Are We There Yet?

“It is (easy) to agree with this blog except it does not allow the possibility that the economy may rebound and grow or that inflation will take to hold and make 1 trillion dollars today look smaller. If the economy were to begin to grow faster, the debt as a percentage of GDP would go down. If inflation were to take hold (especially in real estate) it could well lead to many currently insolvent borrowers and banks breathing above water once again. Of course inflation is likely to occur in areas which will hurt rather than help (oil for example), and I do not believe this will happen. I guess what I am saying is that, as a person who often has to project the future economy, I and many others did not see the depth of the 2006-2009 fall and this tells me that I and many others may not be taking the potential for a rebound into our calculations of the future. The economy is a herd and does not always act rationally.  If it did we would not have created a bubble to begin with. 


You are absolutely right about the lack of intelligence and back bone that appears to appeal to the electorate. Long term infrastructure, Research and Development and targeted Education were the right places to have spent the stimulus and are still the right places. The American people are far too uneducated for their own good and will believe fairy-tails of riches to be gained by a flawed trickle-down theory to economics. These small tax breaks (when figured on an individual basis) could not possibly offset the value of more investment in research and development which could lead to the next big thing which reinvigorates the outlook for our society. Plastics, computers, the internet, GPS, all came from government (financed) research.  We could not live without these things now and they account for huge portions of the market. Sometimes you cannot make money unless you spend money.” (end of reader’s quote)


There are two points which this reader makes which is worth reinforcing:


1> inflation is a path out of the debt mess. If all assets went up in value, even overpriced real estate, and related debt will not seem so onerous. And whether we are concerned about 7 million units of US homes, or 1 million in Spain, if everything else rose in cost, then housing will eventually find a bid. 


In fact, this is what occurred in the US in 1946-1948. Over the course of 2 years, from mid 1946 to mid 1948, CPI rose 28%, while GDP rose 22%. During this time, the US government must have run a surplus, because total Federal debt went down. All told, during this time period, Debt to GDP shrank from 122% to 91%. While real economic growth should have contributed to this decline, you cannot underestimate the impact of inflation on improving the US’s precarious fiscal position. Not only would inflation help make the US government’s balance sheet look more manageable, but it should also have a positive influence on housing prices.


Whether or not inflation can be created while the world is de-leveraging remains to be seen. If the government prints enough money, then eventually inflation will be hatched.


2> I agree with this reader’s contention that the government is not spending enough money on infrastructure, R&D, or education; items which will serve our country well as we march into the 21st century.


3> one should never under-estimate the impact of current stimulus measures and deficit spending. So long as the markets allow the government to borrow its $1.3 to 1.5 trillion a year deficit, then it is possible that the government will prevent aneconomic collapse. In fact, if I carry my cycle work forward, then a 3.5 to 4 year cycle (in stock prices) occurred last summer, which means that the winds are going to be behind stock prices for at least the next 12 months. The repeal of the Bush tax cuts reinforces this proposition. Despite my concerns about an upcoming catastrophe, the timing remains very uncertain.


The body of work documented in the book, “The 4th Turning”, suggests that sometime over the next 10-15 years, we will be endure a very severe crisis phase, which should be on par with the depression/WW2. Again, this suggests that something dramatic is coming, yet it is very imprecise as to the timing, except that it will likely commence in this decade. Now, lots of wood can be chopped over a multi-year period, if the crisis, which is to come, is a few years off. And to that end, I would recommend that you do what I am doing: chop as much wood as you can, but remain vigilant towards how a financial catastrophe might affect you.


The analogy “picking up nickels in front of a steam roller” might very well apply to the current environment, since the nickels we are picking up might be more than just 5 cents, and the steam roller might be moving real slow. Nonetheless, I would not invest blindly in long term bonds, or leveraged financial corporations, as I think that these asset categories will come under pressure well before the calamity is upon us.


* Are we there yet? How we will know we are getting closer to the time in which such a crisis is upon us? One key metric to look at is the 10 year treasury rate. If this rate spikes enough, then it will be a sign that the world is abandoning US debt. Despite the fact that rates rose about 1% over the last couple of months, 10 year rates are well within the declining rate trend which has ruled the roost since 1980; see attached. There is strong resistance around 4%, and there is trend channel resistance around 4.5%. I would view rates rising to about 5% as being the canary in the coal mine, that a crisis is afoot. We are still quite a bit away from that situation.


Watching precious metal prices is also a good barometer about how the world feels about the fiat currencies of the world. In yen, dollar and euro, New Zealand dollar, and Swiss Franc terms, gold is at or near an all-time high. So long as this trend remains intact, then I will remain cautious about the unfolding events, and likelihood that it will come to a bad end. I would view a rise above $2300 in a sharp fashion, the inflation adjusted peak of the 1980 high in gold, (when it hit $880), as a good indication that the calamity was upon us.


The opposite outcome to the inflation, currency debasement scenario, is that of tight monetary policy and fiscal austerity. This would mean that the Fed stops printing money, and at some point, the government stops running such massive budget deficits. Such an outcome would cause the credit de-leveraging scenario to gain momentum, accompanied by falling housing prices, liquidation of the shadow inventory of 7 million homes, and on average, conditions which will push unemployment up at least a few more percent. In my opinion, it is by virtue of the governments massive deficits and money printing operations, that the ship we call the economy, appears to be quite viable to many. In reality, danger is at the door, and the minute the government pulls back from its aggressive easing policies, is the when the wheels come off the bus. The bottom line is that so long as the bond markets allow the US government to run 10% deficits a year, the sun will appear to shine on the US.


So, while I am vigilante towards the inflationary end-game, I am also cognizant of the deflationary outcome. At this point in time, it would take a stock market drop below the summer lows at 1010 on the S&P as an indication that this scenario is unfolding. Over the short term, and especially into the Jan/Feb time frame, I expect stocks to correct 10% or so, but that would just be a healthy correction in the current uptrend. A more pronounced drop below the summer lows would definitely put the deflationary outcome into focus.


What about the idea that our fearless leaders would manage to walk that fine line between inflation and deflation? That always remains a possibility, yet at some point in time, this juggling act will still be subject to the markets interest in underwriting US debt, which is currently going above $14 trillion, and 100% of GDP.


* Last weekend, the NY Times ran this lead story about the housing mess in Spain. It echos comments which I made in this blog a few weeks ago. Here is the link for those who are interested: 


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This will be the last blog before Christmas. Next week I will publish the blog twice, with a discussion on my outlook for 2011.