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It took some time, but it looks like the economic environment I was depicting this time last year is starting to play out. Deflation risks are prevailing, along with a growing acknowledgment about the lack of sustainability in the nascent economic recovery. Extreme fragility and volatility is what one should expect in a post-bubble credit collapse and asset inflation that we endured back in 2008 and part of 2009.

History is replete with examples of this: Balance-sheet recessions are different animals than traditional inventory recessions, and the transition to the next sustainable economic expansion and bull market (the operative word being sustainability) in these types of cycles takes between five to 10 years and is fraught with periodic setbacks.

This sounds a bit dire, but little has changed from where we were a year ago. We had a tremendous short-covering and a government-induced equity market rally on our hands and it's really nothing more than a commentary on human nature that so many people rely on what the stock market is doing at any given moment to base their conclusions on what the economic landscape is going to look like.

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So we had a huge bounce off the lows - but we had a similar bounce off the lows in 1930. The equity market was up something like 50 per cent in the opening months of 1930. While I am sure there was euphoria at the time that the worst of the recession and the contraction in credit was over, it's interesting today to see that nobody talks about the great runup of 1930, even though it must have hurt not to have participated in that wonderful rally. Instead, when we talk about 1930s, the images conjured are hardly joyous.


I'm not saying that we are into something entirely like the 1930s. But at the same time, we're not in Kansas any more, if Kansas is the type of economic recoveries and market performances we came to understand in the context of the post-Second World War era.

We are now in the process of unwinding the excesses of a parabolic credit cycle of the prior decade; the first of the boomers are retiring with few buyers for their monster homes; and the U.S. Federal Reserve is fighting a deflation battle that is prompting comparisons to Japan. We also had the Fed unexpectedly cutting its forecast for growth and inflation recently, and we had Fed Chairman Ben Bernanke tell us that the macro outlook is "unusually uncertain."

The world's most important monetary authority (with all deference to the People's Bank of China) is now openly contemplating more experimental quantitative-easing measures to propel economic growth at a time when policy interest rates are zero. It's also happening when the size of the Fed's balance sheet is triple its normal size, and while the budget deficit exceeds $1-trillion (U.S.) - 10 per cent of GDP. There are now cries even from incumbent Democrat senators for President Barack Obama to extend the once-vilified Bush tax cuts. You can't make this stuff up.

Meanwhile, I continue to receive Wall Street research telling us to overweight stocks and underweight bonds. This does not happen at true fundamental bottoms in equity prices and Treasury yields. I continue to be asked what will turn me more bullish. This doesn't happen at lows, either.

At the true lows, the bears are asked why they're not even more bearish. At the lows, people threaten to call the police when equity brokers go cold-calling.

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What the bulls still refuse to see is that we are in an entirely new paradigm and that the old rules of thumb are rarely, or ever, going to be able to be relied upon, as was the case in the credit-expansion days of yore. There is simply too much debt overhanging the U.S. household balance sheet, the largest balance sheet on the planet. Despite the deleveraging efforts to date, the process of balance-sheet repair is still in its infancy.

Consider the facts: U.S. household debt-income ratio peaked in the first quarter of 2008 at 136 per cent. The ratio currently sits at 126 per cent, but the pre-2001 norm was 70 per cent. To get down to this normalized ratio again, debt would have to be reduced by about $6-trillion. So far, nearly $600-billion of bad household debt has been destroyed.

We have much further to go in this deleveraging phase. Folks, we are in this for the long haul. It's not too late to enter the acceptance stage.

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About the Author
David Rosenberg

David Rosenberg is chief economist and strategist for Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave. More

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