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Waiting for The Other Shoe to Drop   November 18th, 2009
Markets based on fluff and spin cannot endure       

 
QUICK OBSERVATIONS

More observations...
 

The markets, especially the stock market, have had a solid bull run since their lows in March. Mortgage rates and U.S. Government Bond yields have defied the expectations of many (myself included) by staying low far longer than many of us have expected.

Yet I cannot avoid the conclusion that the recent market rallies do not reflect the fundamental realities of the economy and must, therefore, be based on unrealistic hope and spin, probably stoked by another government induced bubble. It's not that I want to preach gloom and doom, but the fundamental economics in play today still support the conclusions I wrote earlier this year.

I'm increasingly concerned that there will be a significant correction sometime between now and the end of April 2010. The fact that the markets have rallied so strongly may only make this correction all the more painful.


And it seems that a growing number of people are reaching the same conclusion--if not predicting the specific time frame I am, they're at least predicting what is increasingly looking like an inevitable correction.

In reality, there's not really much good news out there that justifies a 60% run-up in the stock market. A brief look at some of the problems:

Problem: Devaluing Dollar

The dollar has been on a downward trend for most of the year. The excuse the entire time has been that while last fall we had a "flight to safety" with people moving their investments into the safety of dollars-based investments, we now have the opposite happening: people are more willing to take risks overseas so they are moving out of dollars to invest elsewhere. This leads to a devaluation of the dollar. Maybe.

However, it would be naive to ignore the reckless monetary policy that the Federal Reserve is engaging in combined with the unsustainable fiscal policy the Federal Government is engaging in--the Federal Reserve has flooded the economy with trillions in new money while the Federal Government is busy running trillion-dollar deficits. While it's possible everyone is just moving their investments overseas to take more risk elsewhere, it's at least as likely that people are seeing the dollar as risky and are abandoning it. With the value continuing to plummet against major currencies, any dollar-based investment has to make even more money for the foreign investor just to break even.

And the dollar has lost 15% of its value since March. China currently holds approximately $1.6 trillion in dollar-based assets which means it has effectively lost $240 billion in the last seven months due to the devaluation of the dollar. No wonder China, in March of this year, called for a new global reserve currency to replace the dollar.

Problem: Appreciating Gold

As the value of the dollar has continued to fall, the value of gold in dollar-terms has increased. This is not surprising since gold usually moves in opposite directions as the dollar. As the dollar loses value, it takes more dollars to buy the same amount of gold--so the nominal price of gold increases.

Additionally, gold is generally considered a hedge against significant inflation. With the Federal Government and the Federal Reserve pumping trillions of new money into circulation, fewer and fewer people are accepting the Federal Reserve's official line that discounts the possibility of inflation. Simply, you don't pump this much money into the economy and not have inflation eventually. So investors are hedging against inflation by buying gold.

However, it's not just individuals and private investors that are buying gold. It would appear that the central banks of other countries are starting to do so. Two weeks ago the Central Bank of India bought 200 tons of gold from the IMF in order to "diversify its foreign-exchange reserves." That is, India doesn't want all its foreign-exchange eggs in a single dollar basket. This is not surprising since India also joined China, Russia, and Brazil in pushing for a non-dollar reserve currency. Since an alternative reserve currency has not been established and India is not comfortable with dollars, it would appear that it's simply buying gold instead.

And as I wrote this article, it's reported that now Mauritius's central bank has bought 2 tons of gold. What countries are going to start divesting out of dollars and into gold in the coming weeks and months?

Keep in mind that gold is really not a profitable investment. It doesn't pay interest. It doesn't pay dividends. And, over the long term, it doesn't really appreciate much in real value. Rather it is a store of value.

The fact that individuals, private investors, and central banks are choosing to park their money in gold rather than invest their money in dollars suggests that the price of gold will probably continue to increase and reinforces the argument in the previous section that investors aren't leaving the dollar for riskier investments... they're leaving the risky investment that is the dollar. They'd rather park their money in gold and earn no interest than risk their assets to a devaluing dollar.

Problem: Foreign Banks Buying Gold, Not U.S. Bonds

Related to the appreciating value of gold is the fact that every dollar foreign central banks use to buy gold is a dollar they don't use to buy U.S. Government Bonds.

That wouldn't be a problem if the government wasn't running $1.5-trillion annual deficits. But it is. And in order to borrow $1.5 trillion per year, the money either has to be borrowed from someone or printed. The Federal Reserve supposedly ended its $300 billion Treasury-buying (money-printing) program which means , in theory, the Federal Reserve is no longer printing new money in order to finance the deficit (though we'll have to see how long that lasts).

While it's good the Federal Reserve isn't printing money to finance the deficit, that means the U.S. Government depends on investors and central banks to loan it money. So when India and Mauritius (and probably other countries in the future) use their money to buy gold instead, that's suggesting that a significant amount of money is not being spent to buy U.S. bonds.

