At the outset it must be said that, regardless of the day to day fluctuations of financial news, we are entering into unprecedented territory. What may be construed as long term planning may well be categorically different than medium term common sense.

The increases in the total federal debt outstanding are off of all known scales that we have a historical measure to compare against. In essence, the catastrophic toxic products that nearly imploded out financial system haven’t exactly vanished, as the chart below will make clear. As in a very large shell game, much of this highly problematic material has been shifted off of private books and on to public books.

One of five possibilities will ensure, or some politically expedient combination of the five.

1.    default on the debt (very low probability)
2.    debase the currency (high probability)
3.    massively curtail public spending (one can only cut so far)
4.    raise taxes (count on this one)
5.    experience such massive technological change that we can innovate our way past it

Chances are excellent that our political class will engineer a mixture of currency debasement/inflation, spending cuts, tax increases, and pray for a technological breakthrough. In other words, as for long term prospects, even if we do have a respectable recovery from the lows, as the folks at the Bank Credit Analyst are predicting, we will remain burdened with exceptional social, fiscal, and taxation problems, riding on top of demographic changes, that cannot be waved away with any known magic wand.

E-Commerce sales remain a relatively small component of the entire US economy, however we feel that they are a worthy leading indicator on one hand, and also a sign of the ways in which the consumer is moving away from the higher overhead brick-and-mortar economy to the more customized, flexible, and more deflationary economy of mobile capital and business structures.

Fascinatingly, real retail and food service sales are only about four times bigger that e-commerce sales at this point, and real storefront sales are quickly being overtaken by internet commerce. The difference obviously remains sufficiently great that one will not displace the other overnight. Having said that, e-commerce has advanced with remarkable alacrity, and the implications cannot be ignored. Soon the competitive dynamic of algorithmic pricing will displace and undercut a significant amount of that traditionally associated with face to face commerce. And that impact is likely to be disinflationary if not deflationary.

The employment cost indices make instructive viewing. Whether we look at the manufacturing, service, or private industry indices YoY, we see punishing deceleration in wage and salary gains, in line with earnings fall-offs through 2009. The great question that faces us on many levels is whether an inflationary surge that might well appear as a result of unsustainable debt will be, or could be, an effective index for private sector wage gains and sustainable retail price gains.

In the inventory to sales ratio we see a similar process of “inventory deleveraging” which is by no means merely a product of the last downturn; this is a structural change that clearly demonstrates the US economy moving closer to a just-in-time, lean run model. The move toward e-commerce suggests that this structural change will also reduce many job descriptions as the relationship between the consumer (don’t forget, this mythical being, in toto, accounts for about 70% of the US economy) and the seller removes one or more traditional layers of distribution and marketing.

So where does the estimable Robert Shiller and his cyclically adjusted price/earnings ratio fit into this picture? We tend to see the CAPE index, as it is sometimes known, as a kind of long term fair value estimator. Shiller ingeniously has taken the average of the previous 10 years of earnings as the denominator (hence the “cyclical” part) and compares his adjusted price to this long term measure of earnings capacity, instead of simply a quarter by quarter comparison of price to earnings.

We have made a minor, but we feel useful adjustment to Dr. Shiller’s calculation by instead computing the rolling ten year median earnings value and then drawing a line one standard deviation above the mean of the CAPE series and another line one standard deviation below the mean. We feel that this is a good estimate of the long term fair value band, or we might say, the not-emotionally-driven-by-panic-or-euphoria band.

We have also included this second chart which shows the long term average on the CAPE value from 1881 to present.

Our conclusion is this: at the moment the US equity markets are reasonably priced against long term trends and there could be an extended period where they perform acceptably. However, they are by no means historically cheap; one could say they are about fairly priced, and the market will be very sensitive to perceived inflation in the unfolding of the story.

As long as inflation remains tamed by disinflationary pressures, money will remain parked in the debt markets, and equities will be vulnerable to blips of bad news. There are no absolute guarantees, however, we do accept that there are vast amounts of capital forced to find a home should the economic landscape suddenly change.

As a final thought, we include this study of trends in federal debt maturities.

One can only rationally conclude that the disinflationary and pro-inflationary crosswinds will sooner or later interact with violent energy. Either large sectors of the US working population will find themselves trapped by an inflation that damages them as a social class, potentially producing an extreme and irrational political response, or there may be some novel form of social irresponsibility as the American governing class tries to finesse its way out of an impossible position.

