- Editor's Note: About Last Week's Letter
- The Economy – What to Expect Going Forward
- Stocks & Bonds – What Lies Ahead?
- Speaking of “Faith”… What About the CBO?
Editor's Note: About Last Week's Letter
I felt really bad about sending out last week's E-Letter in which I predicted that we will face another serious financial crisis and perhaps another depression sometime in the next several years, especially when few mainstream economists envision such a dire future anytime soon. However, within a couple of hours of pushing the “send” button last Tuesday afternoon, I read a brand new poll with some very surprising results.
The latest poll by Fox News/Opinion Dynamics shows that 79% of registered voters believe that an economic collapse is still possible. 84% of Republicans, 80% of Independents and 71% of Democrats all agree that the worst may not be over. Only 18% still cling to the White House position that a collapse will not happen. 65% now believe that the National Debt is more of a threat than terrorism – wow! Only 35% think Obama has a plan to fix the economy, down from 42% last July. For Congress, the numbers are even worse. Only 24% think the Democrats have a clear plan to heal our economy, and only 16% think Republicans have a solution.
This poll was a shocker, not only to me but also the mainstream press. Obviously, there are a LOT of Americans that agree with me that Obama's trillion-dollar deficits and the skyrocketing national debt represent the biggest threat to our economic and financial futures.
The American people have already demonstrated that they were against the massive healthcare bill passed by Congress and signed into law by Obama last week. But it is very clear from this latest poll that millions of Americans want this runaway spending stopped at all levels. If Obama continues this out-of-control spending, despite the public's widespread concern, I predict he will be defeated in 2012.
In this week's letter, we will touch several bases. We begin with a look at the latest economic reports, which are mixed. We will take a look at the stock and bond markets and ponder whether the equity gains so far this year will continue. And finally, we will explore how the Congressional Budget Office calculates its cost estimates for the various government spending programs it “scores,” such as the latest healthcare reform legislation. I think you will be very surprised, and I doubt you'll put much faith in their estimates going forward.
It's a lot to cover, so let's jump right in.
The Economy – What to Expect Going Forward
Barring some negative surprise, we have seen the worst of the recession and the credit crisis, at least for a while. The Commerce Department released its third and final report on 4Q GDP last Friday, showing that the economy expanded at an annual rate of 5.6% in the final three months of 2009, down from the 5.9% earlier estimate. The downward revision was somewhat unexpected as the consensus was that growth remained at the 5.9% rate in the 4Q.
The greater question is how will the economy perform in 2010? We won't get our first estimate of 1Q growth until late April. In the meantime, we have to look at other economic reports. Most all of the sources I read and respect believe that the economy will grow in 2010 by much less than the 5.6% rate in the 4Q, which was largely due to inventory rebuilding.
Before going into the latest reports, I will tell you that there has not been much to give us a definitive view of what lies ahead, other than another few quarters of 5.6% GDP are not likely.
The widely followed Index of Leading Economic Indicators (LEI) rose less than expected in February, up only 0.1%. While the LEI has risen briskly over the last year, it now appears to be flattening out as shown in the chart below, suggesting a sluggish economy going forward.
The government's “Coincident Economic Index” (CEI) shown above is much more influenced by the level of unemployment, which remains very high, so its rise since bottoming last June has been very modest as would be expected.
Speaking of unemployment, the numbers continue to look discouraging. The official unemployment rate for February was unchanged at 9.7%. New weekly filings for unemployment benefits continue to run around 450,000. Remember that the official unemployment rate does not include those that have stopped looking for work or have been forced to accept part-time jobs. The real rate of total unemployment is approaching 20%.
In other reports, orders for durable goods increased 0.5% in February following a 3.9% gain in January. Industrial production rose a scant 0.1% in February following a 0.9% gain in January. The ISM manufacturing index fell to 56.5 in February from 58.4 in January. Retail sales rose 0.3% in February from +0.1% the month before.
