Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
1. What Might Be Different This Time?
Observing the presidential travels this week, and listening to the message he has carried to Asia and to the G20 meeting, we come to a sobering conclusion. The erosion of U.S. leadership is in full swing. Yes, we still carry the biggest stick, and when needed can turn our soft voice into a roar (usually, the sound of fighter jets, unmanned aerial vehicles, and bombers). If, however, we are talking about fiscal, monetary, or general economic issues, we have lost credibility, and our opinions and prescriptions are twaddle.
What might be different this time is that the U.S. dollar, so critical to world trade and economic prosperity in times past, is now at the other end of the pendulum. As a transactional unit, it is becoming less critical, and is quickly becoming the cause of consternation and conflict (currency wars are a reality, not just a possibility). We once were seen as an asset. Now we are a liability. The dollar was desirable. More and more, it is despicable.
How are things different this time? It is not our fiscal or monetary policy that is any different. Those policies have remained backward for 40-50 years. What is different is the degree to which we are interfering in the markets and propping up asset values. Such interference has never been seen before (the Plunge Protection Team and the Fed are working around the clock). And this is an issue that has forced the world to reckon with the possibilities of U.S. sovereign default, either outright or more subtly through liquidity creation and inflation. Thus, we see more overt discontent following the recent announcement of treasury monetization (I thought Bernanke swore before Congress that there would be no monetization?)
The G20 is a case in point. Mr. Obama has pleaded the case this week that extreme currency manipulation by the Chinese has caused the trade imbalances we see today, and destabilized the world economy in consequence. The suggested remedy reads like a comedy act (more Three Stooges than anything with wit or intelligence behind it). It is believed that we need the Chinese currency to appreciate so there is less of a trade surplus with all the evils of misallocated capital that follow from it, and a more level playing field for jobs and employment. The retort from Asia: U.S. monetary policy is aborting any possible recovery.
Here is the rub. Should our good President succeed in pressuring the Chinese to eliminate their trade surplus, we will have effectively cut off our nose to spite our face. Without those trade surplus dollars recycling into dollar assets, specifically treasuries, we are faced with a crisis of epic proportions.
As you know, we have a budget deficit of more than $1.5 trillion this year, with similar projections for next year. That means we have to find someone to lend us that money. We also have 70% of all U.S. treasuries coming due in the next 5 years – which means we either have the capital at that time and pay off the loans or we roll them over and extend the terms of those IOUs, on top of new funding needs. In essence, we are asking the Chinese to cut off a critical line of credit as we exponentially increase our need for it.
What is not different this time is desperate politicians resorting to a traditional ploy: scapegoat “foreigners” and avoid any responsibility for the actions that landed us in our current economic mess.
2. What’s Next for Stocks?
Earnings growth is slowing fast among the 500 companies that comprise the S&P 500 Index. Since the crisis of 2008, earnings growth for the last four quarters has produced returns of 306%, 19.54%, 10.13% and 7.03%, respectively. Earnings growth for the 4th quarter this year is expected and likely to show a contraction, showing no progress at all. Combined with facts we’ve discussed previously about the current relationship between commodity inflation and profits, this development makes it very hard to see the index progressing from here.
So are stocks trapped? We would say so. If the Fed decides to print at an accelerated rate, inflation eats corporate profits. If the Fed decides to tighten and force our fated bankruptcy, leverage deteriorates and prices collapse across the board for all productive assets. It’s a no-win deal.
The chart below shows S&P earnings from 1978. It helps to put earnings volatility in perspective. The current earnings level is nearly equal to the peak reached in 2008, just before the crisis began, even though the economy hasn’t fully recovered – at least in regard to jobs and corporate revenues on the whole. Also, the last time earnings reached their current mark of approximately $71 per share, the index sported at $1500 price tag – almost 25% higher than where it stands today at $1199.21.
Why the price difference? That’s easy – inflation. Because of inflation, the financial system is doing predominantly two things. First, it’s squeezing discretionary funds out of the markets and into the higher cost of living. And second, it’s switching investment dollars to assets that are performing better than stocks while the Fed prints excessive new funds.
Where is the money going? Defensive commodities. That’s a trend we suspect will continue until stocks can be considered cheap, which won’t happen until earnings revisit levels below the trend line shown in the chart for an extended period of time.
Have a wonderful weekend.
President and CEO
VP Investment Management