There are many doomsayers on the economy and markets. They all say roughly the same thing: we have been profligate as a nation and as a world, and there is a big price to pay. This price will be paid in the form of a very long period of economic stagnation and declining markets. The doomsayers give many seemingly sound reasons for their outlook, that to some may seem irrefutable evidence of a coming economic armageddon.

Unfortunately, history does not support their thesis. If anything, what economic history proves is that there is a wired-in persistence of growth in the economy. When we look at our financial surroundings on a day to day basis, we get confused by the noise. Daily, monthly, even quarterly data might seem to indicate some watershed change in the economic future. But the facts show us that year after year, decade after decade, the economy continues to grow very evenly and consistently. The markets will mirror this growth in the long term, and once all the daily noise is removed.

Here is a chart I prepared showing this persistence. It dates from the earliest Gross National Product data available on the government economic data website. It shows that even the 1930s disaster looks relatively benign in an 80 year perspective.

The conclusion: invest for the future, not the next day. And you will be richly rewarded for your patience.

Once again Doug Kass pens a Bearish take on the economy and markets. Once again, I must take exception to Kass’s assessment of the future. Where Kass and his brethren, such as Bill Gross, Mohamed El-Erian and David Rosenberg fail in their analysis, is in the idea of “this time it is different”. Every time I hear those five words, I know the opposite is true: “this time is the same as it ever was”.

Kass and the others contend that we will face “non-traditional headwinds” to the economy. This implies that most often the economy must deal with traditional headwinds, I guess. That premise is a fallacious idea from the beginning. No two economic crises are the same. Every event in my 50 plus year experience is different. And always, the economy recovers. Any so-called statistical “outliers”, or what are called by the Bears “black swans”, always mean-revert.

So too will it be this time. Housing prices which did dramatically diverge from long term price appreciation trends that roughly follow long term inflation, shot up in the early 2000's.  Then, as is normal for an overshoot, they have over-corrected to the downside.  Now they will revert to the old pre-2000 trend line. Credit creation which was excessive in the past ten years will return to a path dictated in the early 1990s. The same is true for every economic series. All revert to a long term mean that is determined by human behavior and the governing economic system, not by short term policy mistakes and resultant excesses.

Kass’s (and El-Erian’s) assertion that many of the “headwinds” are non-traditional, is questionable in the first place. In his most recent post titled “Bearish Arguments Are Roaring in My Ears” Kass, as is his wont, gave readers ten such headwinds. I will challenge several of the points he makes, that are in fact, traditionally part of an economic recovery, not unusual as suggested by Kass:

1.  That deep corporate cost cuts can’t be maintained to improve corporate bottom lines, and that top line revenue growth is required to continue profit growth; this is obvious and is a characteristic of every recovery, not just this one. To the degree that corporate managers have studied their history and have been much more aggressive and anticipatory in cost cutting in this cycle, it actually bodes very well for tremendous profit growth when revenue growth returns. Companies are very lean at this time and have very high operational leverage.
2.  That cost cuts “pose an enduring threat to the labor force”; while this may be true, it is not new. This condition accompanies every business cycle since the Industrial Revolution. Productivity improvement is constant and recessions provide the cover for corporate managements to reduce labor made unnecessary by productivity improvements. The economy adjusts and new more meaningful jobs are created to replace mundane or dangerous jobs displaced by advances in technology.
3. That the consumer entered into this recession with credit badly damaged and with a need to save and invest to replace lost equity; this is also true, though again is true in every economic cycle. There is always a de-leveraging accompanying a recession. Over-leverage, either operational (too much new production capacity) or financial is most often the reason for the recession. The increased savings resulting from a natural defensive reaction to a recession will most likely end up in equity investments with interest rates currently near zero. So, a return to savings and investing is good for the equity markets and will be good for consumer markets with an eventual return of the wealth effect.
4. Kass’ fifth point was that Federal monetary efforts are “experimental”; this is simply not true. They have been used in the past and were mostly innovated in the Great Depression. What is somewhat different this time was the magnitude of the monetary policy; but such a response was needed due to the magnitude of the credit contraction;
5. In Kass’ eighth point, he declared that fiscal stimulus to compensate for the recession (unemployment benefits, for example) creates a negative multiplier effect; How So? That makes no sense at all; to the extent that money is put in the hands of a consumer, then that money will multiply as it always does; putting money to consumers would never cause less spending by others in the food chain, this is just common sense; it might be inflationary at some point if the Federal government runs a deficit to fund the transfer; but that is an entirely different set of problems and inflation normally accompanies too much monetary multiplication, not too little;
6. Kass declares that “Municipalities have historically provided economic stability during times of economic weakness “, but not this time; again I challenge this assertion; it makes no common sense; municipalities are always challenged by economic downturns; revenue (tax) sources of all types see contraction and expenses for social services always expand to cover economic hardship (housing services, etc); Orange County, CA and New York City both experienced near-death during economic crises (1994 coming off the Mexican economic collapse for OC and 1975 during the 1974-75 recession, to name two high-visibility incidents);
7. And to Kass’ last point regarding higher marginal tax rates and the deleterious effect on consumption, it is unclear to me that the recession has anything to do with the potential for higher tax rates; with a more Democratic, “big government” Congress and Presidency, higher national taxes would have a high probability regardless of the economic backdrop; and the current recession pushes that eventuality back in time, if anything;

