America Bankrupt/Dangerous Market

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.

Currency War!

On 11 October we wrote, "The Federal Reserve is going to print more paper dollars, likely beginning shortly after the November elections. The estimates from the folks in the know is a minimum of $500 billion to $1 trillion. The U.S. economy is currently around $14 trillion and public debt is around $12 trillion - so a trillion in freshly printed greenbacks is not small potatoes. Recent comments from the likes of Federal Reserve Vice Chairman Dudley and the recently released FOMC meeting minutes all but assure that the Federal Reserve will act soon and in size. The September/October stock market rally is telling us as much."

NAILED IT!

The Federal Reserve announced on 4 November that they would be buying $600 billion in government bonds beginning immediately and running through the middle of next year. The stated intention is to drive interest rates even lower in an effort to stimulate spending and job creation in order to fight the deflationary threat which the Federal Reserve governers insist is looming. Well, most of the Federal Reserve governers anyway.

In a rare public disagreement with the consensus, FED Governer Warsh announced that he isn't concerned about deflation, citing Dr. Allan Meltzer's position that there is no deflationary threat. Dr. Meltzer, the author of dozens of academic papers and books on monetary policy and the Federal Reserve Bank, issued a scathing critique of the Fed just last week saying, "All this is not relevant now, since there is no sign of deflation in the United States. The Fed's claim that there is a risk of deflation should embarrass it." Meltzer's views carry weight since he is considered one of the world's foremost experts on the development and applications of monetary policy. It's time to take notice when Meltzer derides Federal Reserve policy in such strong terms.

So what is the Federal Reserve up to if it isn't slaying the deflationary dragon?

Well, it is almost a certainty that its real goal is to debase the U.S. dollar, making it easier for the United States to pay back the trillions it owes to its citizens, to the Chinese and other sovereign nations, and also making our exports more competitive in world markets. Of course the U.S. can't publicly admit it is following a classic "beggar thy neighbor" policy. Fed Chairman Bernanke isn't about to own up, nor is Treasury Secretary Geithner. On the contrary, Geithner just appeared on CNBC and said (with a straight face) that, "“THE U.S. WILL NEVER DO THAT. WE WILL NEVER SEEK TO WEAKEN OUR CURRENCY AS A TOOL TO GAIN COMPETITIVE ADVANTAGE OR TO GROW THE ECONOMY.” …

So is the rest of the world buying the baloney? Not hardly...

China's Dagong Global Credit Rating Co. just cut its credit rating on the U.S. to A+ from AA because of the Fed's plan to purchase bonds to spur growth and inflation. Dagong Global wrote, "The credit outlook for the U.S. is negative amid deteriorating debt repayment capability and a "drastic" drop in the government's intention to repay debt. The Fed's quantitative easing policy will erode the value of the dollar and is against the interests of creditors." Ouch!

And here is what German Finance Minister Schaeuble had to say about QE2 in an interview with Spiegel magazine last week, "I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don't recognize the economic argument behind this measure." He went on to say that, "It's inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money."

It would appear that the rest of the world understands very well what is going on. But why should the U.S. consumer care if the rest of the world is getting hosed (with dollars)?

INFLATION!!!!!!

Gold is saying the inflationary threat is real, reaching more than $1400 per ounce before pulling back (temporarily most likely). Although it is always difficult to forecast price levels, it is quite possible that gold will reach $2500 per ounce within a few years if the Federal Reserve continues in its madness. The bottom line though is that inflation is bad for savers and good for debtors and U.S. savers will suffer right along with the Chinese, Germans, and Japanese. Inflation erodes wealth. Inflation destroys middle classes. U.S. citizens will suffer greatly in coming years as their purchasing power is dramatically eroded by the inflationary genie that the Federal Reserve appears determined to let out of its bottle.

Biechele Royce Advisors builds properly diversified portfolios using individual stocks and bonds whenever possible to reduce costs. We are currently overweight tangible assets such as real estate, precious metals, and commodities as well as non dollar assets, including international stocks and bonds. It is our belief that Inflation is coming and it could get pretty ugly if Bernanke and his lunatics continue to run the asylum.

