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Mark's Market Blog

1-6-13: We Missed The Fiscal Cliff!

By Mark Lawrence

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Markets shot up this week on news of the fiscal cliff deal, closing the week at the highest price since 2007. The Fed released their minutes from their last meeting, and more than half the voting members were in favor of scaling back or quitting QE late this year. I expect the markets to trade more or less flat for the next week or two. Sometime around February the reality of the coming congressional war over the debt limit, the end of the authorized spending for the current approved budget, and the required budget cuts are going to get everyone seriously spooked and the market will drop significantly - a 10% drop would not be surprising in the least. Warning: it's very dangerous to short stocks. I don't advise it.

S&P 500 July 7 2012 to January 4 2013

Washington managed to come up with a fiscal cliff compromise: taxes go up for pretty much everyone that works, those who don't work get extra benefits, and Hollywood and a few other well-connected industries get continuances on their desperately needed special tax breaks. There were also difficult decisions to make about cutting spending - all those decisions were put off until March 1st, corresponding rather frighteningly with the need to raise the US debt limit to avoid default. The fighting will start in early February, and by the last week of February there will be blood in the streets. I have little idea of what will happen or how long it will take, but I can guarantee you that the result will be very very messy and unsatisfying, the debt limit will eventually get raised, and nothing will happen on time. Congress will certainly be late, late for a very important date. I will be startled if Social Security takes any kind of hit. On the other hand, if Medicare and Medicaid don't get major revisions, like allowing negotiation with drug companies over prices and possibly placing limits on tort lawyers, then all this political chaos will have been a complete failure and we'll still be on track for a nasty stagflationary ending. A year or three from now gold might start to look really good.

The fiscal cliff compromise raises tax rates on people making more than about $400k, putting them back at the Clinton-era 39%. However, there was also a temporary cut a year ago in social security taxes and that cut is ended, effectively raising taxes on everyone else with a job by about 4% or so. It's estimated that the total effect of these tax increases will be to lop about 1.5% to 2% off GDP; in other words, a recession which is expected to last a couple quarters. Of course we're navigating in completely uncharted economic waters, so I have little idea how these projections can be made. Anyway, expect corporate earnings to drop for a bit this year, and for that to be reflected in stock prices for the next couple of quarters. All things considered, if you own a bunch of stock, this would be a good week to sell in my estimation.

There's a good chance that late this year the Fed will back off on QE, interest rates will start to rise, and stocks will go down. This will prove to be a real test of our weakened and addicted banking system. Expect bank stocks to drop in the 3rd and 4th quarter, and another round of mergers in the first six months of 2014.

How's that unemployment curve coming along? For all the talk in Washington about the Fed creating jobs with QE and cheap money, and the government creating jobs by holding hands and chanting "We care, We Care, We Care!" the simple truth is we're on a multi year curve of slow recovery and there has been no apparent change in the form of the curve for a couple years. Of course politicians admitting to the public that they're impotent to effect the single biggest fact in the voter's lives is unthinkable. And there's no little blue pill for politicians suffering from this particular form of impotence.

Perhaps something interesting is happening to the markets. The last few days the Nasdaq and the S&P have moved in different directions. The Nasdaq is about 25% Apple by weight, and Apple has everyone scared; however for the last four years the markets have moved together - Nasdaq, S&P, Dow, gold, commodities, if one was up, all were up. This has been a sign of an unhealthy market. The fact that these things are perhaps not so strongly coupled means perhaps the markets are regaining their health. You may feel free to note that that last sentence had two qualifiers in it; personally I ignore sentences that have three or more.

As oil has gotten expensive and stayed that way, gas mileage has gone up. People are driving fewer trucks and boats, and more economy cars. In just the last five years average gas mileage has gone up by 20%. We can expect this trend to continue as economic reality continues to drive most people to smaller cars and smaller engines, and as the government mandates higher gas mileage.

What do governments do? Declare war. War on Vietnam, war on Iraq, war on Afghanistan; war on drugs; war on inequality; war on poverty. How are these various wars going? 2000 years ago a rather famous guy said "You will always have the poor among you," seemingly forecasting that a war on poverty was doomed to failure. Others might look at the above list and conclude that it's governments that are doomed to failure. In any case, there's certainly been no shortage of spending: we're spending 16 times more since this particular war was declared a couple generations ago, and yet we're frequently told there is still hunger. A quick trip to my local Walmart makes that statement seem unlikely, it looks to me like we've managed to convert hunger into obesity on a cultural level. Well, anyway, here's the cost of this particular little war according to the Heritage foundation.

