Anyone watching the stream of economic news surfacing this year has to wonder if there is a growing gap between perception and reality.

Virtually all the old wise men, people like former Fed Chairman Alan Greenspan and Harvard University's Martin Feldstein, who chaired former President Reagan's Council of Economic Advisors, are convinced the U.S. economy is in a recession.

Some observers, like hedge fund manager and commodities aficionado Jim Rogers, have said they assume the government is just lying. Others, like Northern Trust's Paul Kasriel, think the official arbiter of recessions, the National Bureau of Economic Research (NBER), is simply waiting until the election before making it official. It is worth noting that Feldstein, who chairs the NBER, has indicated on the record he believes the economy's woes are serious and may continue well into 2009, even if he refuses to make an official recession call.

But the statistics don't support this growing consensus. Instead, they paint a picture of a business climate exhibiting wide variances between different industrial sectors which, when aggregated, depict an economy that is managing to keep its head above water, although it requires massive doses of fiscal and economic stimuli to stay afloat, fanning fears of inflation.

It's obvious that the pace of global economic change is accelerating and that the world of investing, like the rest of the world, is headed to a place it's never been before. This new world appears to be characterized by sudden, sharp surges in asset prices, driven in part by increasingly liquid global capital markets. Facts are troublesome things, and when statistical patterns change, old rules of thumb are open to question. For example, in 2007 the notion that five consecutive months of rising unemployment virtually guaranteed a recession used to be the closest thing to an economic law set in stone, and back in those good old days, net employment was still rising.

Dodging a recession ultimately will depend on a few key factors, chief among them productivity, which advanced at a surprisingly strong 2.5% clip in the second quarter. That's good news, but productivity figures are subject to more revisions than most. Exports expanded at a 2.4% rate in the second quarter, turning what would have been a 0.5% GDP decline into a 1.9% gain. But the dollar is strengthening as foreign economies experience their own downturns, so it's uncertain how long American companies can rely on strong sales abroad.

Nowhere is the seeming chasm between perception and reality more glaring than among economists themselves. Those who work in the real world see it very differently from those who work on Wall Street or in academia, both of which reside as far away from the real world as Mars. In a recent note to clients, economist Ed Yardeni cited a survey by members of the National Association of Business Economics in which only about 10% of the 101 respondents expected a decline in gross domestic product (GDP) in this year's second half. Among the remainder, 45% forecast anemic growth of zero to 1.1%, and 44% saw growth exceeding 1%. (Note: The percentages don't add to 100 presumably because of rounding.)

Of course, more and more economists are using alternative definitions of a recession beyond two consecutive quarters of negative GDP growth. "It's easy to get trapped by definitions," says Dan Fuss, the Loomis Sayles vice chairman and uber-bond fund manager. "Year over year, we've been in a period of economic softness since last November. Units of economic activity have been going down for eight months. In my mind, that's a recession."

Looking at a cross section of industrial sectors, Fuss sees few rays of light. Variable or discretionary consumer spending is taking it on the chin. Consumer durables, housing, construction, autos, banking, retail sales and airlines are all experiencing declines in unit sales, while some consumer non-durable businesses are eking out revenue gains from price increases, not unit sales gains. Even the supposedly recession-resistant gaming industry has been pasted. "I don't think we'll see many new casinos being built," he remarks.   

While the month-to-month rise in unemployment has been relatively mild in 2008, Fuss says that until recently, strong state, local and federal government hiring has muted declines in the private sector. "It's not that layoffs are going way up, it's that new hires are dropping off a cliff," he explains. Indeed, the last recession in 2001 produced a bigger net loss of non-farm jobs in one month-September, when that recession had officially ended-than we've witnessed in the first seven months of 2008.

Ironically, the pockets of strength in the American economy are located primarily in areas that have floundered for most of the last two decades: the farm belt and the energy areas. Export-related businesses remain a bright spot, and some even think it might be possible for American auto manufacturers to start selling cars abroad for the first time in decades if the dollar stays soft. But there is growing concern about whether the U.S. auto industry can remain solvent and survive.

Of course, downturns in the business environment can help purge the excesses in an economy in ways that are positive, even if businesses and individuals feel a lot of pain. Some would argue it's hardly a tragedy that the slot machine activity in many casinos is comatose, or that SUV sales are plunging, or that revenues at some of the nation's largest law firms are down as much as 30% so far in 2008, or that more Americans have stopped shopping until they drop and are actually trying to save.

    The real problem isn't whether we're experiencing a recession or a slowdown; it's what kind of shape the recovery will take. Consumer spending, which accounts for 70% of all economic activity, is down-and would appear to be out for a few years.

