By Michael Lewitt, Editor, The HCM Market Letter

The fourth quarter GDP loss of 6.2 percent (did anybody really believe the 3.8 percent estimate?) illustrates just how deep a hole our economy has to climb out of. The economy fell into this hole almost literally overnight, but it's going to take much longer to climb out. A quick recovery is out of the question. HCM expects first quarter GDP to be in the -6.0 to -7.0 percent range based on our reading of employment, housing and other economic data as well as the data we are seeing from the 200 or so companies in our portfolios across a wide variety of industries. Moreover, based on our view that the stimulus plan will be largely ineffective this year and that more large-scale business failures are in the works (many of them slow-motion car wrecks), we do not expect to see positive economic growth until sometime in mid-to-late 2010 (and then only modest growth).

Investors expecting a conventional bear market/bull market cycle are likely to be sorely disappointed. Over the past several decades, U.S. stock market investors have been conditioned to believe that the market will bottom and then rebound. Bear markets have been brief within the context of a long bull market that stretches back to the 1980s. But the current environment is likely going to be different. We are now experiencing a destruction of wealth on a scale that is both unprecedented and permanent because much of that wealth was built on a fragile foundation of debt; in reality, much of that wealth didn't really exist in the first place. As a result, what people believed to be economically valuable and stable was in fact nothing of the kind. In many respects, the latter stages of the bull market were little more than an illusion. Real corporate earnings and genuine productivity peaked years ago, and the economy has been operating on debt-induced fumes for years.

Depression or Recession?

Accordingly, investors need to prepare themselves for a future that will not resemble the recent past. Ray Dalio, the wise man who runs Bridgewater Associates, noted in a recent Barron's interview that investors need to recognize that the current environment more resembles a depression than a recession: "Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis of the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process." (Barron's, February 9, 2009, "Recession? No, It's a D-process, and It Will Be Long," pp. 38-40.) Mr. Dalio's view is consistent with HCM's long-argued view that we are in a debt-deflationary spiral whose end is nowhere in sight.

The characteristics of our current economic situation are as follows:

• Interest rates have dropped to zero.
• Bank stocks have plunged by 90 percent or more.
• The Federal Reserve's balance sheet has exploded.
• Credit spreads have widened to historic levels.
• The economy is seeing massive asset deflation.
• Debt is being destroyed in record amounts.
• Unemployment is increasing each month.
• The financial industry is shrinking radically.
• Manufacturing activity has slowed sharply.

This is not a situation that is consistent with recent American experience. HCM has previously described a depression as an economic condition in which traditional monetary and fiscal policy is rendered ineffective. For the moment, we are deeply entrenched in such a situation. The question is how long the economy will remain depressed before some of the remedies that have been proposed start to work. Unfortunately, HCM fears we may be in for an extended stay.

For these reasons, HCM believes that after the stock market bottoms, it will drift along at a depressed level for an extended period of time. The American economy will experience less-than-trend growth for a similarly prolonged period of time. The economy will have to absorb trillions of dollars of bad debts and transition its resources away from speculative activities and toward new productive endeavors. The economy has to be completely retooled, and this process will not happen overnight, particularly because such a program must be directed by a highly inefficient democratic political system that is inefficient in reaching consensus about its goals and how to achieve them. Unfortunately, the deeper involvement of the government in the financial and other sectors of the economy is likely to stifle growth, innovation and creativity and further contribute to lower growth for years to come.

Investing Today

This by no means is intended to suggest that investors will be unable to make money. It does suggest, though, that the era of bull market geniuses is probably over. Too many were paid too much for doing too little over the past several decades. Being at the right place at the right time is not going to cut it anymore. But as the debt destruction process plays out, new investment opportunities will arise in the capital structures of restructured and surviving companies.

(Adapted for Wealth Management Exchange with permission from The HCM Market Letter)