No Clear Path

We need to step back, take a look at our investment life and redefine where profits will come from in the future. More than any time in our lives as Americans, paper assets are in danger of falling apart. There are reasons our best investment moves may be to liquidate most paper assets other than several dozen existing AAA-rated international corporations.

How could America’s great economy be falling apart? Is it just “politicians” again? Does history repeat itself?

History doesn’t repeat itself, but the characteristics of man, bread into all of us, pass from generation to generation. Man does not change. Laws, governments and societies change, but man’s characteristics are the problem. They are generally recognized as the 7-Deadly sins of Pride, Envy, Greed, Anger, Lust, Gluttony and Laziness. Government is the ultimate power in man’s earthly life. Government attracts people who crave power at any price. “At any price” in history has meant borrowing large sums of money to sustain their time in power, which leads to currency meltdowns from inflation. Money is always borrowed to either pay for war, or pay for government welfare programs.

Currency meltdowns are not planned. They occur over a prolonged period of time as a result of government overspending. The overspending is financed by debt. The money made to supplement the government’s spending is put into the economy in the form of added currency. The additional cash in the economy causes the price of goods and services to increase. This “inflation” of prices is “ok” until the inflation accelerates and the country’s currency becomes worthless.

Our economy is on the verge of a currency collapse. Economic crisis are usually accompanied by an increase in the reach and power of government, coupled with a decrease in the resources and the freedom of individual citizens. Government uses their taxing power to literally gobble up an economy’s cash. Let’s verify this by looking at a few statistics:

Government debt as of 1/31/13	$16.5 trillion
Total Federal Spending	$3.5 trillion
Federal Spending Deficit	$1.1 trillion	46% of government spending (the $1.1 trillion deficit) is borrowed money, which the government makes out of paper, and which is backed by nothing. We pay interest on that debt every year, forever.
Gross Domestic Product (GDP)	$15.6 trillion	Government debt is 106% of GDP. This is “third world” type debt, by which time most countries would have crashed and burned.
Total State, Local and Federal spending	$6.5 trillion	Equals an astounding 42% of GDP.

Bearing those numbers in mind, look at the chart that shows 24 years of U. S. Government debt increases. Take note these 24 years include 12 years of democratic and 12 years of republican presidencies. Both major political parties are culpable in running up the debt of this country. The real danger is that the increase in debt has reached amounts where it cannot conceivably be paid off. Alarmingly, interest payments on our debt are so great that we must borrow money simply to make the interest payments. This is a prescription for disaster. All socialist economies overwhelm themselves by borrowing money simply to sustain the government: Argentina, Spain, Greece, and before then, England, France, Spain again, Rome, Greece, etc. America is the greatest of all of those past civilizations, and we’re making the same mistakes that crushed them.

24 Years of U.S. Debt Increases
President	Debt Increase	Number of Years	Average Per Year
Bush Sr.	$1.5 trillion	4	$0.4 trillion
Clinton	$1.5 trillion	8	$0.2 trillion
Bush Jr.	$5.0 trillion	8	$0.6 trillion
Obama	$5.7 trillion	4	$1.4 trillion
Total	$13.7 trillion	24 years	$0.6 trillion

Economic statistics tend to confuse the public. They are so large that citizens get “billions and trillions” mixed up. One easy way to understand the economic crisis is to compare annual government spending, and indebtedness, to a family’s annual income, spending and indebtedness. We can then see just what kind of shape a family would be in had they behaved economically the same way our government behaves. You can see that the average family who spent money like the government would have been bankrupted a long time ago. What the public has difficulty grasping is that our own federal government is bankrupt, as these numbers bear out. Further, looking at “recent budget cuts”, one can see that they amount to nothing on a relative basis.

Federal Government Statistics		Remove 8 zeros and pretend it's our household budget
U.S. tax revenue	$2,400,000,000,000	Annual family income	$24,000
Federal expenditures	$3,500.000.000.000	Money spent on living	$35,000
New debt	$1,100,000,000,000	New debt on household credit card	$11,000
National debt	$16,500,000,000,000	Outstanding balance on household credit card	$165,000
Recent budget cuts	$40,000,000,000	Total budget cuts	$400

The current Dow Jones Industrial average is selling at 14,000 representing a price earnings ratio of 14.4 times earnings, and a dividend yield of 2.5%. The average long-term price earnings ratio and yield on the Dow Industrials is 14.5x and 4.3%, respectively. The price earnings ratio indicates the market is selling at a historically average price relative to corporate earnings. The Dow’s dividend yield suggests the market is overpriced by 50%. The reason the market is even at these average PE levels is due to the $10.7 trillion that has been created out of nowhere and put in banks over the last 12 years. Brokers and bankers are the first borrowers of money made by the Fed. They are also the largest donors of money to political campaigns. It therefore behooves the government to make sure the market stays at “reasonable” levels because the sale of stock by investors is the primary source of political campaign money.

While this is all interesting information, what does it have to do with the market? On one hand we know there will be continued “stimulus” (new money created by the Fed) of around $100 billion a month, roughly what is happening now, and what has happened the last several years. We also know there have been no meaningful cuts in government spending and that the debt is so great we must borrow money simply to pay interest. This is very “3rd world-ish” political/economic behavior and cannot be sustained. At some point, the market, even with $100 billion a month added to it, is more likely to stay stable in this range of trading, or go down and trade more based upon yields, rather than go much beyond where it is presently. If the market traded based upon yields, the Dow Industrials would be 8,140 points instead of 14,000 (current yield of 2.5% on the Dow, divided by average long-term yield of 4.3%). If we do have further severe currency deterioration from inflation, only the least indebted international companies would be safe to hold. In addition to safety, those companies should have the greatest probability of growing if the economy continues to react in the future as it has acted the last 10 years.

Investors should be wary about what type of asset can weather, and succeed, through a “day of reckoning”. Properly financed real estate is going to be the best opportunity to preserve wealth. It always has been. The world’s population continues to double every few generations, and the supply of real estate is limited. Other hard assets history has proven it wise to own, through both good times and bad times, are gold and silver. Both have been used as currency for over eight thousand years. While the stock market has done well the last 50 years, gold, silver and income producing real estate have done better.

A day of reckoning wipes out paper assets. Bonds become worthless and get settled for pennies on the dollar. Stocks with very high price earnings multiples fall the fastest, and stocks that pay dividends weather the storm. Highly leveraged companies are usually bankrupted, recapitalized, and sold because the original stockholder’s investment becomes worthless. Such is it with governments, ultimately requiring a reconstitution of the monetary system, when government can no longer meet its obligations. Simple math indicates we’re there!

No clear path for the investor exists today. These times call for defensive investments to insure capital is preserved. The conservative investor will own only AAA-rated stocks and hard assets that will maintain, and grow, in value with further currency deterioration like real estate, gold and silver.

Caveat Emptor.
George Rauch
February 8, 2013

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