The U.S. Government’s Dilemma

December 26, 2009

On some of the lowest volume of the year, the S&P500 moved up 2.2% last week.  The lack of volume suggests that the prices moved up with very little conviction.  The VIX (or fear) index slid to the lowest levels of the year, which suggests that investors are becoming extremely complacent.

As usual lately, the economic data were mixed and certainly not supporting the strong V-shaped rebound in economic activity that many equity market and economic forecasters have called for.  To start, the final revision to Q3 GDP was much lower than expected–only 2.2%, or almost 40% lower than the 3.5% originally reported.  While existing home sales surged (but only because of the temporary home buyer tax credit), new home sales plummeted to nearly the lowest level of the year.  Personal income and spending, while growing slightly over the previous month, were both lower than projected.  Durable goods orders came in much lower than expected.  Initial jobless claims were better than expected, but the continuing claims (when extended and emergency claims are included) were near record highs.

The technicals, for the S&P, on the daily charts are very overbought.  The weekly charts are still completing a gradual topping formation, and the monthlies are still in a two-year bear market downtrend.

Now that the Fed’s quantitative easing program (electronic printing of dollars used to buy Treasury’s and Fannie and Freddie debt and MBS) will be winding down over the next three months, the government is staring at a massive financing problem:  Because the Fed created $1.5 trillion of dollars to buy government debt in 2009, the NET amount of government paper sold to investors was only $200 billion.   Essentially, the Fed financed most of the $1.75 in NET new borrowing by the U.S. government in 2009.

But what happens in 2010?

According to the research performed by ZeroHedge, the U.S. government will need to borrow over $2.2 trillion, beyond the expiration of existing debt that needs to be rolled over.  Since the Fed has $200 billion more left with its quantitative easing program, this means that more than $2 trillion will need to be sold to investors in 2010.

As the folks at ZeroHedge so aptly put it, “Good luck”.   Think about it–the amount of U.S. government debt that needs to be sold to households or corporations or foreigners will be TEN times larger than the amount sold in 2009!

So what’s going to happen?

Here are the possible scenarios, all of them grim:

1. The Fed introduces another quantitative easing program, which will almost ensure that foreign investors will punish the dollar and start heading for the exits to dump dollar denominated assets.  The additional dollars will also make inflation much more likely to explode, meaning that nominal prices of assets and economic activity could rise, but in REAL terms, both would most likely fall.

2. U.S. Treasury rates soar.  This will be the natural way to lure buyers to such a huge supply of debt.  But the higher rates would slam the “green shoots” in the economic recovery sending GDP back into recession territory and unemployment soaring above the already nosebleed levels.

3. Scare some of the newly created wealth in the stock and bond markets into safe the arms of the U.S. debt markets.  In essence this means that the government could “engineer a market collapse” to induce investors to buy government securities instead.

One of these three scenarios MUST occur.  There really is no other option. 

Now let’s sit back, grab some popcorn, and enjoy the show.  This is going be a good one.

The Spark?

December 20, 2009

The S&P500 slipped 0.4% last week on slightly higher volume.  The VIX (or fear) index inched up as well.   Over the last eight weeks, the S&P has bumped around the 1,100 level which has proved to be a strong resistance level as many traders had expected. 

The economic data were mixed.  Producer prices jumped more than expected as the recent run up in commodity prices is beginning to show up in manufacturers’ costs.  Consumer prices, however, have yet to see the effects these upstream costs; the CPI came in modestly higher, as expected.  The Empire State Manufacturing Survey was much weaker than consensus, but industrial production and the Philadelphia Fed survey were both better.  Finally, the weekly jobless claims were weaker than projected, and the total of all continuing claims (at almost 10 million) continues to hit all-time records.

Technically, the daily charts point to a consolidating S&P at toppy levels.  Although prices are near cycle highs, a multitude of other indicators are still flashing negative divergence signals.  The weekly charts are also toppy with several indicators pointing to a looming price correction.  The monthly, two-year old, bear market downtrend line is still in effect. 

So what will it take for investors and traders to sell?  What are the possible early warning signals that could push prices down and finally bring about the much delayed correction?

Well, the groundwork has been laid.  Since the Fed’s liquidity pump has almost perfectly coincided with the runup beginning in March, the shut down of this pump would take a lot of tailwind away from the upswing.  Last week, the Fed did exactly that.  While the pump has not yet been fully shut down, the Fed announced that it will proceed with its scheduled wind down of various liquidity programs between February and March 2010. 