Quantitative Easing a.k.a Money Printing

The Federal Reserve is going to print more paper dollars, likely beginning shortly after the November elections. The estimates from the folks in the know is a minimum of $500 billion to $1 trillion. The U.S. economy is currently around $14 trillion and public debt is around $12 trillion - so a trillion in freshly printed greenbacks is not small potatoes. Recent comments from the likes of Federal Reserve Vice Chairman Dudley and the recently released FOMC meeting minutes all but assure that the Federal Reserve will act soon and in size. The September/October stock market rally is telling us as much.

Will quantitative easing(QE2) more effectively stimulate consumption the second time around? After all, the Federal Reserve is estimated to have bought $1.5 trillion in bonds and mortgages between 2008-2010 during the first money printing exercise. Nevertheless, and despite $860 billion in fiscal stimulus thrown in by Congress, final demand grew at only a 1.3% rate in the first four quarters of recovery.

Although the public might not fully appreciate it, the Federal Reserve is boldly going where no central bank has gone before - and the unintended consequences could be disastrous. But what exactly is the Fed trying to accomplish with its radical departure from orthodox central banking? According to a Goldman Sachs report covering a Q&A session with Vice Chairman Dudley, successfully pushing interest rates down will allow those who are able to borrow to do so at lower rates, freeing up some of the income now being spent on debt service. Perhaps more importantly, QE2 will work on other elements of financial conditions, including equity prices and the exchange rate.

And there you have it. QE2 is intended to push the U.S. stock market higher and the dollar lower. The Federal Reserve is targeting the stock market and the dollar... and the smart money knows it, which goes a long way in explaining the recent stock, gold, and commodities rallies. Furthermore, Wall Street investors are also front running the Federal Reserve in the bond market, pushing rates lower without help from the Fed, but with the understanding that the Fed has their backs. (Not coincidently, the Federal Reserve began to signal its intention of carrying out another dollar debasement campaign in early September, just as the S&P 500 looked ready to test the early July low at 1003.)

But what could go wrong? Well first, it is possible that the Federal Reserve QE2 program will be smaller than expected, which would likely result in a bond market sell off. Rising rates could quickly end the stock and commodities market rallies as an already sluggish (contractionary?) economy reacts poorly to a higher interest rate environment. Conversely, the Fed may move HUGE and actually succeed in pushing interest rates down to the point where a falling dollar begins to generate significant inflation. In the latter case, you can expect interest rates to once again start to rise as inflation takes hold. Private bond investors will run for the exits, once again front running the Federal Reserve (with its now even bigger inventory of government bonds).

Who will the Federal Reserve sell to in order to reverse its successful inflation generating policy? What private investor is foolish enough to step in front of that kind of supply? Not the Chinese, who've let Washington know in no uncertain terms that they are opposed to another round of dollar debasement. Yet, unless the Federal Reserve can find a willing buyer for its trillions in bonds, it can not start to drain money from the economy and prevent inflation from ripping out of control. Unfortunately for stock investors, the second scenario will also likely lead to a stock market sell off due to the negative impact rising inflation and interest rates will have on the economy.

All in all it seems to us that investors would do well to sell into the current stock, bond, and commodities market rallies, locking in profits and preparing for a better buying opportunity down the road. Biechele Royce Advisors continues to hold higher levels of cash than normal in its client accounts because we continue to struggle to find good businesses available at great prices.

(Fun Fact: The U.S. stock market has now lost about 80% of its value in gold since the secular bear market began in March of 2000. We see the trend continuing.)

Debt, Inflation, and Governments

The S&P 500 may motor higher if the Federal Reserve implements an aggressive Quantitative Easing program as is increasingly likely. The July bottom may hold and the S&P 500 may take another run at the April 1219 high. Or perhaps the Federal Reserve will wait too long and the combination of a weakening economy and (still) overpriced market will lead to further selling, taking the S&P 500 back to a three digit number in coming months. Predicting short term market movements is a difficult task at best, in part because policy decisions yet to be made can greatly influence the market's path. For the record: we are of the opinion that the probabilities favor a sell off back below 1000 as the market digests the implications of a weakening economy and weaker than expected corporate profits. However, we are far more confident about our prediction of rising inflation in the years to come...

