Gauging the Net
Effect of Katrina

Hurricane Katrina will
reduce employment by 400,000 people in coming months while trimming economic
growth by as much as a full percentage point in the second half of this year,
according to a Congressional Budget Office assessment.

     —The Modesto Bee

The initial reaction of
analysts and pundits to Katrina was that it would be the recessionary shock to
finally knock the economy and markets off track.  Ironically, with the Bush
Administration’s colossal mishandling of the crisis, Katrina may turn out to be
a net stimulus.  The reason: The Bushies and Republican Congress facing an
unhappy electorate are going to throw gobs of money at the beast.  Initial
estimates of the Fed funds top $60 billion and will likely exceed $100 billion —
roughly equal to a year’s expenditures on the war in Iraq.  But guess what: at
least the money will be spent here.

Look for the markets to
benefit from this in the short run.  But a burgeoning budget deficit will
eventually be inflationary….  Right now: The Bulls are running.

The Week Ahead

The big reports this week
include the PPI, CPI, trade numbers, auto sales, and consumer sentiment.  It’s
unlikely that there will be any surprises in any of these reports so whatever
moves the market this week, it likely won’t be the data.

Peter’s Portfolio

Penny Stock of the Week:
Crossroads Systems
(
CRDS |
Quote |
Chart |
News |
PowerRating) provides data routing solutions for storage area
networks.  For a change, the insiders are buying and not selling the stock. 
I’ve got a big position and see this as a longer term proposition.

Bulls of the Week: 
(
EGHT |
Quote |
Chart |
News |
PowerRating)
as a VOIP play whets my whistle.  I’m in and looking to add shares.

Long term holds:
(
ASTM |
Quote |
Chart |
News |
PowerRating)
and
(
STEM |
Quote |
Chart |
News |
PowerRating) are both losing air from their tires but these are long term
holds.  Still like
(
VION |
Quote |
Chart |
News |
PowerRating).  Sold
(
TMTA |
Quote |
Chart |
News |
PowerRating) for a nice chunk of change.

Options:This is a fascinating
little story.  I’ve got 2007 Leaps on
(
CHIR |
Quote |
Chart |
News |
PowerRating) with a strike price of $45. 
Last week, when Novartis bid to buy CHIR, the stock shot up to $44$ and quess
what.  My leaps went nowhere.  The reason: the bid was below my strike price. 
How about dem apples.

I’m glad CHIR execs told
Novartis to take their own leap.  Look for a higher bid.  But I’m going to lose
a nice little chunk of chain if the bid comes in at $44.99 or less.  That’s a
harsh little lesson in how many different ways you can lose playing the options
game.  No worries though.  CHIR is worth more than $45 so maybe it will turn out
all right.

Hedging Your Bets With Matt Davio:
The Big Picture — literally

NOTICE:  Just as companies report their
earnings, so does my Red Rock Fund.  If you are an accredited investor and would
like a copy of the latest report, please contact me at

redrock@peternavarro.com.  We are very pleased with our results year to date
and would be happy to share them with qualified investors.

            I would like to start our refreshed weekly chat with a little
chart.  I think we are all tired of Katrina and her terrible aftermath.  That
will play itself out in a long and slow recovery. However, I would like to
address a favorite subject of mine again, and that is real estate as an asset
class.

Note the two scales are very different. The chart doesn’t specify, but I am
assuming that its in 1,000s.   The key takeaway is the ongoing shift —
now in its 3rd decade — away from a manufacturing economy and towards a
services based one.

BOOO—YAHHHHH … the US
Unemployment Rate fell to 4.9% during August, matching the ‘all-time’ low of
4.9% set in August of 2001.   INDEED, there are several macro-points worthy of
note herein:   First, we can CLEARLY see the polarization of wealth/income
within the combined facts noted above, as per the sharp DECLINE in those
Employed who hold less than a High School Diploma …

… AND the decline in ‘production’ and ‘administrative support’ jobs, usually
lower paying fields requiring less specified and intense ‘academic’ skills …

… especially, in the era of highly-efficient, cutting-edge productivity gains
generated by the automation of production facilities, and office administrative
support tasks.

This is EXACTLY what we have been talking about for YEARS … symptomatic of the
FACT that it takes LESS human labor/time input to create the same, or increase,
output of goods and services …

… and … for less labor input cost.

