Stuck Between a Rock and a Hard Place


Now that the Fed has decided it is time to end the free lunch period for the economy, investors must be prepared for all possible scenarios. The White House, the Treasury Department, Congress and the Federal Reserve have all been engaging in a massive program of stimulus-a veritable alphabet soup of relief such as TARP, ARARA, TALF-which has been essentially a free lunch period for the markets. These programs, in addition to a zero interest rate policy, has provided relief along with a stronger stock market, improvements in housing, notable upturn in manufacturing and service sector activity, and a more confident consumer.

Nevertheless, recovery could be very short-lived, especially among consumers. Retail sales outside of the "cash-for-clunkers" scheme have been tepid at best, with consumers' focus still squarely centered on the weak state of the labor markets and negative home equity values. While actual job losses have abated in recent months, the jobless problem is not to be understated. When discouraged and underemployed workers are worked into the calculation, the U-6 unemployment is 17.6%. Unfortunately this figure is not likely to get better as the economy continues to adjust to the new level of declining demand for good and services from an aging population which naturally saves more and spends less and from a severely damaged over-leveraged consumer.

Corporations are in better shape, but have achieved profitability only through massive cost-cutting measures rather than top-line growth. Meanwhile, according to the Fed's Senior Loan Officer Opinion Survey, business and personal lending has increased only modestly, and lending standards remain restrictive, as banks react to escalating losses and increased delinquencies on consumer, business and real estate loans.

The deleveraging process is still in its early stages and is destroying wealth at an alarming rate. With U.S. consumer deleveraging and the banking system weakened, the U.S. economy could easily falter without the support of the stimulus, and a hoped-for "V"-shaped scenario could easily be distorted into a very slow rebounding "U" shape or even a double-dip "W"-shaped recovery with one false move.

President Roosevelt faced a similar picture, and many would argue he made a critical mistake in late 1935 and early 1936; when it seemed the economy was recovering, and the stock market had staged an impressive recovery, he systematically slashed government spending in an effort to balance the budget. These cuts, in combination with some protectionist, anti-business measures and restrictive monetary policy, were enough to pull the economy back down into a recessionary quagmire (sound familiar?). The stock market then proceeded to plummet another 49.1%. It never fully recovered until 1954.

Recent efforts to withdraw the stimulus have been met with sharp public outcry, and policymakers have ultimately succumbed to demands for more of it even as concerns about the size of the federal deficit grow. The homebuyer tax credit, originally set to expire on November 30, 2009, was extended to the end of March. And on the heels of the "cash-for-clunkers" program for cars, the Federal government is expected to finalize details of another tax-supported shopping extravaganza, known as "cash-for-appliances," that will offer rebates to consumers who buy energy-efficient refrigerators, dishwashers, air conditioners and other appliances to replace their older models. That will be good for me. I could use a new dishwasher, and I would love someone else to pay for it, but is it good for the country?

The Fed is likewise under pressure to maintain a position of low interest rates in its monetary policy "for an extended period," and there is already much discussion about what would happen if it ended its quantitative easing program in March. Some argue the Fed should consider extending that program if necessary and avoid a subsequent spike in interest rates that could derail the stabilization of the housing markets, which are relying on low mortgage rates. The economy to me seems like one big game of Jenga.

Many believe Obama and Bernanke want to avoid a double-dip or prolonged recession, and will take the risk of letting the stimulus measures run too far, too long. But survival can only trump fiscal prudence for so long. However, the more we want to avoid a prolonged deflationary period or return to a recession, the more we run the risk of spiraling budget deficits and out-of-control inflation. We also risk shattering the dollar's credibility.

It is clear that our national debt as a share of GDP will double in the next five years, approaching or exceeding 100% of GDP. If so, the U.S. would be one of the largest debtors (relative to GDP) in the world. Welcome to the
new North American Banana Republic with friends like Zimbabwe, Jamaica, Italy, Japan and Lebanon. Our "AAA" credit rating would certainly be on the chopping block, which would in turn raise our annual interest expense. When we factor in unfunded Social Security and Medicare liabilities, which dwarf outstanding public debt by well more than eight times, it becomes clear that the Federal government will be digging too deep a hole, even if the maximum marginal income tax rate reaches 60%, as some predict it will.

Though inflation has yet to rear its ugly head, the risk
is imminent, given the scale of the stimulus and our questionable ability to unwind it at the proper time. However, serious threats exist with a move to raise borrowing rates or sell assets in the still-fragile open market. Given how the economy has become ever more highly leveraged to interest rate changes over the last 30 years, the Fed may quickly find a choke point once it begins to tighten interest rates, creating a premature easing in monetary policy in order to avert another recession. Thus, the Fed is likely to miss the exit window and reflate the economy all over again, allowing debt burdens to increase further and setting the stage for another asset bubble burst in the future.

The phrase, "stuck between a rock and a hard place" was invented for this exact situation. There is little we can do about the hand we have been dealt, as the reality that this recession, underwritten by out-of-control stimulus measures is unavoidable.

Investor Strategy

Given what we know about the economy, investors must be nimble and essentially pray for peace but prepare for war. The impending crises could take months to develop or begin tomorrow, so investors must walk a fine line: Take what the market gives you when it gives it to you but also protect yourself from the future inevitable catastrophe. At some point this bubble is going to burst and the pain could be worse than last time.

Unfortunately, investors can't sit in cash or CDs for long either, as they are guaranteed to lose purchasing power. One must find the right strategy that participates in the ups but protects in the downs. It is essential that investors have an active portfolio that gets the very best return with the least amount of risk possible and also one that actively adapts to changing conditions. That's where we can help.

Our proprietary process has been building successful retirement and tax-advantaged portfolios for over 25 years. If you would like to discuss the market, economy or just get a free 2nd opinion on your portfolio, simply click this link - Info Request

Regards –Keith

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Keith Springer
President
Capital Financial Advisory Services
1383 Garden Hwy, Suite 200
Sacramento, CA 95833
www.KeithSpringer.com
Phone -916-925-8900
Fax – 916-925-8914

Providing Professional Financial Advice since 1985

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