Who's in Charge?

Dr. John P Hussman, (www.hussmanfunds.com), the great Economist noted that “…Monetary policy is effectively subordinate to fiscal policy. No amount of monetary discipline can offset an undisciplined fiscal policy”. The only US Government budget spending constraint is a simple accounting identity, namely Spending = Taxes Received + Treasury Bonds Issued to the public + Increase in the Monetary base. This is not a theory, but fact. We worry about inflation, and the growth of money supply but the real problem is the growth of US Government Spending, which is fueled by Debt Expansion.

National Debt on May 7, 2008 was $9.35 Trillion. Interest alone is now $500 Billion a year, which is equal to the cost of the Iraq War for five years. Since September 2006, debt has increased at an average of $1.46 Billion a day. From December 2002 the National Debt has expanded at a monthly compound rate (annualized rate) of 7.08%. This is Inflation. As I have discussed before, Our Government and Federal Reserve has a Paradox. Less Government, less spending, less debt, will lead the economy into a deep recession or even a depression. Thus the Government must spend and spend heavily. Of course the question is who is going to buy our debt? The answer—foreigners and investors at higher yields than offered today. That is, the dollar is going down further, and interest rates and inflation will rise.

Further good news: At the end of the first quarter of this year, US Households were worth a combined $56 trillion down $1.7 trillion from the previous quarter. Falling home prices accounted for $305 billion and declining stocks accounted for $965 billion, the rest of the difference ($ 43 billion) was due to other asset value declines.

Preserving Capital has trumped risk, as traditional asset values fall. Housing, Stocks, Bonds, are all falling. Risk seeking is on hold as investors crowd into T-Bills yielding 1.84% for 90 days. In my view, all traditional assets are overvalued. For example, the S&P 500 Index is currently trading at 1,320.80. The SP index yields 2.14%, and has a current price/earnings ratio of 18.20 for 2008 estimated earnings and 18.83 for 2009 estimated earnings. The current yields and PE’s might have been “cheap” in the easy money days, but in my opinion are not cheap in today’s environment. My value model prices the “Fair Value” of the SP to be 1214.80 (8%) below the current value. The 10 Year T-Bond provides a 4.11% yield. With the real inflation rate at 7.50% (as calculated by John Williams), who would buy T-Bonds? Mr. Williams calculates the inflation rate on the same basis the Government used pre Clinton. A 2600 square foot house has an asking price of $1,100,000 or $423 per square foot. Is this cheap? Where is value versus risk? The answer is---it currently does not exist. The good news however, is like all previous Economic and Investment downturns, proper risk/reward ratios will appear. The bad news, probably later than sooner. Gold, Cash and no debt is the ideal combination to stay out of trouble. I choose to follow that advise.