Update              “For where your treasure is, there will your heart be also.”—Matthew 6:21                   August 2008   

I’d Like to Know Where You Got the Notion!  (Part 1)

            More than ever, Americans conduct their lives (sometimes more than one of them) based on notions.  Having rejected both Faith and Truth, we live, love, spend, money, invest money, vote and make other choices based on what our notions are about the people or principles-and we use the second term loosely-involved. 

            Webster defines “notion” as: 1. An opinion or belief; 2. A mental image or representation: IDEA; 3. A fanciful impulse: WHIM…His dictionary defines “notional” as: 1.  Of, pertaining to or constituting a notion; 2.  Speculative or theoretical; 3.  Existing in the mind: IMAGINARY…

            That second work has particularly been exercised considerably in the last several years to describe the perceived value of those financial instruments known as derivatives.  AS many of you already know, the notional value of the various new-fangled wonders of the financial world- which have only now begun to play the role of “financial weapons of mass destruction” predicted for them by Warren Buffett, was recently approaching one QUADRILLION dollars before the inevitable small (so far) implosions began to occur.  These notional values perceived to exist in the trading either and therefore, perceived to represent real wealth-were relied upon for considerably more legitimate economic activities on the part of businesses and consumers alike.

            Sadly, this was neither aberrant nor unexpected behavior for those-whether professional investor or Joe Six-pack – who have long since lost their moorings.  Think about it:  some of the great crazes of recent years involve unabashed fantasy; but fantasies, which soon become confused with reality.  One can be whoever he or she wants to be via a simple My Space web page.  More recently, there are the phenomena of “avatars” on the Internet.  Here, rather than just creating one or more variations of your true person via words, you can have an alternative being, and, through it, live a fantasy, notional life apart from reality. 

            Notional communities even sprang up on the Internet in recent years; here, you could move to a “virtual community”, buy and later flip virtual real estate (but the REAL money), join virtual community groups and more.  It wasn’t just in the real world that there grew a housing bubble; such a thing remarkably even happened in one of many “notional” worlds!

            We could go on and on (and steal some thunder from assorted subjects for future commentaries) by talking about the seemingly endless notions apart from these few recent creations of man which have not only overtaken, but have become our faith and culture these days in America.  We won’t. 

            We will point out in this series of commentaries, though, some notions being clung to by the majority of investors which, we feel, will ultimately-like a few of the more extreme examples-be revealed for what they really are.  Hopefully, you will be among the first to discard these varied whims and, as the case may be, either run for cover or run for opportunity.

            We’ll start our “I’d Like to Know Where You Got the Notion” examinations here in Part 1 (with both thanks and apologies to The Huges Corporation for our title) by looking at one notions which appear to have changed recently: namely, those involving the U.S. dollar. 

NOTION – THE U.S. DOLLAR HAS BOTTOMED

Until an abrupt reversal and ensuing strong rally several weeks ago, it seemed that the value of the U.S. dollar knew only one direction-down.  With a currency in inexorable decline, rapidly rising inflation, debt dominoes beginning to fall and all the rest, it was beginning to look like we should take seriously a tongue-in-cheek suggestion of the Financial Times’ Guy de Jonquieres.  He quipped a while back that America should change the inscription on its rapidly devaluing currency from “In God We Trust” to “I Hope That My Redeemer Liveth” 

            Suddenly, though, the buck has been on a tear.  The overall U.S. dollar index has surged nearly 10% from its bottom in a scant few weeks.  Having touched $1.60 to the euro, the greenback has roared back to an exchange of around $1.47 to a unit of the common currency from across the Atlantic. What gives?  Has the dollar’s secular trend been broken?

            No.  But many have the notion that it has been.  And getting too attached to what they believe to be a new trend could be costly, if when the real fundamentals and reality reassert themselves. 

            The dollar’s rally has been built on, essentially, two legs.  One is the simultaneous correction in the prices of most commodities, and fall led by crud oil prices.  Thus, one has fed on the other; and traders have commensurately unwound some (or, by now, all?) of the excesses in both the dollar’s move and those of many commodities.  Second, with the headlines suggesting that economic growth has slowed markedly in both Europe (led by Germany) and Japan, the U.S. suddenly looks less bad than others.  So, at the least, the greenback is for now winning “…a contest of the ugly ducklings…whose data look least ugly”. As RBS Greenwich Capital’s chief international strategist Alan Ruskin put it a few days back. 

            Yes-Europe and Japan have also now stumbled.  But by virtually every measure, the U.S. economic and, especially, fiscal picture are far worse than others.  Only the notions to the contrary that have recently provided the excuse for the greenback’s bounce stand in the way of the inevitable resumption of the dollar’s woes.

            Let’s dismiss those notions one by one: 

            GDP Growth.  The German and Japanese economics both contracted slightly in the second quarter, and show little prospect of changing for the better soon.  Against this, the U.S. claims that GDP was up by an admittedly stimulus check bolstered 1.9% in the second quarter, following a revised 0.9% gain in the first.  Both numbers more than take the sting from a relatively paltry 0.2% contraction in last year’s fourth quarter and, in any event, compare favorably with the recent figures elsewhere.  Or do they?

