Stocks went on a violent roller coaster ride on Friday before ending slightly positive. It was a typical of market action during a time of heightened fear in the wake of the 500+ point loss in the Dow on Thursday. Friday’s performance came in the wake of a better than expected employment report and rumors of an imminent S&P downgrade of the U.S. credit rating. Of course, that downgrade came to fruition right after the market’s close.
The actual downgrade was done at an extremely difficult time in an unusually messy way. S&P didn’t help itself by admitting to an arithmetic error and putting a little too much political commentary into its statement accompanying the downgrade. But, on the other hand, the visceral reaction of politicians to the downgrade was just as disconcerting. Everyone either blamed S&P for reckless action or blamed the other side of the aisle for the mess we are in. In issuing the downgrade, S&P said that steps to reduce future deficits by up to $2.5 trillion wasn’t enough and it believes that after the required second tranche of spending cuts coming this December, Congress wouldn’t have the willingness to do anything more prior to the 2012 elections. It further noted that the cuts do not put the U.S. on a course toward reducing debt, the ratio of debt-to-GDP or deficits-to-government spending.
The downgrade in one sense is clearly inappropriate in that the U.S. clearly has the capability (and the printing press!) to pay off its debts under any logical or extended set of circumstances. That understanding is clear in the markets. While the airwaves were full of pundits fear mongering of how added interest costs associated with a downgrade would cripple the economy and everyone from credit card holders to homeowners, yields on government bonds are actually lower this morning. As I have noted previously, markets price debt, not the rating agencies. What worries markets more is that Congress and the President will fail to heed yet another warning that the time left to fix our debt/deficit mess without extreme pain is getting shorter. The debt rating downgrade from S&P is another warning shot over the bow to demonstrate courage and move faster in the right direction. The debt ceiling debate, as messy as it was, did start to move the needle ever so slightly. But it is only a minor start at a time when bolder action is required.
We see exactly the same scenario playing out it Europe. In parts of Europe, the debt crisis is more current but there, as well as here, markets are screaming that actions to date are insufficient to avoid a meltdown later.
Various prominent economists have pointed out that the burden of excessive debt becomes a tax on the economy. Debt-to-GDP of 90% (we are getting close) subtracts 90% from growth. Right now U.S. debt held in public hands is a bit over $10 trillion in an economy slightly larger than $14 trillion. It isn’t hard to see that a couple of more years of trillion dollar plus deficits will strangle the economy. If still uncontrolled, the ultimate consequences are dire. Ultimately, the alternatives are default, devaluation, deflation/depression, or hyperinflation. Those are some pretty horrid choices.
But we aren’t to that point yet and don’t have to get there if Congress and the President take the warning signs seriously and start to do something. The stock market is screaming that (1) there isn’t a whole lot of time left and (2) it has little faith that Congress or the President gets the message.
One of the problems is that Congress appears to be very bifurcated. There is the Tea Party libertarian side that says the solution is to cut spending drastically and quickly. Spending as a percentage of GDP is alarmingly and historically way too high and has to come down. At the other end of the spectrum you have the Keynesian liberal faction that wants to drop money from a helicopter, willing to absorb more deficits in the short run in order to goose growth which, hopefully, would boost revenues so much that the additional tax receipts will offset the spending increases. They would also sharply increase taxes, mostly by raising taxes on the rich.
Both sides have some merit but both plans are both incomplete and wrong. If spending cuts are too draconian and not accompanied in some manner by tax reform and growth initiatives, revenues will fall faster than spending. You will end up with a smaller economy and a bigger deficit. On the other hand, borrowing and spending clearly doesn’t work either in a world where deleveraging is paramount. The financial disasters of the past few years have simply moved the excessive debt that was the seed for the crisis from individuals and banks to the government. While the private sector has been paying down debt, increases in government debt have more than offset the decline. We are still moving in the wrong direction.
