February 2014 A. Gary Shilling's INSIGHT 1

INSIGHT (ISSN 0899-6393) goes to press by the third business day of the month. © 2014 A. Gary Shilling & Co., Inc., 500 Morris Avenue, Springfield, NJ07081-1020. Telephone: 973-467-0070. Fax: 973-467-1943. E-mail: insight@agaryshilling.com. Web: www.agaryshilling.com.President: A. Gary Shilling. Editor and Publisher: Fred T. Rossi. Research Associates: Colin Hatton and Tea Gongadze.All rights reserved. No part of this publication may be reproduced or redistributed without the written permission of A. Gary Shilling & Co. Material contained inthis report is based upon information we consider reliable. The accuracy or completeness is not guaranteed and should not be relied upon as such. This is not asolicitation of any order to buy or sell. A. Gary Shilling & Co., Inc., its affiliates or its directors and employees may from time to time have a long or shortposition in any security, option or futures contract of the issue(s) mentioned in this report.

The Fed Capitulates—And For Good ReasonIn This Issue

April 2014

The Federal Reserve finally threw in the towel on its unfortunate target—the6.5% unemployment rate (Chart 1) at which it would likely raise the federalfunds rate in controls from essentially zero at present.

“Unfortunate”

We say “unfortunate” for two reasons. First, setting quantitative targets isridiculous in an era when monetary policy is subject to fiscal drag due to higherincome tax rates and the expiration of 2009's massive stimuli, uncertainconsumer spending, a skittish housing sector, Congressional gridlock and theunknown effects of foreign developments such as slowing growth and

Volume XXX, Number 4 April 2014

The Fed Capitulates—AndFor Good ReasonThe Fed junked its 6.5% unemploymentrate target for raising interest rateslargely because the declining laborparticipation rate has artificiallydepressed joblessness. About 60% ofthe participation rate drop from its 2000peak is due to demographics, principallythe retiring postwar babies. Fortypercent of the decline is due to youthswho stayed in school due to poor jobprospects. Middle-aged discouragedworkers also dropped out but wereoffset by the rising number of 65+people who work due to inadequateretirement funds as well as betterhealth.The overall participation rate droppedfrom 67.4% of those age 16+ in 2000 to63% this year, and current trends willpush it to 60.1% in 2020. Even at thelow level, population growth will provideenough people to accommodate thereturn to rapid economic growth,assuring the proper skill matches andproductivity growth at the 2000s rate.

How China's WoesCould Shock InvestorsThe ongoing "risk on" investment climatewould shift to "risk off" with asubstantial shock. Difficulties in Chinamay result in such a jolt, and 8 problemsthere point in that direction:1.Slowing Economic Growth2.Transition from Export-Led to Domestic-Driven Economy3.Rising Militarism4.Anti-Corruption Campaign5.Manipulation of the Yuan6.Shadow Banking Risks7.Interest Rate Deregulation8.Botched Bailouts

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CHART 1Alternative Measures of Unemployment

Source: Bureau of Labor Statistics

Last Points 2/14: unempl. 6.7%; alt. measure 12.6%

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-142%

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Total unemployed (U-3)

Total unemployed + marginally attached workers + employed part time for economic reasons (U-6)

Economic Research and Investment Strategy

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financial problems in China and other developingeconomies.

After the meltdown of the subprime mortgage marketrevealed its opaqueness, transparency became the goal inWashington and in financial markets. Federal Reserveofficials, as mere mortals, caught the bug and have triedto apply transparency to their policy targets even thoughmonetary goals are driven by uncertain data and thereforeimpossible to quantify with any degree of precision.

Even if monetary goals could be precisely and predictablydelineated, doing so would remove the uncertainty andmystery from policy. And that unpredictability is whatkeeps markets honest and speculation in check. Considerthe Chinese yuan, which was raised vs. the dollar sosteadily in recent years that speculators jumped in to takeadvantage of a one-way bet, often moving money intoChina illegally to do so. That induced the government todepreciate the yuan, starting in mid-February, to createuncertainty and punish speculators but with as yet unknownunintended and possibly destabilizing consequences.

A Poor Indicator

The second reason the Fed's unemployment rate goalwas unfortunate is because even though this is the headlinenumber, it is a notoriously poor indicator of labor marketconditions. It’s the ratio of the jobless, those who saythey’ve actively looked for work in the last four weeks, tothe sum of that group and the employed. So it doesn’taccount for the quality of jobs.

As we’ve noted in past Insights, leisureand hospitality jobs have risen by 1.53million since the trough in January 2010while manufacturing jobs have climbed622,000 since their February 2010bottom. But since leisure and hospitalityworkers are paid less and work fewerhours than in manufacturing, theirweekly pay is only 35% as large.

Furthermore, the headlineunemployment rate—U-3 in Bureauof Labor Statistics parlance (Chart 1)—doesn’t say anything about the leap inthe Great Recession in the long-termunemployed (Chart 2) or the widenedunemployment rate gaps based on race

and education levels. Ditto for the leap in part-timeemployees who would like to work full-time (part-timefor economic reasons). And, of course, the standardunemployment rate does not measure the ongoing incomepolarization in America, which we discussed in detail lastmonth, and the drop in median real income, even in theongoing economic recovery.

Labor Participation Rate

Most importantly, the headline unemployment rate doesn’taccount for the hordes who have dropped out of thelabor force and therefore aren’t counted as unemployed.As discussed in detail in “How Tight Are Labor Markets?”(June 2013 Insight), if the labor participation rate nowwere the same as the 67.3% in February 2000, the laborforce would be 10.6 million bigger than it is.

