Ignorance Is Bliss (A Peter Schiff Commentary)

The economic commentary article below authored by Peter Schiff perfectly summarizes why we are far from recovery.

While all the talk at present is about economic corners turned and markets charging ahead, no one is paying much notice to an American economy deteriorating before our eyes. These myopic commentators seem to be simply moving past the now almost-universally held conclusion that before the crash of 2008, our economy was on an unsustainable course. If these imbalances had been corrected, then perhaps I too would be joining in the euphoria. But evidence abounds that we have not veered at all from that dangerous path.

Last week, the Bureau of Economic Analysis reported that consumer spending as a percentage of U.S. GDP has risen to 71%, a post-World War II record. This level is notably higher than other wealthy industrialized countries, and vastly higher than the levels sustained by China and other emerging economies. At the same time, our industrial output is contracting, our trade deficit is expanding once again (after contracting earlier in the year), and our savings rate is plummeting (after an early year surge).

The data confirms that government stimuli are worsening the structural imbalances underlying our economy. The recent ‘rebound’ in GDP is not resulting from increased economic output, but merely from the fact that we are borrowing more than ever. That is precisely how we got ourselves into this mess. An economy cannot grow indefinitely by borrowing more than it produces. Not only is such a course untenable, but the added debt ensures a deeper recession when the bills come due.

This soon-to-be-called depression will not end until the pendulum of consumer spending habits swings violently in the other direction. This will be a jarring change, but it is the splash of cold water that we need to return our economy to viability. I believe that consumer spending as a share of GDP will need to temporarily contract to roughly 50% of GDP, before eventually moving toward its historic mean of 65%. Such a move would indicate a restoration of our personal savings, a decline in borrowing and trade deficits, and an increased industrial output. That would be a real recovery.

In the meantime, the higher the spending percentage climbs, the more painful the ultimate decline becomes.

Consumers and governments must spend less so their savings can be made available to businesses for capital investments. Businesses, in turn, will produce more products and employ more people – increasing domestic prosperity. However, rather than allowing a painful cure to return our economy to health, the government prefers to numb the voting public with a toxic saline-drip of deficit spending and cheap money.

The primary factor that enables our government to peddle economic snake oil is the dollar’s unique role as the world’s reserve currency, and our creditors’ willingness to preserve its status. By buying up dollars and loaning them back to us through Treasury debt, productive countries give American politicians carte blanche to play Santa Claus.

Ironically, as foreign governments finance our spending spree, they are simultaneously scolding us for our low savings rate. At the recent G20 meeting in Pittsburgh, all agreed – including President Obama – that resolving the global economic imbalances was a top priority. By definition, this would require Americans to spend less and save more. However, with foreign central banks continuing to buy our debt, the President has shown no political will to encourage this change.

Normally, if politicians run up the government deficit, voters soon suffer the unpleasant consequences of higher inflation and rising interest rates. Yet, if foreign central banks keep supplying the funds, these consequences are indefinitely postponed. As a result, there is no need for American politicians to ever make the tough choices required to solve our problems.

Instead, the burden may fall squarely on the citizens of those governments doing all the lending. The conflict is that within the creditor states, a vocal minority actually benefits from this subsidy (owners of Chinese exporters, for example) while the overwhelming majority fails to make the connection. Thus, foreign politicians have the same incentives as ours to keep playing the game.

The bottom line is that foreign governments can lecture us all they want about the need for prudence but if they keep lending, we’ll keep spending. Any parent knows that if you give your child a curfew yet never impose any penalties when it’s violated, it will not be respected. My gut feeling is that foreign governments are tiring of our conduct and on the verge of finally imposing some discipline. That means the dollar’s days as the world’s reserve currency are numbered, and the days of American austerity are about to begin.

