The following editorial was published in Price Perceptions issue 1202 on September 22, 2001

Shift in Focus - Part I

The economy was already slowing before the attack on Wall Street. Following the attack, news organizations and the Federal Reserve made valiant efforts to fortify public confidence in the economy. As a result of those efforts, the Dow industrials lost only 685 points when markets reopened September 17. Although commodity markets have fallen since reopening, the decline has been relatively small and orderly. Have markets responded adequately to the potential impact of this historic event?

The physical damage and cost in human life is now well known. But, the impact on: consumers, business investment, and world trade is far from known. Instead of assuming that market reaction is nearly over, it is important to recognize that it may have only begun. The following observations and questions indicate the economy and markets are not likely to return to normal anytime soon...

  • Nearly everyone has seen video clips of airliners crashing into the World Trade Center. Although security has been tightened considerably, people are fearful of flying. But, a large segment of the pre-terrorist economy was based on vacation and business travel. Now, hundreds of conventions and business meetings are being canceled... Disneyland is nearly empty... Airport vendors are going broke... and, expensive restaurants report a collapse in business. How long will it take for people to regain confidence in traveling?

  • The terrorists will strike again in an unexpected way and place. The US cannot possibly defend against all potential targets. Public sentiment is currently positive and Americans feel relatively safe near home. Can positive sentiment be maintained after the next attack?

  • It took only a few days of grounding to virtually bankrupt the airline industry. Although a government bailout was approved in record time, can business pick up fast enough to avoid more bailouts? Why were airlines so undercapitalized? Are there other industries and businesses equally undercapitalized?

  • The Federal Reserve cut fed-funds by 50 basis points to 3%, the lowest level since 1994. The discount rate was allowed to fall to 2%, the lowest level since 1959. However, the stock market has continued to tumble. Why?

  • Government spending has ballooned in the aftermath of the attack. Economists say the budget deficit may soar to record proportions in months ahead. What will this do to the value of the dollar?

  • Consumers account for 65% of GDP. They were the primary support of the pre-terrorist economy. Will they continue to support the economy? Can military spending offset a loss in consumer spending?

  • This week the Commerce Department reported that July’s trade deficit narrowed to $28.8 billion. However, the improvement pointed to economic weakness rather than strength... Imports were down for the fourth consecutive month, confirming weakness in the US economy... More importantly, US exports dropped $2.1 billion from June, the largest monthly decline in history. This is a clear signal that weakness is spreading to foreign economies. What will happen to Asian and Latin American economies that depend on US imports?
Answers to the above questions are critical in analyzing tomorrow’s economy and markets. It is important to see that America’s focus is shifting from consumerism to patriotism... Instead of re-financing homes at new low mortgage rates, consumers are paying down debt. Instead of charging a buying spree on credit cards, they are beginning to save. Instead of buying a new car, they repair the old one. Conspicuous consumption is out - practicality is in.

We will begin a series of editorials designed to analyze the unfolding shift in focus and how it will impact markets. Growing uncertainty and volatility create risk... The key ingredient to opportunity in futures.

Bill Gary
CIS, Inc.

The following editorial was published in Price Perceptions issue 1203 on October 6, 2001
Shift in Focus - Part II

Until last year, we assumed economic growth would continue indefinitely. Sure, we realized some periods would be slower than others, but we held supreme confidence in the economic machine that has provided steady progress for more than two decades.

Our Federal Reserve chief, Alan Greenspan, was viewed as a miracle worker. He put the brakes on the economy when it grew too fast and stepped on the accelerator when it slowed. He was viewed as the genius that held inflation in check and interest rates low.

Our confidence in the economy grew so strong that the average American owed $8000 in credit card debt. We refinanced our homes when interest rates fell and used money saved on house payments to purchase new cars. Even those with dubious credit ratings were able to borrow 125% of home equity and use the proceeds to vacation in Disneyland. It was as close to an utopian economy as any in the history of man.

The new world of globalism opened foreign doors for investment and trade. It made our “information” economy more affordable and provided us with innovative electronics and luxury cars at prices we could never have afforded in times past. Globalism brought underdeveloped economies in Latin America and Asia into the modern world of consumerism. They developed their own capital markets and built new, efficient factories that produced even more affordable products to export to the US.

However, in the millennium year of 2000, economic momentum began to stagnate. The market that had made thousands of young millionaires began to crack. By early this year, it became apparent that the mighty economic machine was slowing. Alan Greenspan immediately came to the rescue. He began cutting interest rates aggressively to revive our spending spirits. However, economic response to lower interest rates failed to perform the old magic. Following the seventh cut in nine months, it was becoming apparent that something fundamental had changed in the economy.

