Fundamental Trends

January 29, 2009 · Posted in Strategic Insight

As we stated yesterday, Wednesday’s rally in the market was on unexciting volume. The corresponding rallies in global markets were also on unexceptional volume. Today US equities sold off, again, on lack luster volume. European markets sold off last night on, average volume. Despite all the news about a aggregator bank in the US and the stimulus package passing the first vote in the House the fact remains that unemployment is rising sharply globally, companies are posting dismal losses (Ford wracking up a 5.9 billion dollar loss), and the economic data here and abroad continues to get worse. Today, new Home Sales for December showed a decline of 14.7% - the largest on record, first time jobless claims were 588, 000, and durable goods dropped 2.6% in December. To cap it off, word is now starting to circulate that the bailout of the banks will not stop at the $750k of TARP funds already allocated nor will it add an additional $1 trillion to the deficit as we hypothesized here a couple of weeks ago (see “Stimulating Comments: Ben Bernanke on Further Bailouts“. The figures are now estimated at between $2 and $4 trillion dollars before we have taken care of the banks. The Congressional Budget Offices estimate for the 2009 deficit is $1.2 trillion before the stimulus package. The stimulus is estimated to add $1.2 trillion over 10n years.

Let’s review fundamental trends for a moment to gain clarity into our investment strategy. Our specific trading posture is at the end of the post.

The US economy is impaired by a huge overhang of debt accumulated during the past 10 or so years. That debt overhang impairs the consumer’s ability to continue purchasing, municipalities and state’s abilities to fund their commitments and possibly to pay their debts, bank’s abilities to remain solvent, non-financial companies abilities to sell product and the Federal governments ability to function and fund it’s activities. Most western nations have the same range of issues. Some better, some worse. Asian nations are not suffering from the debt overhang but the western consumer’s inability to buy is hitting their economies hard. Developing nations are impacted as well by the lack of market for goods and the lack of credit for development. As long as this situation persists, western stock markets in general and the US in particular are impaired. The fundamentals are not there to provide the necessary environment for a new bull market. As we are seeing with most major markets are drifting and may continue to do so for sometime. We could have a sharp deep drop, we could have a sharp rally but it has become increasingly clear that these should not be our focus.

For strategic investors, that is, for those who prefer to invest where the fundamental global economic forces are flowing in their favor. Equities do not represent a compelling case. Murdock Global Insight has stated that we believe the enormous quantity of debt that the US as accumulated and is now in the process of growing will cause bond prices to collapse and the dollar to drop sharply as our fiscal situation becomes a growing concern for the world. That flight from US paper will, likely be replicated world wide as paper assets of many countries become suspect. That will lead to a sustained rise in physical assets.

Let’s look at some data:

In this first chart we see US Federal Government debt vs. GDP. This chart has been getting a lot of play lately. Many commentators including Robert Reich, former Labor Secretary under President Clinton have quoted this chart to justify why the sizable spending and deficit increase that the TARP, the stimulus package and the additional, as yet unnamed measures will create is not an issue. The argument goes like this: US Federal debt was higher as a percentage of GDP at the end of WW II(1946) than it is now so we should not be alarmed about increasing the debt temporarily as we have been in this debt to GDP range before.

US Federal Debt vs GDP

This argument is overly simplistic as it ignores both the conditions existing then and now and the the total debt load that America had at these two junctures in history. At the end of WW II the US had spent an enormous amount of money winning the war and, in the process, had developed a massive manufacturing base and a very large merchant marine. We had become the leading power in the world both economically and militarily displacing Britain. Europe, Japan, and parts of Asia lay in ruins. America was presented with a world needing to be rebuilt and with hungry markets to feed. The world demanded American goods and we were well positioned to respond. These are very different conditions than those which we find ourselves in today. Based simply on the differing initial conditions, this plot of US debt vs GDP cannot be used in isolation to justify higher deficits. We do not find ourselves in a world that is clamoring for US products or needing to be rebuilt. We have in fact become the world’s great consumer running persistent high trade deficits and borrowing from foreign nations to fund or appetites. 1946 and 2009 are completely different worlds. The most critical issue though is seen in this second plot.

In this second chart we see the plot of Total US Debt vs. GDP (courtesy of Hoisington Investment Management)

Total US Debt vs GDP - includes Federal, State, Municipal, Corporate, and Personal

As seen in this second plot the total debt that US society had accumulated was actually at a low point at the end of WWII. This was due to a huge increase in GDP during the war with credit expansion confined largely to the Federal government. What most people fail to accept is that the total debt burden on the US is the sum of all types of debt. That is what must be managed by America as a nation. That is what impairs future growth of the nation. Looked at in that light we see that the surge in debt in recent years eclipses all previous episodes and is growing massively while the GDP is shrinking. The various bailout plans, aggregator bank schemes etc are serving to increasingly transfer municipal, state, corporate and personal debt onto the Federal books. That is, the right side of the first graph is inexorably morphing into something like the right side of the second graph.

In other wors, non-Federal debt is increasingly finding it’s way onto the Federal books and setting America up for structural deficits for decades to come. This debt must be financed by bonds in a world filled with governments seeking to raise capital through sovereign debt auctions. No nation can run unbounded deficit growth perpetually without expecting to encounter higher interest rates, a flight of capital from it’s shores, and increased borrowing costs for it’s debt. The US has held the distinction of having the worlds leading reserve currency - the dollar - but we cannot assume that situation will persist indefinitely. There comes a point it seems where our foreign creditors recognize that we are so financially impaired that our ability to consume their goods in the quantities they require has been lost. Their willingness to continue to fund our bonds will diminish at that point.

We continue to believe dollar strength is temporary. Readers should see our article “The Dollar’s Rise is Temporary” as well as read “How a Reserve Currency Can Collapse – An Extrapolation of Current Trends”. The dollar is in a flight to “quality” bubble despite being well down from highs it had enjoyed a few years ago. this will not be sustained.

The second chart above really captures in one picture the departure point for our investment strategy.

We remain short US treasury bonds through PST. Bonds appear to have begun breaking down today as the market is starting to come to grips with the volume of debt offerings that are beginning to come to auction. We added to this position today. Readers are encouraged to look at the Members Only Post “The Coming Bond Debacle”.

We added precious metals positions last week and again today. The turmoil in global financial paper will drive physical assets higher. Frankly, we dislike the very idea that modern markets need something like gold to hang on to. However, what we like and dislike are irrelevant – what will work for us is what’s important. We have more to say about this in the Members Only Post “Gold - Reluctantly”.

To view previous Members Only posts - “The Coming Bond Debacle” or “Gold - Reluctantly” simply follow the instructions under the “Become a Member” tab and select the “One Month Free Membership” when you get to the Products page. You must complete the checkout process in order for the Membership to complete. Registration is not sufficient. You are under no obligation to continue beyond the One Month Free Trial and your e-mail and address will not be shared with third parties.

We hold the following positions as of 01/29/2009.
Short Treasury Bonds through PST* +
Long gold and silver bullion through CEF +
Long gold mining stocks through TGLDX +
Long Agricultural commodities through RJA
Short US dollar through UDN**
Long Australian dollar through FXA**
Trading accounts approximately 40% in cash.
401k remains 100% in cash

This continues to be an interesting week.

*ProShares leveraged short ETF. Investors need to understand thoroughly the risks associated with these leveraged products in light of their personal investment needs and risk tolerance. They may not be suitable for all investors.

** Position is currently in loss but we are sticking with it as we believe the fundamentals will drive the dollar substantially lower.

+ added to position 1/29/209