The Eye of the Hurricane

Putting today's pullback aside, equity markets have continued their tear over the past several months with the S&P sitting comfortably above 1,000. The dollar index has fallen another 2% since my June post, providing additional support for equities. Although the rally extended further than I originally anticipated, as I was early calling for investors to short cyclical stocks, my original premise remains intact. The fundamentals have only gotten worse over the past quarter, and it's only a matter of time before equities begin to price in the actual economic state, not projected recoveries or wishful thinking. Below are the main drivers underlying the recent stock market run-up as I see them:

Government Capital Market Manipulation
The mainstream media has the general public convinced that equities are simply reflecting the improved economic state and inevitable rebound that is destined to take place over the next several quarters. The reality, however, is a little more sinister. Market observers agree that trading volume has been anemic over the past six months, so the rally is not as broad based as they would lead you to believe. Low volume makes the conditions ripe for government manipulation of the market. This is accomplished through open purchases of futures contracts in the open market with the assistance of large investment banks.

The chart below perfectly illustrates my point. This represents an S&P e-minis futures daily one minute chart for Friday, May 29. It was a sleepy Friday with no news released and very low trading volume throughout the day as depicted by the volume bars below the main line graph. In the last few minutes of trading, enormous buy orders hit the market with over 200,000 contracts purchased right before the market close. This volume spike immediately pushed the S&P up roughly 10 points for no valid reason. I am not a conspiracy theorist by nature, and I'm well aware of the program trading that often takes place near the end of the trading day, but this pattern has continuously repeated itself over the past several months. Downside volatility has disappeared while the major indices often closed right at the highs of the day. Even during the market meltdown in late 2008 and early 2009, equities experienced vicious upside volatility through short covering and government bailouts.



With a large percentage of Americans having seen their 401Ks decimated, I am not at all surprised to see the government try to restore confidence in the economy. It is also no accident that consumer confidence has risen with the stock market, but this correlation will prove short lived as unemployment continues to soar.

Massive Government Stimulus Programs
I underestimated the short term impact that the coordinated response of governments around the world would have on equities and economic activity. I am a strong advocate of free market capitalism and tend to analyze such programs from a longer term perspective. Long-term, debt based government spending adds no value and only serves to increase the national deficit. Although in the near term, such policies act as stimulant, akin to an addict getting his fix. The euphoria will wear off leading to a more violent crash once participants realize that despite the government's best efforts, the long term contraction has only been slowed.

The cash for clunkers program is a perfect paradigm for our current economic state. Some analysts have gone as far to suggest that the four year decline in auto sales may have reached a turning point with the success of the program. The government of course allocated billions it doesn't have to fund the program, representing yet another example of taking from the taxpayer (or borrowing from the Chinese in this instance) to artificially create an increase in auto sales. Even with the deep cuts made by the auto manufacturers over the past several years, the sad truth is that there are still too many dealers and too much excess capacity still remaining in the system. As a result, auto sales showed a nice bump over the past several months, but this only shifted future sales to the present.

I've had many people come up to me over the past several weeks pointing to the stock market's recent performance as an indication that the worst has past and we are on the road to recovery. They also point to the housing uptick and question my long term bearish stance on the economy. I have two words for these individuals.....just wait! The FHA is providing mortgage loans with as little as 3.5% equity that has resulted in 50:1 leverage on their books. Although this is better than the 100:1 leverage sported by the Fannie Mae and Freddie Mac, the risk has only been shifted from the private sector to the tax payer.

A brief note on my investment strategy. I do not buy or sell individual stocks but instead sell deep out of the money naked call options on stocks, commodities and broad-based equity ETFs. Through time decay on these options and proper risk management, I have not had one losing trade in 2009. However, it has taken me longer to realize my profits as a result of the market run-up. The early cyclical names that I highlighted in my prior post represent excellent shorting opportunities if you have the patience and the wherewithal to profit from the coming collapse in consumer spending. Consistent with my prior posts, I fully expect the S&P to drop below 500 by the end of 2010 with the only risk to my forecast being a weak dollar that artificially inflates equities.

Ask yourself these two questions: If the equity rally was for real, why is gold trading over $1,000/oz? Second, how in the world is cheap credit and increased personal spending going to lead us out of this "recession" when these were the primary drivers leading to the excesses in the first place?