One media reporter likened this to the loudspeaker announcement one hears in a store that’s about to close: “attention shoppers, the store will be closing in 15 minutes”.  The Fed will be shutting the liquidity party down over the next 90 days.

How about the actual spark, the trigger to instill a sense of fear in the capital markets, the fear that would cause investors to sell riskier assets such as stocks?

One of the most likely sources will be a sovereign default.  Several weeks ago, Dubai (a tiny pseudo state, or emirate, within the United Arab Emirates) almost defaulted on several billion dollars of debt and caused the global equity markets to drop 3% almost overnight.

But how much more would equity markets get spooked if a larger, more mainstream state defaulted? 

The credit default swap market tracks the risk of such defaults.  And the signs are ominous.  Near the top of the “most likely to default” list are Ukraine, Latvia, Venezuela, Argentina, Pakistan and Greece.

And last week, Greece made the most headlines with its sovereign debt downgrades.  Greece is on a clear road to fiscal disaster.  With only a few months to put its fiscal house in order, it’s highly unlikely that a solution will be found.

And as the Dubai crisis taught us, the next sovereign crisis can come from the most unsuspected places.  If Greece, or any one of more than a dozen nations, implodes, the impact could be Dubai times five or even ten.

Pay close attention to sparks.  The explosion could be devastating.

Economic and Market Headwinds

December 13, 2009

The S&P500 went almost nowhere last week, see-sawing every day to finish 0.04% higher by the end of trading on Friday.  The VIX (or fear) index rose almost 2%, suggesting that the current prices are being insured against a possible drop.  Volume fell, also not supporting the slight price rise.

The week’s economic data were mixed.  Consumer credit fell, again, but less than expected.  Initial jobless claims jumped more than expected.  Continuing claims were lower, as they have been for several months.  But these 5+ million of insured unemployed are not rolling off this benefit program because they’re finding jobs; instead, they’re shifting, in droves, to the emergency unemployment claims program.  When these programs are combined, the actual total is at record highs.  Retail sales rose more than forecast but less than it did in the preceding month.  And consumer sentiment rose as well.

Technically, the daily charts have a bearish bias.  Last week, prices literally stalled at levels lower than prices reached several times over the preceding four weeks.  On the weekly charts, the S&P is also continuing to bump up against the 1,100 resistance level first reached in October.  The two-year bear market downtrend, on the monthly charts, is still holding.

As the year draws to a close, it might be useful to re-examine the big picture, secular forces that U.S. equity markets will face over the next several years.  While the S&P has bounced off decade low prices earlier this year, we must not lose sight of the long-term forces that will affect the market going forward.  And most of these forces do present a headwind–almost exactly the opposite of the tailwind forces that helped propel the equity markets since 1982.

First, regulation will rise again.  Financial, climate related, and other regulations will increase starting as early as 2010.

Taxes will almost surely rise.  The accumulated federal debt and ongoing budget deficits will need to be paid down and reduced, respectively.  State and local taxes will also rise as non-federal governments struggle to get budgets back under control.

Global trade, which has virtually collapsed over the last 18 months, will struggle to grow again.  Already, major trading nations (including the U.S., Japan and China) are engaging in unofficial currency wars to promote their respective exports.  But as more nations engage in such beggar thy neighbor policies, all trade will suffer.

Consumer spending will not roar back at former growth rates.  As consumers in the U.S. (the major engine of economic growth for the nation over the last 20 years) struggle to de-leverage, they will certainly not have the capacity to spend through borrowing as they did 10 and 20 years ago.

Consumer spending will also suffer because unemployment in the U.S. will stay at elevated levels for many years.  Currently at 10%, unemployment (U-3) could rise to 11% or higher before starting to drift lower at the end of 2010 or even 2011.  But the drift lower could take it down to only 8% over five years, because millions of the jobs lost in this recession will never come back.

Corporate investment spending will also languish for many years.  With so much idle capacity already, businesses will have little reason to boost capital expenditures when final demand will not bounce back quickly.

Finally, as federal government spending becomes a larger part of the nation’s economy, the added borrowing will eventually push up interest rates, hurting the spending capability of businesses and consumers.

Put these forces together and a grim picture emerges.  Even if our nation manages to avoid another financial crisis, the economic growth rate will structurally slow down.  This means that corporate profit growth will also slow down and that the ratio of corporate profits to GDP will drop.  Lower earnings and lower earnings growth mean that valuation multiples ought to come down as well. 

