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Economy Is Out of the Woods, But Into a Swamp


Watch out for sinkholes!

By all accounts, the global economy appears to be out of the woods. But, does that mean we're now in the clear? Perhaps the move out of the woods doesn't lead to a wonderful open field, but into a swamp -- a swamp of economic uncertainties and unresolved issues.

In a swamp, there are many sinkholes and other dangers waiting to bog down, and even submerge, the unsuspecting traveler. In our economic swamp, there are many such sinkholes, and none greater than the risk that the virtuous circle won't take hold.

The bullish case rests on this one primary point -- the virtuous circle.

Government spending begets inventory building, which begets consumer demand that provides a sustainable economy recovery. Without that last piece of the economic recovery, it's on to plan B -- more government spending. With a mountain of debt already on the governmental books, no one can predict how the world economy and the markets will react to plan B. What can be assumed, however, is that it won't be good.

Most traditional-thinking investors and investment strategists are banking on the virtuous circle. "Pent up demand," they say. "The profligate US consumers will return to their old bad habits," they state reassuringly. To this I say, "Yeah, maybe."

In an economy dominated by baby boomers -- who have witnessed the decimation of their nest eggs via wealth destruction, been unnerved by the stagnation and decline surrounding wages and employment, and harbor major doubts about social security -- it's completely understandable that many have gotten the memo that the best way to ensure their retirement future is to control what they can control, which is their spending and saving habits.

Nothing captures this shift toward greater frugality more dramatically than the enormous contraction in US consumer debt. The accompanying chart shows this quite clearly. Issued two days ago, the actual number, -$21.6 billion, far exceeded consensus expectations of $4 billion. Moreover, the prior month's data was revised downward from $10.3 billion to $15.5 billion. And this trend of exceeding consensus expectations has been underway for months, suggesting a gross misunderstanding by economists as to just how stressed consumers are.

Source: The Wall Street Journal

What the US consumers are engaged in via less borrowing is a very healthy repairing of their personal balance sheets. Overleveraged and concerned about their economic future, getting their personal economic house in order is a constructive course of action. And, herein lays the virtuous circle rub: In order for the US economy to achieve a sustainable recovery, consumers must rise to the occasion and spend.

On the assumption that the conveniently politically timed stimulus package kicks into high gear in 2010 and monetary policy remains highly accommodative (which it should be), it's reasonable to expect that US consumers will spend, but perhaps just not to the degree that the stock market anticipates with its generously optimistic valuation levels.

With a world economy still highly dependent on US consumers (now that emerging-market giant China has squandered its opportunity to use its massive stimulus package on more infrastructure projects), the end user dilemma that I wrote about on my blog several weeks ago remains the key cog in the virtuous circle's wheel of fortune.

Investment Strategy Implications

Before investors break out the champagne bottles to celebrate the return to normalcy, the key investment strategy decision has to be whether the virtuous circle will take hold. In this regard, I believe it's probable that some of this will come to pass. US consumers will exercise their desire to sate the pent up demand.

However, this is not likely to take hold to any significant degree until the employment picture brightens, wages show signs of not just stabilization but growth, and consumer credit contraction diminishes. All of which will likely not occur until well into 2010.

Until then, much can go wrong. The swamp's other sinkholes -- corporate top line growth, weak pricing power, the weak US dollar, regulation in key economic sectors, further polarization in Washington, and that unknown exogenous event that seems to occur around this time of the year -- could easily depress equity markets that have priced in no margin for error.

All things considered, a less than fully invested position is advisable. And an above average holding in gold is also advisable. In prior articles I have also emphasized the attractiveness of high yield bonds as an alternative to equities. At 10% to 13% yields (HYG and JNK, respectively), these ETFs offer an excellent alternative to equities.

Out of the woods? Yes. Into the clear? Not likely.
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