So what is the right direction? It is some combination of all the ideas. Clearly, we need to cut spending and the government needs to put in place a roadmap that will reduce spending to 21% or GDP or less (Republicans would prefer 18% or less). At the same time, tax reform that broadens the tax base and lowers marginal rates will stimulate growth and bring receipts back from the mid-teens toward the same 18-21% of GDP. Note that there is a Republican/conservative solution that moves both numbers to 18% and a Democratic/liberal solution that moves both numbers toward 21%. Either works; it depends on one’s view of the role of government. But today’s mix of low taxes, high marginal rates, fractured entitlements, two wars, and lack of spending discipline clearly don’t work.
Politicians need to be pulled kicking and screaming into action by crisis. They simply don’t seem capable of reacting in front of crisis. In Europe, countries will keep adding austerity measures and the wealthy EU nations will keep adding euros to the backstop until the markets stabilize. They could save a lot of pain getting to the endpoint faster. Central bank purchases of sovereign debt won’t solve the problems directly.
The same is true here. Everyone from the President on down knows that there isn’t a solution to the cost problems without entitlement reform. Everyone agrees from 30,000 feet. The Simpson-Bowles deficit reduction commission spelled it out late last year. But no one has put a specific plan on the table yet. Balanced budget amendments are simply a political ploy to make a statement without addressing the problem directly. Congress doesn’t need to hear from Tea Party members how much to cut; it needs to see the specific proposed cuts.
As noted earlier, spending cuts alone won’t solve anything. What they will do is lead to recession and deflation. Indeed, markets are suggesting today that is the current path of least resistance. It explains why stocks are down and bonds are up, even in the wake of the S&P downgrade. Markets are making a statement that they believe we are headed from austerity without offsetting growth initiatives and that could lead to very unpleasant consequences.
The logical question is how can an economy grow while government spending is being cut by hundreds of billions of dollars annually? Actually there are many possible growth initiatives. Let me just offer a few ideas.
Lower the corporate tax rate to 25% offsetting the lower rate by closing ineffective tax loopholes.
Allow corporations that have a trillion dollars or more overseas to bring them home and invest them in job creative activities in the U.S.
Understand that small businesses are the job creators of this world. Do anything and everything to encourage small business development. Lost in all the TARP controversy is the fact that Treasury made money as they invested in the bailout of the largest banks because to acquired preferred stock and warrants in the process. The government could help to fund small business development in many ways by creating a venture capital funding facility (equity or debt), by making more small business loans, and, mostly, by eliminating or reducing the regulatory burden small businesses face.
Along those lines, a lot of the new regulations (think Dodd-Frank) were aimed at curing perceived problems at large commercial and investment banks. But some rules are so broad that their relative costs to small banks and small businesses are excessive and unwarranted. A small fuel oil distributor who hedges as a normal course of daily business shouldn’t be treated the same as a large speculator in oil futures.
It is too expensive for small companies to come public. Fledgling drug and medical device companies require so much time to bring products to market that they can no longer get funding from traditional resources. That has to be fixed immediately.
These are a few simple choices. There are countless more. Congress needs to focus with a laser on creating growth opportunities without directly spending taxpayer money. Investing and spending aren’t exactly the same. Investments generate returns. Spending doesn’t.
If growth initiatives are combined with spending cuts and reforms of both taxes and entitlements, there is a pathway to salvation. That path isn’t free. The governments of the developed world have overpromised for years. To date, they have borrowed to close the gap. That option is disappearing. Leaders of the world need to work to make their constituencies understand that it isn’t the grandchildren who will pay for the excessive borrowing. It will be them if markets collapse and one of the dire options is the only choice left. The “pain” need not be severe. Raising the starting Social Security age by 1-2 years isn’t dire. Nor is making Medicare more efficient. I understand that for every dollar saved in Medicare, a doctor, a hospital or a device company is going to receive less revenue. Look at Medicare Part D, the prescription drug program enacted under President Bush. It is rightly criticized for having no funding source. But lost in that argument is that the plan is costing almost 40% less than predicted because it provided a competitive mechanism for the insurance companies and drug companies that wanted to participate and it includes a patient co-pay that shifts a modest part of the cost burden onto the recipient. Yet the program is doing everything it was supposed to do; it just does it more efficiently.