            Almost everywhere we look, the statistics under these deliberately misleading headlines show a U.S. economy that has been contracting for a year now.  The accompanying graphics from the August 4^th issue of Investors Business Daily show some of this.  Joblessness has been steadily rising for all of 2008; indeed, if we calculated unemployment as do the more statistically truthful Europeans (to include long term unemployed, those who have stopped looking, prisoners and others) U.S. unemployment exceeds the euro areas.

            The Institute for Supply Management’s figures also have been at recession levels (below 50) for pretty much all of THIS year.  The figure for new orders in July was the lowest retail sales have been declining across the board in spite of the recent government “stimulus”, even at the Wal-Marts and other discounters.  Indeed, once one removes the price-fueled  “growth” in sales of food, gasoline and utilities, the truly horrid picture of our economic downturn becomes more manifest; a deepening recession also testified to by the growing volumes of unsold homes, new and used cars and assorted “toys” building up everywhere you look.

            So where’s the lie-in the GDP number, or in the rest of the above? No doubt you have already divined the correct answer.  America’s GDP figure is arrived at, in part, by using an absurdly-but intentionally inadequate measure of how much “growth” really is not growth in economic activity, but is instead the result of inflation.  Called the “GDP consumption deflator”, it is scarcely half of what merely the headline number for the increase in the Consumer Price Index (CPI) is; the latter now running at 5.6% over the past 12 months through July, and almost 8% annualized in the second quarter!  Even that number is suspect, as we’ll discuss shortly; but assuming for the moment it’s accurate, a use of a “deflator” closer to this more realistic number would-in the second quarter-have indeed showed a decline in inflation-adjusted GDP on the order of an eye-catching 3%.  That would be commensurate with the doldrums reflected in the rest of the above-but would put the dollar at too much risk.  Thus, the continued reliance on the notion of relative U.S. strength; a notion that will give way to reality in the end.

            The U.S. fiscal position- the federal government did recently fess up to at least some bad news.  It was announced that, due to a combination of factors-among them slower growth, the drain of the recent stimulus efforts and the first wave of bail-outs for troubled financial firms-the budget deficit for fiscal year 2008 will be approaching $500 billion.  Never fear, though, it’s for the eventual good and health of the economy and, in any case, is not as large (as a percentage of GDP) as the deficits of the Reagan years. 

            This is silly and misleading on two counts.  First, our leaders understate the effects on money markets of such a voracious customer for the world’s capital.  Ultimately, all of Uncle Sam’s borrowing needs-which will only grow now due to all the same factors as cited for this year’s number-will push up the cost of capital for everyone.  Indeed, a slowing world economy will additionally mean less dollars available from abroad to help support the Treasury market.

            Second, we also have here an example of the federal governments’ fuzzy math.  Since the mid-1980’s, when yet another economic formula was changed to mask our true state of affairs; we have received what’s called a unified budget deficit (or surplus for a few years) from Washington.  Among other things, this math takes the annual surplus being run by the Social Security Trust Fund and throw it into the “general fund”, to be replaced by an I.O.U.  Further, recent years have seen the feds keep ever more present and future obligations off budget; among them, some of the costs of the invasion of Iraq.

            Each week, Barron’s, among its many charts and tables of economic data, records the overall figures for reported U.S.  Treasury debt.  As of a couple weeks ago, you would find year-over-year rise of a staggering $627 billion!  With the admitted position of that now rising rapidly, we are probably a mere year or two from adding $1 trillion in acknowledged debt in a 12-month period.

            This explains why, in an answer to a friend’s question posed the other day, we view U.S. government bond yields currently as by far and away the most aberrant pricing of any asset class.  Anyone who based on the foregoing (and following) would loan money to Uncle Sam for 10 years at less than 4% interest deserves what he gets!

Inflation/Stagflation.  In his recent speech to the graduating class at Harvard, Federal Reserve Chairman Ben Bernanke protested that “This isn’t the 70’s” in relation to the current mix of an economic slump and rising prices.  He’s right; in some respects-were the government’s published statistics more truthful as they were back then-our cu8rrent predicament is already worse!  And to think that we’re closer to the beginning than the end of this great unwinding…

            The government’s admitted figures tell only some of the story.  Year-over-year, both import prices and producer prices are rising at double-digit rates.  The CPI is now up nearly 6% over the last 12 months.  Far from doing anything about the steady erosion of the dollar’s purchasing power, Bernanke only occasionally tries to talk tough, while throwing both gasoline and napalm on the proverbial fire.  One of the most hilarious headlines we’ve seen recently, in fact, was from this past Wednesday’s Financial Times, which read: “Fed United in Battle to Control Core Inflation”.

            At least here where published inflation rates are concerned, more people are starting to treat Bernanke and his colleagues with the derision they deserve.  We like what the Julius Baer International Equity Fund’s co-manager Rudolph-Riad Younes said recently, “The inflation index, to use an analogy, reminds me of a parent who invents Santa Claus for his children and then begins to believe the fantasy himself”.

            More and more, people will begin to lose their faith in Santa; and based on all the preceding and more they’ll take the U.S. dollar for what it is: The most fanciful notion of perhaps, all time.

            (Next: The notion that commodity prices have peaked.)

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