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Searching for Absolute Returns, Part 2


Long-term bear market lies ahead.

Editor's Note: This is the second part of a 2-part series. Part 1 can be found here.

The End Game

The US is in a deep recession, and soon the whole world will be. The US is going to try and combat that recession with stimulus on a scale never before attempted. It's a grand experiment. There's the theory that you can allocate stimulus and keep the velocity of money from falling, but once the deleveraging process starts, there's not much you can do about it: It's going to work its way through the economy. We're about to find out which theory is correct.

So, let's look at 3 possible outcomes, with the best result first. The basic optimistic assumption is that, while this recession is deep and the worst in the post-WWII era, it's still just a recession. Free-market economies eventually recover. Recessions do their work of reducing excess capacity, and the businesses that survive enjoy increased market share and potential for profits to rise.

And companies do indeed have on balance stronger-than-usual balance sheets going into this recession, except for most financial corporations. Another exception is businesses that were bought by private equity firms with large leverage, many of which will have to be restructured. And those with too much leverage or who were too aggressive with expansion programs will go the way of all over-leveraged flesh.

Besides, the optimistic scenario holds that the massive amount of stimulus being applied to the US economy is on a scale never before seen. It will work, just as an easy monetary policy has always worked. (Except in the '70s, but we won't make that mistake again. Paul Volker can stay in retirement!)

This scenario assumes that the psyche of US consumers has not actually been seared all that much, and that they'll return to their spending habits as soon as able. It also assumes this is a normal business-cycle recession: business as usual. There's been no fundamental altering of the US dynamic. Banks will start lending again, businesses and consumers will start borrowing, and things will get back to normal. Deflation is just some bugaboo that a weird coterie of economists and investment writers harp on to scare the children into behaving more rationally. It can't really happen here. And besides, the Fed can print enough money to make deflation go away. The real worry will be if they overshoot and inflation comes roaring back.

Problem # 2: Pushing on a String

The economy clearly let leverage run to an irrational level. You've seen the graphs. US debt to GDP is now over 300% and has risen precipitously in the last 10 -- and especially the last 5 -- years. Leverage and debt fueled the growth of the economy, but debt growth hit a wall and now the deleveraging process is the painful result. This brings us to the worst-case scenario: All the efforts of the Fed will go for naught and we're in a liquidity trap.
No positions in stocks mentioned.

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