Keep Your Belts Fastened: It's Still a Wild Ride

Here's something you don't hear much these days: The economy is not doing well. Shocker, right? We've noticed with considerable amusement that typical Wall Street market commentary has evolved from a "soft patch" to a "global slowdown" and now into "prospective recession." Amazing how the commentary can change so quickly while the underlying economic fundamentals have changed very little.

Laksham Achuthan of the Economic Cycle Research Institute (ECRI) notified clients on September 30 that the US is heading into a recession and there's nothing policy makers can do to prevent it. The ECRI has correctly predicted the past three recessions without any false alarms, so its predictions are widely respected.

• Q3 was the worst quarterly performance for the markets since Q4 of 2008. The S&P 500 fell 14.3%.
• The S&P 500 is down almost 20% from late April highs and has now fallen in each of the past five months. This is the longest losing streak since March 2008.
• Financials have dropped more than 25% and the energy sector is down by 11%, while transports are down to July 2010 levels despite lower energy prices -- a sure signal that economic contraction is imminent.
• The average US adult is spending 2% less on goods and services in real terms compared to four years ago. Only a decline in the savings rate, which has gone from 5.3% in June to 4.5% in August, is preventing an even bigger drop. This is the lowest savings rate since Dec 2009.
• The income of the typical family has dropped for the third year in a row and has dropped to 1996 levels when adjusted for inflation.
• Mortgage delinquencies rose in Q2, after declining for five consecutive quarters.
• The unemployment rate remains unchanged at 9.1%.

Bottom Line: We think a recession is very likely. Years of excessively loose monetary policy in the form of artificially low interest rates helped fuel an unprecedented rise in household debt, from a historical norm of 70% household debt to GDP to a peak of 140% in 2007. We are now around 120%, thus much more debt reduction must occur. This will depress spending and economic expansion. Attempting to stimulate the economy with lower interest rates in order to increase debt levels is counterproductive. We believe further action on the Fed's part is simply shooting a water pistol at a charging buffalo.

For now, volatility and uncertainty rule. Volatility represents change, and the world is changing. True volatility is neither fear nor the VIX index, but rather tracks the path from the world as we believe it to be to the world as it truly is. We are in uncharted territory on a global basis and have a long way to go to get from conventional wisdom's erroneous beliefs to the underlying realty of the global economy:

• The US dollar, the world's primary reserve currency, has only been a pure fiat currency since 1971 when Nixon canceled the direct convertibility of the dollar to gold. It is currently being manipulated to a level never before experienced in modern history, with ramifications that are likely to be painful.
• The US Treasury Bond has historically been considered the standard for the risk-free rate. The risk-free status is now in question, given our current debt level, future liabilities, and poor growth prospects as noted when Standard and Poor's downgraded US debt for the first time in history.
• The euro, the second largest reserve currency and second most traded currency after the dollar, is an 11-year-old experiment under enormous strain as nations with exceptionally heterogeneous economies attempt to repair themselves under a unified monetary policy and constrained fiscal policies.
• The global banking system is more interconnected and more interdependent than ever before.
• High frequency trading has come to represent somewhere between 40% and 75% of daily trading volume.
• The growth rates for emerging economies are surpassing those of developed economies and are arising from nations with far less onerous debt levels -- a global changing of the guard.

We are in a period of violent economic change. Markets are experiencing the highest correlations between securities ever measured, which we believe is largely due to the unprecedented degree of loose monetary policy.

Markets are driven almost exclusively by headline news concerning what new solution is being proffered by bureaucrats, which can only mean continued volatility and uncertainty. No one can consistently predict the desperate acts of politicians as they face continuing crises with fewer and fewer arrows in their collective quiver and eroding credibility.

Bottom Line: The conventional wisdom approach to solving national and global problems has not delivered results, thus the difference between the world as the market expected it to be and as it truly is continues to widen. We expect market swings to be increasingly wild with securities moving together more and more, making diversification exponentially more challenging.

— Lenore Elle Hawkins is a principal at Meritas Advisors and a registered investment advisor with offices in San Rafael and San Diego, Calif. She has 18 years of experience in finance, strategic planning, risk management, and asset valuation.