Next year the Federal Government is expected to spend approximately $3.8 trillion, exactly twice as much as the 2001 budget of $1.9 trillion. Amazingly, the federal government has managed to double its size in just one decade. Further, the U.S. has almost doubled its national debt in just the past 7 years. It now totals almost $120,000 per taxpayer. Unfunded liabilities, such as social security and medicare, equate to approximately $355,400 per U.S. citizen. Clearly the United States will default on some of its obligations because there isn't any way that every man, women and child in the United States of America can generate that amount of cash in time to meet all of those obligations as they come due!

But the form of default is critical because it determines who bears the burden, since not all defaults are created equally. For instance, the U.S. government could choose to default on its public debt, leaving foreign governments and U.S. bond investors holding the bag while John Q. Public escapes unscathed. Another option is for the government to renege on some of its social security and medicare promises by curtailing benefits, which means the elderly and poor would bear the brunt of the default. Or the government could decide to let inflation run wild, thus devaluing ALL of the debt it owes to everyone. Savers bear the brunt of this defacto default while debtors cheer (paying debt back with cheaper dollars is much easier to do).

It should be obvious which option is easiest politically. And in fact, inflation has always been the choice of every government everywhere throughout recorded history when too much debt was accumulated. The Federal Reserve has ballooned its balance sheet from $850 billion to $2.3 trillion in the last year or so and will likely explode it again to around $4 trillion over the next year if QE2 is implemented, as is increasingly likely. What is highly unlikely is that the same Fed who failed to see the tech and housing bubbles form, will successfully pull off what amounts to a high wire artist performing without a safety net... blindfolded... as it attempts to siphon all of that extra cash back out of circulation once it deems the economy rescued....

Biechele Royce Advisors continues to overweight non dollar and real assets and under weight fixed income and financial assets. We also continue to strongly prefer dividend paying stocks, which make up the bulk of a stock investor's return in secular bear markets....

Increasing Weakness

The S&P 500 is down almost 4% since we last blogged about the increasing likelihood of renewed recession and market weakness. Unable to retake the flattening 200-day moving average a second time, the market sold off and is now 2.5% below the 50-day moving average. Further, the 20-day moving average is set to fall below the 50-day, which would put the four main moving averages (200, 100, 50, and 20) in bear market order. The Japanese Nikkei is already in a bear market. The S&P 500 was down almost 18% at its low in early July and looks increasingly likely to retest it - and fall below 1000 on a failed retest. Our forecast is based on our outlook for the economy, which continues to show every sign of falling back into recession.

Our December 2009 forecast of at least a 20% pullback in the S&P 500 sometime in 2010 looks increasingly like another solid win for the home team. We had written that the spring of 2010 was the most likely time (missed it slightly as the pullback stopped at 18%) and that the fall was next most likely. Our belief in a 2010 bear market stemmed from a few basic observations. First, the 2009 market recovery went further and faster than any bear market recovery since 1933, leaving the S&P 500 about 35% overvalued based on a number of long term valuation metrics (metrics Wall Street doesn't like to acknowledge because it gets in the way of them selling product to the unsuspecting public). Second, the economic recovery touted by the Fed and the Obama administration just wasn't supported by the numbers. Inventory swings were the main factor in the positive GDP numbers in Q4 of 2009 and Q1 of 2010. Final demand remained punk, as you would expect given the huge debt load born by the consumer, the lack of credit formation, and unbalanced make up of GDP (the consumers' share had grown to a record 72% during the spending orgy and is likely to fall back to a more sustainable 66% or so in the coming years).

