Recent reports that the U.S., European Union and Japanese economies are still in trouble isn't news. All three have been stinking it up in various degrees for some time. Don't hold your breath waiting for that to change -- because it's not the war, it's the lack of credit that's behind it.
What keeps changing isn't the economy, it's our expectations. Our brains adopt a metaphor, or pattern, and stubbornly hang on until proven wrong, at which point they snap to a new one. The fancy name for this is metaphor attractor, a piece of jargon good for a free drink at any bar in America (read The Cerebral Code for the cognitive/neurology view and Sync or Linked for the complexity/network theory take on tipping points and self-generating systems.)

The best example I know is the curve ball. To a batter expecting a fastball, a curve ball breaks sharply at a certain point. To a physicist, it follows a constant curvature. The break is in the batter's head --- it occurs when he gives up on one metaphor and abruptly switches to another.

We should be wary of our tendency to accept patterns as laws of gravity. Hubris is very dangerous for investors today. There is sufficient chaos in the air to guarantee that patterns drawn from the past (whether fundamental or technical), when the disturbances to the world were familiar and incremental, are likely to be unreliable. After bad things happen, of course, we will refer to them as Six Sigma events, i.e., not our fault. But the money will be gone all the same.

Plan on This
In all this chaos, however, there are two things we do know about the economy. First, manufacturing activity is frozen like a fly in amber and will stay that way until the war is resolved. You don't need government data for this -- go to the shopping mall. From my position as director of several companies, I see daily sales numbers for a wide variety of industries. Believe me, the economy is still dead.

The second thing we know is companies aren't getting the working capital from banks they need to operate. Bank lending has fallen almost every week for two years, now $952 billion from $1.1 trillion in December 2000. Banks that would lend businesses 3.5 times cash flow two years ago will lend 1.5 times today, if they will lend at all. And their minimum profit hurdles are up from $2 million to $10 million.

This credit shortage is the real cause of the recession and weak pricing power that have plagued American companies for two years. The Federal Reserve and the Treasury are doing nothing about it. Although recent data look a little more promising, the credit crunch is still with us.

When the war is over, the economy is going to go from completely dead to mostly dead. This will be good for interest rates and stock valuations, because it will encourage both the Fed and the bond vigilantes to hold their fire for the rest of the year.
The implied slow gross domestic product growth, however, is not so good for sales or earnings growth. There are gains to be made in sectors where prices are far below intrinsic values. But we will have to wait for the big gains until we have a functioning banking system again. Expecting more than that could get us into trouble.