Most economists’ projections of how economies will perform are incredibly similar, due to:

1 - Most forecasters work for firms at financial institutions which are designed to SELL something…and I don’t mean good economic advice.  The economist is considered someone who can explain what at times is the unexplainable…and who can help legitimize the recommendations of his or her firm.

2 - There is very little advantage to being an outlier, unless you want to gamble on getting it right when all others are wrong.  The latter is a risky strategy (one can look like a fool in many cases), so most economists, like most investment managers, stick close to their benchmark — and the benchmark for the economist is what his peers are predicting.

However, every once in a while, an independent economic group is able to add significant value.  We have found that in the case of the Economic Cycle Research Institute for recession/inflation predictions, and we recently found it in a paper from the Levy Economics Institute of Bard College.  Take a peek at their publicly available research, "The U.S. Economy: Is There a Way Out of the Woods?" 

Like any good academic paper, it starts with multiple equations — that took me back to my old economics courses.  But, please take a look at the last two graphs for what they are predicting for US GDP over the next five years in a ’soft landing’ and a ‘credit crunch’ scenario.  Yes, there are lots of assumptions here, but the conclusions are fascinating:  In a ‘credit crunch’ scenario, expect no to -1% growth in GDP by the end of 2008, before things start picking up.  And, in a ’soft landing’ scenario, GDP falls as low as a bit under 1% toward the end of 2008, before picking up.

This is significantly different from the expected 2.5% growth in GDP forecast by the heard of economists in the recent WSJ survey.  More importantly, its carefully reasoned approach provides solid insight during this interesting time in the financial markets.

And that is the kind of solid insight we all need, as we take time to reflect on the most important part of our lives: family and friends.  I hope you and your family have a very Happy Thanksgiving!

Over two months ago, we noted that it appeared the ‘carry trade’ between risky assets (represented by the S&P 500) funded by borrowings in a low interest rate currency (Japanese Yen) had seemed to unwind.  In other words, Yen strengthening coupled with S&P 500 declines may mean that the ‘carry trade’ was being unwound…and with it, we would have further signs of deleveraging in the world financial system.

In the update, below, it is fairly obvious that this unwind of the carry trade has been rather consistent over the last nine months and certainly has picked up in two of the last three months.  We’ve seen similar analyses, where the New Zealand dollar is substituted for the SP 500, as NZ has relative higher rates…and the results point to a similar conclusion.

Until we see this correlation decouple, the unwinding of the carry trade will continue to be a drag on global financial markets.

Markets are notorious for moving between the states of fear and greed.  For a number of years, we were living within the greed state.  Low corporate bond spreads…no problem.  Low credit capability for mortgage borrowers…no problem.  The great amounts of liquidity in the global financial markets assured that more dollars would be chasing financial assets, looking for a home, any home, even a subprime home, that could provide a yield or return of some kind.

However, first the bond market and now the equity market have shifted gears to the state of fear.  The US economy is slowing and may move into recession by the end of next year.  The equity markets await the salve of Fed easing, but Mr. Bernanke must be careful not to tip his hand, lest the dollar will fall swifter than few of us can imagine.  Any corner of the financial or real economy subject to the use of credit has been and will continue to be impacted by what we called over a year ago "Deleveraging".  (Those that simply refer to this as a credit crunch are missing the fact that financial institutions will probably be forced to delever to some degree to meet their capital requirements; while we have already seen this occuring in other areas like hedge funds.)

What can be done to alleviate the grip of fear?  Let’s start by getting at the truth.  It may not set us free, but it sure would give us all a better idea of how pervasive subprime and other credit related problems are.

What if, instead of, slowly leaking out credit related write downs, banks and brokerages actually had to list the securities subject to write down? 

Transparency in our time. 

Shocking?

Not really.  Here in the world of US insurance companies, annual statement filings must list all investment holdings along with significant data, including cusip, book value, market value, yield, credit rating, etc.  Quarterly, insurers file statements that include their investment transactions.  And the NAIC (National Association of Insurance Commissioners) is even considering going further with a proposal to add an annual statement disclosure outlining all subprime exposure (direct and indirect), including MBS, CDO’s, other structured securities, debt and equity securities of companies with ’signficant subprime exposure’, and the always perplexing ‘other assets’.

Of course, banks and brokerages would complain mightily about this proposal.  However, I am only suggesting detail on securities subject to write down.  Why shouldn’t we know how problemmatical these holdings are and how they are being valued? 

Would it be a violation of trade secrets or trading strategies?  No, because such disclosure would only apply to a portion of the overall investment portfolio.  And, I’m not sure what partial disclosure of a portfolio really tells us about overall strategy.

Would it let others know what they might be trying to ‘unload’ in the future?  Possibly, but once the securities are written down, the rush to unload may not be so great as the ‘pain’ should already be felt.

Or, would it allow banks and brokerages to hide the extent of the ‘damage’ from bad investment decisions, hoping markets would reverse before they have to revise their write downs at a later date?  Such banks are acting like the two year old boy who doesn’t want to tell his parents he unloaded in his pants…until he positively had to do so.

We’ve read talk of a ’super’ regulator being established with authority to require such disclosures.  However, I believe that existing regulators have the ability to do so (and the last thing we need is another regulatory bureaucracy).  In the US, the SEC, promoters of the ‘disclose but caveat emptor’ approach to regulation, should require this transparency.

The accountants are indeed trying sometimes, but they are trying to be quasi-regulator (tough to do when the institutions ‘quasi-regulated’ pay your audit fees) by forcing public companies to show how they obtain valuations on securities and allowing them to choose mark to market.

Please, no new regulator, just a requirement for transparency.  Once we know how bad these credit related problems, the market will swiftly adjust.  And, like members of Alcoholics Anonymous, the banks and brokerage firms, after admitting they have a problem and how large it is, can begin taking steps to improve.

Transparency is the lubricant that can loosen the grip of fear in the markets.  The tools are there.  We only have to use them.