The recovery we are embarked on has a schizophrenic quality about it; it is typical and it is anything but typical, the diseased roots have been cleaned out and the diseased roots remain very much in place, central bankers have matters in hand and central bankers are clueless, economics offers sufficient explanations and economics is in crisis.

We believe that the distinction between normal cyclic processes and deeper level long term processes will offer clarification. The hidden layers, one might say, are generally obscured from view behind (an often politically convenient) smokescreen of day to day and week to week noise processes which drive the media cartoons that pass for informed discussion.

To begin with, we must look at Total Public Debt, which unfolds in three acts. The first shows a rising debt through the eighties until the late nineties, until it began to slow and level off going into the 21st century. This was a period when the world was expecting a reduction in military expenditures and a globalized neoliberal trade arrangement.

When the attacks of 9/11 occurred, and the American project was suddenly recalibrated as the GWOT, the Global War On Terror, the public debt surged at about a fifty degree angle between 2001 and 2008. During this phase, the equity value of the defense sector increased fourfold, by 400%. There was a phenomenal boom in real estate. Credit became absurdly convenient and absurdly lax.

Oddly, very oddly, the entire credit for this seismic shift was given to innovations in the lending and loan securitization markets. No mention was made of the stimulative effects of ramping up a militarized economy which was, in effect, shifting future growth into present hot expenditure. We would argue that it was a combination of massive public borrowing during a low interest rate boom that produced the extreme overshoot in multiple asset classes in the late 2000s.

Then, with the collapse of the private sector in 2008 the Total Public Debt exploded by about 3 trillion dollars in one final vertical surge. With very little clear idea as to how this debt will be paid down, or even how the annual interest on this debt will be paid off.

Even at 3% per annum for the aggregate debt, we’ve got to come up with a 360,000,000,000, that’s three hundred sixty billion dollars per year in interest, for a very long time.  We’re basically sticking future American generations with a long term multiple hundred billion debt obligation to pay for the current generation’s missteps.

A phenomenal, unsustainable debt obligation that will hit us hardest precisely as the baby boom generation becomes most dependent on public solutions to long term health care problems. As it stands, the Congressional Budget Office has calculated that the United States will experience a significant output gap (enforcing deflationary pressures) between now and 2015. We believe that this problem has been greatly understated.

One critical factor not to be overlooked is the progression of the American demographic. In 1956 the future of the country was literally in its infancy, and following a long decline in the birth rate during the Great Depression and WWII, there was a massive population surge. This baby boom would define many of the dominant characteristics of both our economic operation and our cultural and political tastes throughout its life cycle.

As the Baby Boom outgrew its’ younger, more radical student phase in the Viet Nam era, with drugs, lifestyle experimentation and protest, and then embarked on adult concerns and a rightward drift in their political tastes, the financial culture of the United States also morphed from a Great Depression inspired risk averse way of thinking into the New Thing, which fetishised theories like the Efficient Market Hypothesis, Neo-Classical economics, Monte-Carlo simulations, Gaussian probability distributions, and the salutary effects of unrestricted capital flows.

The Baby Boom had grown into financial power and drifted away from its youthful political radicalism, slowly but surely into an airlessly dogmatic sense of the revealed truth, while retaining its elemental characteristics, what Freud referred to as Die Anlage, the “essential blueprint”, the idea that reality could be remade by the imposition of a theory. One could say that the fate of Cuba and the fate of a business school worldview had a common spiritual ancestor.

This generation would exchange radical theories of society for radical, very typically for that generation, academic ideas that were prized more for their elegance than their practical conformation with reality. This avaricious, indulged, entitled, theory and model loving generation would, combined with global changes in finance and technology, unleash the long wave that ran from 1982 until 2007.

The final denouement coincided with the beginning of the end of the Baby Boom driven cultural cycle and the  ascendancy of Generation X, the air pocket behind the Baby Boom, whose first major representative is Barack Obama. We feel that whatever his imperfections, far too much has been imputed to the person of President Obama, and far too little to the mass dynamics of one asymmetrical generation leaving the stage, with all of their self serving narcissism, with all of their sense of being owed, with their irresponsibility and shallow thinking, and being replaced by another generation whose worldview is based in a very different relationship to advantage and opportunity.