VOILA … it’s the ‘missing-link’ … as pertains to the COMPLETE LACK of
wage-income reflation. Continuing in this vein, we also note the areas of actual
‘strength’:

• Business and Financial Operations Management … payrolls rose 1,175,000 in the
last 12 months

• Construction jobs rose 513,000 in last 12 months

• Natural Resource and Mining jobs soared by 855,000 in last 12 months

What makes this all the more interesting, other than noting the gains in
monetarily REFLATED sectors … is the fact that these same sectors revealed the
strongest numbers in terms of Hours Worked, and Average Earnings …  against
which, we note that the MAJORITY of other sectors, posted outright DECLINES
along three data-points, Employment, Hours, and Income:

• Hours Worked, Natural Resource and Mining … 46.1 hours in August, up from 45.9
hours in July, 45.6 hours in June, and up big from the 44.4 hours worked per
week posted last August-04.

• Hours Worked, Motor Vehicle Industry … 43.1 hours, up HUGE from the 41.4 hours
per week posted in May

• Average Weekly Earnings, Construction … $769.89 in August, up significantly
from the $758.93 posted in July, and up $14.09 year-over-year.

• Average Weekly Earnings, Natural Resource and Mining … $871.88 in August, up
HUGE from $851.76 in July, and a monstrous $67.22 per week rise compared to
August of 2004, representing a sizable reflation of +8.4% yr-yr.

• Employment, Specialty Contractors … posted the LARGEST percentage increase
during the month of August, of ANY industry sub-sector, by creating 18,300 new
jobs during the month. Indeed, an increase in Real-Estate jobs was the second
largest, by sector.

Yet, when we look at the broader picture, not including the monetarily reflated
financials, construction, or natural resources and real-estate, we see a LOT of
NEGATIVE numbers. For example, noting the large increases in Hours Worked posted
above, we note the following sectors that posted DECLINING hours worked during
August:

• Leisure and Hospitality

• Warehousing

• Transportation

• Apparel

• Wholesale Trade

• Private Service Production

Indeed, we could make a case to suggest that even in the LABOR market, reflation
is disinflationary, in terms of natural resource and financial paper reflation,
versus disinflation in the discretionary-consumption sector. So, where IS the …
reflation.

Is there reflation … in savings ??    Is there reflation … in income ??

Ooooops, guess NOT, since ‘real’ income is DEFLATING, as is consumer savings,
which sits at a RECORD LOW, and, is NEGATIVE. Prior to grabbing the scalpel and
dissecting the data, we note the visual aid on display below, revealing the
PLUNGE into NEGATIVE territory, and, a new RECORD LOW, in the US Savings Rate
(as a percent of disposable income).

GEE, it was NOT long ago that US consumers SAVED ten percent of their disposable
income … indeed, it was as recently as 1994.

Carving the data provides an
even MORE OMINOUS picture. Note the data-details extracted from the Commerce
Department’s report on US Income and Consumption Expenditures:

• Personal Spending … up +1.0% during the month of July, coming hard on the
heels of June’s equally large increase of +1.0%.

• Personal Income … up +0.3% in July, on the back of June’s increase of +0.5%

In other words … the two-month, nominal, cumulative increase in Spending, at
+2.0% … is MORE than TWICE the increase posted by Income, at +0.8% for the two
months combined.

The details are WORSE YET.

• Rental Income … down (-) $3.3 billion … the second monthly decline, for a
total erosion of (-) $ 7.6 billion

• Non-Farm Proprietors Income … deflated by (-) $3.0 billion during the month, a
major shift from June’s income increase of + $15.5 billion

And, perhaps most disturbing, given the US consumer’s over-reliance on ASSET
reflation, for INCOME …

• Personal Income, Receipts on Assets … up only + $7.8 billion, or LESS than
HALF the rise posted in June, at + $18.0 billion … representing a single-month a
decline of (-) 56.7%.

AND, if NOT for a CUT in income taxes … the DISINFLATION posted in Disposable
Income would have been MORE pronounced. Note:

• Disposable Personal Income, After Taxes … $27.2 billion in July, down
significantly from June’s income of $45.9 billion

Indeed, BEFORE taxes, the monthly decline in Income was (-) $25.4 billion, after
taxes it was (-) $18.7 billion.

INDEED, with the hurricane re-construction costs putting even more pressure on
the fiscal front, at a time when the fiscal front is in full retreat … does
ANYONE seriously believe, that tax cut support for the US worker/consumer will
be maintained, into 2006 ???