Pair an overvalued, overbought market with an under performing economy and you are likely looking at poor market action going forward - which was our call in December 2009 and remains our call today. Market performance in 2010 has more than justified our cautious stance coming into the year. And unless the Federal Reserve gets busy printing more paper, the S&P 500 looks increasingly like it will sink to new lows for the year. The market is unlikely to test new lows for the secular bear market that began in March of 2000 however, because the Fed is clearly targeting the stock market now as a source of wealth and will eventually get around to supporting it. The Fed is likely to act sooner rather than later with renewed quantitative easing - given Bernanke's latest statements - and that just might give the market a lift into year end, but perhaps starting from the 850-900 level....

Biechele Royce Advisors continues to advocate proper diversification among all major asset classes with emphasis on blue-chip dividend paying stocks in the U.S., tangible assets, and nondollar assets. We continue to believe that inflation will pose a major threat to wealth preservation over the next ten years. Finally, we offer another reminder that secular bear markets require a focus on capital preservation first and capital appreciation second…

Posted by Chris Norwood, CFA(R) at 8:42 AM

Recession Looming

We did get the short term pullback predicted in our 14 July blog. We referenced the 20-day moving average sitting at about 1075 as a likely destination. The actual decline bottomed on 20 July at about 1060 before the S&P 500 motored higher once again, retaking the 200-day moving average in the process. Unfortunately, the S&P 500 was unable to maintain above that long term trend line, peaking at 1130ish in early August, before sliding back below the 200-day (We had written about strong resistance in the 1100-1130 area likely putting a lid on the stock market for the foreseeable future).

The stock market has essentially gone nowhere since last October, validating our concerns about an overpriced market that had climbed too far and too fast after the March 2009 bear market bottom. We have stated repeatedly since last October that it is a high risk market and investors should proceed cautiously. We are even more concerned today because the market has now put in a ten month top and a broad decline is increasingly likely in the fall, or next spring at the latest. It increasingly appears as if distribution is occurring whereby professional investors distribute shares to the public, leaving the public holding the bag when the market decline starts in earnest. One indication of distribution is On-Balance-Volume (OBV), which is showing a negative divergence over the last few months, portending coming weakness.

But what is the fundamental case for a broad stock market decline? Well, how about a return to recession? The probability of another recession (or continuation of the one which started in early 2007) is quite high. Real M-3 (the broadest measure of money supply) is still contracting strongly year-over-year. Recession has followed 100% of the time when real money supply contracts on an annualized basis, typically with a six to nine month lag. As well, the ECRI is now contracting sharply and, again, recession has followed 100% of the time when the contraction is as sharp as now. Likewise, real retail sales are weakening with July real retail sales growth essentially zero - opening up the possibility that Q3 real retail sales will turn negative. Furthermore, a surprisingly bad June trade deficit number will result in a reduction in reported Q2 GDP. The deteriorating trade balance also increases the likelihood of a negative Q3 GDP number. Finally, a developing contraction in housing starts, along with deterioration in a slew of other housing numbers, adds further pressure to an economy already under siege.

Expect a retest of the recent 1010 low on the S&P 500 with a likely decline into the 800 to 900 area within the next six months. Investors should continue to proceed with extreme caution in a very high risk market.

(A major caveat: the Fed appears likely to initiate a new quantitative easing program sooner rather than later, which would provide major support to the stock market, at least in nominal terms.)

Short Term Top

The S&P 500 continued to fall until finding support just above 1000 (big round number), which we suggested might happen in our 30 June blog. The S&P 500 then rallied furiously over the next nine days, gaining 9% before running smack into the leading edge of resistance yesterday. (Also noted in our last blog - 1100 to 1130). The S&P tested 1100 yesterday and again today but has been unable to punch through. A couple of positive earnings reports from Alcoa and Intel have probably helped hold the index aloft, but it certainly looks as if the market is getting ready to move lower very short term - likely back to the 20-day moving average sitting around 1075.

More broadly speaking, the S&P 500 is now firmly entrenched in a downtrend and would need to break above about 1130 to renew any semblance of short term upside momentum. To the downside, the recent low of 1010 is likely to be tested in the coming months as increasing weakness in the economy translates into disappointing earnings. We are maintaining our price discipline, selling stocks as they approach fair value and buying stocks only when we believe we have a sufficient margin of safety to warrant taking the risk of adding new positions in what remains a high risk market.