September 2011
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The Thread is Unraveling - Why We Think Bulls Should Think Twice

We have been arguing that the S&P 500 is pretty close to being ‘fully-valued’ on historical basis, even on the most optimistic of outlooks. In our view, there is less-reason-than-ever to believe that we should be optimistic, and we definitely aren’t buying into the recovery thesis. While lower jobless claims as reported this morning is definitely welcome, the fundamental thread holding the country’s economy is fraying.

We are moving to raise the debt ceiling again. This country’s national debt, at $14.2 trillion is approaching 100% of GDP, and our nation’s unfunded liabilities are well over $100 trillion.  Meanwhile, Washington’s partisan environment has very diverging agendas and we don’t expect to see these parties get together on a serious policy to address the debt – short of being compelled to do so by national crisis.

The GOP pats itself on the back because it is proposing $100 billion in spending cuts. This is nothing. We have been fighting a war in Iraq and Afghanistan on the debt which has been running at a clip greater than $10 billion a month (greater than $1.1 trillion to date). Prior to Iraq/Afghanistan, this country never fought a war on the debt. It made the hard decision to tighten its fiscal belt, often raising interest rates, and paying, for the most part, as it goes.  

The GOP’s extension of the Bush tax cuts cost another $400 billion in debt. While the Democrats will likely continue to advocate stimulus programs like QE2, again, on the debt.

The problem is that if Washington enacted serious policies to really put a dent in the country’s $14.2 trillion debt, it would have to include higher taxes, and a step away from stimulative policy which would almost certainly result in slowed growth, continued, if not higher, unemployment, further softness in the housing markets, continued tightness in the credit markets and a high, if not certain, level of probability that the country slips back into a recessionary economic environment.

This is what it would really take to reduce our debt substantially. It is a price that Washington is not willing to pay because it would be political suicide to adopt policies leading to the aforementioned scenarios. It is a game of chicken that each party is playing with the other to see if the other will blink, and make grown-up, hard, but necessary prescriptions for the U.S. economy first – so that it can pin the inevitable consequences (slowed growth, higher unemployment, etc.) on the other. Suffice it to say that neither will act until it is compelled to do so, by national crisis.

So the debt will continue to rise. The can will get kicked further down the road. Interest on the nation’s debt alone, as of today’s data, is more than $3.5 trillion annually. The taxpayer liability on its portion of the national debt is more than $45 thousand per person.

At some point sooner than later, the credit ratings agencies will reduce the ratings on our debt which will make it harder for the U.S. to fund its habits. China, the largest foreign creditor to the U.S., is already making very public criticisms about the way that the U.S. is running its economy and mismanaging its balance sheet, suggesting that there be an alternative reserve currency to the dollar. Niall Ferguson, noted economist, says that the dollar is about as much of a ‘safe haven’ as Pearl Harbor was back in 1940.

Following the thread further, less access to debt financing will ultimately compel Washington into those harder, tougher decisions that need to be made anyway. The problem is, is that at that point, the national debt levels will be substantially higher than even today. The interest owed will be substantially higher than even today. The taxpayer liability will be substantially higher as well. There will be a bigger fiscal problem to fix. This will be the crisis that compels Washington’s partisans to work together, and make the difficult decisions.

At which point, the can kicked which has been continually kicked down the road is right in front of us and it is going to be much more difficult to move this time. The cuts that need to be made will likely be more drastic. The recessionary implications will likely be more severe and long-lasting.

This is our outlook. There is no way to avoid tough decisions that could very well, or that certainly will, result in some real pain for the U.S. economy. We either deal with it now, or later.

We aren’t buying into some lame proposal from the Tea Party that cutting taxes is going to jump start and free-up the economy. We don’t buy into tickle-down, or supply-side economics, which were as much a political theory as an economic policy, championed in the Reagan era by David Stockman as a means of growing the nation’s debt sufficiently to create a dilemma in Washington – cut social programs or cut defense. This policy has been dusted off time and again by the GOP, and needs to be put down once and for all. It is the foundation for rhetoric spewed by the last administration, when Dick Cheney boasted, “Reagan proved that deficits don’t matter.”  And we don’t buy into the notion that any serious progress can be made to cutting the nation’s debt by cutting earmarks and discretionary spending.

A real solution is going to be a difficult and hard one. It is going to mean that U.S. citizens are going to feel some pain. They are going to have to reign in their credit purchases. They are going to have to reign in discretionary spending. Businesses are going to have to start paying higher taxes, and in some cases like Exxon (which has been able to avoid paying taxes in the U.S. on $9 billion in profits last year) they will have to start paying their taxes.

U.S. corporations are going to have to show their commitment to the country, and patriotism by hiring their fellow citizens to keep them employed and with a roof over their heads even if it means a negative impact to their earnings reports. While it is certainly a right in America to ‘shoot for the moon’ and to pursue ambitious lifestyles and incomes (legally), it is myopic to think that this right can be sustained and protected in an economic environment which unsustainably leveraged.

Again, there is no expectation here that these difficult decisions will be made and adopted short of being compelled by crisis. There is only the depressing expectation that the crisis is inevitable. The thread is unraveling. And against this backdrop, the equities markets look precariously balanced and more than fully valued. They have not looked-forward, and discounted appropriately against the building systemic risk.


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