Archive for July, 2011
The ceiling is leaking, but it’s unclear whether it will be repaired? Rather than fix the seeping fiscal problem, Democrats and Republicans have stared at the leaky ceiling and periodically applied debt ceiling patches every year or two by raising the limit. Nanosecond debt ceiling coverage has reached a nauseating level, but this issue has been escalating for many months. Last fall, politicians feared their long-term disregard of fiscally responsible policies could lead to a massive collapse in the financial ceiling protecting us, so the President called in the bipartisan plumbers of Alan Simpson & Erskine Bowles to fix the leak. The commission swiftly identified the problems and came up with a deep, thoughtful plan of action. Unfortunately, their recommendations were abruptly dismissed and Washington fell back into neglect mode, choosing instead to bicker like immature teenagers. The result: poisonous name calling and finger pointing that has placed Washington politicians one notch above Cuba’s Fidel Castro, Venezuela’s Hugo Chavez, and Iran’s Mahmoud Ahmadinejad on the list of the world’s most hated leaders. Strategist Ed Yardeni captured the disappointment of American voters when he mockingly states, “The clowns in Washington are making people cry rather than laugh.”
Although despair is in the air and the outlook is dour, our government can redeem itself with the simple passage of a debt ceiling increase, coupled with credible spending reduction legislation (and possibly “revenue enhancers” – you gotta love the tax euphimism).
The Elephant in the Room
Our country’s spending problems is nothing new, but the 2008-2009 financial crisis merely amplified and highlighted the severity of the problem. The evidence is indisputable – we are spending beyond our means:
If the federal spending to GDP chart is not convincing enough, then review the following graph:
You don’t need to be a brain surgeon or rocket scientist to realize government expenditures are massively outpacing revenues (tax receipts). Expenditures need to be dramatically reduced, revenues increased, and/or a combination thereof. Applying for a new credit card with a limit to spend more isn’t going to work anymore – the lenders reviewing those upcoming credit applications will straightforwardly deny the applications or laugh at us as they gouge us with prohibitively high borrowing costs. The end result will be the evaporation of entitlement programs as we know them today (including Medicare and Social Security). For reference of exploding borrowing costs, please see Greek interest rate chart below. The mathematical equation for the Greek financial crisis (and potentially the U.S.) is amazingly straightforward…Loony Spending + Looney Politicians = Loony Interest Rates.
To illustrate my point further, imagine the government owning a home with a mortgage payment tied to a 2.5% interest rate (a tremendously low, average borrowing cost for the U.S. today). Now visualize the U.S. going bankrupt, which would then force foreign and domestic lenders to double or triple the rates charged on the mortgage payment (in order to compensate the lenders for heightened U.S. default risk). Global investors, including the Chinese, are pointing a gun at our head, and if a political blind eye on spending continues, our foreign brethren who have provided us with extremely generous low priced loans will not be bashful about pulling the high borrowing cost trigger. The ballooning mortgage payments resulting from a default would then break an already unsustainably crippling budget, and the government would therefore be placed in a position of painfully slashing spending. Too extreme a shift towards austerity could spin a presently wobbling economy into chaos. That’s precisely the situation we face under a no-action Congressional default (i.e., no fix by August 2nd or shortly thereafter). To date, the Chinese have collected their payments from us with a nervous smile, but if the U.S. can’t make some fiscally responsible choices, our Asian Pacific pals will be back soon with a baseball bat to collect.
The Cops to the Rescue
Any parent knows disciplining teenagers doesn’t always work out as planned. With fiscally irresponsible spending habits and debt load piling up to the ceiling, politicians are stealing the prospects of a brighter future from upcoming generations. The good news is that if the politicians do not listen to the parental voter cries for fiscal sanity, the capital market cops will enforce justice for the criminal negligence and financial thievery going on in Washington. Ed Yardeni calls these capital market enforcers the “bond vigilantes.” If you want proof of lackadaisical and stubborn politicians responding expeditiously to capital market cops, please hearken back to September 2008 when Congress caved into the $700 billion TARP legislation, right after the Dow Jones Industrial average plummeted 777 points in a single day.
