The jobs report this morning, April 2, was pleasantly neutral (not too hot and not too cold, but just right) Everyone agreed that the report showed the economy is making progress and the stimulus is working. The markets showed that at the open (bond and futures). There is really nothing to stop the market from moving up another 10%, now. But further out, there is a debate. Today that debate was led between Robert Barbera and Mohammed El-Erian.

Of course, El-Erian was pumping the "New Normal" paradigm of PIMCO. Barbera was maintaining his "Old Normal" posture, for which he has been an outlier the last year (there are a couple others like Mike Darda and Jim Paulsen, our local MN boy). The New Normal states that we are stuck in a stagnant recovery like in the 1930s with high unemployment and low economic growth. PIMCO has been whoring this idea for the past year. PIMCO led by Bill Gross, really thinks they have ALL the answers and everyone else is just wrong. But we have caught Bill Gross being wrong on interest rates in the past. No reason to think they are right this time.

Meantime, Barbera, like Paulsen, has been calling for 4-5% GNP growth this year (same as my call, by the way), with enough momentum to achieve "escape velocity". This is another way of saying the economy will not stagnate near no-growth, but will get back on to a normal cyclical track.

I agree with Barbera and my investing posture shows that. I believe we will get back on a positive economic track and for a lot of good reasons. I have maintained the only thing that can screw up the economy is the government making the wrong moves. But for demographic reasons, I think the Feds will be forced to make the right moves, even against the will of Obama.

Obama is an ideologue. He doesn't seem to care much what happens to the economy so long as he can socialize the country. He wants to "lift up the poor" on the backs of the rich. Unfortunately for him, that is NOT what most Americans want. They didn't want more of the Bush Jr. regime. They did want "change", whatever that means. Now they have found they are getting way too much change. The Dems will lose power in November and that will allow our economy to get back to the "Old Normal".

This is my take and for this reason, I am staying long.

Bill Gross and his PIMCO shop started using a term for our economic future that they term "the New Normal". I hate this term. It is the same thing as saying "this time its different". It is never different. The same old story is played over and over. The costumes might change, but the story's the same. It is a bit arrogant for the PIMCO shop to think they are the first to find this new thing.

Mario Gabelli and Bill Gross were on CNBC this morning at the same time. Mario made the point to Bill that the past 100 years saw a 4-5% annual appreciation in the stock market, so if we average 4-5% per year for the next 100 years, then it really is not so new, but is in fact quite an old average. Bill did not have a good rejoinder to this point. Score one for Gabelli. Gross and Gabelli also agree that a good manager can add a few points of "Alpha" to that average return. So, 7-8% is possible with good portfolio management, in a very low inflation environment.

What is really important, after all, is not the nominal return, but the real, or net of inflation, return. PIMCO is not projecting anything "New" here. In the very long run (hundreds of years), "Real Return" averages 2 to 3 percent. Gross is not saying that will change. What he says will change is nominal return which average 8-10 percent from 1929 to 2005. But this was also a period of higher than historical average inflation due to loose dollar policies in the 1930s and again in the 1970s. If inflation returns to its long run average of 2%, than the "New Normal" of 4 to 5 percent has an embedded 2 to 3% Real Return, which is the old normal. I am not sure why Bill Gross is making such a big deal about it.

"The new normal basically recognizes that we're in an economy that's de-levering and that we'll move to an average level that's lower than before," Gross said. "We're de-levering, loans are going to be less available…homeowners are going to have to put 20 percent down now, as opposed to zero."

The Federal Reserve is likely to keep rates at the same level for a while, because the economy would need to grow by nominal rates of 4 percent or 5 percent to prevent debt from destroying growth, Gross said. "They (the Fed) have to stay low because the embedded cost of debt (interest payments) in the economy is 6 to 7 percent," of GNP, said Gross.

This brings up an interesting quandary for many of the Bears who frequent the investing world today. Bill Gross, who many consider to be the world's leading private sector expert on the future of interest rates and bond prices, says they are staying low and must be kept low in order to achieve his "New Normal", Excess productive capacity and an emerging market with excess and cheap labor also suggest this future reality. Gross implies a long period of low inflation and low return.