Rumors are flying that Hugo Chavez, the president of Venezuela for the last 13 years, is in a coma and dying of cancer. This is his fourth round of cancer treatment, so it's a bit surprising he's lasted this long. His populist programs have, in the opinion of economists all over the world, squandered a once in a lifetime chance for Venezuela to build universities, hospitals, attract business, and generally get their economy ready for the coming century. Instead they bought cheap gasoline and food for their voters, and almost certainly a bunch of Swiss bank accounts for various Venezuelan insiders. Chavez has brutally suppressed any competition, so after he dies expect a long period of inbred incompetence running Venezuela. But he was popular and meant well. That should count for something, right?

Spain has been avoiding asking for a formal IMF / EU bailout because they don't like the attached requirements for austerity. So how have they been paying their bills? They've been raiding their Social Security reserve fund to buy their government debt. If the government debt ever goes bad, like Greece's did, they're going to be in serious trouble. Of course we've been doing the exact same thing in this country for at least three decades, but then Our Debt Will Never Go Bad.

Japan's incoming prime minister, Shinzo Abe, promised extreme money printing to get Japan out of their deflationary recession. In response the yen has been dropping in value by something like 5% per month for a couple months now. This will lower the US price of Japanese products like the Prius and various Lexii, and no doubt sooner or later provoke a complaint from Detroit who is just getting back on their feet and really doesn't need an attack like this. As we've seen, lower currency values buys your economy jobs at the expense of someone else, and typically that someone else is the US. We're not going to be willing to tolerate an unlimited amount of this. Notice that Europe, which desperately needs a Euro around $1 to get their unemployment under control, in fact has a Euro around $1.30. They do not wish to engage the US in a trade war.

On Thursday the Fed released the notes from their previous meeting. Unsurprisingly, as we approach 6.5% unemployment likely in the next 12 to 18 months, Fed members are discussing when to end QE - buying bonds to pump up the money supply - and when to start considering raising interest rates to cut off any possible inflation. Some members think this should happen perhaps as early as this summer, most think by the end of 2013. When unemployment drops below 7%, which could happen later this year, expect changes in Fed policy. The markets promptly dropped on news that there might be a return to adult supervision and an end to the endless free money.

Treasury Secretary Geithner has apparently decided to quit in the next few weeks, before the fight over the debt limit gets started. I have not been impressed with Geithner's spending and throwing money at big banks, and I for one won't miss him. Perhaps he'll be replaced by a Chicago insider of questionable ethics - sadly, imho this would be an improvement over a Wall Street insider of questionable motives. Or perhaps we'll get John Kerry, whom I consider to have both questionable ethics and intellect.

Talk is increasing about the possibility of minting a trillion dollar coin. Rather than fight with republicans over debt limits and be forced to make actual budget cuts, the Obama administration is considering minting a single trillion-dollar platinum coin. Then they take it to the Fed and use it to buy back $1T of US debt. The result is we're now $1T under the debt limit and the Fed puts a pretty coin in their vaults. Or perhaps their lobby; if it was stolen, it's not like you could go to Walmart or your local Harley dealership and ask if they had change for a trillion dollars. Heck, the treasury could mint three or four of the coins and cut our debt by a quarter. There's also talk that the platinum coin solution is illegal. I've read the law and I consider it ambiguous at worst: in my suspect opinion such a treasury action is defensible, and quit possibly legal. This is not a new idea, decades ago I was taught in economics class that if a US creditor like Japan (China these days) ever demanded we buy back their bonds, we could simply print up a whole bunch of $100 bills and tell them "Come get your money." This is called monetizing the debt. It's never been done, but it's thought that it would result in a quick step in inflation due to the huge increase in the money supply, then the inflation would immediately end, as the printing would be over and the US budget and debt would suddenly look pretty good. It turns out it's not looking like Japan or China who is going to call us on our debt, but perhaps rather Tea Party congressmen.

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