeded 10% for 10 consecutive months in 1982-1983!

Even Cult of the Perma-Bull High-Priest Alan Greenspan, speaking in San Francisco on January 11th, said that US unemployment will continue to rise throughout 2002. As more unfortunate Americans lose their jobs this year, they will obviously have far less to spend. Even more importantly, the continuing ubiquitous tidings of layoffs on the news each evening will eventually alter the psychology of those who are blessed with jobs, probably reining in spending.

Income Outgoing
Even for the vast majority of Americans who won't lose their jobs, income growth is still likely to stall in 2002. We are probably already seeing the vanguard of this development as the 2001 holiday season was the worst in 16 years. During October and November disposable personal income fell by almost $23b. Because many corporations instituted profit-sharing programs with employees during the boom, many Americans have come to rely on annual bonuses as a significant portion of their income. Profit-related compensation is expected to plunge $40b in Q1 2002. Consumer income is under siege.

Mega-Bull Market in Debt
Without income growth, the only way for Americans to increase their expenditures is to enlarge their already crushing debt burden. With heavier debt loads come many more problems, risks, and higher default rates.

Home mortgage debt has rocketed by $1.2t since 1999. The FHA reports that 11.4% of its mortgages were more than 30 days behind in payments in Q3, the highest since 1972 when the FHA began collecting data.

While overall consumer assets fell 4% since 2000, household debts rose 15%. In Q3 2001, household liabilities as a percentage of household assets reached a post-WW2 record high.

November 2001 witnessed a record increase in consumer borrowing, with debt leaping-up at a 14.6% annualized rate or $19.8b, following October's increased consumer borrowing of $11.2b. Economists had only predicted $4b! Of the massive November debt-ramp, $5.4b was for revolving debt including credit cards. First USA, the third-largest credit-card debt merchant, said its bad loans soared 43% from a year earlier to $3.6b!

Overall during the two months, consumer credit exploded up by $31b while personal income fell by almost $23b, an unsustainable trend.

Tragically, the debt culture of the American consumer is now so out-of-control that they are starting 'em young. The GAO reports that the average student now graduates with over $19k in student loans and almost $3k in credit card debt. People under 25 are declaring bankruptcy in record numbers. It is almost unimaginable that kids can get into enough debt trouble so young to already have a bankruptcy against their once-good names while under 25!

The black plague of gargantuan consumer debts is highly likely to overwhelm any fledgling US recovery. Typically in past recessions, American spending on homes and cars plummets going into a recession, and then soars as the recovery takes hold. In this strange moment in time, there has been no relent of consumer spending on big-ticket items!

Even with personal savings plunging to an all-time low of 0.2% in October, consumers continued to spend as if the recession never existed. For comparison, in the early 1980s recession the personal savings rate hovered over 11% for 14 months in a row, reaching 12.2% in November 1981. In the early 1990s recession, the savings rate reached 10.2% in December 1992. It strains credibility for Wall Street to happily claim that this current recession will suddenly end without a substantial increase in the savings rate as consumers retrench.

Deutsche Bank Chief Economist Peter Hooper agrees, "With a need on the part of many families to restore net worth after the huge stock market losses of the past couple of years, consumer spending is likely to be subdued with the personal savings rate rising." Unlike in past recessions, this time around Americans have built-up no cash reserves to aid recovery. Their actions suggest the worst is yet to come, that any light in the tunnel must just be swamp gas.

Robbing from the Future at Zero Percent
As we mentioned briefly in the December ZI, artificially-low manipulated interest rates have cannibalized future sales, creating a feast in Q4 2001 but most likely a famine in Q1 2002. The optimistic Wall Street economists are already predicting that we will witness the first decline in consumer spending in Q1 since Q4 1991's 0.8% pace contraction. Economy.com Chief Economist Mark Zandi, "A lot of sales were brought forward. People have recently bought a lot of cars and homes, so we've already witnessed large increases in consumption. Now, we'll see the commensurate declines."

Unlike the past recoveries of the early 80s and 90s that were driven by pent-up consumer demand for big-ticket items, the equivalent forces today have already been unleashed and expended yet the recession continues. In 2001 new home sales were 2.8% higher than in 2000, compared to an average 23% drop in the late-stages of earlier recessions. In 2001 car sales fell by 2% compared to an average 15% plunge in past recessions.

