Bizarre Conditions for a Bull Market
Stocks were up yesterday…the Dow rose 196 points.
What were investors thinking?
“Home prices fell more than forecast,” reports Bloomberg. They’re still going down at a 19% rate. Unemployment is still rising too.
The state with the biggest economy in the nation is going broke. So is the nation’s biggest manufacturer. Profits are falling. And the government is racing to put in place a form of state-sponsored socio-capitalism much like Mussolini’s Italy…or Peron’s Argentina.
These do not sound to us like ideal conditions for a bull market.
Did we say thinking? There’s not much thinking going on. People don’t often think…not if they can avoid it. And it’s probably better that they don’t. Who knows what opinions they might come to if they put their minds to it?
Instead of thinking, they react. And after a big drop in stock prices, they bounce. We’re now in an extended bounce…which could last until mid-summer…and could take the Dow back to 10,000.
That is to say, there is nothing unusual about this kind of stock market action. Au contraire…it’s classic.
Investors are also reacting in the bond market. They’re buying Treasury bonds in reaction to bankruptcies, defaults and falling asset prices. Investors feel they can put their money into Treasuries and not worry.
But maybe they should spare a thought or two about what is really going on. Lending money to the US government is no sure thing. Far from it. In fact, under the present circumstances, lending money to the feds is asking for trouble. Recently, you could put your money in T-bills and get zero yield. “An extraordinary thing…” said Warren Buffett – so extraordinary that he was “not sure [you’d] see that again in your lifetime.”
The US Treasury market is in a bubble. Like all bubbles, it will pop.
On the numbers, the US government is the worst credit risk in the world. You determine a man’s creditworthiness by looking at his balance sheet. Add up his assets and subtract his liabilities. Do that to the federal government and you get a very big number with a minus sign in front of it. Even if they were to sell off the Capitol building and all the federal lands west of the Mississippi, the feds would still have a hole in their finances larger than any other in the entire world.
While the balance sheet looks awful, the cash flow is worse. In the current year, the feds will take in about $1.9 trillion in taxes and spend $3.6 trillion. In other words, the feds aren’t just living beyond their means…they’re not even on the same planet. Who in his right mind would lend to a spendthrift whose outgo exceeded his income by nearly 100%?
The only way any loan can reasonably be repaid is from income. Income must exceed expenses or there will never be money for debt repayment. Lending to a corporation or an individual, the lender expects the borrower to earn his way out of debt. Otherwise, it’s a fool’s game. The debtor is soon kiting checks and going deeper in the hole. He borrows from one lender in order to pay off the first lender… In effect, he operates a pyramid scheme – depending on fresh suckers to keep giving him new money – until the whole thing comes crashing down.
The federal government doesn’t even pretend that it is going to earn its way out of debt. It presumes that there’s an endless supply of money it can borrow…and new suckers born twice a minute who are willing to lend. But this is exactly where all Ponzi schemes crack up. The fed’s pyramid will fall in the same spot; where it runs out of new money.
Mr. Obama says he plans on cutting the budget deficit in half by the end of his term. Let’s see…that’s four years out. If he’s true to his word, that will mean deficits averaging about $1.5 trillion a year…or about $6 trillion total. Where will that money come from? What sucker has that kind of cash?
America’s savers are putting their backs into it. They’re saving about 4% of GDP currently, which could rise to 5%. They typically only put less than one percent of their wealth into Treasury paper; but let us imagine that they use every penny to buy it. Over Obama’s term that could be as much as $2.4 trillion. The other big buyer is the Chinese. If they were somehow able to continue buying at the same rate that they have for the last 6 months, that would add $2.8 trillion more. So even if both these Hollywood endings should come to pass, the show would still be a horror. There would still be $800 billion worth of Treasuries left unsold.
More likely, Americans might multiply their purchases of Treasuries by 10 times…not 100 times. And more likely, the Chinese might buy another $1 trillion or so. But sooner…not too much later…buyers are going to begin to notice that there aren’t enough of them to keep this Ponzi scheme going. The smart ones will head for the exits early…the slow and the dull will be crushed at the doorways.
The price of oil remains at $62…the American peso is still trading for peanuts ($1.39 against the euro)…and gold lost about $5 yesterday; it trades this morning near $953.
Do you have your positions in gold, dear reader? We hope so. We advised readers to buy gold when we first began our Daily Reckonings 10 years ago. Back then you could have bought an ounce of gold for less than $300 any day of the week. Today, you’ll have to pay more than 3 times as much…and you could have to wait a few days to find gold coins.
Of course, you remember our “Trade of the Decade”? It was very simple. Buy gold on dips; sell stocks on rallies. We’re almost at the end of the decade. So far, we’ve got a nice profit on the gold side. And a nice profit on the stock side too.
And we’re beginning to wonder what our trade will be for the next decade.
Why do we trade just once a decade? Mostly because it’s hard to figure out a winning trade; we’re too lazy to do it more than once every ten years. But it turns out that frequent trading is a losing proposition anyway. Major trends are the only ones you can spot reliably…and they take time.
In the present case, our Trade of the Decade may turn into the Trade of Two Decades. Because neither the bull market in gold nor the bear market in stocks has fully expressed itself. The price of gold is barely higher, in nominal terms, than it was 29 years ago. Some people will look at that bit of information and conclude that gold is always a losing bet. We conclude that it is sometimes a losing bet. Other times it is a winning bet. For the last ten years, gold has been in the money. Even so, it would have to nearly triple from here in order to beat its price record (in real terms) set a generation ago.
There are good reasons to think it might. Not the least of which is the aforementioned shortage of ready cash to fund the US government’s deficits. As the supply of Treasuries increases, the supply of willing and able Treasury buyers is likely to lag. Into the gap comes the Federal Reserve, checkbook in hand. Rather than allow Treasury yields to increase – which is what happens when there are more borrowers than lenders – the Fed will do the buying itself. It will buy, not with savings but with money of its own making.
As the Fed creates more new green money, the old-fashioned yellow money is likely to look better and better. Perhaps only because it will be harder to find.
There are about $1,600 trillion worth of derivatives in the world…$125 trillion worth of real estate and business assets…$100 trillion worth of stocks and bonds secured by assets…$65 trillion worth of government bonds (rising rapidly)…$4 trillion worth of actual currency…and only between $2 and $4 trillion worth of gold and silver.
We’ll take the gold and silver…at least until the bubble in Treasury debt blows up.
The Daily Reckoning