Sadistic Tendencies

Even though Mr. Market is capricious – bordering on
sadistic – he often responds to persuasive "lobbying" from
the real world. If, therefore, the real world convinces him
that the global economy is slowing, he may respond by
knocking a few more points off of the Dow Jones Industrial
Average.

Already this year, the major U.S. stock averages have
struggled to keep their statistical heads above water. The
Dow and the Nasdaq are both down about 5% for the year-to-
date, while many economically sensitive indices like the
Morgan Stanley Cyclical Index have dropped twice as much.
Perhaps, therefore, Mr. Market is already responding to the
prospect of impending economic weakness.

All the classic leading indicators of future U.S. economic
activity are heading in the direction that neither Alan
Greenspan nor President Bush has authorized: Down.

The bond market, for one, argues persuasively that economic
weakness looms. It has also convinced us. Not only are
long-term interest rates probing all-time lows, but they
are doing so at a time when short-term rates are climbing.
These divergent trends are producing a "flattening yield
curve," which often augurs recession.

Specifically, the difference (or spread) between the 10-
year Treasury note and the fed funds rate, which reached a
plump 359 basis points in the second quarter of 2004, has
been narrowing ever since. (In other words, the yield curve
has been flattening). As of yesterday, the spread had
narrowed to less than 70 basis points.

"There is a strong correlation between a narrowing yield
spread and a subsequent slowdown or decrease in final
sales," Comstock Partners notes. A slowdown in final sales
is just another way of saying: Recession. We are not yet
tempted to buy a 10-year Treasury note yielding 3.90%, but
we are very tempted to believe the message that bond market
is sending: the global economy is slowing down, perhaps
quickly.

Not for nuthin’, it seems, does the Conference Board
consider the yield curve to be the most important of its 10
leading economic indicators (LEI). Interestingly, the other
nine leading indicators portray an equally dismal picture
of future economic activity. The LEI, which also measures
things like employment growth, fixed capital investment and
personal income, has been slumping for many months.

"The leading indicator index as a whole has now declined
year-over-year," Comstock notes, "and over the last 40
years such an occurrence has always led to a slowdown or
recession.  Moreover, these U.S. indicators have been
supported by persistent ongoing weakness in the global
economy.

"Therefore," Comstock deduces, "it appears probable that
the economy is headed for a significant slowdown or
recession that has not been discounted by the [stock]
market."

The "Grande Dame" of economic indicators – the growth of
the money supply – is also signaling economic weakness.
Specifically, the monetary aggregate called MZM (money of
zero maturity), which includes cash and cash-like assets,
is showing year-over-year growth of almost zero percent.
"For the past 40 years," International Strategy and
Investment explains, "every time MZM growth has been this
low, the economy has either had a significant slowdown or
recession. EVERY TIME."

If the money supply and the LEI both predict recession, who
are we to question their wisdom? The chart above, which
portrays the recent trends of these two indicators, argues
forcefully on the side of economic weakness. You will note
that both indicators are sliding sharply toward the
southeast…and that’s not a good thing. Two of the last
three times the LEI and the money supply slumped together –
in 1993-4 and 2000-01 – a recession, or near-recession,
followed shortly thereafter.

Astute observers may notice that the money supply had been
slumping throughout 1998, before it jumped in the months
leading up to Y2K. This monetary fillip likely boosted the
already-over-hyped stock market into early 2000. But as the
money growth faded away, so did its simulative effects,
both in the stock market and in the real economy.

The growing signs of economic weakness lead bond fund
manager, Bill Gross, to predict that the Federal Reserve
will be LOWERING interest rates by December. Gross’ view
remains a minority opinion for the moment, but we expect it
to become a majority opinion sometime before Halloween.

If Gross is correct, the economy and the stock market may
be in much bigger trouble than most folks imagine. If, for
example, the economic growth that most Wall Street analysts
anticipate fails to materialize, the share price gains
these analysts also anticipate would fail to materialize.

Out in the real economy, a recession might inflict even
more harm than usual, according to Gross, because the US
economy is poorly equipped for adversity. Since we have
been relying so heavily upon asset inflation (mainly
housing) to power our economy, the consequences of the
approaching economic slowdown could be much more dire than
in times past.

Unfortunately, an inverting yield curve and slowing
employment growth often create a toxic effect on asset
inflations. "The current, rather mild U.S. recovery has
been driven by asset appreciation/consumption and not
employment or cap-ex growth," says Gross.

"If, therefore, the asset-inflation well runs dry," he
warns, "the inevitable path of the U.S. economy will
reflect slow growth at best." In which case, long-term
bonds might perform very well. Stocks might not.

Quiet Mr. Gross!…Mr. market might hear you!

Even if most Americans are facing lean times ahead, the
"uber wealthy" intend to continue throwing their uber
wealth around.

The "Elite Affluent" (net worth of $10 million+) plan to
boost their spending this summer, according to a survey
conducted by Elite Traveler/Prince & Associates. These
wealthy individuals, for example, expect to spend an
average of $317,000 renting yachts, a 19% increase over
last summer’s yacht-rental expenditures.

"Increased spending by the Elite Affluent provides trickle
down economic benefits," beams Douglas D. Gollan, President
and Editor-in-Chief of Elite Traveler, the luxury lifestyle
magazine of the Elite Affluent which is distributed
worldwide aboard private jets and mega-yachts. "The amount
of money spent by the Elite Affluent segment of the
population is really staggering…[which] is very good news
for the luxury segment of the economy."

Thank goodness for trickle-down economics.