Real personal consumption expenditures surged at a 4.5% rate in Q4 2001 because of Greenspan's frantic manipulation of short-term interest rates. This has not happened in a recessionary quarter since Q2 1960, when growth hit 5.1%. During average recessionary quarters of the last five decades, real consumption growth averaged 0.4%.

Americans received a huge break in Q4 2001 with ultra-aggressive retail price-slashing, lower energy costs, and massive cash-outs from home-equity mining. Provocatively, this occurred in a typically lethal consumer environment of rising unemployment and slowing real income growth. American consumers are in deep denial but the realization of their plight is approaching. Until consumers retrench and begin saving and paying-down debt again like in a normal recession, we believe that the prospects of the American consumer riding to the rescue and smiting the recession remain quite bleak.

Fine Then, Bring on the Business Spending!
Unfortunately, the outlook for corporate spending is not much brighter than the dull outlook for the consumers.

Corporate spending is ultimately the result of current corporate profits and projections for future profits. By some measures, US corporations are slogging through the worst profit slump since the Great Depression of the 1930s. We discuss current corporate earnings woes in more depth a little later in this letter in our stock market thoughts. From any perspective which corporate earnings are scrutinized, there is little hope for a recovery unless consumer spending explodes to new heights.

Corporations are unlikely to use other sources to finance spending in the absence of profits. Corporate debt is rocketing just like consumer debt. Since 1994 it has increased by 85%, twice as fast as the US GDP growth of 42%. Corporate debt as a percentage of corporate assets stands at an all-time high. Last year alone, corporate debt increased by 7% even though three corporations had their credit downgraded for every single credit upgrade. Moody's reported that 2001 witnessed the largest drop in corporate credit quality since 1991.

These ill tidings are especially stunning in light of the lowest interest rates in four decades thanks to the Greenspan Gambit rate-slashing extravaganza!

In another derivative measure of slowing corporate activity, the national average for office vacancies rose to 12.3% in Q3, 1 in 8 square feet available for rent. Cities with large concentrations of technology companies including San Francisco and Seattle fared the worst.

US industrial production fell 3.9% in 2001, the first annual decline since 1990 and the largest since 1982's 5.4% drop. The overall US industrial capacity utilization rate fell to 74.4% in December, its lowest level since April 1983. Capacity utilization for high-technology manufacturers plunged from a highly-profitable 88.8% in 2000 to November 2001's loss-ridden record low of 60%.

Jeff Immelt, the CEO of the largest company in the world, General Electric, said on January 28th in a speech at Brussels, Belgium that the US economy is not likely to begin improving until 2003. Immelt said that analyzing past patterns of business activity in GE's many cyclical businesses leads him to believe that no recovery is imminent in 2002. Alan Greenspan himself said in January that business profits and investments "remain weak". US corporations are not in great shape on the profits, debt, and balance-sheet fronts and are unlikely to spend enough to lead a bold last-ditch cavalry charge to clear the path for a US economic recovery.

Foreigners Galloping to the Rescue?
With American consumers and US businesses facing lean times ahead, the only macro-source of buying left that is large enough to boost the economy is foreign spending. Unfortunately, this possibility faces at least one colossal stumbling stone, the vastly overvalued US dollar. Since the world's flagship reserve currency has run so high and far, as we discussed last month, it is prohibitively expensive for foreigners to buy goods and services in the United States.

The second largest economy on earth, Japan, is fighting very tough times of its own right now as is well-publicized and is unlikely to lead the world out of a recession while it languishes in an actual depression. Europe is stronger, but short-term recessionary forces are brewing in fair Europa as well. The US economy, due to the mighty dollar bubble, cannot count on foreigners for consumption spending, only investment in financial assets which ultimately do little to lift the real economy in these challenging post-bubble times.

No Spending Growth = No Recovery
While we would simply love to be short-term bullish on the US economy at the moment like the perma-bulls, as we hopefully surveyed the charred US landscape in January we discerned little in which to place short-term optimism. Long-term we remain wildly bullish on the US economy, the American people, and America itself, but in the short-term there are still enormous speculative imbalances and debt that must be squeezed out of the system before any meaningful recovery can commence. The recession fades not!

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