The stock markets around the world will continue to scream until governments listen. In the U.S., the best outcome would be a bipartisan attempt to enlarge the second round of spending cuts and to at least open the door to entitlement reform. AARP has already said that a higher starting age for Social Security is fine. That’s a great starting point. If markets sense that Congress gets the message, they will rally. If Congress senses that it gets a favorable response for responsible behavior, it may be reinforcing.
With all that said, as investors we cannot ignore valuation. Great companies with high cash flow and good dividends aren’t going to evaporate. They remain good investments. At the moment, based on historic valuations, stocks today are not wildly overvalued or undervalued. Economies around the world are still growing. Despite the turmoil of the past few weeks, there is no evidence yet of consumer retrenchment such as what occurred after the Lehman bankruptcy. In a sense, with the S&P downgrade now history, European debt markets a bit calmer than they were, and the debt ceiling debate now over for a while, stock markets could even experience a rally. But stocks aren’t going to find a bottom until investors feel that sovereign nations are headed in the right direction. The good news is that austerity measures taken by European nations coupled with others certain to come will probably insulate most of the larger nations (think Spain and Italy) from default. If the members of the U.S. Congress want to get reelected, they will have to find a mechanism to work together. Getting to that point may be as messy as the debt ceiling debate and the stock market may be just as tumultuous as it has been until that happens. The emotional cloud overhanging the market today is dark and gloomy with no sun on the horizon. Valuewise, stocks remain attractive.
Futures point to a sharp decline at the opening today.
Today Roger Federer is 30. Connie Stevens is 73. Dustin Hoffman turns 74.
James M. Meyer, CFA
610-260-2220
jmeyer@towerbridgeadvisors.com
Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.
*REPRINTED WITH PERMISSION BY TOWER BRIDGE ADVISORS
Fed Watch
Morning Market Comment August 8, 2011 by James Meyer, CFA
The actual downgrade was done at an extremely difficult time in an unusually messy way. S&P didn’t help itself by admitting to an arithmetic error and putting a little too much political commentary into its statement accompanying the downgrade. But, on the other hand, the visceral reaction of politicians to the downgrade was just as disconcerting. Everyone either blamed S&P for reckless action or blamed the other side of the aisle for the mess we are in. In issuing the downgrade, S&P said that steps to reduce future deficits by up to $2.5 trillion wasn’t enough and it believes that after the required second tranche of spending cuts coming this December, Congress wouldn’t have the willingness to do anything more prior to the 2012 elections. It further noted that the cuts do not put the U.S. on a course toward reducing debt, the ratio of debt-to-GDP or deficits-to-government spending.
The downgrade in one sense is clearly inappropriate in that the U.S. clearly has the capability (and the printing press!) to pay off its debts under any logical or extended set of circumstances. That understanding is clear in the markets. While the airwaves were full of pundits fear mongering of how added interest costs associated with a downgrade would cripple the economy and everyone from credit card holders to homeowners, yields on government bonds are actually lower this morning. As I have noted previously, markets price debt, not the rating agencies. What worries markets more is that Congress and the President will fail to heed yet another warning that the time left to fix our debt/deficit mess without extreme pain is getting shorter. The debt rating downgrade from S&P is another warning shot over the bow to demonstrate courage and move faster in the right direction. The debt ceiling debate, as messy as it was, did start to move the needle ever so slightly. But it is only a minor start at a time when bolder action is required.
We see exactly the same scenario playing out it Europe. In parts of Europe, the debt crisis is more current but there, as well as here, markets are screaming that actions to date are insufficient to avoid a meltdown later.