In the future, the U.S. will most likely run into trouble when it comes to its capacity to raise funds to finance the deficit. This will either lead to the government being forced to cut spending and services, increase taxes, or have the Federal Reserve print more money which leads to its own set of problems.

Problem: Growth Is From Government Spending

Another serious problem is that while the third quarter apparently resulted in a 3.5% growth of GDP , that was largely due to government stimulus spending, the now-expired clash-for-clunkers, and a possibly bubble-inflating homebuyer's tax credit.

The fact that the government needs to artificially inflate the housing market with this tax credit, at a total expected deficit-increasing cost of $19.3 billion , indicates that the government knows that the housing market can't fly on its own.

The result of this tax credit is that, once again, people that can't really afford to buy a home are being enticed into doing so by the government distorting the market with this tax credit. These same people are further being enticed into buying a home by interest rates that are being distorted by the Federal Reserve's efforts to keep interest rates low. And this is happening at a time of rising unemployment where, all things being equal, potential buyers are at higher risk than usual of not being able to pay back their mortgage since they could easily lose their job.

Between the Federal Government paying for some of a homebuyer's house and the Federal Reserve pushing interest rates down with printed money, we're effectively looking at the government making a concerted effort to inflate the housing bubble that already popped. Do we really want to artificially inflate that bubble again?

Problem: More Asset Bubbles

In addition to the real estate bubble that we're apparently trying to re-inflate, it seems that we may be creating other asset bubbles.

With U.S. Government policies pumping so much cheap money into the economy, investors are borrowing this money in the U.S. and investing that money overseas. This is called a "carry trade."

For example, if you can borrow $1000 at 3% in the U.S., convert that money into 700 Euros (0.70 Euros per dollar), and invest it in some European endeavor that pays 6%, then in one year you'll have approximately 742 Euros. If the value of the dollar has dropped another 20% (now 0.56 Euros per dollar) then your 742 Euros is now worth $1,325. You pay back the $1030 you owe and you've made a profit of $295.

You'll have made 29.5% profit in one year by taking money out of the U.S. and investing it elsewhere. You haven't helped the U.S. economy in any meaningful way but have helped drive the market in Europe--but did your investment help Europe? Perhaps. But if you only made that investment because you were enticed by the cheap money then you very well may be just helping run up a bubble in the European market.

And the problem is that other countries are now complaining about precisely that.

Hong Kong has expressed concern that the trillions of dollars of cheap money flowing from the U.S. has contributed to a 40% rise in real estate prices and 50% rise in the stock market in the last year. "So there is the potential risk of an asset bubble"

Our own stock market, which has rallied 60% in the last 8 months, is also most likely being driven by a lot of cheap money being invested in the stock market combined with a dollar that is worth less and less. Just like gold, if the dollar is worth less the stock market should rise because it takes more dollars to buy the same portion of a company.

Which raises the question: Is the 60% rally in the stock market this year really a rally, or is it a combination of the dollar losing value and cheap interest rates fueling another bubble in the stock market?

    Update 11/23/2009: Five days after writing the above, the following conclusion was reported in an article at the Wall Street Journal:

    Against this questionable economic backdrop, many are concluding that the driving force behind the ongoing demand for risky assets now lies solely with the massive injections of liquidity that the Fed and other central banks have maintained this year. There is too much money chasing too few options, they say.

    "This has all been liquidity-driven," said Henrik Pedersen, chief investment officer at Pareto Investment Management. "I think we decoupled from any credibly fundamental forecast a long time ago. We are just seeing a re-inflation of the bubble."


Problem: Unsustainable Government Borrowing & Spending

It goes without saying that the Federal Government is engaged in unprecedented and unsustainable borrowing and spending. The federal deficit tripled from FY2008 to FY2009. The total national debt is now growing by over $1.5 trillion per year.

This creates three problems:

  1. Too much debt. We're adding to the national debt so quickly that it may become virtually impossible to pay back without draconian spending cuts or massive tax increases. Either of those two options would lead to higher unemployment.

  2. Not enough money to borrow. Given that the Federal Reserve has supposedly stopped printing money to finance the debt, that means the federal government needs to raise approximately $1.5 trillion per year. That's about four times what the world has generally invested in U.S. bonds per year.

    In tough economic times with many countries using their money to invest in their own economy, it's questionable whether this much money can be borrowed for multiple years. As I wrote back in February of this year, there's most likely not enough excess income being generated in the world to borrow this much. Investors and countries need to earn money before they can loan it to the U.S.

    That is, of course, unless there's a major stock market crash. If that happens many investors will cash out of the stock market and rush to buy bonds--effectively loaning money to the U.S. So, almost paradoxically, it may require a stock market crash to continue to finance the U.S. Government's borrowing spree.

  3. Lack of Confidence. More and more countries are warning us about what we're doing. As already mentioned, Hong Kong is expressing concern about all the money we're printing. China recently complained about all our borrowing and spending. Countries around the world are openly proposing moving to some other reserve currency because they simply don't have faith in the dollar. And a number of countries are apparently working to price oil in something other than dollars.