This really undermines the Bear argument for high inflation and / or continued crashing of the markets (which is inherently deflationary; never really understood how the Bears expect high inflation and high deflation simultaneously, which underscores how weak is the Bear argument).

As a member of the "baby boom" generation (like Gross) fast approaching retirement, a low inflation environment, with historical 2 to 3 percent Real Return sounds almost ideal to me. I think I will like Bill Gross' "New (Old) Normal".

James Grant penned a commentary in the weekend edition of the Wall Street Journal (September 19, 2009).  James is always worth reading (Grant's Interest Rate Observer).  He has been a moderately bearish commentator for as long as I have been reading his work (10 years), most often in Barron's articles.  He has bemoaned the high consumer and national debt and the very low (even negative) personal savings rate in America.  For this, he has called for a weak dollar and higher interest rates for the past decade.

That he flys in the face of his brethren bears is of no small consequence to me.  Normally James Grant's perspective is closely aligned with so-called other "bond vigilantes" like Bill Gross at PIMCO and perma-bears like Bill Fleckenstein or Peter Schiff.  Those other dollar sellers / interest rate watchers are still looking for a flat to declining economy and dollar and moribund economy.  Grant really is making a departure from his club here, which is good because it is contrary.

He was early to call the stock market decline, as far back as 2005.  But this is news: now he sees it is time to become Bullish, if for the all the wrong reasons in his view.  James Grant is leaving the Bear camp (maybe six months late).   Here is an excerpt from his article.  Click here to read the entire piece from the WSJ.

Though we can't see into the future, we can observe how people are preparing to meet it. Depleted inventories, bloated jobless rolls and rock-bottom interest rates suggest that people are preparing for to meet it from the inside of a bomb shelter.

The Great Recession destroyed confidence as much as it did jobs and wealth. Here was a slump out of central casting. From the peak, inflation-adjusted gross domestic product has fallen by 3.9%. The meek and mild downturns of 1990-91 and 2001 (each, coincidentally, just eight months long, hardly worth the bother), brought losses to the real GDP of just 1.4% and 0.3%, respectively. The recession that sunk its hooks into the U.S. economy in the fourth quarter of 2007 has set unwanted records in such vital statistical categories as manufacturing and trade inventories (the steepest decline since 1949), capacity utilization (lowest since at least 1967) and industrial production (sharpest fall since 1946)......

.....By rallying, equities and corporate bonds not only anticipate recovery, but they also help to bring it to fruition. By opening their arms wide to such previously unfinanceable businesses as AMR Corp., parent of American Airlines, and Delta Air Lines Inc., the newly confident credit markets are implementing their own stimulus program. "Reflexivity" is the three-dollar word coined by the speculator George Soros to describe the dual effect of market oscillations. Not only does the rise and fall of the averages reflect economic reality, but it also changes it. One year ago, the Wall Street liquidation stopped world commerce in its tracks. Today's bull markets are helping to revive it.

I promised to be bullish , and I am (for once)—bullish on the prospects for unscripted strength in business activity. So, too, is the Economic Cycle Research Institute, New York, which was founded by the late Geoffrey Moore and can trace its intellectual heritage back to the great business-cycle theorist Wesley C. Mitchell. The institute's long leading index of the U.S. economy, along with supporting sub-indices, are making 26-year highs and point to the strongest bounce-back since 1983. A second nonconformist, the previously cited Mr. Darda, notes that the last time a recession ravaged the labor market as badly as this one has, the years were 1957-58 —after which, payrolls climbed by a hefty 4.5% in the first year of an ensuing 24-month expansion. Which is not to say, he cautions, that growth this time will match that pace, only that growth is likely to surprise by its strength, not weakness.

And that is my case, too. The world is positioned for disappointment. But, in economic and financial matters, the world rarely gets what it expects. Pigou had humanity's number. The "error of pessimism" is born the size of a full-grown man—the size of the average adult economist, for example.

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.

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