I don’t enjoy paying nearly $100 to fill up a tank any more than do people who are less fortunate than me. It is a tax those over-leveraged consumers don’t need as they face foreclosure and potential layoffs.

It's no surprise, then, that consumer confidence is plummeting to a 28-year low, with a distinct difference this cycle. In the recent past, cyclical lows in consumer confidence have been accompanied by cyclical lows in equities. But again, the unwinding of credit is something we have not seen the likes of since the 1930’s and it is my belief that consumer confidence will go down and stay down. The key takeaway from all of this is that unless the loans that the alchemists used to put together the esoteric garbage that resides on balance sheets of brokers and banks perform, the brokers and bankers (and other investors embroiled in this mess) will not perform either. The daisy chain has begun; the hurricane is approaching our shores. Since I operate under the principle of ‘you cannot be too cautious with other people’s money’, I'm as cautious as ever.

Inflation Adjusted West Texas Intermediate Crude (WTIC)

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(Copyright 2008 Bloomberg L.P.)

It's no surprise that oil crises have led to both recessions and lower stock prices. In the chart below, note that when oil rises dramatically, GDP growth slows or turns negative. Again, since this cycle is so unprecedented in so many ways, the economy is likely to stay weak for a protracted period of time. One of the big questions going around Wall Street these days is not if we are in a recession, but how long will it last and what shape will it take. Will it be a quick "V bottom"? I find this highly unlikely. A "W" bottom, or a "double dip," which some critics of President Bush find to be fitting? I don’t buy that either. The nastiest possibility is an "L-shaped" recession where we go into recession and stay in recession, much like the 1930’s experience here and the post-bubble experience in Japan. I'm not a proponent of that as well. I am looking for a sawtooth pattern where the economy drifts in and out of recession for many years until many of the excesses are wrung from the system. This should not be a great time for long only equity investing. Rather, an absolute return approach with capital preservation at the core, which includes credit risk avoidance for the most part.

Inflation Adjusted WTIC versus Quarter over Quarter GDP (Annualized)

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(Copyright 2008 Bloomberg L.P.)

Non Farm Payrolls versus Gasoline Futures

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(Copyright 2008 Bloomberg L.P.)

Inflation Adjusted WTIC versus S&P 500 Index

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(Copyright 2008 Bloomberg L.P.)

The stresses on the economy are really being felt with the price of gasoline heading north of $4.00 per barrel. The longer prices stay up here, in oil and/or unleaded gasoline, the longer the economy will have a drag on it, and the more pronounced the change in the consumer’s buying habits. There were points along the line, at $2 per gallon and then $3 per gallon, where consumers continued to spend. For the longest time, consumers were using their house as an ATM machine, then credit card usage spiked, and now finally, gasoline consumption is dropping, and dropping rapidly, We are now at the point that the vicious cycle has begun—when higher prices lead to less spending which leads to less job creation (or job destruction) all at a time when the consumer is strapped. This will likely make the recession more protracted than almost anyone believes. The chart below which plots unleaded gas against Non Farm Payroll changes says it all.

What is The Fed’s Next Move?

One thing is for sure. The Bernanke-led Fed has its hands full cleaning up after ex-Chairman Greenspan, who is slowly going from hero to villain. The Maestro certainly didn’t create the whole problem by himself, but his legacy likely won’t be what he had hoped for. I've been critical for years as the Fed from 1995-2005 was clearly targeting asset prices. Like they say, "You know you are in an asset-based economy when the stock market has more of an impact than the real economy does on the stock market." We are there for sure.

While Bernanke has been very imaginative in his policies, there is a sense of desperation in the air. I believe that the Fed will keep at it and simply try to slow down the unwinding process. Note the Federal Funds Futures graph below, which for the first time in a long while the market is pricing in a Fed tightening or rate hike by year-end. I'm betting the opposite way and will be adding duration and convexity to portfolios over the next month as I think inflation fears will switch to deflation fears; this is because we are in a period of debt destruction and periods of debt destruction are usually accompanied by bouts of deflation.

I don’t buy the theory that the falling dollar will result in skyrocketing rates as some do. The U.S. is certainly in trouble, but we aren’t alone—we may just be ‘the best house in a bad neighborhood’. We are all in this together and emerging markets, after a nasty correction, will likely lead the next economic leg up. Demographics, in terms of birth/death rates and deficits for as far as the eye can see are a miserable back drop for our economy. Had the Fed left the business cycle alone and not targeted asset prices, we likely would not find ourselves in this mess. If would be nice if we could just click our heels and make it all go away. It will take time and some pain to pay off all these debts. Longer than most "hopers" are hoping for.

Federal Funds Futures Curve

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Summary: It’s Time to Buy the Storm Shutters

Anyone that has a place on the beach in Florida or other hurricane-prone locales knows all about hurricane shutters. I had them at my beach place, but we always laughed that if a real hurricane hit, the shutters and the building would be swept into the ocean. One thing we never did was to tempt Mother Nature—we always take over "just in case."

Such is the environment now. While I would love to take loads of risk (like hanging out at the beach and hoping the hurricane misses me), I'm not. There are days, weeks and months that we're humbled by the market’s ability to shake off bad news. I think there will be four words that many will hope they had heeded—full faith and credit.

I even believe that while Fannie Mae and Freddie Mac (FRE) have an implicit guarantee from Uncle Sam (Ginnie Mae also has an implicit guarantee), I think that Fannie and Freddie, before it is all over (as their balance sheets may possibly be the worst of all as they soak up all the unwanted loans from defunct lenders and originators) will also have the explicit guarantee of Uncle Sam. What happens to the common shareholders is anyone’s best guess, but my thoughts are that the preferred shares are likely money-good (even though we have recently pared back those positions), the mortgage pools will likely end up like Ginnie Mae.

It is why I, in 99% of cases, do not take credit risk. In the first place, I don’t think I'm being properly compensated. In the second place, given what I know about the balance sheets of everyone from consumers to banks/brokers to the U.S. government itself, I find leverage and way too much of it. I'm humble enough to say that I could be wrong and the fears I have could be overblown, but that is something I can deal with. What I can't do is to recklessly take risk in the face of what will likely go down as the greatest unwind of our lives.

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