Various prominent economists have pointed out that the burden of excessive debt becomes a tax on the economy. Debt-to-GDP of 90% (we are getting close) subtracts 90% from growth. Right now U.S. debt held in public hands is a bit over $10 trillion in an economy slightly larger than $14 trillion. It isn’t hard to see that a couple of more years of trillion dollar plus deficits will strangle the economy. If still uncontrolled, the ultimate consequences are dire. Ultimately, the alternatives are default, devaluation, deflation/depression, or hyperinflation. Those are some pretty horrid choices.
But we aren’t to that point yet and don’t have to get there if Congress and the President take the warning signs seriously and start to do something. The stock market is screaming that (1) there isn’t a whole lot of time left and (2) it has little faith that Congress or the President gets the message.
One of the problems is that Congress appears to be very bifurcated. There is the Tea Party libertarian side that says the solution is to cut spending drastically and quickly. Spending as a percentage of GDP is alarmingly and historically way too high and has to come down. At the other end of the spectrum you have the Keynesian liberal faction that wants to drop money from a helicopter, willing to absorb more deficits in the short run in order to goose growth which, hopefully, would boost revenues so much that the additional tax receipts will offset the spending increases. They would also sharply increase taxes, mostly by raising taxes on the rich.
Both sides have some merit but both plans are both incomplete and wrong. If spending cuts are too draconian and not accompanied in some manner by tax reform and growth initiatives, revenues will fall faster than spending. You will end up with a smaller economy and a bigger deficit. On the other hand, borrowing and spending clearly doesn’t work either in a world where deleveraging is paramount. The financial disasters of the past few years have simply moved the excessive debt that was the seed for the crisis from individuals and banks to the government. While the private sector has been paying down debt, increases in government debt have more than offset the decline. We are still moving in the wrong direction.
So what is the right direction? It is some combination of all the ideas. Clearly, we need to cut spending and the government needs to put in place a roadmap that will reduce spending to 21% or GDP or less (Republicans would prefer 18% or less). At the same time, tax reform that broadens the tax base and lowers marginal rates will stimulate growth and bring receipts back from the mid-teens toward the same 18-21% of GDP. Note that there is a Republican/conservative solution that moves both numbers to 18% and a Democratic/liberal solution that moves both numbers toward 21%. Either works; it depends on one’s view of the role of government. But today’s mix of low taxes, high marginal rates, fractured entitlements, two wars, and lack of spending discipline clearly don’t work.
Politicians need to be pulled kicking and screaming into action by crisis. They simply don’t seem capable of reacting in front of crisis. In Europe, countries will keep adding austerity measures and the wealthy EU nations will keep adding euros to the backstop until the markets stabilize. They could save a lot of pain getting to the endpoint faster. Central bank purchases of sovereign debt won’t solve the problems directly.
The same is true here. Everyone from the President on down knows that there isn’t a solution to the cost problems without entitlement reform. Everyone agrees from 30,000 feet. The Simpson-Bowles deficit reduction commission spelled it out late last year. But no one has put a specific plan on the table yet. Balanced budget amendments are simply a political ploy to make a statement without addressing the problem directly. Congress doesn’t need to hear from Tea Party members how much to cut; it needs to see the specific proposed cuts.
As noted earlier, spending cuts alone won’t solve anything. What they will do is lead to recession and deflation. Indeed, markets are suggesting today that is the current path of least resistance. It explains why stocks are down and bonds are up, even in the wake of the S&P downgrade. Markets are making a statement that they believe we are headed from austerity without offsetting growth initiatives and that could lead to very unpleasant consequences.
The logical question is how can an economy grow while government spending is being cut by hundreds of billions of dollars annually? Actually there are many possible growth initiatives. Let me just offer a few ideas.
Lower the corporate tax rate to 25% offsetting the lower rate by closing ineffective tax loopholes.
Allow corporations that have a trillion dollars or more overseas to bring them home and invest them in job creative activities in the U.S.
