Fiscal & Political Chemotherapy

November 11, 2012 at 11:39 pm 5 comments

Chemotherapy is a treatment that uses a mixture of toxic drugs designed to destroy cancer cells, so patients can recover to a healthy state. Similarly, our government system combines a mixture of toxic politicians designed to destroy our nation’s problems, so Americans can benefit from a healthy, expanding economy. In the long run, history teaches us that despite painful periods of political battles, beneficial results are eventually achieved.

Unfortunately, in the short run, political side effects relating to our country’s legislative process can result in extremely unpleasant outcomes, just like experienced during chemotherapy treatment (including nausea, vomiting, hair loss, and fatigue). Politically, we are going through a comparably repulsive period. The good news is, regardless of your political persuasion, a major source of contention is now behind us in the rearview mirror (i.e., the presidential elections) and we can temporarily recover from the barrage of venomous super PAC commercials that have temporarily halted.

Regrettably, the looming “Fiscal Cliff” poses larger consequences than election outcomes, if these out-of-control economic issues are not credibly resolved (see Fiscal Cliff: Repeat or Dead Meat?). Most Americans realize a responsible mixture of real spending cuts coupled with limited tax hikes, like proposed by the bipartisan Simpson-Bowles commission is a great starting blueprint to hammer out a deal. For the time being, I’m happy to hear both Republicans and Democrats are playing nicely in the sandbox. Republican Speaker of the House, John Boehner has signaled he is willing “to put (tax) revenue on the table” and President Obama has said he is “open to compromise.” So what’s all the worry then? We already know that $600 billion in tax increases and spending cuts kick in seven weeks from now, which has the real potential of spinning our economy into another recession if Congress doesn’t act.

You don’t need to go far back in history to see what the effects could be from continued gridlock or a lackluster agreement that kicks the can down the curb. For starters, last year’s initially unsuccessful debt ceiling negotiations resulted in a swift kick in the pants for stocks, as investors watched the S&P 500 index crater -18% within three short weeks. If the $600 billion impact of the Fiscal Cliff and sequestration actually occur, many pundits are predicting up to a -4% hit to GDP (Gross Domestic Product), which makes it virtually certain the economy will slip back into recession.

This game of political chicken can last only for so long. Congressional approval ratings are near record lows, and if inaction continues, voters will ultimately take powers into their own hands and vote out apathetic politicians.

Preparing for the Melt-Up

Would I be surprised to see a market pullback in the coming weeks and months? The short answer: NO. While I may be cynical about the short-term probabilities of a bipartisan “grand bargain” because brinksmanship will likely win in the coming weeks, as both sides jockey for negotiating leverage, I am also keenly aware of the melt-up risk that few investors are currently talking about. You don’t have to be a brain surgeon or rocket scientist to see the amount of pessimism that has built up over recent years. If you don’t believe me, you can just look at the following charts to get the gist:

i) A half of a trillion dollars has been pulled out of the equity markets by nervous investors, despite the market more than doubling from its 2009 lows.

Source: Calafia Beach Pundit (Scott Grannis)

ii) Panicked bond buying has caused the yield on the benchmark 10-year Treasury note to evaporate by about -90% since its peak more than 30 years ago.

10-Year Treasury Yield (Source: Yahoo! Finance)

iii) Fear insurance has been gobbled up by worrywarts as witnessed by gold prices sky-rocketing more than 500% in a little more than a decade.

Historical gold prices (Source: InvestmentTools.com)

A grand bargain doesn’t guarantee a return to the stock market circa the 1990s, but in an environment where trillions of dollars have been stuffed under the mattresses of corporations and individuals, earning next to nothing, it won’t take much to ignite the animal spirits of investors. Changing the perception of a market that sees the glass as -90% empty to the view of a glass 10% full, could lead to a happier 2013 for equity investors. However, if no Fiscal Cliff agreement is made, locating me may be a challenge – I suggest you try me in my bunker.

While our fiscal and political health conditions have reached crisis levels in recent years, there are reasons to be optimistic, now that a hotly contested presidential election has concluded and discussions move forward on a Fiscal Cliff solution. Chemotherapy involves a toxic and destructive regiment of harsh medicines, but in certain situations, like the present political environment, investors need to survive the unpleasant side effects before economic health and prosperity can be gained.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct positions in any 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.

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5 Comments Add your own

  • 1. mr Dave  |  November 15, 2012 at 8:05 pm

    How long can we run trillion dollar deficicts? If Congress and Obama make a deal that does very little to address that issue, What is the market and economical risk in that? we have to take our medicine sometime don’t we? why not go off the cliff?

    Reply
    • 2. sidoxia  |  November 15, 2012 at 8:21 pm

      Mr Dave:

      Technically, we can run trillion dollar deficits in perpetuity, if GDP is growing faster than the deficit (i.e., Debt/GDP% will continue to go down over time)…a big assumption. If no deal is reached, GDP will likely turn negative, and deficits will drive Debt/GDP% higher. Would most rational people, myself included, prefer a balanced or surplus budget? ABSOLUTELY. But of course, the tough medicine you are talking about is not preferred by politicians (and many voters) because expense cuts or tax increases do not garner re-election votes. We’ll find out real soon (over the next few months) if the $4 trillion debt reduction bogey is reached. I’m hopeful common sense will prevail…

      ~WS

      Reply
  • 3. Mr Dave  |  November 16, 2012 at 7:48 am

    WS,

    Thanks for the reply. GDP will go negative at sometime won’t it? Post war recessions come every 6 years on average. Not all of this can be controlled by juggling around regulation, tax rates, entitlements and or other government spending.

    There is an ebb and flow to every economy. Politicians and voters are often wrong about economics, and many other things. That’s how we got here.

    Simpson Bowles was on the table a long time ago. I don’t think its what Obama wants. He never used the bully pulpit to push it. We’ll see how it plays out.

    What’s the long term risk, when or if GDP no longer out paces the deficit?

    Reply
    • 4. sidoxia  |  November 19, 2012 at 7:58 pm

      MD:

      You’re absolutely right, we have about two recessions every decade. Objectively, this expansion could last longer than the average recovery, because this has been the SLOWEST recovery in decades. There are literally trillions of dollars sitting on the sidelines on corporate balance sheets and in consumers’ bank accounts (earning next to nothing). IF governemnt can come together to solve some of these difficult problems, a lot of this idle cash could be unleashed to help kick start a faster growing economy. If apathetic politicians ignore the problems, then yes, I think we are headed for another recession. The great thing about investing is investors and corporations are not hostage to investing solely in the U.S. – there is another 75-80% of the world to invest in. The other positive aspect about this Fiscal Cliff dilemma is that the answer will land on our lap in the next few months, one way or the other, whether it’s resolved successfully or not.

      ~WS

      Reply
  • 5. Mr Dave  |  November 20, 2012 at 8:20 am

    Interesting point about cash reserves.

    Reply

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