Market Watch - February 12, 2016

The Tale of Two Economies

Our economy has evolved into two economies: a private sector economy, and a public sector economy. The private sector has never been healthier, and the public sector remains in a dangerously risky posture.

The U.S. private sector is in excellent economic shape. It is as well off, and more liquid, than ever: household debt is 103% of income, down from 140% eight years ago; cash balances have never been higher; and employees took home 4.75% more cash to spend in 2015, than in 2014.

In the public sector, the government's debts are great and growing, and potentially a huge problem. The size of the federal government's debt, coupled with the size of government as a percent of our GDP, have the greatest potential to upset the economic apple cart. In 2007 our public debt was 63% of GDP. It has climbed to 101% today, an unfathomable increase without a war. Failure to get this spiraling debt under control will eventually create a volatile downturn, as debt has in each of the four recessions since the Reagan Administration.

Question: Will the world's economic situation cause our economy to go into recession?
Answer: One must look at two parts of the U.S. economy: the government sector, and the private sector. The government sector's financial house is not in order. On the other hand, the reduction in private sector debt has eliminated the risk in which the private sector existed in 2008. In spite of the government's outsized leverage, there is no current indication that anything close to a liquidity crisis is imminent in either the public, or private, sector. A recession is not on the horizon.

Question: Every time there is a recession, it is led by bank failures. Banks still have lots of bad loans on the books. If the banks fail, won't the private sector fail?
Answer: Commercial banks "equity capital ratio" has increased from 5.5% to 12.5% of total, risk-weighted assets. U.S. banks are much better off than seven years ago.
U.S. bank's current vulnerability is $10 trillion of loans extended outside of the country compared to $5.3 trillion eight years ago. Should deflation take hold around the world, coupled with continued economic recessions in countries that owe U.S. banks money, U.S. dollar based debt would be difficult to repay. It is likely U.S. businesses, however, would carry on without too much interruption, even if banks suffer a temporary liquidity crisis.

Question: The EPI (Everyday Price Index) showed 2015 prices down 2.3%. The CPI showed inflation of .005%, or ½ of one percent. Which is correct?
Answer: A private sector company created the EPI, and the CPI is put out by the federal government's Department of Labor. The EPI is more realistic. It takes into account what is happening every day to the average family. The CPI leaves out and distorts key chunks of a consumer's budget. The inflation we have had the last 40 years has been driven by energy price increases. As increases in energy prices spearheaded inflation, decreases in energy costs leads to deflating prices. The EPI reflects what is happening to the average consumer on an annual basis. Prices are decreasing.

Question: Is that why the average consumer is spending more money?
Answer: It could be. Of the 2.9% GDP growth in 2015, 2% was from consumer spending. An interesting article recently published in the New Yorker points out that of every dollar consumers save on energy, 75% of the energy savings is used for consumer spending.

Question: With oil prices so far down, so quickly, are they likely to rebound and increase just as rapidly?
Answer: The Wall Street Journal's average of "Wall Street leading experts" estimate oil prices at the end of this year to be $48 a barrel. Who knows? Many of the world's low cost producers like Venezuela, Iran, Saudi Arabia and Russia are desperate for cash, so their cash demands could prompt them to sell as much oil as they can produce. That should suppress rapid increases in oil prices.

Question: How do we get back to a balance between the size and services provided by government, and what the private sector can pay for?
Answer: There are two extremes of government: liberty and socialism. Liberty is a system of law that protects individual's rights to life, liberty and property ownership. Socialism is any form that does not protect liberty. A republic, our government, is in-between. It provides rights for all (the right to life, liberty and the pursuit of happiness), while specifically protecting individual property rights. A republic attempts to safeguard individual liberty by constitutionally limiting the size, and powers, of the central government. Democracy, to which we are moving, is rule by the majority. When tried throughout history, beginning with the Greeks, democracies have always failed. They end up with the majority voting to confiscate the property of the minority, through taxation, in order to satisfy the "needs" of the majority. Eventually there becomes no such thing as "private property". Currently, with an equal number of voters on welfare, compared to voters with jobs, it's very difficult to reverse our country from becoming more socialistic. More socialism means more debt, until the government finally collapses from not being able to make payments on debt. The only way to avoid that is to return to governing as instructed by the Constitution. The Constitution itself provides for a balance of services between the private and public sectors by specifically limiting the powers of government.

Question: If our government collapses, how will all the services provided by the government survive?
Answer: A government collapse might not be such a bad thing. Consider that the government has already wrecked the schools; destroyed the value of the dollar; made a mockery out of national security by spying on "us"; ruined railroad transportation; misused and overly indebted, the financial system; undermined the Constitution; rewarded millions of welfare recipients for bad behavior; and is now in the process of ruining the best medical care system in history. This country has so much talent in each one of those areas that if that talent were unleashed from the control of government, every single thing would improve. Additionally, costs would be reduced in a competitive market. Almost ¾ of the federal government's total expenditures are on items not mentioned as a power of the federal government in the Constitution. In a government collapse, we would have sufficient money available for government undertakings required by the Constitution, such as providing for the armed forces, the Commerce Department, the State Department, and other services required by the Constitution. All the rest of "government services" are constitutionally argumentative. The 10th Amendment is clear: "The powers not delegated to the United States by The Constitution are reserved to the states, or the People".

Conclusion

There is concern because the market has sold off a few thousand points. It's really not worrisome as the chart points out. Today's Dow yields 2.75% and is selling at 16,000 points. Points equal dollars, and 2.75% of $16,000 is $440, which is the amount of dividends the Dow Jones stocks currently pay to stockholders. The historical average dividend yield on the Dow is 4.1%. If the Dow got to its average dividend yield, the market would drop another 5,000 points. It appears the market is still well above average values and that it is becoming more reasonably priced than it has been the last few years.

In spite of the market's behavior, most companies are beating earnings estimates. Real estate is back, and there's building everywhere. Merrill Lynch analyst Francisco Blanch points out the drop in oil prices could turn out to be the greatest transfer of wealth to consumers in history. This is a once in a lifetime economy. How long it will be sustained depends upon weather the government can reduce expenditures and quit borrowing money.

There is no limit to what our private economy can do if the government quits eating up capital by being the biggest, and most aggressive, borrower in the market.

Carpe Diem.

George Rauch
February 12, 2016