Our focus in this letter will be twofold: first on the prospects of a cyclical economic recovery over the next twelve months, and second on the secular or longer term outlook that may unfold after cyclical recovery has been achieved. As we focus on the cyclical recovery it is important to remember that the U.S. economy is making its way back from the brink of disaster. Last fall we approached the edge of the abyss and our financial system threatened to melt down. The shocks to the system were great, and it takes time for an economy to recover from such severe blows.

 

Currently we are on a recovery watch, looking for signs that are either indicative of economic recovery or suggest that it lies not too far ahead. As we assess the elements in place at this point, we are encouraged about the prospect of cyclical recovery. While the signs are not robust, there are areas of improvement. We cite the Leading Economic Indicators which have improved for two straight months, a precedent that suggests strongly that recovery should commence within several months. The stock market has recovered substantially from its low point, and while its recent progress has been halting, it is still pointing towards recovery. We note that housing affordability has improved dramatically. Prices of houses relative to disposable personal income, and the low rate on mortgages, make housing more affordable than it has been in decades. Finally, we point to the U.S. Treasury yield curve. When the yield curve becomes steeper as a result of low short term interest rates relative to long term interest rates, it is an excellent predictor of recovery.  Currently the curve is at record steepness, not only in our country, but around the world. Considering these and other economic series, our conclusion is that we are moving toward recovery, with positive economic growth expected in either the fourth quarter of this year or the first quarter of next year. 

 

Shifting our attention to the longer term or secular trend, we note that something very fundamental is going on in our economy that promises to shape the recovery as it extends further into the future. We believe the American consumer is undergoing a basic change of attitude. This change is psychological to a certain extent, but mostly is born of necessity. The American consumer has begun saving at a rate not seen in many years. The savings rate has gone from zero to 6% in just a matter of a few months. It is not yet certain that this is a permanent change, but we believe the odds of it becoming a more regular entrenchment of attitude is likely because of several factors. First, last year consumers suffered the loss of significant amounts of wealth. A 20% decline in home equity and a major decline in common stocks left the asset base of consumers in a depressed state. The result was that their debt, which has been rising consistently since 1980 to historically high levels, became even greater in relation to their asset values. This simple fact makes people feel poorer, and it makes them want to do something to improve their financial condition. Since many consumers are also fearful of unemployment, this over-levered position leads to the conclusion that the only way to impro