So, once again Kass, who is an otherwise special and thoughtful, even poetic commentator on the economy and markets, twists data points to build a case to justify his own Bearish position, rather than allowing reality to dictate his strategy, as he did back In March when he called the market bottom. There is enough real evidence to build a case for a conservative or neutral market stance. On the other hand, it takes a lot of effort to trump up or distort facts to try to make the case for a Bearish market scenario going forward.

A Mid-Year Checkup on some of Doug Kass' 2009 Predictions (made on December 31, 2008).  If he would review his own work from 8 months ago, he would not be so negative today:

2.  Housing stabilizes sooner than expected. President Obama, under the aegis of Larry Summers, initiates a massive and unprecedented Marshall Plan to turn the housing market around. His plan includes several unconventional measures: Among other items is a $25,000 tax credit on all home purchases as well as a large tax credit and other subsidies to the financial intermediaries that provide the mortgage loans and commitments. This, combined with a lowering in mortgage rates (and a boom in refinancing), the bankruptcy/financial restructuring of three public homebuilders (which serves to lessen new home supply) and a flip-flop in the benefits of ownership vs. the merits of renting trigger a second-quarter 2009 improvement in national housing activity, but the rebound is uneven. While the middle market rebounds, the high-end coastal housing markets remain moribund, impacted adversely by the Wall Street layoffs and the carnage in the hedge fund industry.

Comment:  This would have been a great idea to turn around housing; but it looks like housing prices are bottoming anyway, without much help from the Feds (I don't count the $8000 First Time Buyers program; way to narrow to have much effect);

3. The nation's commercial real estate markets experience only a shallow pricing downturn in the first half of 2009. President Obama's broad-ranging housing legislation incorporates tax credits and other unconventional remedies directed toward nonresidential lending and borrowing. Banks become more active in office lending (as they do in residential real estate lending), and the commercial mortgage-backed securities market never experiences anything like the weakness exhibited in the 2007 to 2008 market. Office REIT shares, similar to housing-related equities, rebound dramatically, with several doubling in the new year's first six months.

Comment:  Check out the REIT index and GGP; the Commercial RE market is recovering as Kass predicted with good benefits to banking and the economy;

4. The U.S. economy stabilizes sooner than expected. After a decidedly weak January-to-February period (and a negative first-quarter 2009 GDP reading, which is similar to fourth-quarter 2008's black hole), the massive and creative stimulus instituted by the newly elected President begins to work. Banks begin to lend more aggressively, and lower interest rates coupled with aggressive policy serve to contribute to an unexpected refinancing boom. By March, personal consumption expenditures begin to rebound slowly from an abysmal holiday and post-holiday season as energy prices remain subdued, and a shallow recovery occurs far sooner than many expect. Second-quarter corporate profits growth comfortably beats the downbeat and consensus forecasts as inflation remains tame, commodity prices are subdued, productivity rebounds and labor costs are well under control.

