The following is based on remarks given by Lew Altfest during his “Lunch with Lew” conference call on January 28, 2009.

My theme today is that the country must take bold action.

In 2008, the economy was in recession, starting with the Lehman bankruptcy in September and accelerating when money market fund values dipped below a dollar.  As I have discussed in the past, a prime cause was former Fed Chairman Greenspan’s low interest rate policy, along with the Republican’s failure to adequately regulate the markets and the Democrat’s push for unbridled home ownership.  China’s huge investments in Treasury bonds kept the US in debt and interest rates low.

The economy is weak and will get weaker.  The actions taken by Fed have not met the economy’s requirements.  Help was given but not enough.  Our problems are getting worse.

With that background, there are seven major action items to discuss regarding the economy and the markets:

1. Stabilizing the banks.  We gave the banks money and they didn’t lend it out. This was understandable, since they didn’t know the scope of financial decline, and whether creditors would pay them back.  Many banks are insolvent, but we cannot do without them.  The US government will need to put in another $1 trillion dollars to restore the banking system.  This is not about bailing out Wall Street; it is required by the American people.  Previously, the American people were not ready to pay for it.  But now, with a new President, they may be ready.  I prefer the plan to buy “bad” assets and put them in a “bad bank.” The bad bank will need funding and the sticking point will be price paid for these assets.  Independent third parties may be used to price the bonds.  Hopefully, only the banks with the wherewithal to survive will get the money.  If this fails, the government will nationalize the weaker banks or the whole system.  The government will do whatever is necessary to stimulate lending.  Once that happens, the money system will make strides. 
2. More sweeping aid for the economy.  The delay in taking sufficient action has weakened the economy.  The first and second quarters of 2009 will have the worst declines, as will Q4 of 2008.  By Q4 of 2009 the economy will see the benefits of the stimulus plan.  Optimists forecast economic improvement in second half of 2009, but I expect it will occur in 2010.  This will not be the usual strong turn-up following a recession.  Instead, we will see many quarters of modest to moderate growth, due to ongoing de-leveraging.  Government spending will be reduced once consumer spending comes back.  Higher interest rates and fear of inflation will inhibit recovery.  Forget the tax cuts you have heard about – tax increases are coming.  Government spending will pick up for lack of consumer spending, and the stimulus plan will cost more than the $800 billion quoted.  Infrastructure spending is a smart move, because it can provide a return over many years.  The spending process will be corrupted by Congress as they put in their goodies, but the majority of it will not be wasted.  Obama is folding in Democratic priorities on redistributing wealth, which would be difficult to implement after the crisis is over. 
3. Inflation/Deflation.  Inflation is a risk, largely because of the size of our debt.   I do not expect systematic inflation over a long period.  Instead, higher inflation will surface a few years from now.  The Government needs to be really good at taking money out of the system when the economy turns.  And it must raise interest rates when inflation begins to appear.
4. Unemployment.  High unemployment will continue even after the economy turns up in 2010.  Much of the currently reported layoffs are from companies that did not want to take action before Christmas, for fear of being perceived as “meanies.”  Unemployment will be a problem into 2011, and may exceed 10% before it is finished (in 1982 it was over 10% and in the Depression it was over 25%).  Efforts will be taken now by Government to moderate unemployment. 
5. The dollar.  The dollar will trade in a narrow range following the prior 18 months of wide fluctuation.  If inflation hits, the dollar will go down.  For now, Great Britain and Eastern Europe are on sale.  It costs one-third less than a year ago to go to England.  No action is needed here now, but we should not be complacent.  The dollar will go down ultimately, but not right away.
6. Deficits.  There will be a huge deficit, on the order of 10% of GDP or more.  It will go down as government spending declines.  Trade deficits will drop as imports go down, more than offsetting the decline in exports. 
7. Real Estate.  The outlook is not good.  Real estate will continue to drop well into 2010.  It will not bounce back strongly.  Home values will stay where they are. On an inflation adjusted basis, it will be years before home values improve.  Government actions may moderate the period of decline but will not improve the housing market.

Markets will continue to be volatile, particularly as investors lose patience over news such as increasing corporate bankruptcies.  Fifteen percent of high-yield companies may default. 

The market will bounce back just when it looks like it is time to “throw in the towel.”  As Government actions take hold and bank lending increases, markets will move up for economically justifiable reasons.

President Obama is highly intelligent. He likes to take his time in making decisions.  He is a compromiser, which is generally a good approach.  But we have an emergency situation. Obama must be bold and make Congress and the American people follow his lead.  He must get in front of these difficulties and cut them off.  He must spend more than he originally thought.  If he is sluggish, the markets will speed him up.  As a basketball enthusiast, Obama should understand that he needs to lead a few fast breaks down the court.  Obama has presented himself as a middle of the road Democrat, like Clinton.  If he moves to the left he will lose support.  Some redistribution of wealth is okay, but not too much.

As a country, we had unhealthy practices for many years.  We borrowed too much and believed in ever-increasing real state values.  We were warned about this, but not until the economy weakened did we look for a solution.  In the Government’s emergency room, we are being treated by doctors Bernanke, Summers and Volcker.  They are real doctors – the kinds with PhDs.  Our new President has said to expect further deterioration.  This is smart, as a way to control expectations. 

Looking ahead, the rate of decline will moderate and people will start to relax.  This is already happening in the bond markets.  It did not take a turn-up in the economy - just the impact of our policies.  We will see some moderation in the decline of the economy later this year, which should be enough for the economy to turn up in 2010.  The markets could temporarily decline - even substantially so – but I am not predicting that.  Compared to today, the market will be significantly higher at the end of 2009.  In successive years, there will be above average gains.  In five years, or even sooner, we will reach 14,000 for the Dow or the equivalent for other indices.

(c) LJ Altfest & Co.

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