Brotherly Nepotism

January 17, 2011

Since my sisters will be actively managing investment income, this episode is mainly for them but I have expanded it for anyone who cares.

In short, the equity market is becoming a game of chicken. The broad consensus is for a gain of between 10 and 20 percent. Inherent in this prediction are the assumptions that the economy will expand between 3-4%, inflation will not be a problem and interest rate changes are moderate. Simultaneously,anyone with half a brain knows that ominous structural problems exist which will ultimately derail this scenario. Since it's the third year of a Presidential cycle, few believe it will be this year.

In keeping with the tradition of horrifying my sisters, let's consider these aforementioned structural problems. Consider the financial straights of state and municipal governments. Since many are on the precipice of default, their options are massive budget cuts/tax increases. Meredith Whitney, admittedly a bear, states that local government layoffs this year will approach one million workers. Alternatively, tax increases are hardly compatible with economic growth. How many will default? What effect might sizable defaults have on the financial markets? The Bernanke is already on record as stating the Fed has no intention of buying this debt. Federal "stimulus" money will stop flowing to the states in a few months and, given the makeup of this Congress, it is unlikely that taxpayer money will be available to coverup the shortfalls.

Consider the US government. The next rise in the debt ceiling will take debt to 100% of GDP. That excludes the debt of the GSE's and the nonfunded liabilities of the entitlements programs. In short, the USA is insolvent. When will it matter? Don't know but my guess is that sooner rather than later. Now we could correct this problem readily: withdraw from Iraq, Europe and leave only killer squads in Afghanistan. Repeal Obamacare, the Bush drug bill, drastically cut Medicare/Medicaid spending and put SS on a credible plan. Call me cynical, but I don't think these obvious solutions are about to happen. Could you imagine a politician of either stripe successfully running on this platform? History will regard the baby boomers as the most selfabsorbed, extravagant materialistic and financially irresponsible of all the generations of Americans. Contrary to their protestations, they desperately wish to pass on this debacle to their grandchildren but long before these children realize the imprudence of their grandparents, the situation will be corrected by the financial markets. I have stated before and will say again that the US Treasury market is the greatest Ponzi scheme in human history.

I don't know when some one says, "the emporer has no clothes" but it's going to happen well before out grandchildren have to worry about it. If I haven't depressed/annoyed you enough, consider your currency: the almighty $, the reserve currency of the world. It is the express purpose of this government to reduce the purchasing power of the $. The thought is that if the $ is worth alot less than other currencies, then the US will be able to export products more competitively. Of course, this is the express purpose of many other countries and watching them fluctuate against one another is like trying to pick the best horse in the glue factory. The consequence of this devaluation is simply that real stuff, you know gas, utility bills, food, etc cost more dollars. They haven't changed; the value of the $ has declined. Gas at the pump has risen almost 50 cents since my return to Florida. The next time you go to the gas station and pay more, say "Bernanke knows his stuff. QE2 sure has depressed our currency."

The problem with this strategy is that 5% of our economy is based on exports and 70% is due to consumption. The real question is not whether the $ will decline but will the decline be orderly or chaotic. Add to these previously discussed issues, the "normal suspects" , war, terrorist actions, natural or climatic catastrophes and you can see that I am not as sanguine about the markets as most. I remain long but with one foot out the door.

-Guga