    All of this points to an increasing lack of confidence in the dollar which would exacerbate any of the above problems. In fact, President Obama said as much on November 18th, "I think it is important, though, to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession." It's good the president understands that. The question is whether he actually believes it or is just saying it to placate the growing contingent of countries that are dismayed at our economic course.

Possible Upcoming Triggers For the Other Shoe

All of the problems mentioned above are significant and any of them could explode into significant problems at any time. But there are two issues between now and the end of April 2010 that could possibly trigger a significant pullback in the economy and markets:

  1. Weak Holiday Sales. We're being told that we have some kind of recovery underway. But in the end the consumer is really the one that decides that. If consumers are feeling optimistic, they're going to spend some money this holiday season and perhaps fuel the perception of a recovery. In a best case scenario, that could be self-sustaining and lead to a real recovery.

    If, on the other hand, holiday sales are weak, that's going to send an ominous message to the markets. It'd be a vote of "no confidence" from the consumer and that's going to tell industry that it's not time to ramp up production and hire new employees. A weak holiday season could also lead to more businesses going bankrupt and laying off more people.

    With still-rising double-digit unemployment at its highest level in 26 years, consumers planning on reducing their dependence on credit cards for purchases , and with the retail industry expecting flat sales , it doesn't seem that there are high expectations for the holiday season.

    It seems to me that a lackluster holiday season in the retail market could be a potential trigger for bad things.

  2. The End of Government Intervention in Housing Market. The Federal Government plans to end its homebuyer tax credit on April 30, 2010 and the Federal Reserve is planning on terminating its Mortgage Backed Security purchase-program at the end of March 2010 .

    That means that buying a house will become more expensive (because the U.S. Government will no longer be paying for some of it with a tax credit) at right about the same time as mortgages will be harder to get (because the Federal Reserve will no longer be providing liquidity) combined with upward pressure on interest rates due to the U.S. Government borrowing trillions of dollars per year.

    Update 12/28/2009: Over a month after writing this article, the following article stated the same thing:
    Parrish said that he's not sure just yet what will happen to the housing market once the Federal Reserve stops buying mortgage-backed securities early next year. Many credit the Fed's purchases with helping to keep mortgage rates relatively low.

    "Right now, the government is buying all these mortgage-backed securities and that is still propping up the housing market. It will be interesting to see what happens to rates after that."


    It seems to me that even if we make it through the first quarter of 2010 without any major economic problems, there's going to be some serious stress on the system in April due to the termination of these artificial government supports.

Of course, these are just theories. And even if the theories are right it's entirely possible that the Obama Administration will just double down on their policies and kick the can further down the road. They may extend the homebuyer's tax credit again. The Federal Reserve may start printing money by buying U.S. Treasury's again. And the Federal Reserve may extend the MBS purchase-program further again. Any of these actions would help avoid a correction in the short-term.
    Update 11/23/2009: Five days after writing the above, there are reports the Fed is starting to hedge whether or not it will really stop participating in the MBS market in March.

    St. Louis Fed President James Bullard set up world markets for an opening rally when he told Dow Jones Newswires on Sunday that he believes the Fed should continue its asset purchases program - often called "quantitative easing" - for as long as its benchmark rate stays near zero. The policy-setting Federal Open Market Committee had previously signaled it would soon begin paring back its purchases of mortgages and Treasurys.

    So we may, in fact, be looking at the Fed and U.S. Government simply kicking the can down the road as long as it can.

    Update 12/28/2009: A month after writing the article, others are drawing the same potential conclusion:

    "Things don't look too bad for the next 6 to 12 months," he said. "But there is an argument that the Fed and government engineered a stop-gap measure to save the economy and delayed the inevitable. There is a potential for debasing the currency."


    Update 2/24/2010: Three months after writing this article, Federal Reserve Chairman Bernanke is now hinting at the possibility of extending the MBS purchasing program.

    In testimony prepared for the House Financial Services Committee, Bernanke left the door open to further purchases of mortgage backed securities and agency debt beyond March, and in response to questions from committee members, he said the Fed would also be evaluating whether it should extend its financing of new commercial mortgage backed securities past June...

    He did not elaborate on what form such "additional stimulus" might take. The Fed has no room to lower interest rates further, but it could do more quantitative easing through purchases of Treasury, agency and agency-backed MBS.



But all of these approaches are just duct tape on a leaking dam. It's not going to hold back the flood forever. And the longer we keep trying to patch this economic dam with duct tape, the more "water" will build up behind it and the resulting disaster will only be more catastrophic when it finally happens.

Obviously the administration is hoping that all of these dangerous economic plans will bring the economy back to life before the other shoe drops.

We better all hope they're right.

    Update 2/23/2010: Three months after writing this article, an article at CNN was published that came to essentially the same conclusion.

    Update 2/24/2010: Three months after writing this article, an article at American Thinker was written that came to essentially the same conclusion.

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