NOT.

Thus, there is little reason to seek a turn-around in savings …

… UNLESS … consumption deflates dramatically !!!

Note the dour-data-details on US Savings:

• Disposable Income, Less Outlays = Savings … NEGATIVE (-) $58.8 billion, during
July, swinging into the red versus the barely positive + $0.9 billion in savings
posted for June.

YES folks, the decline in ‘savings’ is TWICE the size, in billions of dollars,
as is the increase in ALL after-tax income … in July alone.

Folks, we are talking about an annualized pace of decline in Savings, equal to
nearly a TRILLION DOLLARS over a twelve month period, pegged at (-) $708 billion
over 12 months.

Clearly, this is unsustainable, and just as clearly, consumption MUST take a
‘hit’, for this dynamic to ‘correct’. It is NOT going to do so, via any
expansion in wage-income, as can be concluded via a perusal of the labor market
statistics detailed in the first few pages of today’s Monitor.

We SPOTLIGHT the following commentary offered within the TEXT of the report
issued last week by the Commerce Department …

… “Negative personal saving reflects personal outlays that exceed disposable
personal income. Savings from current income may be near zero, or negative, when
outlays are financed by borrowing, or selling investments or other assets.”

YES, it is that last passage that piques our macro-interest, ala the thought,
that IF debt-creation were to become more difficult for the average consumer (ie:
if the Fed goes to far, with rate hikes) … then … in order to maintain
consumption patterns …

… the consumer might be tempted to SELL his ASSETS …

… which of course, offer the ONLY source of ‘income reflation’ currently
available, AND, the only places in which US wealth has been ‘stored’.

Thus, we note some other OMINOUS statistics related to Savings:

• Savings has now declined by a WHOPPING (-) $106.4 billion in just the last two
months.

• Savings has declined in six of the last seven months

• Savings has DEFLATED by a monstrous (-) $462.2 billion over that seven month
period, covering the year-to-date since January 1st.

YES, savings being depleted at a HALF TRILLION over the last seven months, also,
like the month-month rate, equal to a near ONE TRILLION DOLLAR PER YEAR PACE,
pegged at (-) $792 billion.

In total, on an annual, year-to-year basis … the US Savings Rate has plunged
from +2.1% in 2002 … to +1.8% in 2003 … to +1.2% in July of last year … and has
collapsed in 2005, now pegged at just +0.3%.

And, worse still:

• Disposable Personal Income in Chained 2000 US Dollars, has PLUMMETED during
the year-to-date, falling from a total of $8.393 trillion as of the end-4Q 2004
…to $8.172 trillion in July.

In other words … ‘real’, non-monetized, Disposable Personal Income has DEFLATED
by nearly a QUARTER TRILLION DOLLARS in the year-to-date (minus $221 billion to
be exact).

And, the icing on the cake comes in the form of a disinflating Personal
Consumption Expenditure Core Deflator, which has slipped back below the 2% level
over the last two months, and in the process, has broken down, by violating the
low seen in early 2004 …

… and … as can be seen in the chart visible at the top of the next page, the
core PCE Deflator appears to have PEAKED, in line with previous secular peaks,
in the 2.5% region. This is perhaps the MOST influential inflation indicator, in
terms of monitoring the prospects for further Fed tightening, basis inflation
vigilance, and, it has just turned from ‘red’ … to ‘yellow’.

AND, the Income and Spending report covers JULY … long before the word Katrina
had become one associated with death and destruction. We cannot imagine, given
the $4.25 per gallon price for gasoline charged this weekend in NYC … that
consumers will be SO willing to spend MORE than they earn, in September.

Peter Navarro is a business professor at the University of California-Irvine (www.peternavarro.com). 
Matt Davio is a managing partner at the hedge fund, Red Rock Capital Fund. For
investment management services, contact Matt at
redrock@peternavarro.com .  
Contact Peter at peter@peternavarro.com

DISCLAIMER: This
newsletter is written for educational purposes only.  By no means do any of its
contents recommend, advocate or urge the buying, selling, or holding of any
financial instrument whatsoever.  Trading and investing involves high levels of
risk.  The authors express personal opinions and will not assume any
responsibility whatsoever for the actions of the reader.  The authors may or may
not have positions in the financial instruments discussed in this newsletter. 
Future results can be dramatically different from the opinions expressed
herein.  Past performance does not guarantee future performance.