Consumer confidence took a sharp drop in February after rising for the three previous months. Upon releasing the February confidence data, the Conference Board stated:
“Consumer Confidence, which had been improving over the past few months, declined sharply in February. Concerns about current business conditions and the job market pushed the Present Situation Index down to its lowest level in 27 years. Consumers' short-term outlook also took a turn for the worse, with fewer consumers anticipating an improvement in business conditions and the job market over the next six months. Consumers also remain extremely pessimistic about their income prospects. This combination of earnings and job anxieties is likely to continue to curb spending.”
The University of Michigan Consumer Sentiment Index, another widely followed barometer of confidence, also fell in early March from 73.6 in February to 72.5. Remember that consumer spending accounts for apprx. 70% of GDP, so these confidence numbers suggest slow growth in the economy this year.
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Late Note: the latest Consumer Confidence report released this morning showed that the Index improved somewhat in March. The accompanying language from the Conference Board stated:
“Consumer confidence, which had declined sharply in February, managed to recoup most of the loss in March. However, despite this month's increase, consumers continue to express concern about current business and labor market conditions. And, their outlook for the next six months is still rather pessimistic. Overall, consumer confidence levels have not changed significantly since last spring.”
On the housing front, there was across-the-board bad news last month. New home sales plunged for the fourth consecutive month to the lowest monthly rate ever recorded. New homes sold at a seasonally adjusted annual rate of 308,000 units in February, a 2.2% drop from an upwardly revised January pace of 315,000 units and 13% below the 354,000 sales for February 2009. It was the lowest sales level since the government began tracking these statistics in 1963.
The number of new homes for sale in February rose 1.3% from January to 236,000, a 9.2-month supply at the current pace. Existing homes sales also fell in February. The National Association of Realtors reported that sales of previously owned homes in February slumped for the third consecutive month to 5.02 million units. Housing starts fell 5.9% in February from January levels, and building permits declined as well last month.
Analysts point to the inclement weather in February as a reason for the big declines in all the housing numbers, and that factor can't be totally dismissed, but remember these numbers are all “seasonally adjusted.” So, unless we see a significant rebound in the March numbers, this is just one more indication that we're in for a sluggish rebound in the economy in 2010.
Stocks & Bonds – What Lies Ahead?
Despite the recession and the credit crisis, stocks unexpectedly bottomed a year ago and have staged an impressive rally. As measured by the S&P 500 Index, US equities have rebounded a surprising 73% since the lows just over a year ago. The S&P is up over 5% so far in 2010 as this is written.
Unfortunately, millions of American investors bailed out of the equity markets last year near the lows, and most have not gotten back in as suggested by the mountain of cash still on the sidelines. In fact, many retail investors continue to bail out of the stock market. According to Morningstar, investors pulled $3.7 billion out of US stock funds in February, the fifth month of outflows in the last six months. A March 25 survey by the American Association of Individual Investors showed 34.7% of respondents are bearish, which is more than the 32.4% who are bullish and up from a 23% bearish reading at the end of 2009.
The S&P 500 Index plunged 57% from the peak in late 2007 to the lows last March. That bear market followed the decline in the S&P 500 of 49% in 2000-2002. The good news is that the S&P 500 has rebounded 73% since last year's low.
After two major bear markets in the last decade, many of these investors have written off the equity markets forever – they will not be back. I could launch into a discussion on how the actively managed investment strategies I recommend serve to limit these kinds of massive losses, but I assume you've read these discussions before if you have read me for long.
The real question now is, will these kinds of stock market gains continue? We know that the Fed pumped a massive amount of liquidity into our monetary system during the height of the recession/credit crisis. Short-term interest rates were ratcheted down to near zero. Money had to go somewhere, and much of it went into the stock markets, both here and in the global equity markets. This, not surprisingly, drove prices up more than most analysts expected.
Now, expectations are becoming more realistic. The economy, after experiencing a big jump in the 4Q due largely to inventory rebuilding, is coming back to the reality that consumers are still retrenching – lowering spending and increasing savings. This trend will continue, for how long we don't know. So, we are not likely to see 5.6% GDP growth in the near future.