Since the unemployment rate back then was 4.1%, thisimplies 14.3 million more job holders. Without thatdecline and with today’s employment, the U-3unemployment rate would be 12.7%. Furthermore, 88%of the decline in the jobless rate since its peak at 10% inOctober 2009 was linked to the drop in the participationrate from 65.0% back then to 63.0% in February 2014.......

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CHART 2Duration of Unemployment

Source: Bureau of Labor Statistics

Last Points 2/14: 27+ weeks 37.0%; avg. weeks 37.1

Jan-48 Jan-58 Jan-68 Jan-78 Jan-88 Jan-98 Jan-080%

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% Unemployed for 27+ Weeks as a % of Total - left axis

Avg. Weeks Unemployed - right axis

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How China's Woes Could Shock Investors

In last month’s Insight, we noted that the “risk on” investment climate persists with robust U.S. equities even though

—Consumer spending is subdued, even after accounting for inclement weather early this year—The housing recovery is slipping and has been driven by rentals, not the solid foundation of new homeowners—The Administration’s fixation on income redistribution reinforces gridlock in Washington as the 2014 elections loom—Tepid labor markets have weakened further and the weather isn’t to blame—Obama’s minimum wage proposal will cut employment by 500,000 while adding a trivial net $2 billion to incomes,according to the CBO—While Obamacare confuses individuals and employers alike, the CBO forecasts a 2.5 million job loss as people arepaid to not work—The Fed is determined to taper despite deflation risks, falling commodity prices and emerging market crises—Reduced Fed largess is separating the well-managed developing country Sheep from the poorly-run Goats whileglobal contagion remains a possibility—The crisis in Ukraine threatens a slowdown in East-West trade and a revival of the Cold War

Shocks

This month, we’ll begin to examine themany shocks that would force investorsinto an agonizing reappraisal and aswitch to a “risk off” strategy. Mostinvestors with long-only equityportfolios don’t want to walk awayfrom a winning game. Like mosthumans, they play until they lose, as wastrue of the dot com stocks in the late1990s (Chart 1) and the housing bubble-driven market in the mid-2000s (Chart2). They prefer to ignore the removalof fuel under the boiling equity potprovided by the Fed since August 2008.They also turn a blind eye to the basis ofcorporate earnings: the unsustainableleap in profit margins driven by cost-cutting (Chart 3) and the lack of solidsales volume gains in a slow growtheconomy and the absence of pricingpower in an inflation-less businessclimate.

It’s possible, of course, that equityinvestors’ enthusiasm will be vindicated.All the problems we just listed may besolved without significant stock marketimplications. Economic growth mayspurt this year and fulfill expectationseven though similar hopes in each of thelast five years have been dashed. But

CHART 1Nasdaq Index

Source: Yahoo Finance

Last Point 4/1/14: 4,268

Jan-80 Dec-83 Nov-87 Nov-91 Oct-95 Oct-99 Oct-03 Sep-07 Sep-110

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CHART 2S&P 500 Index

Source: Yahoo Finance

Last Point 4/1/14: 1,886

Jan-80 Dec-83 Nov-87 Nov-91 Oct-95 Oct-99 Oct-03 Sep-07 Sep-110

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CHART 4Problems In China

1. Slowing Economic Growth

2. Transition from Export-Led to Domestic-Driven Economy

3. Rising Militarism

4. Anti-Corruption Campaign

5. Manipulation of the Yuan

6. Shadow Banking Risks

7. Interest Rate Deregulation

8. Botched Bailouts

absent these salutary developments, theongoing “risk on” euphoria willprobably be ended by a significantshock.

Last month, we listed five potentialmajor shocks: A financial crisis in Chinaif she bungles her attempts to shiftfrom an export-driven to a domestic-led economy while opening financialmarkets; an escalating confrontationbetween Russia and the West overUkraine and nearby countries; a spike inoil prices resulting from a blow-up inthe Middle East or in Venezuela; andglobal contagion resulting fromdeveloping country woes.

We’re not forecasting one or more ofthese shocks to materialize.Nevertheless, in a slow growth world,they can’t be ignored since it doesn’ttake much of a hiccup to turn meagergrowth into a self-feeding decline ineconomic activity. Also, the number ofpossible shocks is important since onecan trigger others, just as the subprimeresidential mortgage collapse, startingin early 2007, spread to Wall Streetquickly and required massive financialrescue to avoid a meltdown.

Even if all of these shocks areindependent of the others and each hasonly a 20% likelihood, the statistical probability that oneor more of them will unfold is 67%! This month, we’llconcentrate on China, and then examine the other shocksin the future.

China has vaulted to become the second largest economyworldwide. She’s the 800-lb. gorilla among developingcountries even though China is still an economy pigmy interms of GDP per capita. Her global importance hasbeen magnified in the last several decades as manufacturingshifted there from North America and Europe. So herimports of raw materials and exports of manufacturedgoods have exceeded greatly her internal demand.

This means that China’s problems are the world’sproblems, and there are eight of them that singly—or

CHART 3Corporate Profits and Employee Compensation

Source: Bureau of Economic Analysis

Last Points 4Q 2013: corp. profits 14.7%; employee comp. 60.7%as a % of national income

1947-I 1959-III 1972-I 1984-III 1997-I 2009-III 58%

59%

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Compensation of Employees - left axis

Corp. Profits with IVA and CCAdj - right axis

more likely, in combination—could precipitate a majorcrisis (Chart 4).

Even if only one difficulty surfaces, it’s far from clear thatit can be contained without leading to a full-blown crisis,despite the best efforts of Chinese leaders.......

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