Who exactly are these cops? These cops come in the shape of hedge funds, sovereign wealth funds, pension funds, endowments, mutual funds, and other institutional investors that shift their dollars to the geographies where their money is treated best. If there is a perceived, heightened risk of the United States defaulting on promised debt payments, then global investors will simply take their dollar-denominated investments, sell them, and then convert them into currencies/investments of more conscientious countries like Australia or Switzerland.
Assisting the capital market cops in disciplining the unruly teenagers are the credit rating agencies. S&P (Standard and Poor’s) and Moody’s (MCO) have been watching the slow-motion train wreck develop and they are threatening to downgrade the U.S.’ AAA credit rating. Republicans and Democrats may not speak the same language, but the common word in both of their vocabularies is “reelection,” which at some point will effect a reaction due to voter and investor anxiety.
Nobody wants to see our nation’s pipes burst from excessive debt and spending, and if the political plumbers can repair the very obvious and fixable fiscal problems, we can move on to more important challenges. It’s best we fix our problems by ourselves…before the cops arrive and arrest the culprits for gross negligence.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in MCO, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Ask any average Joe off the street what investment category is at or near record all-time highs, and a good number of them will confidently answer “gold,” as prices recently eclipsed $1,600 per ounce. But of course this makes perfect sense, right? The Fed is printing money like it’s going out of style, the dollar is collapsing like a drunken sailor, inflation is about to sky-rocket to the moon, and China is on the verge of becoming the world’s new reserve currency. Never mind that Greece, Portugal and Ireland are in shambles with the Euro on its death bed. Or Japan has achieved a debt to GDP ratio that would even make U.S. vote grubbing politicians blush. A sub-3% 10-Year Treasury Note doesn’t appear to discourage fervent gold-bugs either.
While gold has experienced an incredible sextupling in prices over the last decade and hit new-all time highs, believe it or not, there is an unlikely asset class that is reaching new historic highs and has outperformed gold for almost 2.5 years. Can you guess what asset class star I am talking about? If I said U.S. “stocks,” would you believe me? OK, well maybe I’m not referring to large capitalization stocks like Johnson & Johnson (JNJ), Microsoft Corp. (MSFT), Wal-Mart Stores (WMT), Intel Corp. (INTC), and AT&T Inc. (T), all of which have effectively gone nowhere in the 21st Century. However, the story is quite different if you look at small and mid capitalization stocks, which have received about as much respect as Rodney Dangerfield.
As a matter of fact, the S&P 400 (MidCap Index) and S&P 600 Index (SmallCap Index) have more than doubled gold’s performance since the lows of March 2009 (SmallCap +149.0%; MidCap +145.1%; Gold/GLD +71.0%). Given the spectacular performance of small and mid-sized companies, I’m still waiting with bated breath for a telemarketer call asking me if I have considered selling my small and mid cap stock certificates for cash – since everyone has melted their gold chains and fillings, a new hobby is needed.
Has the fear trade ended? Perhaps not, if you consider European sovereign debt and U.S. debt ceiling concerns, but what happens if the half empty glass becomes half full. The early 1980s may be a historical benchmark period for comparison purposes. An interesting thing happened from 1980-1982 when Federal Reserve Chairman Paul Volcker began raising interest rates to fight inflation – gold prices dropped -65% (~$800/oz. to under $300/oz.) from 1980-1982 and the shiny metal lived through approximately a 25 year period with ZERO price appreciation. Since there is only one direction for the Fed’s zero interest rate policy (ZIRP) to go, conceivably history will repeat itself once again?
In hindsight gold was a beautiful safe haven vehicle during the panic-filled, nail-biting period during late-2007 throughout 2008. Since then, small and mid cap stocks have trounced gold. Like stocks, Rodney Dangerfield may have gotten no respect, but once fear has subsided and rates start increasing, maybe stocks will steal the show and get the respect they deserve.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including small cap and mid cap ETFs), and WMT, but at the time of publishing SCM had no direct position in JNJ, MSFT, INTC, T, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.