Brace Yourself

KAL's Cartoon from the Aug 13th issue of the Economist sums up our current predicament. What we are facing today is not the prospect of a double-dip recession, it is the reality of a severe economic recession that was never properly addressed. Many of the culprits and conditions that bred the 2008 Subprime crisis continue today.

1. The developed world is experiencing an enormous debt overhang. Weaning off that debt, or de-leveraging, is a painful process. And contrary to what Republicans or Democrats would like us to think, it wasn't the other party's fault. It was the fault of both parties and there is plenty of blame to go around. Just take the Clinton administration for example, although he left us with a budget surplus, Glass-Steagall repeal also took place under his watch and that was a major contributor to the 2008 crisis, which in turn, required a huge bailout under Obama's administration. My only point here is that it took decades of mismanagement, political lobbying from financial firms and protected special interests to get us where we are today. That's just the tip of the iceberg. Frankly, the recent and unprecedented S&P of the US credit rating is a minor issue compared to the possibility of an actual default by any of the PIIGS. A Greek default could be absorbed by the EU, Spain possibly with alot more pain but Italy? That's a G7 nation.

2. So Greece has been bailed out and Italy will be rescued somehow. What does that solve? We've just kicked the can down the road a few years. These countries will never be solvent. A friend of mine was telling me how evading taxes in Italy was a national pastime. How will these countries ever run a surplus? The dependence on debt has become culturally entrenched in the Western world.

3. How much does the USA really owe? As a corporation the US would be a junk bond, the S&P's AA+ rating is rather kind. It owes $14.3 trillion and loses about $1.4 trillion every year. But this is where things get hairy, if we were to sum up long-term liabilities in present value, the US actually owes something close to $200 trillion, healthcare alone accounts for $80 trillion. The recent debt ceiling drama was purely political. The US has been bankrupt for quite some time.

4. USD is the world's reserve currency. A few days ago, I heard the perma-bulls over at CNBC argue that it matters not what the US owes because it is the world's reserve currency and can always find a lender or print it's way out of trouble. That's the kind of shoddy logic that has let us to this mess. Using debt to pay off debt or printing more money aren't permanent solutions. The first simply exacerbates the problem and the second, debases your currency.

5. The US government does not work. The brinkmanship, partisanship, irresponsibility or both parties in Congress should be evident to everyone by now.

6. It doesn't help that a large section of the country believes the government is the problem. Invoking Reagan, they remind us that "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help.'" I would argue that there are certain things the government is better at doing, such as providing public goods without a profit motive. Why must every thing generate a profit? Getting mad at Amtrak for losing money is like getting mad at the Marine Corps for not making money. But rather than searching for a better system, many have decided to work against any system.

7. Education or the lack of. The US spends more than anyone else in the world and is ranked 20th in the recent PISA rankings. Click here. While the US isn't anywhere near No.1 for Math, Science or even Verbal, at the very least it's No.1 in one category--self-esteem, justified or not. How can any leading nation maintain an edge with sub-par education? This has resulted in the anti-intellectualization of America, science and factual knowledge have been supplanted by emotional superstitions. Sure, America continues to have some of the leading institutions like the Ivy Leagues, MIT, Stanford and Caltech, but go take a look at the engineering departments and see where the students come from.

8. What leadership? "...when faced with the greatest economic crisis, the greatest levels of economic inequality, and the greatest levels of corporate influence on politics since the Depression, Barack Obama stared into the eyes of history and chose to avert his gaze. Instead of indicting the people whose recklessness wrecked the economy, he put them in charge of it..." The full article can be found here.

9. Widening income inequality. John Steinbeck wrote that 'socialism never took root in America because the poor see themselves not as an exploited proletariat but as temporarily embarrassed millionaires.' However, it still amazes me that we've been unable to raise taxes on the top 1% of the population. The economic agenda for the factory line wage earner is no different than a corporate jet owner, even in a day and age where income inequality is at an all-time high. Click here.

10. Entrenched Interests. When I look at American politics, I do not see the world's greatest democracy at work, I see competing lobby groups channel their influence through the various Senators and House Representatives. The Supreme Court's Citizen's United decision has granted the same rights of an individual to a corporation. Corporations are now free to spend unlimited amounts of money to buy political decisions. Click here.

As an equity investor, I am deeply bothered. A widely accepted school of investing says that "buying and holding" with a diversified portfolio of stocks, with a heavy bias towards the US and developed markets, is the way to financial prosperity in the long-run. I've always accepted that as being a reasonable view but that has been dented by Ed Easterling's research, appearing in the recent NYTimes article here. It is very possible to buy and hold for decades and still come out with real losses if you get the timing wrong, and we all know market timing is virtually impossible unless you were Steve Cohen over at SAC Capital.

Today, the developed markets look more fragile than ever before. It is evident that debt-fueled growth, entrenched welfare benefits, combined with lax regulations and ineffective government are the reality. What is most worrisome is the lack of a political will to bring about any revitalization. The economic trajectory of the developed world is clearly unsustainable. We are in the midst of a tipping point, where the West may no longer be the Best. The complex and disruptive forces of technology and globalization have truly converged to bring about a new global paradigm. I am hesitant to raise China's hand as the victor, but we are seeing a seismic shift in economic power, opportunity and output from West to East. To deny that, seems delusional to me.

More practically, I've decided to slaughter the sacred cow of "buy and hold". I am waiting for the right opportunity to exit the equity market altogether. My sense is that Obama will have to do something that amounts to a QE3, propping up the stock market as housing prices and other assets deflate. I will keep you posted as I develop an alternate plan to preserving my net worth.