The Debt Problem

Monday before the market opened, Standard and Poor’s reaffirmed the U.S. government's top credit rating of AAA but not before expressing concern that our legislators are not move quickly enough to stop our growing budget deficit. S&P said there is a 33 percent chance it would lower the country's credit rating from AAA in the next two years if Washington fails act.

U.S. Treasury Bonds have historically been known as the safest investments on the planet. But now top money managers such as Pimco’s Bill Gross are calling our debt issuance a Ponzi scheme, where one arm of the government – the Federal Reserve Bank, is supporting the US Treasury, by buying as much as 70% of the new debt that has been issued since last September.

Many pundits are stating that this move by the ratings agency to lower its outlook for U.S. paper from "stable" to "negative" caught investors off guard. While this is a first since it began rating the creditworthiness of government bonds back in 1860, this action should hardly be a surprise. Our debt has skyrocketed over the last few years to levels only achieved during major wars.

Today the total outstanding public debt in the US is around $14 Trillion. The debt to GDP ratio is among the highest in the world. The federal deficit has approached this echelon only a few times in US history; during the Civil War, World War I, World War II, and today in aftermath of the financial crisis of 2008.

Should our government debt get downgraded in the future, we would have to pay a higher interest rate to attract new buyers. More problems would occur, as many institutions are banned from holding anything but AAA rated investments. That would force a sale of their holdings, which would result in lower prices and even higher interest rates.

As troubling as this may be for the US, the situation in parts of Europe are even more problematic. Greece and Ireland have already needed to be bailed out by the IMF and other Euro zone countries and are still reeling. Both countries have had their credit rating downgraded again in the last month.

Portugal is now and need of a bailout. Also there is speculation that Spain and Italy will need help in the near future. Should Spain require a bailout, it is estimated that the money needed would amount to the sum of all three of the previous countries combined. It can be surmised that as bad as the situation is over here with our current debt warnings, the problems are even bigger in Europe.

The Dollar Destruction

As infamous trader Jesse Livermore used to say, “Conditions are ripe for a sell off.” The litany of global problems that exist seem to be compounding every day. As if the market doesn’t care, the major indexes have spiked up over the last few weeks. It does seem odd to see such strength under these circumstances.

This week however, trading started off the day quite positive but then gave back much of it by the close. Strength in the morning followed by weakness in the afternoon is usually a bearish sign. While the S&P 500 has been up three of the last four days, we‘ve had only a fractional gain this week.

Usually the start of each month and especially the start of a new quarter is a time for strength as retirement plans of every ilk get funded and new money flows into the market. With April’s monthly strength period now over, hardly a dent has been made towards a market advance.

The strong season for the market is also coming to a close. There is historical statistical evidence that gives credence to the “sell in May and go away” concept for period investing. While markets don’t have a calendar, the November through April timeframe historically has significantly outperformed the May through October period, and May is coming soon.

Investor sentiment is running high. The recent Investors Intelligence Sentiment Survey reveals that less than 16% of professional newsletter writers are bearish and over 57% are bullish. This Bull to Bear ratio of 3.65 displays even more optimism than at the market peak in 2007.

This survey has been widely adopted by the investment community as a contrarian indicator. Since its inception in 1963, the indicator has had a consistent record for predicting the major market turning points.

Another contributing worrisome factor is the coming end of the Fed’s Quantitative Easing Program (QE2). When the Fed stops buying bonds, monetizing our debt, and pumping billions of new dollars into our economy on a daily basis, how will the markets fare? That is a big question. Currently it’s as if the economy is cycling ahead with training wheels on. What happens when they come off?

Should markets correct on anticipation of or at the end of the QE2 money pumping machine, it would mean that a market top was occurring at almost precisely the same time it did last year, which included the Flash Crash.

One of the key factors that markets appear to be ignoring today is the ever rising price of oil. High oil prices have always led to a recession. Oil is a direct reflection of a falling dollar. With the ongoing destruction of the US dollar, caused in a large part by the QE2 program, commodity prices are going through the roof. Now is a time for caution.

The New Era

Many believe that the old saying, “it’s different this time” is never true. It is widely held that situations are never completely different; they’re just another version of events with slightly divergent circumstances. History may not repeat, but it sure rhymes, is another old saw bantered about Wall Street.

It is believed that the reason market events repeat generation after generation is that human emotions of greed and fear has always been and always will be present when it comes to money and investing. Today’s technological advances may create a contradiction to those old beliefs. It has made life simultaneously simpler and more complex, and has brought an element of change that hasn’t been present in the past.

Use Major League Baseball as an example. Baseball hit upon a new era with the development of steroids and human growth hormones. Old pitchers well past their prime became Cy Young award winners. Not just one but two players broke a 40 year old home run record in the same season, only to be surpassed again within a couple of seasons.

It became known as “the steroid era.” It truly was different. Fans were enthralled at the new found power of the times. They cheered along, but the Commissioner had to know that something was up. Those feats of athleticism had never been witnessed before, but the baseball brass stayed mum because ticket sales and TV revenues were doing great.

Now many fans are shocked to find out that the game was rigged by players’ use of steroids. They must have figured that players were just eating better and working out more. But no – things were different.

Today the Fed has done the same thing. They have created a new era. They have put the money printing press on steroids. Since August, the Fed has bought 70 percent of all the new government debt issued by our Treasury. The Fed is in effect monetizing our debt and creating an artificial stimulus for the economy. Fed Chair Ben Bernanke hopes that this crutch will be enough to create confidence among consumers to become a self fulfilling recovery.

Some very well known bond managers are not so sure this new era will work. Pimco’s Bill Gross calls the Fed’s path a Ponzi scheme. Gross believes that everything the Fed is currently doing will prove to be harmful in the long run.

Investors, like baseball fans in the steroid era, are currently very happy. We just had the best first quarter returns since 1999. Since the market was actually negative for the year on March 16th, if the media really called it correctly, it’s been a good couple of weeks! The commissioner (in this case the Fed Chair) is participating in the juicing of the game so to speak. At some point all this will come to a tragic end, but for now it’s just “Play Ball!”