Just as federal policy makers began to realize the economy wasn’t responding as normal, the worst terrorist attack in American history occurred. Government moved swiftly to shore up consumer confidence. Alan Greenspan cut interest rates a full percentage point to the lowest level in 40 years. The Administration proposed tax cuts and massive public works programs to offset rising unemployment. After all, the economy could really fall into a tailspin if consumers pull in further because they represent two thirds of GDP.

However, consumer confidence and demand were already slumping before the attack. Why? Can it be reversed with “free” money? Can fiscal spending increase enough to offset damage already done?

In future installments of our editorial series on the Shift in Focus, we will discuss the classic stages of past economic cycles and how they compare to the current developing situation.

Bill Gary
CIS, Inc.

The following editorial was published in Price Perceptions issue 1204 on October 20, 2001
Shift in Focus - Part III

As we have explained in previous editorials, America is undergoing an historic shift in focus. In the first installment, we indicated that focus was shifting from consumerism to patriotism... That conspicuous consumption was out and practicality was in. In the second installment, we explained how globalization made our “information” economy more affordable and how we had come to assume economic growth would continue indefinitely... But, domestic cuts in interest rates were not stimulating growth, even before the terrorist attack.

In this installment, we discuss the classic stages of past economic cycles and how focus changed during those transitions. Our studies of past periods of economic growth and contraction can be divided into three distinct phases...

The Inflation Stage

Following a long period of moderate and stable economic growth, demand grows and eventually exceeds productive capacity of the economy. Prices are pushed to incredible heights. Investment focus shifts toward physical assets for price appreciation. In other words, people begin to buy real estate, precious metals, and other tangible assets in anticipation of profiting from price increases, rather than investing in industry which would expand production and curb spiraling prices.

This stage was evident from 1918 to 1921 when rampant German inflation spread to other economies. German employers paid workers daily so they could buy groceries and other necessities before prices increased the following day. The inflationary spiral was broken in the US during 1921 when the government raised interest rates to historic levels. High interest rates curbed consumer demand and shifted investment focus from physical assets toward paper assets (savings and equities).

The Inflation Stage was also evident from 1973 to 1981. Following a period of relatively stable economic growth in the Fifties and Sixties, demand once again began to exceed production capacity. With savings accounts paying only 3%, returns were much greater in physical asset appreciation. The shift in focus to physical assets became so strong that grandmothers bought 100 pound bags of sugar, fearing that prices would be much higher in months to come.

The Productivity Stage

Following a period of high interest rates that curbs inflation, investment ideas shift from buying physical assets for price appreciation to buying paper assets for investment income. The shift to paper assets provides cheap capital to industry, resulting in expansion of factories, mines and oil drilling. This leads to expanding production of physical assets and consumer goods. A period of economic harmony occurs as price stability returns and expanding consumer demand is met by greater production and technical innovation.

This stage was evident from 1922 to 1929 when production of refrigerators, radios and automobiles expanded sharply. New factories resulted in greater supply. Stable prices made these luxuries affordable for nearly all households. Industry invested in methods of greater efficiency, such as “time and motion” studies, increasing production even more. Greater production stimulated price competition, making goods even more affordable to the masses.

The Productivity Stage was also evident from 1983 through the Nineties. Investors shifted focus to paper assets, providing cheap capital for the building of new factories in both the US and foreign countries. This led to expanding production and made more consumer goods affordable to the masses. The advent of computers and widespread use of the internet created greater efficiency and stimulated price competition, making goods and services even more affordable.

The Overcapacity Stage

As the period of economic harmony extends, production and innovation begin to provide more goods and services than required. In other words, too much capital flows into production and begins to pressure prices. As price erodes, businesses strive to become more efficient and competitive, pressuring price even more. The end of this stage is normally characterized by the destruction of capital. In other words, stock prices fall and businesses are forced into bankruptcy... destroying capital that was built during the Productive Stage.

The Overcapacity Stage was evident from 1930 to 1939 when the US experienced one of the worst depressions in history. Stock prices fell from 1929 to 1932. Bankruptcies reached epidemic proportions and nearly all the capital created during the Twenties was destroyed.

It appears we are currently in the middle to latter portions of the Overcapacity Stage. Prices are beginning to erode... business is becoming fiercely competitive... and the stock market has lost about one third of its value from last year’s high.

The degree of eventual capital destruction is unknown. It could end near current levels or continue to deteriorate for years to come. However, one thing appears certain... A return to rapid capital formation of the past decade is unlikely. Therefore, rallies in most markets should be anemic in nature. This should lead to a shift in focus from the past decade when setbacks were always viewed as buying opportunities.

In future installments of our series on the Shift in Focus, we will discuss trade, protectionism and government efforts to halt destruction of capital.

Bill Gary
CIS, Inc.


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