Understand that small businesses are the job creators of this world. Do anything and everything to encourage small business development. Lost in all the TARP controversy is the fact that Treasury made money as they invested in the bailout of the largest banks because to acquired preferred stock and warrants in the process. The government could help to fund small business development in many ways by creating a venture capital funding facility (equity or debt), by making more small business loans, and, mostly, by eliminating or reducing the regulatory burden small businesses face.
Along those lines, a lot of the new regulations (think Dodd-Frank) were aimed at curing perceived problems at large commercial and investment banks. But some rules are so broad that their relative costs to small banks and small businesses are excessive and unwarranted. A small fuel oil distributor who hedges as a normal course of daily business shouldn’t be treated the same as a large speculator in oil futures.
It is too expensive for small companies to come public. Fledgling drug and medical device companies require so much time to bring products to market that they can no longer get funding from traditional resources. That has to be fixed immediately.
These are a few simple choices. There are countless more. Congress needs to focus with a laser on creating growth opportunities without directly spending taxpayer money. Investing and spending aren’t exactly the same. Investments generate returns. Spending doesn’t.
If growth initiatives are combined with spending cuts and reforms of both taxes and entitlements, there is a pathway to salvation. That path isn’t free. The governments of the developed world have overpromised for years. To date, they have borrowed to close the gap. That option is disappearing. Leaders of the world need to work to make their constituencies understand that it isn’t the grandchildren who will pay for the excessive borrowing. It will be them if markets collapse and one of the dire options is the only choice left. The “pain” need not be severe. Raising the starting Social Security age by 1-2 years isn’t dire. Nor is making Medicare more efficient. I understand that for every dollar saved in Medicare, a doctor, a hospital or a device company is going to receive less revenue. Look at Medicare Part D, the prescription drug program enacted under President Bush. It is rightly criticized for having no funding source. But lost in that argument is that the plan is costing almost 40% less than predicted because it provided a competitive mechanism for the insurance companies and drug companies that wanted to participate and it includes a patient co-pay that shifts a modest part of the cost burden onto the recipient. Yet the program is doing everything it was supposed to do; it just does it more efficiently.
The stock markets around the world will continue to scream until governments listen. In the U.S., the best outcome would be a bipartisan attempt to enlarge the second round of spending cuts and to at least open the door to entitlement reform. AARP has already said that a higher starting age for Social Security is fine. That’s a great starting point. If markets sense that Congress gets the message, they will rally. If Congress senses that it gets a favorable response for responsible behavior, it may be reinforcing.
With all that said, as investors we cannot ignore valuation. Great companies with high cash flow and good dividends aren’t going to evaporate. They remain good investments. At the moment, based on historic valuations, stocks today are not wildly overvalued or undervalued. Economies around the world are still growing. Despite the turmoil of the past few weeks, there is no evidence yet of consumer retrenchment such as what occurred after the Lehman bankruptcy. In a sense, with the S&P downgrade now history, European debt markets a bit calmer than they were, and the debt ceiling debate now over for a while, stock markets could even experience a rally. But stocks aren’t going to find a bottom until investors feel that sovereign nations are headed in the right direction. The good news is that austerity measures taken by European nations coupled with others certain to come will probably insulate most of the larger nations (think Spain and Italy) from default. If the members of the U.S. Congress want to get reelected, they will have to find a mechanism to work together. Getting to that point may be as messy as the debt ceiling debate and the stock market may be just as tumultuous as it has been until that happens. The emotional cloud overhanging the market today is dark and gloomy with no sun on the horizon. Valuewise, stocks remain attractive.
Futures point to a sharp decline at the opening today.
Today Roger Federer is 30. Connie Stevens is 73. Dustin Hoffman turns 74.
James M. Meyer, CFA
610-260-2220
jmeyer@towerbridgeadvisors.com
Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.
*REPRINTED WITH PERMISSION BY TOWER BRIDGE ADVISORS
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