This Market Just Likes News

The US stock market is enjoying one of those delightful episodes when all news is good news. The Dow Jones Industrial Average jumped 221 points yesterday to 8,721 – lifting the Blue Chip index to within a whisker of a positive year-to-date performance.

Let’s give credit for the rally to good news… and also to bad news, because that’s also good news. In fact, let’s just give credit to news in general.

Topping yesterday’s headlines was the “news” that General Motors had formerly declared bankruptcy. The automaker’s de facto bankruptcy of the last several years finally yielded to the de jure variety. That’s good news, because now we taxpayers get the chance to increase our charitable giving. We get the opportunity to write a $50 billion check to one of America’s largest and most beloved nonprofit organizations.

But wait, GM’s bankruptcy wasn’t the only good news to cross the wires yesterday. Stock market investors celebrated the following stories as well:

1) Treasury bond prices plummeted, exacerbating the bond market’s worst January-through-May performance in 32 years.

2) The Dollar Index slipped to a fresh seven-month low.

3) Activity in the nation’s factories fell for the 15th straight month.

Curiously, there were also a few news items yesterday that the stock market blithely ignored…like the news that our largest foreign creditor is becoming increasingly nervous about supplying fresh credit. On the eve of Treasury Secretary Timothy Geithner’s goodwill mission to China (OUR goodwill, not theirs), Yu Yongding, a former central bank adviser, remarked, “I hope Geithner’s visit can soothe our nerves. The Chinese public is worried about the safety of its foreign-exchange reserves.”

China is the largest foreign holder of U.S. Treasuries – with almost $800 billion worth in its national piggy bank. Understandably, therefore, the Chinese are not thrilled to see Treasury prices plummeting, while America’s budget deficit is soaring. Seventeen of twenty-three Chinese economists polled in connection with Geithner’s visit said holdings of Treasuries were a “great risk” for their nation’s economy.

“It will be helpful if Geithner can show us some arithmetic,” said Yu. Regrettably, basic arithmetic would produce more consternation than comfort. No matter how you line up the numbers, the sum will always be an enormous, gigantic, colossal NEGATIVE number.

No, Geithner does not need arithmetic; he needs a miracle…or a printing press. Without some sort of miracle that converts liabilities into assets, America’s debt is already larger than national cash flow would support. We would be broke already, were it not for two convenient facts: 1) Our creditors keep lending us money; 2) Even if they didn’t, we can print for ourselves the money with which we must re-pay our debts.

So it’s probably safe to say that America will not default on its debt. But it’s also probably safe to say that the dollars our creditors receive in the future will be worth much less than the dollars they loaned us in the first place.

“We are committed to bringing our fiscal deficits down over the medium term to a sustainable place, to a sustainable level,” says Geithner. “We believe in a strong dollar. A strong dollar is in the U.S. interest.”

China’s Yu Yongding does not seem to believe him.

Says Yu: “I wish to tell the U.S. government: ‘Don’t be complacent and think there isn’t any alternative for China to buy your bills and bonds.’ The euro is an alternative. And there are lots of raw materials we can still buy.’’ To sharpen the point, Yu continued, “Some people say the euro is very weak. Okay, weak is good, we’ll buy very cheap.’’

Geithner promises that America will keep its spending under control. But the promise rings hollow from a leading member of an economic team that will produce a $2 tillion deficit in its very first effort to “control spending.” The Obama Administration did not invent deficit spending, but it has quickly mastered the art.

“The borrower should keep their promises,” China’s Yu insists. “The U.S. should be a responsible country.”

It should be, but it’s not. The nearby chart, based on data provided by Shadow Stats, tracks the explosive growth of America’s national indebtedness over the last few years. This chart presents America’s indebtedness in terms of both cash-based accounting and GAAP-based accrual accounting. The latter of these two methods is the one that every corporation in America must use. As such, GAAP is real-world accounting, which would include things like the present value of the Social Security liability and the Medicare liability. At $12 trillion for year-end 2009, the cash-based deficit is bad enough; but at $74 trillion, the GAAP-based numbers are a catastrophe.

$74 trillion is about five times GDP, which is a ratio that would put America well within emerging market parameters. The only problem is; we aren’t emerging. We are submerging…at least from the standpoint of national indebtedness.

These data points should frighten any student of financial history. Therefore, these data points should terrify every holder of dollar- denominated assets. The good news – and remember, it’s all good news right now – is that Rome wasn’t destroyed in a day.

There may be a way out of this mess – we certainly hope so – but America’s current fiscal plight reminds us of General Motors. For many, many years, General Motors survived on its reputation. Despite the company’s obvious financial distress and obvious inability to book a profit selling cars, investors continued to buy the company’s bonds and to bid its shares higher. Thus, GM racked up liabilities far in excess of what it could ever hope to repay.

Sound familiar?