Comment:  Kass needs to drink his own Koolaid (nutritious), not that of the Ultra Bear crowd (poison)

5. The U.S. stock market rises by close to 20% in the year's first half. Housing-related stocks (title insurance, home remodeling, mortgage servicers and REITs) exhibit outsized and market-leading gains during the January-to-June interval. Heavily shorted retail and financial stocks also advance smartly. The year's first-half market rise of about 20% is surprisingly orderly throughout the six-month period, as volatility moves back down to pre-2008 levels, but rising domestic interest rates, still weak European economies and a halt to China's economic growth limit the stock market's progress in the back half of the year.

Comment:  Not optimistic ENOUGH; First half was right on, but 2nd half looks to be better than Kass' "surprise"

6. A second quarter "growth scare" bursts the bubble in the government bond market. The yield on the 10-year U.S. Treasury note moves steadily higher from 2.10% at year-end to over 3.50% by early fall, putting a ceiling on the first-half recovery in the U.S. stock market, which is range-bound for the remainder of the year, settling up by approximately 20% for the 12-month period ending Dec. 31, 2009. Foreign central banks, faced with worsening domestic economies, begin to shy away from U.S. Treasury auctions and continue to diversify their reserve assets. By year-end, the U.S. dollar represents less than 60% of worldwide reserve assets, down from 2008's year-end at 62% and down from 70% only five years ago. China's 2008 economic growth proves to be greatly exaggerated as unemployment surprisingly rises in early 2009 and the rate of growth in China's real GDP moves towards zero by the second quarter. Unlike more developed countries, the absence of a social safety net turns China's fiscal economic policy inward and aggressively so. Importantly, China not only is no longer a natural buyer of U.S. Treasuries but it is forced to dip into it's piggy bank of foreign reserves, adding significant upside pressure to U.S. note and bond yields.

Comment:  Right on with 10 year Treasury

7. Commodities markets remain subdued. Despite an improving domestic economy, a further erosion in the Western European and Chinese economies weighs on the world's commodities markets. Gold never reaches $1,000 an ounce and trades at $500 an ounce at some point during the year. (Gold-related shares are among 2009's worst stock market performers.) The price of crude oil briefly rallies early in the year after a step up in the violence in the Middle East but trades in a broad $25 to $65 range for all of 2009 as President Obama successfully introduces aggressive and meaningful legislation aimed at reducing our reliance on imported oil. The price of gasoline briefly breaches $1.00 a gallon sometime in the year. The U.S. dollar outperforms most of the world's currencies as the U.S. regains its place as an economic and political powerhouse.

Comment:  Wrong; stronger oil pricing than expected; no violence required;

11. State and municipal imbalances and deficits mushroom. The municipal bond market seizes up in the face of poor fiscal management, revenue shortfalls and rising budgets at state and local levels. Municipal bond yields spike higher. A new Municipal TARP totaling $2 trillion is introduced in the year's second half.

Comment:  Wrong; stronger economy than anticipated; (he cheats a little here with surprises in both directions, so that at least some of them will be right!)

12. The automakers and the UAW come to an agreement over wages. Under the pressure of late first-quarter bankruptcies, the UAW agrees to bring compensation in line with non-U.S. competitors and exchanges a reduction in retiree health care benefits for equity in the major automobile manufacturers.

Comment:  Right on

15. Focus shifts for several media darlings. Though continuing on CNBC, Jim "El Capitan" Cramer announces his own reality show that will air on NBC in the fall. At the time his reality show premieres, he also writes a new book, Stay Mad for Life: How to Prosper from a Buy/Hold Investment Strategy. Dr. Nouriel Roubini continues to talk depression, but the price of his speaking engagements are cut in half. He writes a new book, The New Depression: How Leverage's Long Tail Will Result In Bread Lines. "Kudlow & Company's" Larry Kudlow proclaims that it's time to harvest the "mustard seeds" of growth and, in an admission of the Democrat's growing economic successes, officially leaves the ranks of the Republican party and returns to his Democratic roots. Yale's Dr. Robert Shiller adopts a variant and positive view on housing and the economy, joining the bullish ranks and writes a new book, The New Financial Order: Economic Opportunity in the 21st Century.

