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Published: September 9, 2009
The stock market is up +51% from its March 9
lows. The leading economic indicators have turned sharply
positive, showing gains for each of the last four months.
Manufacturing is on the rebound. And banks are promising to pay
record bonuses, as their earnings have rebounded.
With this recent rush of upbeat economic news, it’s no wonder
commentators are trumpeting the rebound of the U.S. economy.
But I think it’s time to short U.S. stocks.
Shocked?
Don’t be.
What most experts see as a strengthening U.S. rebound, I see as
an increasingly dangerous “false dawn” -- for these two key
reasons:
* An overly expansive monetary policy that’s almost certain to
spawn inflation.
* And a record-level budget deficit that will cause interest
rates to spike, crimping economic growth.
A Foundation for Trouble
U.S. policies that were intended to combat the financial crisis
that broke last year -- as well as the recession that’s been
plaguing us since December 2007 -- have actually inflicted a lot
of weakness upon our economic system.
For instance, the federal government has made $11.6 trillion in
financing commitments, many of which will saddle us with debt
for generations -- some of it forever. Outlays of that magnitude
in a $14 trillion economy are bound to have lasting
implications: Think of the consumer who has a series of
maxed-out credit cards -- he’ll make the minimum payments, but
the actual balance will never get paid down.
And the foundation for this financial fiasco was actually
constructed several years ago.
After the bursting of the 1996-2000 “dot-com”
bubble, the U.S. Federal Reserve re-inflated the money supply.
That caused stocks to resume their upward march, and as we now
know, also inflated a housing bubble of such enormous size that
it caused a general financial-system crash when that real estate
bubble burst in 2007-08.
This time around, the Fed has been even more expansive. The
benchmark Federal Funds Rate was 1.0% in 2002-04. This time it
is 0.25%. What’s more, this time around we’ve had a $2 trillion
expansion of the Fed balance sheet, a doubling of the monetary
base and $300 billion worth of direct central bank purchases of
government debt. Given this orgy of Fed expansionism, it’s
likely that the onset of inflation -- whether it’s in consumer
prices or asset prices -- will be correspondingly worse. In
fact, we’re already seeing that gold prices are once again
making a run at their all-time high. And crude oil hovers at
about $70 per barrel, a level that would have been unimaginable
before 2004.
Now that he’s been nominated for reappointment, U.S. Federal
Reserve Chairman Ben S. Bernanke says he will tighten monetary
policy in good time. But why should we believe him? If he tries
to tighten significantly, he will incur the wrath of the Obama
administration and the Democrats in Congress.
Even back during the 2001-04 time
frame -- when there was an
administration in place that claimed
to believe in monetary stringency --
the Fed didn’t tighten. Bernanke
himself was among the most
aggressive opponents of tightening.
Back in 2002, in fact, when
inflation was running at a perfectly
respectable 2%, Bernanke actually
spun myths about the imminent onset
of “deflation.”
Given what we know, it seems that if
the current economic bounce shows
even the slightest signs of
faltering, Bernanke won’t tighten --
he’ll pump even more money into the
U.S. financial system. Rest assured
that the administration, Congress,
and much of the media will be
cheering his move.
Borrow Now, Hurt Later
If an overly expansive monetary
policy was the only problem we
faced, it might not be so bad.
Unfortunately, there’s more.
Lots more.
Unlike in 2002 -- in fact, unlike
any other time in U.S. history --
this country now has a budget
deficit in excess of 10% of gross
domestic product (GDP). For fiscal
2009, that was forgivable: We’ve had
a major recession, and a shattering
financial crisis, which the federal
government has tried to battle with
aggressive bailout programs.
Here’s the problem, however: The
projected deficit remains above 10%
of GDP for fiscal 2010, even though
no additional bailouts are
contemplated and the Obama
administration is projecting a
modest-but-steady economic recovery.
The result is harder to predict --
this country hasn’t traveled down
this particular path before. This
strategy bears some resemblance to
the position Japan found itself in
during its so-called “Lost Decade”
of the 1990s. But even Japan’s
deficit never reached this 10%
threshold.
In Japan, the effect seems to have
been the gradual abandonment of
small business finance, and the
resulting starvation of the most
critical factor in economic growth
-- entrepreneurship.
The small-business sector creates
most of the new jobs in the U.S.
economy. But in a challenging
environment, it’s easy to see why
this sector gets overlooked. Without
political connections or large
contracts to hand out, the
small-business sector ends up being
last in line in the financing queue
when the economy faces strong
headwinds. Why should banks or other
people lend to small businesses when
the U.S. government bond market
stands as such as huge, safe parking
place for their cash?
Interest rates will also become an
issue. With the inflationary
pressures we expect to see from the
overly expansive monetary policy
we’ve described, long-term interest
rates are likely going to rise
anyway. As was the case in Japan’s
decade-long malaise, these forces
will combine to spark high default
rates in the banking system, low or
zero economic growth, and a general
downward trend in the stock market.
All of this will make it tough for
small businesses to obtain the cash
they need to grow, meaning this key
job-creation engine will have to
sputter along.
It’s still early in the game, and
there are many factors to consider,
so the future economic picture
remains a bit murky right now. But
my guess is that the bubble in asset
prices will be largely confined to
commodities, that economic growth
after this current initial burst
will relapse, and that U.S. stocks
will prove to be the same generally
unattractive investment that they
were in 1970s -- the era of the
so-called “Nifty Fifty.” If the
stock market bubble gets even more
exuberant from here, the relapse
will be correspondingly more
painful.
Profitable Pockets
Despite this dour backdrop, three
things are worth remembering:
* First, all U.S. stocks are not
created equal. Although I’m saying
it’s time to short U.S. stocks, and
I see tough times ahead for the key
indices, there will always be
individual stocks worth
consideration, such as the “Alpha
Bulldog” stocks I highlight in the
Permanent Wealth Investor
service.
* Second, the best way to play this
looming downdraft -- either as a
direct profit opportunity or as a
way of hedging your current
portfolio -- is through the use of
what I like to call “Stage 3″
investments. An example of one such
investment is long-dated “put”
options on the Standard & Poor’s 500
Index, which trade on the Chicago
Board Options Exchange. If you buy
these options when they are way “out
of the money” with a strike price
far below the current price, in a
real bear market (like that of
2007-09), you will see them really
zoom up in value as the S&P drops
down closer to the strike price, or
possibly even falls below it.
* And third, understand that my
pessimism about the U.S. market
doesn’t apply to every other market
around the world. While the monetary
problems are more or less global,
the budget-deficit problems are not.
For instance, you might want to
consider investments in Japan, where
a recent election should spawn the
kind of economic changes that will
benefit savvy investors. Germany,
too, looks to have avoided the
contagion of “stimulitus,” which is
why its economy is now viewed as one
of the healthiest in Europe.
Consider the iShares exchange-traded
fund (ETF) entry for each of those
two markets: The iShares MSCI
Japan Index Fund (NYSE: EWJ) and
the iShares MSCI Germany Index
Fund (NYSE: EWG). They each
warrant a look.
-- Martin Hutchinson
Contributing Editor
MoneyMorning.com
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