January 2010

You don't need a degree in Latin to know what "terra firma" means. It's what the Haitians would love to have more of this month. Compared to what's going on in Haiti, the world feels downright rock-solid so far this year -- not at all like last January.

Do you remember last year? Fear and talk of depression was in the air. The stock market turned down 8.84% in January -- the worst January since 1916. This all followed the "end of the world" atmosphere that gripped Americans in the last part of 2008.

So what happened after that? The Dow ended up over 18%. Talk of depression morphed into talk of "green shoots." All of a sudden the worst was behind us.

So what are we to believe now, as 2010 unfolds before us?

This dilemma faces investors all the time -- what seems to be certain today changes in the course of months, weeks, sometimes days. It's easy to be deceived -- and rattled. And we can guarantee that 2010 will be no different.

Just look at the typical issues you hear talked about on CNBC or read about in the financial press. Issues like:

• Will unemployment stay at 10% - or grow even higher?
• Will the stock market continue its upward momentum, stay in a trading range, or head down to test its bear market lows?
• Are we really out of the recession, or will we head back in as the initial government stimulus "wears off" this year?
• Will all the credit problems still sitting out there cause yet another financial crisis -- maybe even worse than 2008?
• Will America's legendary creative, entrepreneurial spirit overcome the challenges it faces going into the next decade and bring back the prosperity we knew in the 20th century?

They're all important issues. And this is only a partial list. But even if we spent hours talking about all these, as some people do, where would it get us? Most of this is frankly unknowable. What we want, what we need right now, is some "terra firma" -- something we can wrap our fingers around, something that holds some key to our future that we can all agree on.

We think we've found one.

Whether you believe things are looking up or you're just waiting for the next shoe to drop, let's push our prejudices to the side and start fresh in this New Year. Rather than throw your hat into either the "end of the world" or the "everything's coming up roses" camp, why not just jump into 2010 with us and land with both feet planted firmly on good old "terra firma."

The Key To Understanding Where We're Going in 2010

Before we leap, let's take a quick look back at where we've been.

While you can argue over exactly when the United States replaced the British Empire as the "top banana" in the world (after World War I?), it's hard to argue the point that since World War II, the United States economy has dominated world commerce right on up into the 21st century. After all, with most of the world in ruins in 1945, the U.S. emerged from that terrible war physically intact and financially secure.

Since 1945, in spite of wars and recessions, as well as social, moral and cultural revolutions, America remained the greatest single power the world has ever known. With only the old Soviet Union to rival our power and influence, the American government dominated world affairs, America's companies manufactured most of what the world wanted and the U.S. dollar could buy anything anywhere. Even the criminal underworld and our worst enemies accepted and used our dollar as a means of trade and exchange.

American culture spread everywhere, even before the collapse of the Soviet Union. Films, music, theater, television -- the good, the bad, the beautiful and the ugly -- poured out of Hollywood and New York and continue to be seen on every screen and heard on every speaker on Earth. If it was said that the sun never set on the British Empire, then we have to say that the moon always rises on someone somewhere in the world watching or listening to some product of the great American cultural and entertainment machine at the end of a hard day's work.

Quite remarkable, wouldn't you say?

From its start in the early 1600's as a tiny gathering of dissenters, adventurers and outcasts struggling to survive under often hostile conditions, America became the destination of choice for more and more of the world's ambitious, as well as a place of hope for its tired, poor, hungry and huddled masses.

And so by the end of the 20th century -- the so-called "American Century" -- it seemed the sky was the limit. With the fall of our chief rival, the Soviet Union, we actually heard some speak of the "end of history." The "shining city on a hill" that inspired the Pilgrims to face the harsh realities of those early days had become the undisputed king of the hill.

Looking back, it sounds presumptuous, a bit arrogant, even prideful, to think that America would be #1 forever by some sort of natural or divine right. Nevertheless, many believed that America's unbounded political, economic and financial success would continue forever.

How else can you explain the American stock market in the 1990's? After a hot run in the 1980's some thought the market might slow down a bit in the '90's. Instead, it took off on an historic tear. Instead of shunning stocks with P/E ratios over 20 -- always thought of as overvalued by astute investors in the past -- people poured their hard-earned money into stocks with P/E's in the 30's, 40's, 50's -- even the 100's. To question the sanity of it all meant you just didn't understand the brilliance and creativity of America's entrepreneurs and the power of its "free markets." The country that had first landed men on the moon could now touch the stars.

Then, in quick succession, we watched the stock market turn down with a vengeance from 2000-2002, interrupted and punctuated by the cataclysmic 9/11 attacks. From the "sky's the limit," some cried that the sky was falling.

Yet, even as history taught us that the cycle of manias and crashes were the natural order of things, we decided to ignore history. Instead, the powers that be -- the government and the Federal Reserve -- stepped in. Continuing a misguided policy that started in the 1980's under Alan Greenspan, the Fed threw more and more money into the economy -- they called it "liquidity" -- and convinced too many of us that they could prevent bad times and virtually guarantee good times. The stock market revived and shot back up until October 2007.

But then the wheels started falling off yet again. And this time it would be everything -- not just stocks -- coming down at the same time, culminating in the great crisis of October 2008 when it seemed we were heading off a cliff.

Again, money was thrown at the problem and, lo and behold, "the end of the world as we know it" was held off one more time -- with things seemingly picking up yet again in 2009.