Comment:  Funny comments on Nouriel Roubini; I bet he isn't even getting 1/4 of his price late last year

20. The Middle East's infrastructure build-out is abruptly halted owing to "market conditions." Lower oil prices, weakening European economies and a broad overexpansion wreck havoc with the Middle East's markets and economies.

Comment:  He was pretty close on this as the infrastructure projects were shut down in the first quarter, but are already coming back;  this is a good reason to own FLR;

Reflation. It is a very provocative concept. We all know what is meant by the term Inflation. It is almost intuitive because we have lived with it all of our lives. Those of us over 40 have a special affection with that word as we experienced the 1970s and some of the worst that inflation can bring.

But few of us have a good idea what is meant by the term reflation. Whether we should embrace or fear it. My way of looking at reflation is to "fill the hole" left by the deflation caused by housing, stock market and other financial asset price contraction. All that asset value had to go somewhere. The assets underlying value didn't just disappear, though much of the derivative paper might have.  Assets were revalued by a mass panic of the entire American and global population. But this was a psychological phenomonon, and so it can be reversed.  It is quite possible for assets to regain their previous value with some encouragement.  That encouragement comes in the form of reflation and what it encourages: the "animal spirits" of the market place.  Until we find asset price recovery through the process of reflation, diminished values will wreak havoc on the economy through slashed consumption, falling corporate and tax revenues, declining profits and higher unemployment.

Reflation is made possible by the expansion of the monetary supply, offsetting money supply reduction that occurs from asset price contraction. But it is an indirect offset. If my house was worth $600,000 in 2007 and is now worth $400,000 in July 2009, to reflate the economy the government doesn't just send me a check for $200,000 (though a case can be made for doing just this ala "Helicopter Ben"). Rather, monetary expansion trickles through the economy: first to bolster the banking system where it originates from programs like TARP and TALF, then through Federal "stimulus programs" that eventually (belatedly?) result in a "Cash for Clunkers" program, and finally to home owners through firming home prices and higher wages with economic expansion and increasing demand; all from the proverbial "thawing" of a frozen credit system enabled by backstopping the banking system.

But reflation comes with a price, and it is political, not numerical. Because reflation originates within the Federal government (the Federal Reserve Banking system and the Treasury), the only entity which can legally create money from nothing, it comes with plenty of strings attached. Those strings will be pulled by the majority political power, Democrats at this point in time. The party in power will seek to use economic reflation policy to achieve social policy and, in the case of liberals, a redistribution of wealth. Whether one agrees or disagrees with a specific policy or program,  it is beside the point. The point: because there are strings attached, reflation through fiscal policy or monetary means there are conditions that are inefficient and carry plenty of future baggage (entitlements).

Bill Gross wrote about our economic reflation policies and what it means for our economic future. In his eyes, the future is none too optimistic. Bill Gross suggests we are doomed to many years, perhaps decades, of below trend economic growth, his "new normal". Those of us less than 70 years old, who did not experience life during the 1930s and 40s, will probably need to recalibrate our expectations.

I personally take exception to the characterization of 3% Nominal GDP growth, as Bill Gross forecasts, as being a "New Normal".  Such a growth rate is an aberration and would mean perpetual recession. It is actually an old normal at a time of zero or negative inflation, like right now when Nominal GDP equals Real GDP.  Rather, 3% "real" growth in a mature economy like the American, is an "old normal"; more like the economy of the 1950s, 60s, 70s and 80s, on average. In fact, the Real GDP expanded by an average of 3.45% between 1951 and 2004. It is important to look at "REAL" data as it strips out the effect of inflation, which was pronounced during the latter half of that range.

In Bill Gross' words:

Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.

