We have maintained since late 2007 that both the U.S. and European banking systems are insolvent. Were they required to mark assets to market they would have insufficient assets to cover their liabilities - a basic definition of insolvency. Fortunately for the banks on both continents, central banks have waived the requirement to mark assets to market while the banks attempt to earn enough profits to (eventually) write down bad assets sufficiently to return to solvency. Meanwhile the Federal Reserve has been stuffing its own balance sheet with toxic assets purchased from U.S. banks in an effort to expedite the process. Unfortunately for U.S. taxpayers, the Fed is paying top dollar for toxic assets, ensuring that taxpayers will suffer billions in losses. One example should suffice to make the point. The Fed's Maiden Lane LLC purchased $30 billion from Bear Stearns in order to facilitate Bear's sale to JP Morgan Chase - Jamie Dimon refused to go through with the purchase unless the toxic assets were first removed from Bear Stearn's balance sheet. Outrageously, the Fed allowed Bear to value the assets sold it without so much as a cursory inspection.
The U.S. government is insolvent as well. The number's don't lie! Well, okay they do, but only because government bureaucrats keep changing the accounting treatment to hide the true extent of the situation from the public. The government uses a quasi-cash basis to produce its yearly deficit totals - 2010 is expected to run around $1.3 trillion (almost 10% of GDP!!!) when the numbers are finalized. However on a GAAP basis (using generally accepted accounting principles), the 2010 number is $2.1 trillion - more than 50% higher than the official number. Broader GAAP-based federal deficits that include the unfunded liabilities represented by Social Security and Medicare have been running between $4 and $5 trillion over the last three fiscal years (2010's deficit is approaching $5 trillion).
Now here's the really important part...
The U.S. government can't make up the annual shortfalls through higher taxes as, "there are not enough untaxed wages and salaries or corporate profits to do so," according to Dr. John Williams, a noted private economist. Nor can the government cut spending sufficiently without touching Social Security and Medicare. To wit; the government could cut all other spending and still not eliminate the deficit! The United States will default on some of its liabilities. It is simply a question of when and how. The most likely scenario for default is through a combination of inflation (paying debt off with less valuable dollars) and a reduction in social security and medicare benefits (reneging on promises already made). The public should plan for retirement accordingly...
Meanwhile, the U.S. market is very overbought on a short-term basis and expensive longer term. It is highly likely that we will experience a painful pullback at some point in the next two to four quarters. It is also increasingly likely that the 2011-2013 investing period will result in a loss for the U.S. market and that the next ten years will see returns of only 5% to 6% versus a long run average of between 10% and 11%. Consider the following:
1) S&P 500 more than 8% above its 52 week (exponential) average 2) S&P 500 more than 50% above its 4-year low 3) *Shiller P/E greater than 18 4) 10-year Treasury yield higher than 6 months earlier 5) Advisory bullishness greater than 47% with bearishness less than 27%. (Investor's Intelligence)
“The historical instances corresponding to these conditions are as follows:
1) December 1972 - January 1973 (followed by a 48% collapse over the next 21 months)
2) August - September 1987 (followed by a 34% plunge over the following 3 months) 3) July 1998 (followed abruptly by an 18% loss over the following 3 months) 4) July 1999 (followed by a 12% market loss over the next 3 months) 5) January 2000 (followed by a spike 10% loss over the next 6 weeks) 6) March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002) 7) July 2007 (followed by a 57% market plunge over the following 21 months)
8) January 2010 (followed by a 7% "air pocket" loss over the next 4 weeks) 9) April 2010 (followed by a 17% market loss over the following 3 months)
10) December 2010 ….?????”
*The U.S. stock market has experienced losses over the following three-year period one-third of the time when Shiller's PE is above 19.5 - the ratio is currently 22.7!
Biechele Royce Advisors is currently overweight cash in its models and is maintaining a strict sell discipline in order to limit price risk in its clients' portfolios. We continue to favor blue-chip, dividend paying stocks in the U.S.