Writing in The Wall Street Journal on August 6, Martin Feldstein voiced his surprise that the government stimulus program, which involved sending $500 rebate checks, turned out to be a bust, the result being that only 10% to 20% was spent and recycled into the economy. Like most of the bipartisan bigwigs on Capitol Hill, Feldstein and other leading economists had assumed mistakenly that at least 50% of the $78 billion in rebate dollars sent out in the second quarter would be spent.

Sad to say, but the whole silly rebate affair revealed how out of touch Washington politicians and academic elites are with ordinary Americans, who for once might be a little more serious than the wonks. Credit cards, home equity lines and, for the fortunate few, margin equity accounts are either tapped out or suddenly sinking in popularity. Most folks opted to either bank the money or pay off some debt. So it calls into question the value of future one-shot stimulus plans, including Sen. Barack Obama's plan for a $500 billion stimulus package and bond fund legend Bill Gross' suggestion that Obama double it to $1 trillion. Indeed, the whole idea that government has the ability to get us out of this predicament appears ludicrous.

The events of the last year also call into question the efficacy of monetary policy. Despite dramatic interest rate reductions by the Federal Reserve Board, interest rates for consumers and corporations have actually climbed over the past 12 months.

It seems that the more the Fed relies on monetary policy as an instrument to deal with a raft of problems, the blunter their instrument becomes. During the last downturn from 2000 to 2003, the Fed lowered its key rate to 1.0% and unemployment kept climbing into 2003. Back then the problem was capital expenditures, not consumption. But the low rates set in motion a sequence of events that set the stage for the current credit bubble. So many are wondering what future problems are being created by these current ineffectual solutions.

In early August, Feldstein also told Bloomberg Television that he couldn't "see" a recovery. The prospect of an extremely tepid rebound is a view that's shared by many observers, including Fuss and ISI Group's Ed Hyman. "The slowdown may be shallow," but the bounce-back is likely to be "shallow as well," Fuss notes.

Two factors are central to the problem-each centers on the deleveraging of the U.S. consumer and the global banking system. Speaking at Morningstar's Investment Conference on June 25, Mohammed El-Erian, co-CEO of fixed-income behemoth Pimco, described this rolling deleveraging process, which began in emerging markets at the end of the last century, rotated into corporate America during the 2000-2003 period, and is now in full swing in the global financial system. He suggested that the likely future destination for deleveraging would be the U.S. consumer and, in fact, their response to the stimulus program supports that view.

In his new book, When Markets Collide: Investment Strategies for the Age of Global Economic Change, El-Erian notes that for the last decade the global economy has been like a jet flying on one very big engine-the U.S. consumer-and everyone made an effort to keep the plane flying fast at stratospheric altitudes. According to some top Wall Street executives, foreign banks were all too eager to load up on tranches of U.S. subprime debt.

Just as many emerging economies sucked it up a decade ago, embraced fiscal responsibility and now find themselves sitting pretty as they buy big equity stakes in many of Wall Street's pre-eminent names at whopping discounts that dilute U.S. investors, so American consumers are going to have to start living within their means and saving more than they have for the last two decades. Evidence indicates this type of transition is already under way, but it will take time. A sustained deleveraging among American consumers would translate into slower lending for financial institutions, backfiring on already-beleaguered value investors who rushed in early this year to buy bank and brokerage stocks after their initial decline last fall.

In recent talks, El-Erian has also addressed how the rapid pace of change has caught the financial world off guard, even when this change involves megatrends everyone saw coming. For years, the real estate bubble consumed cocktail party conversations across the nation before subprime exploded, but experts such as Fed Chairman Ben Bernanke were among many who thought the problems would be confined to the subprime world. While the financial system was fully capable of interpreting the narrow ramifications of each individual signal, El-Erian thinks the system proved to be a disaster at understanding how the systemic implications of a wide array of different developments interact. Similarly, everyone accepted the notion that China and India were becoming major players in the global economy, but nobody expected it to happen so fast.

    The question facing financial advisors today is: Where do the global financial markets go from here? Some, such as El-Erian, are far more optimistic today than they were early in 2007, when all financial assets were richly priced and real estate values were just starting to crack. In the intervening 18 months, one lesson we've learned is just how difficult it is to manage success. From El-Erian's viewpoint, one asset class that looks extremely attractive is the U.S. municipal bond market.

Brian Wesbury, chief economist of First Trust Advisors, recently penned a letter to clients that posed the question of whether equities weren't "the only game in town." One of the few economists who has consistently observed that all the carnage in real estate and financial services have caused a slowdown, not a recession, Wesbury notes that most alternatives, particularly bonds, commodities and real estate, are all confronted with their own set of troubles.