Gross goes on to make the point that we can't expect to see 5% Nominal GDP growth as we did in old normal times.  But his point doesn't make much sense as it was actually much higher on average in the past 50 years.  Even at face value, his statement begs the question "what part of that nominal GDP  will be inflation?"

I expect we will actually see moderate inflation once reflation has been achieved.  It is the natural result of successfully reflating the economy and having it run at productive capacity and full employment all while running a Federal fiscal deficit to fnance reflation policy. Because full employment (around 95% of the workage population) is a Federal policy goal, and because the Feds have the means to control reflation (monetary expansion), I expect this goal to be successfully met.  So, we can therefore expect moderate inflation once stability is achieved.

Bill Gross concludes his August 2009 newsletter by making the case for 3% Nominal GDP for the forseeable future:

A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.

Yes, I suppose a 3% Nominal GDP would have the effects described if it were possible.  But the PIMCO scenario is highly unlikely and Gross' reasoning is flawed in many ways.  If we are  indeed in a period of lower interest rates, then P/Es will not contract but will likely expand.  P/Es run inverse to the Treasury Yield Curve, the infamous Greenspan "Treasury discount model".    So, low interest rates should result in higher stock prices once stability returns to the economy.  However, I believe we will see higher interest rates once the economy is reflated and the economy stabilized.  This will result in attenuated economic growth of around 2-3% Real GDP, plus an inflation rate of 5% which will cause Nominal GDP to run above 7% as opposed to the 3% forecast by Bill Gross.  American Nominal GDP ran between 7 to 13% during the late 1970s, a period of anemic economic growth (real), large fiscal deficits and moderate to high inflation.  Even in 1981, during a severe recession, nominal GDP grew by 4.4% due to the high embedded inflation.

Like Gross, I do worry that the "strings attached" to reflation policy will "substantially change the character of the American capitalistic model".  But political pressure from the right should counter the most extreme of what the left has to offer.  We already see evidence of this in respect to nationalized medicine and "cap and trade".  So, even this concern of Gross' is overblown.  Another threat comes from foreign interests who might not want to help America reflate by continuing to buy Treasury bond issues that support monetary expansion / quantitative easing.  But I think these foreign entities (China, India, Oil Nations, etc) see that it is their own self-interest to reflate the American economy and rekindle its consumer sentiments.

I think Mr. Gross has fallen prey to his shifted paradigm of a "New Normal". His position does not take into account the resultant moderate inflation that must naturally  follows a reflationary policy.  We can expect inflation in 2012 and after of perhaps 5 to 7%. This will result in a Real GDP that is negative if we sutract inflation from the Nominal GDP forecast of 3% suggested by Mr. Gross. Zero or negative Real GDP is not consistent with full employment and will not be tolerated by our political process.  So it cannot happen for an extended period of time invalidating the PIMCO argument. I suggest the PIMCO triumverate re-examine their assumptions.

Bill Gross August 2009 Investment Newsletter

This severe recession (Great Recession?) has given life to the isolationists among us in America. I see more and more calls on our President and Congress to close our borders to protect jobs. This happens everytime unemployment rises, but becomes fever-pitched when it approaches 10% as it does right now. I feel compelled to provide the reasoned arguments against protectionism.

The primary point against isolationism is that business is now global. The internet has seen to that. The jingoists among us will just need to deal with the fact that this ball of yarn can't be unwound. If the Iranian and Chinese governments, with their lack of Constitutional protections for their citizens, can't stop the Internet, most certainly neither can Obama nor our Congress.

The study of economics reveals that first, in the 1700s, Adam Smith through his "Invisible Hand" analogy theorized that labour would be directed to those who can do the work best (at the lowest total cost). Half a century later and building on Smith's work, David Ricardo developed the "Principles of Political Economy", and introduced the theory of "Comparative Advantage". According to Ricardo's theory, even if a country could produce everything more efficiently than another country, it would reap gains from specializing in what it was best at producing and trading with other nations.

Here is a little background information on both of these seminal economists:

Adam Smith

David Ricardo

I would add a corollary: If a country is less efficient than another at producing a good, then most certainly it will reap gains by trading with other nations who are better (lower cost) at that task (China and India).