As of this writing, year 2010, the US population is yet again 10 years older, with the maximum age cohort from 45 years to 54, now in their positions of senior management and positions to direct policy. The absolutely essential point to grasp is that this generation will be in their last stages of public involvement within the coming decade and there will be a wholesale shift from the Baby Boom mode to the Generation X mode, of whom Barack Obama is but a stylistic harbinger.

There will be an accelerating shift toward health and medical expenditure, a much lowered interest in foreign involvements, and a phenomenal amount of debt outstanding.

We note with some alarm that the Dallas Fed’s in house measure of inflation and deflation pressures, the Trimmed Mean CPE inflation rate, which we take as a more reliable indicator as to what the Fed really thinks versus the popular CPI numbers that are sops thrown out to give talking heads something to mumble about, is diving quite nicely into deflationary territory.

Deflation implies staying put, real estate sells with less vigor when inflation isn’t there to justify price increases, the arguments for wage increases are less convincing, and yes, we’re stuck with an awful lot of debt to service. Inflation may ultimately reduce debt service real costs, but the path there as rates increase can get painfully expensive, painfully quickly.

The Fed, the Treasury, Congress and the President must feel as if they’re walking on a razor’s edge. Maintaining a slow, steady, low growth posture risks plunging into a deflation spiral and attempting to use inflation as a way of ultimately evaporating the debt risks a hyperinflation spiral. It will be exceedingly hard to find the Goldilocks wonderland that gave the late 1990’s their “end of history” quality. The 2010s are sure to be a “history is back, with a vengeance” epoch.

As we can see from the Rectified Unemployment chart (total unemployment minus five week and less), serious unemployment has just barely turned the corner, but we feel that this unprecedented destruction of work opportunity has been so cauterizing that it will leave scars on the public psyche long into the future.

2010, the year than began with a whimper and may leave with a bang.

First up, Iceland’s parliament, known as the Althing, has announced that it will make good on deposit guarantees…. quotes from their ministry of finance below:

“Yesterday evening the Icelandic parliament Althingi approved a legislation authorising a state guarantee for loans by the UK and the Netherlands to the Depositors’ and Investors’ Guarantee Fund to cover payment of mandatory minimum deposit guarantees to holders of savings accounts in branches of Landsbanki Islands hf. in those countries.

Adoption of this legislation marks the end of a difficult and protracted international dispute with an agreement providing for the equitable sharing of the burden of the lost savings deposits between the states concerned. The dispute has impeded Iceland’s relations with other nations and the issue has been the subject of heated and widespread controversy among the general public. The adoption of the Act was a difficult step for the Althingi. Resolving the dispute in this manner is regarded as a prerequisite for continuing reconstruction efforts which have been underway since the economic shocks suffered by Iceland in the autumn of 2008 and which have already made very significant progress”.
(Ministry of Finance, December 31, 2009)

We’ll take that as a good sign that the reconstruction of the post-crash economy is proceeding apace. Note, however, that a condition of relative stability is not the same thing as a full return to normality.

Goldman Sachs’ chief economist Jan Hatzius sounded somewhere between restrained and downbeat for the prospects of 2010 in the brief interview he granted the WSJ. See the interview here.

Our own chart study of inflationary expectations based on the data from the University of Michigan and published on the Federal Reserve’s FRED database shows a weak concern for inflationary processes taking hold anytime soon. Mind you, this isn’t a chart of actual inflation, but rather the prediction of inflation in the future.

Note also that the phase after the dot com meltdown until the credit crisis showed an accelerating belief that inflation would assert itself in the future. It is the expectation of future inflation that drives people to accumulate debt (as inflation reduces the cost of repaying debt, assuming you got a fixed rate loan), accumulate real estate and physical assets, and generates a general surge in “animal spirits”. For now, the inflation mind set appears to have fallen well below the trend of the past 25 years.

Anything else we might care to notice ? The map below – first published on Wikipedia and composed by Mike Sefras – shows an interesting situation with regard to US unemployment. There are regions with much worse than average unemployment – some which appear to be bordering on the true desperation conditions of a real depression mirroring the 1930s (black zones on map), other regions that appear to be in fairly good shape (light blue), and an equal amount of in-between zones.

The take home lesson is that the generalized state of misery that brings about massive collective action is absent in the US. There’s enough true catastrophe to get a certain amount of legislative change done, but not nearly enough for a grand social overhaul. This no doubt explains the long and contentious debates in the media and the political mechanisms where radical change and social stasis are in a tug of war for meme dominance.