Despite the sharp drop in oil and other commodity prices in July and early August, savants like Wesbury and Fuss remain concerned about long-term inflation risks. Consumer prices are up 5% year over year, while 10-year Treasurys are yielding about 4%. Moreover, as Wesbury says, changes in monetary policy take 18 to 24 months to influence inflation, and it was only 12 months ago that the Fed started cutting interest rates from their 5.25% recent highs to the current 2% level. So even though commodity inflation may be receding, Fed-induced inflation has yet to come. In the clash between Fed-inflation and commodity disinflation, whichever force emerges as the victor will have a major influence on the direction of bond prices-and other asset prices-in the next two years.

Wesbury explains that, "Even if we discount earnings with a 6% rate (well above market rates) and use earnings depressed by 'paper' losses at financial firms due to 'mark-to-market' accounting requirements, historical relationships between stocks, profits and interest rates suggest a fair value of at least 15,000 on the Dow by the end of 2008. As a result, stocks are not the contrarian investment, but the only one where there is a true chance of outsized gains in the years ahead." For his part, Fuss thinks that "stocks are cheap and could remain cheap," but nonetheless he is upbeat about traditional growth stocks "like Johnson & Johnson and Emerson Electric with good cash-on-cash returns."
Still, Wesbury and Fuss are only two voices in a growing chorus of experts who view U.S. equities as cheap. Hedge-fund manager Barton Biggs, a major bear in the 1990s, has described American stocks as the only cheap asset class left on the planet. In early August, value-investing shop Tweedy Browne told clients "pricing opportunities are surfacing and the discount between market value and intrinsic value in the bulk of our portfolio has rarely been cheaper than it is today."

The almost universal love affair with large-capitalization U.S. growth stocks is understandable following a decade in which the Standard & Poor's 500 posted single-digit cumulative gains. Mid-cap and small-cap stocks performed far better. In late July, Yardeni noted that the S&P MidCap 400 climbed 113.6% over the previous decade while the S&P 600 Small-Cap index rose 87.4%. So diversification has its benefits, even within our borders.

Even a so-called perma-bear, Jeremy Grantham, has changed his tune somewhat in recent months. The chief investment officer of GMO, LLC is now underweighting emerging market stocks, an asset class he has favored ever since they cratered famously in the summer of 1998. Yet via a spokesman, the value-conscious Grantham also said that, if you have to own stocks, one should pick the elite members of the Standard & Poor's 500 and short the     Russell 2000. But then, Grantham's favorite investments are timber and hedge funds (apparently, he knows how to pick them).

Hedge funds endured one of their worst months in history in July as many vehicles were forced to unwind what had been the favorite 2008 trading strategy: long on oil, short on financial stocks. Like others, Grantham believes oil and other commodities are likely to poop out in the short term as other nations around the globe follow the U.S. into a slowdown. While the worst may be over in America, the downturn in business activity now seems to be spreading around the globe. Deflating real estate prices lie at the heart of the matter. Grantham estimates that U.S housing prices need to fall another 17% or stay flat for four years to reach fair value while U.K. housing prices need to swoon 38% or stay flat for seven years.

But like Rogers and many others, he believes long-term trends favor commodities. "In the next decades, the prices of all future raw materials will be priced as just what they are: irreplaceable," Grantham wrote in a quarterly letter to his investment committee. "Oil, for example, will never again be priced on the marginal cost of pumping a marginal barrel from some giant Saudi oil field, as has been the practice for most of the last 100 years of oil production. Real cost is always replacement cost, and oil, a precious feedstock for chemicals and fertilizers, simply cannot be replaced. Using marginal cost as a substitute was ignorant and conducive to wasteful consumption of scarce energy resources. It also enabled us to put our collective head in the sand and ignore the growing need for an enlightened long-term energy and climate policy.

"Relatively quickly, in 100 years or so, we will run out of oil, underground water and most non-fully-renewable resources. At current rates, we will do it very, very fast. A major complication now, though, is that we have been brainwashed by repetition to reject this whole idea as irretrievably pessimistic and defeatist, and just well...thoroughly un-American," Grantham concludes. Still, Grantham believes the coming transition of alternative energy and conservation will create "a bottomless pit of investment opportunities," even if he questions America's predisposition to enter this new era of economic challenges.

Other observers voice fears that conflict directly with Grantham's concerns. Namely, they worry that big government now is so entrenched in American society that we could be headed in the direction of the European Union, where almost every problem has a government-sponsored solution. Ultimately, such fears could be overblown. "We're a very different country," Fuss contends. "It's hard to keep an economy like this down for a long time."