Special Market Commentary, August 10, 2011
“This stock sell-off has little to do with profits, and everything to do with the relentless need for capital in Europe, plus an American investing class that is only slowly awakening to the fact that yes, this time it’s different.” -- Zachary Karabell, President, River Twice Research
Market Environment Indicator Turns Bearish
We’ve been preaching that, indeed, this time it is different since early 2009. The recent broad stock market decline, and the volatility which intensified dramatically in the last several days, has reminded us, once again, that financial uncertainty remains significantly elevated following the 2007-2008 global financial collapse. Not surprisingly, our Market Environment Indicator (MEI), which has been “bullish” (positive) since July of 2010, turned “bearish” (negative) this week. This has resulted in a significant reduction in stock exposure, and a significant increase in bond and cash exposure in our MEI-based Market Leader’s Model Portfolios (MLMP).
While the S&P 500 has declined 13 percent since July 22, you should be prepared for the market to fall even further this year, before staging another cyclical rally within the context of the long-term secular decline we remain in. As with many other recent corrections, we believe this decline is more about a lack of confidence in government policy versus any other single factor.
The Real Problem: Government Policy
While the debt ceiling deal appeared to have helped the U.S. avoid a financial crisis, it really didn’t solve anything. The so-call “cuts”—which are merely reduced spending increases—almost all come after the 2012 elections, and the national debt is still expected to increase by 50% over the next 10 years. Washington has shown no true resolve in getting its fiscal house in order. In light of this, perhaps it isn’t surprising that S&P cut the AAA rating on US debt. Remember, dear reader, government’s do not create wealth; they only take wealth through taxes. Thus any attempt to “stimulate” the economy through government spending programs cannot create lasting economic growth—government stimulus ultimately leads to higher taxes and lower wealth.
As bad as the downgrade may now appear, it is a clarion call for policy makers to abandon their disastrous attempts to stimulate the economy through failed, Keynesiani influenced government spending programs.
A Silver Lining?
Perhaps there is a silver lining in all this mess as there was in Canada back in 1993 when they lost their AAA credit rating, after running up enormous deficits, and reaching a 72% debt-to-GDP ratio (by comparison, the U.S. debt-to-GDP ratio currently estimated to be 74%)…
Taking over as finance minister in 1993, Paul Martin inherited a looming disaster. His 1995 budget planted a flag in the sand. “Come hell or high water,” Martin said, he would get the budget under control.
To that end, he spelled out a program of massive spending cuts. He reduced welfare and other entitlements drastically. He squeezed every possible program and government transfer, even foreign aid.
Between 1994 and 1996, he slashed government program spending…some 15% once inflation is factored in. By the end of 1997, the government’s deficit had become a surplus, a 6.8 percentage point turnaround in three years. To be sure, the initial effort was painful…There was, though, a deeper shock. The full- service welfare state had come to define Canada to Canadians and everyone else…Canadians were enormously proud of it. And it was gone. Sure, medicine mostly remained socialized. Government services were still considerably better than in many other developed countries. But unemployment and other welfare programs had shrunk to the emergency measures they were meant to be, rather than the way of life they had become. Martin’s legacy was to shrink the state and the state’s role in the Canadian economy to the smallest it had been since the Second World War.ii
Canada regained their AAA rating after nine hard years of austerity resulted in significant debt and deficit
reductions. By 2002, Canada’s AAA-rating was restored, and their debt-to-GDP ratio is now only 34%...
With their backs to the wall, Canadian Prime Minister Jean Chrétien and finance minister Paul Martin engaged in an austerity program which allowed them to completely eliminate a $42-billion deficit in just four years. However, it was painful for the Canadian public. Chrétien reduced federal spending by a whopping 20 percent, fired 23 percent of public sector workers, raised taxes, slashed defense expenditures by 15 percent, cut certain subsidies by 40 percent to 60 percent; and eliminated some ministries entirely.iii
History reveals that periods of great crisis often prove to be tremendous opportunities in disguise: could a seismic shift be under way, where the voting public actually forces politicians to make real spending cuts? Contrary to what many argue, tax hikes cannot solve our federal budget problems. The economist Walter Williams points out that even a 100% tax rate on incomes above $250,000 a year would only fund federal spending for approximately 141 days! We believe America’s best hope is our voting public, and the capital markets: only ordinary Americans and capitalism—not government—can ensure that America doesn’t go the way of Greece. It will take time, but we may be on the brink of major, positive fiscal changes.
In the meantime, we remain skeptical and very cautious. We will rely on our MEI to signal when it is appropriate to increase risk again, but we may not see this opportunity for quite a while. We understand that this letter, and the recent extreme volatility in the capital markets are likely to generate additional questions from you—please do not hesitate to call or e-mail us.
We are most grateful for the continued privilege of being entrusted with your financial welfare—it is a stewardship we take very seriously.
Best wishes for a fine finish to your summer,
Sean Gross, CFP®, AIF®
President & CEO, Telos Wealth Management, LLC
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i Economic theory attributed to 20th century British economist John Maynard Keynes, who argued that aggregate demand was not always enough to spur full employment, and that outside structures, such as governments, could influence the economy to create jobs.
iiAlen Mattich, “So, Just What Did Canada Do?” The Wall Street Journal, http://blogs.wsj.com/source/2010/06/07/so-just-what-did-canada-do/ (June 7, 2010)
iiiPalash R. Ghosh, “S&P Downgrades U.S. Debt: How Canada Survived Similar Fate,” International Business Times,
