Sterling Weekly for the Week of March 4th, 2013

A Look at What Worries the Market

Since the previous edition of the Sterling Weekly, the Dow Jones Industrial Average rose 193.68 points or approximately 1.4% to close at 14,089.66 on Friday March 1st, 2013.  The overall market has been in a fairly reasonable upward trend since the start of the new year.  The Dow Jones Industrial Average is now just a few points away from its all-time high set in the summer of 2007.  Normally everyone would be rather excited when the market is close to a new all time high.  However, while the overall market appears to relatively fairly valued based upon traditional measures there continues to be an overriding sense of anxiety concerning the markets valuation and the status of the U.S. economy. I find that almost everyone, from friends to business owners and other investors,  has some form of this concern or worry. It is like nothing I have ever experienced before.

I think it is worthwhile to ask ourselves where this sense of anxiety and apprehension comes from; and if in doing so the answers may shed some light as to weather the concerns and worries are valid or not?  I see see the primary problem coming from the brass knuckle politics being played out in Washington, D.C.  I have said for a very long time that I believe politics is the single biggest influence on the market,  and I believe that is true now more than ever.  I see four main drivers from Washington that are putting downward pressure on the U.S. economy and the confidence level in the U.S. economy. They are Federal Deficit Levels, Federal Reserve Board policy, Taxation Rates, and new government regulation.  This is how I think they impact the overall market, and U.S. economy.

Federal Deficit Levels:  The Federal Deficit has never been higher, both in terms as a percentage of Gross Domestic Product and in total dollars.  No country in the history of the world has ever used excessive deficit spending to create a stable and prosperous economy.  I challenge you to name one!  In fact it been one of the primary sources of economic ruin for countless countries throughout the history of the world.  It is the source of the fiscal and economic crisis that has gripped Europe for several years now.  Why should it being any different now?  Why should something that has never worked before in the history of the world, suddenly work?  Why should it being any different this time?  These are questions and concerns that are shared by investors, business owners, managers, other decision makers, and citizens in general.  There is no valid answer as to why it will be different this time.  In fact history has shown that when someone really believes that this time it is different, what they are actually doing is setting themselves up to fail.  The bottom line is that these sky high deficits unnerve those who make investment and spending decisions, and as long as the deficit remains high, people are going to be extremely nervous about investing or spending any money.

Long term economic prosperity is created by sound fiscal policy.  By governments that run a balanced budget and are able to properly invest for the future and return excess tax revenue to its citizens.  When you think of strong economic powers in the world today and throughout history,  they have all had balanced budgets or at the very least minimal deficits.

Federal Reserve Board Policy: The Federal Reserve Board is committing 2 major wrongs that are severely damaging the economic growth of the United States.  The 1st being it keeping interest rates artificially low, and the second is it is monetizing the Federal Deficit.  Those are both items that will get a country and its economy in serious trouble.  History has taught us that artificially low interest rates will lead to either excessive inflation or create bubble in the economy, both of which always lead to some form or another of serious economic pain. Since it is not always easy to determine which of the two will occur, the safe thing to do is hold onto your cash until you can figure it out; and that is what it appears people are doing.

Additionally there is a great deal of concern over how the Federal Reserve will unwind or reduce the amount of government securities it owns.  However you want to slice it,  the unwinding of the government securities position owned by the Federal Reserve is going to have a depressing effect on economic growth.  Just stopping the government bond purchases by the Federal Reserve is going to cause interest rates to spike.  That is going to have a hugely disruptive effect on the US economy, and probably the world economy.

Monetizing the national debt is something that was always considered the greatest of economic sins.  When a government buys its own debt, it is essentially printing money out of thin air.  It is destroying the value of its own currency.  It distorts the true level of interest rates, and creates concerns that interest rates will rise too high when they ultimately do rise.  No country in the history of the world has ever created economic prosperity by buying its own debt or simply printing money.  It has never worked, and it always leads to a disaster, usually in the form of hyper-inflation.   Why should the results be any different this time?  Why should the United States be special? The concern is that the current policy by the Federal Reserve Board is creating a bond bubble that will make the housing bubble pale in comparison.  If those concerns are true,  then when the bond bubble bursts, as all bubbles ultimately do, then the crisis it creates will make the financial crisis of 2008 look like the good old days.

Instead of enabling unsound fiscal policy from Washington D.C. and sky high deficits, the Federal Reserve Board should allow interest rates to rise to their neutral level of 1.25% of the rate of inflation, which would be approximately 3.5% for Fed Funds; and stop purchasing new government debt.  This would allow interest rates to move towards their natural market level and enforce some fiscal discipline on Washington DC.  This would also go a very long way in restoring confidence in the economy of the United States.

Taxation Rates:  There is nonstop talk by the Democrats in Washington DC about raising tax rates.  Constant concerns over the changing of tax rates make it difficult to plan for investing, savings, and spending. Higher taxes hurt all three items.  The smart thing for a prudent person to do if you are concerned about higher tax rates is to save your cash and reduce your spending and investments.  Raising tax rates will not solve the deficit problems of the United States.  The Federal Government has never collected more than 21% of the Gross Domestic Product (GDP) in tax revenue.  Raising tax rates to infinity will not change that fact.  What it will do is hurt the economic growth of the country.  No country has ever taxed its way to economic prosperity.  It has never happened.  What higher taxes do create is economic stagnation and corruption. The concern is that the Republicans will eventually loose the battle over higher tax rates, and when they do, tax rates will go to far higher levels than are currently being discussed.

The talk of constantly higher tax rates needs to end.  What this country and the U.S. economy needs is a level of certainty and stability that cannot be provided when there is a non-stop battle to raise taxes.

Government Regulation:  The Obama administration and Democratic controlled Congress under Reid and Pellosi embarked on the greatest increase of federal regulations in my lifetime.  Even loosing control of the House of Representatives in the 2010 elections, the Obama administration has continued on with significantly expanding the level of regulations businesses must understand and comply with.  Just think of the legislation that was pushed through in the first 2 years of the Obama administration.  There was Obamacare and Dodd-Frank;  two pieces of legislation that were so expansive that they still have not drafted all the rules and regulations or taxes associated with either one of them.  That does not even take into account all the regulatory changes coming through all the various government agencies such as the Environmental Protection Agency (EPA).  All these new regulations further add to the level of uncertainty and expenses businesses, their owners, and managers are facing.  This reduces the overall level of spending and investment as businesses work to conserve cash in order to make it through uncertain times.

What the government needs to do in order to help the economy is to slow down the pace of new government regulations and work on streamlining and reforming existing government regulations in order to reduce the compliance cost and burden placed on businesses.

There is an old saying that the market climbs a wall of worry.  However, generally when the market is climbing its wall of worry,  the rest of the country is enjoying the good times. It is not a normal market when the rest of the country is setting atop the wall of worry, and the market is partying up the good times.  Like a lot of people, I have a tough time shaking the feeling that there is a going to be a day of reckoning like we have never seen before.  I do not know when it will occur, but as time goes by I keep feeling we are getting closer to the point of no return.

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