But, in fact, things just aren't the same here. And it's not China's explosive growth, or the awakening of emerging markets that's causing the change. It's us. We've changed. And we're not going back to where we were before.

So let's take a look at what's changed and...

We'll use a couple of simple charts and get to some basic conclusions now. The fact is, we believe this will be a very important "transition" year -- from the old to the new. And we want to understand the true nature of the change as best we can. We'll use two charts, courtesy of www.investmenttools.com, to illustrate our points.

First we look at "Commercial and Industrial Loans." This captures lending activity by businesses. We note here that lending activity by businesses doesn't ever go up in a straight line. That's because of the economic cycle. Business activity goes up and pulls back from time to time. That's normal.

But notice this last pull back. Can you see how much more pronounced it is? The others are a lot smoother. The downturn in lending this time around was quick and steep compared to the others. And there's no significant pick-up -- yet.

OK, you could make the argument that this is still part of a "normal" pattern -- just sharper or more pronounced. And indeed, we do expect business activity to pick up at some point. So commercial lending will pick up eventually. It just hasn't happened yet -- and could take a while.

If business lending is down, what about consumers? Well, we believe this next chart provides a clear picture of not only what's happening now, but also of a fundamental shift of a trend that will have a profound impact on all our lives in the years to come.

Take a good look at the pattern on the chart below, "Total Consumer Credit Outstanding." It basically goes straight up since 1980. You don't get the ups and downs that you did in commercial and business lending activity.

The main components of consumer lending are mortgages and credit cards. Since 1980, mortgages have grown larger and people have borrowed more and more on their credit cards. As they did so, outstanding credit increased.

The first thing you have to remember is that as of 2008, 70% of U.S. gross domestic product (GDP) came from consumer spending. That's why people called our economy a "consumer-driven" economy. It's why the Bush administration sent all of us checks a couple of years ago. It's why the Obama administration put out "Cash for Clunkers" and that tax credit for first time home buyers, followed by yet another tax credit, this time for existing home owners to go out and buy another house.

The first thing the government wants to do is to get people spending. It's as if our very lives depend on it -- or certainly that our prosperity depends on it.

Now in some sense the growth of any healthy economy is driven by consumer spending. China, for example, is attempting to stimulate spending on the part of its own people to buy more of the goods they produce, rather than selling everything they produce to foreigners. But it's the degree to which our economy has been driven by the consumer that we're focusing on here.

OK. With that in mind, let's look at what these charts are really telling us.

Starting with the sheer upward slope of both charts, you can get some feeling for the amount of credit that built up in the U.S. over the last 30 years. We won't get side-tracked with the issue of how much of America's growth was due to all the borrowing that businesses and individuals did. Besides, common sense tells us that, especially in the years following World War II, as we saw above, America was just about the only country in any position to manufacture anything. So our growth wasn't dependent on easy credit. There were solid fundamental reasons behind it.

But common sense also tells us that, as more and more debt piled up over the years, especially since 1980, it makes sense to wonder how much of our productivity in those years was driven by our borrowing. And if that's the case, now that our borrowing is clearly heading south, you have to wonder just what will happen now that borrowing has not only slowed, but is absolutely turning around -- for the first time in 30 years. How productive will our economy be when it won't have this same massive borrowing to keep it going?

To sum up, credit began contracting in 2008 as a result of the recession that began at the end of 2007. Business has picked up a bit since hitting a bottom in 2008 -- 2009 as the economic recession slowed and slightly reversed. At some point, business lending will pick up. But outstanding consumer credit will not pick up. Consumers will not be adding to their outstanding credit.

More importantly, we think the slowdown in consumer borrowing may be the beginning of a reversal of a trend that could go on for years to come.

And if consumers slow down and in fact reduce their borrowing permanently, the economy won't be "consumer-driven" anymore -- at least not to the degree it once was. What will replace it? What will replace the consumer-driven economy? What will drive the engine of an economy that had grown dependent on the fuel of consumers simultaneously digging themselves into a deep hole of debt while they shopped 'til they dropped?

Has the great rising since World War II hit its peak? Will the prosperity we've seen grow dramatically since 1945 end and go into reverse?

We think the answers to these questions will provide the key to understanding where we're going in 2010 -- and beyond. "Beyond" because this will be a big trend, a long-term trend.

This last point is important because we're not used to looking at long-term trends in this country. We tend to focus on tomorrow, then the day after that. But remember, when a long trend turns, it takes some time to pick up steam until you start to see the results of the new trend take hold.

One thing we're pretty sure of though: we're not going back.

So with our feet planted securely on our piece of "terra firma" we'll return next month to further explore the impact of this dramatic change in our world.

But before I sign off for this month, let's wrap up where we started -- with one last word about Haiti. I suspect you've read and seen some remarkable stories of rescues and the amazing resiliency of some of the Haitian people. I wanted to share my favorite with you. The message is "don't be afraid." Whatever happens here in the coming years, I'll always remember this remarkable woman and the message of hope she brings us as she comes back from the brink of death with a song.

After that video, I hope you will appreciate, as I did, that, however uncertain the future, faith and hope can and should be our real "terra firma" in an always changing world.

P.S. -- Next month, in addition to exploring how the dramatic re-ordering of our economy will change our world, we'll bring you the two most important planning issues for 2010. In the meantime, you can find more on our blog), including discussions about: Why I Would Never Invest in Goldman Sachs, The Coming Commercial Real Estate Crash and more.

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com