And lower P/E multiples together with depressed earnings strongly suggest that the S&P will have a hard time surging much further.  In fact, if the markets discover that these secular forces will prevent the return of the Goldilocks economy, then the S&P could correct sharply.

It might take a while, but the odds are fairly high that these headwinds will espress themselves eventually.

The Fed Admits to Taxation Without Representation

December 6, 2009

The S&P500 gained 1.7% last week after quickly brushing off the Dubai debt crisis.  The fear (or VIX) index dropped, but did not revert to levels reached before the crisis hit.  The Fed induced liquidity rally is continuing to feed on itself, despite the fact that fundamental analysis is pointing to full if not over valued price levels.  As long as prices do not collapse, rational trading strategy suggests that you should not sell in anticipation of a reversal; instead, stick with the trend and protect yourself with downside insurance (put options) or tight stop-loss orders.

The economic data were mixed, with several signs that the government’s fiscal and monetary policies are ensuring that the economy maintains a pulse.  Chicago PMI was slightly stronger than expected, while ISM Manufacturing was weaker.  Chain store sales were weak, throwing into question the ability of the consumer to rebound in the face of double-digit unemployment.  Initial jobless claims we slightly better than expected, but this occurred in a holiday shortened week.  ISM non-manufacturing (services) came in decidedly worse than forecast; the 48.7 reading implies contraction, when expansion was forecast.  The big number, non-farm payrolls, was much better than expected; still November showed that thousands of jobs were lost.  The headline (U-3) unemployment rate dipped to 10.0%.  But since 100,000 unemployed people left the workforce (presumably because jobs are so hard to find), the unemployment rate can FALL even as jobs are LOST.  

Technically, the uptrend in the daily charts is intact.  The weekly uptrend is still forming a gradual rolling top pattern.  The 1,100 range on the S&P was initially reached in September; today, over two months later, the S&P is still in the same general price range.  The monthly, two-year, downtrend is still in effect.

In the fall of 2008, the Treasury Secretary (along with the Chairman of the Federal Reserve) came to Congress to demand that a $700 billion emergency intervention bill (TARP) be passed.  They warned that if Congress did not pass such a bill, then the economy would seize up, plunging the country into another depression.  Congress passed the emergency bill and Mr. Paulson promptly invested hundreds of billions of dollars into financial entities that he deemed to big to fail.

But the American people understood, roughly, the deal.  The government would provide the funds and the Treasury department would invest it with the understanding that it would eventually be paid back.  And since the government was already running budget deficits, it was clear that these funds would need to be borrowed (by selling Treasury securities) from domestic and foreign investors.

At the same time, the Fed ballooned its balance sheet from about $800 billion to $2.3 trillion and pumped this money into, well, it’s not quite clear exactly where, but Ben Bernanke insists that wherever the money went, it was money well invested.  He refuses to disclose the destination of these funds because, he argues, if the public knew where the money went, it could destabilize the financial system–again.

Setting aside the debate over whether this is a valid and acceptable excuse for opacity, a natural question might be–where did this extra $1.5 trillion come from?  Like the TARP, which was openly funded by the taxpayers, was this massive amount of funds also coming out of the taxpayers’ pockets?  And if so, why didn’t the taxpayers have a vote–through their representatives–on the matter?

In 2004, in The American Economic Review, Ben Bernanke co-authored a paper on conducting monetary policy when interest rates are near zero.  The financial blog ZeroHedge excerpted a revealing snippet from this paper, where Mr. Bernanke talks about the impact of quantitative easing:

“So long as market participants expect a positive short-term interest rate at some date in the future, the existence of government debt implies a current or future tax liability for the public. In expanding its balance sheet by open-market purchases, the central bank replaces public holdings of interest-bearing government debt with non-interest-bearing currency or reserves. If the increase in the monetary base is expected to persist, then the expected interest costs of the government and, hence, the public’s expected tax burden decline. (Effectively, this process replaces a direct tax, say on labor, with the inflation tax.)”

So there you have it.  Ben Bernanke admitted that, as an explicit policy, the magical creation of $1.5 trillion of additional dollars will be paid for by all citizens, as an “inflation tax”.  But since citizens (though Congress) had absolutely no vote in the passage of this tax burden, it is taxation without representation.

Is it any wonder that Mr. Bernanke is furiously opposed to the Ron Paul bill to audit the Fed?  How will the public react when it finally understands that the Fed, without consent, is TAXING every member of this country (who uses the dollar as a store of value) and funneling the proceeds to the elite managers and owners of the global financial institutions?

Here’s one opinion–No, and not well.