What does this mean for stock market returns? Simple – they are not likely to remotely equal the returns we have seen over the last year. Stock market returns, while they may, or may not, take a big hit just ahead, are likely to mirror the trend in the economy. I continue to recommend actively managed stock market strategies that have the flexibility to move out of the market, or hedge long positions, during bear markets and extended downward market corrections.
The bond market experienced a huge upward move (interest rates fell) in late 2008 and investors moved in droves to the safety of US Treasuries. However, as you can see in the chart below, long-term interest rates have risen since the downward spike in late 2008. Since about this time last year, bond prices have moved in a narrow trading range.
There is widespread agreement that Obama's trillion-dollar budget deficits will lead to higher inflation at some point in the future, which will be bearish for bonds. However, this could be several years down the road. As noted above, consumers are still deleveraging (ie – paying off debt and increasing savings). Given that this trend is likely to continue, and given that the economy is likely to slow down appreciably this year and next, the threat of a significant rise in inflation anytime soon is very low.
As a result, I would expect the bond market is likely to remain in a generally sideways pattern for some time to come, especially in regard to US Treasury bonds. I don't see much opportunity in T-bonds just ahead, unless you invest in them via one of the actively managed bond strategies I recommend.
Finally, it is most interesting that the current yield on some US Treasury debt is actually higher than that of several high-profile corporate bonds. According to a recent Bloomberg article, debt issued by Berkshire Hathaway, Procter & Gamble, Johnson & Johnson and other major US corporations traded at lower yields than Treasuries of similar maturity over the past couple of months. In other words, these corporate debts were deemed to be safer bets than the US government, a situation that Bloomberg called “exceedingly rare.”
Unfortunately, higher Treasury yields may become more common in the near future. By now I'm sure you've heard that the Treasury auctions held last week indicated a lower demand for Treasury debt, especially among foreign investors. This lower demand, in turn, led to higher yields to attract buyers. Treasury debt ended up being sold at prices below those of not only some corporate issuers, but also prices found in the secondary market for similar Treasury debt. Thus, last week's auctions could be an omen of things to come as interest rates rise to combat concerns about rising US budget deficits.
This is clearly another indication of the growing global distrust and anxiety over the current runaway spending on the part of our government. So much for the “full faith and credit” of the United States.
Speaking of “Faith”… What About the CBO?
One side benefit (if you can call it that) of the year-long healthcare bill debate has been that the public has been exposed to a variety of political maneuvers used to make legislation more palatable or even twist the arms of reluctant legislators. We've witnessed everything from outright bribes to tricky procedural maneuvers that few Americans knew even existed.
Even worse, it came to light that some of these kinds of tricks had been used in the past, apparently by both parties at times, to get their way on various pieces of legislation. In the effort to get the massive healthcare bill passed and to take over more than one-sixth of the US economy, the intense political maneuvering, the backroom sweetheart deals and bribes among the Democrats were over the top. President Obama and congressional leaders would stop at nothing to get this bill passed into law. Unfortunately, these tactics may become “business as usual” in Washington going forward.
Nowhere was the search for political “cover” more evident than in the cost estimates prepared by the Congressional Budget Office (CBO). Lawmakers made great efforts to convince the public that these CBO estimates are unbiased and very accurate projections of future costs. Unfortunately, these cost estimates are often little more than fantasy, as I will explain below.
Don't get me wrong, I don't think that the CBO is necessarily politically biased or in the camp of one party over another. Instead, I think the faith placed in CBO estimates is misplaced because of the huge limitations they encounter when producing these cost estimates. Here are just a few examples of the limitations faced by the CBO in doing their job, which most Americans are not aware of:
Assumptions – As in any projection of future events, the CBO must make a number of assumptions when scoring a piece of legislation or projecting future budget deficits. While the analysis involved in any particular assumption might be sound, future events rarely conform to the initial assumptions, especially when projecting 10 years into the future.
As one example, when determining future budget deficits 10 years into the future, the CBO assumes that the Bush tax cuts will sunset (end) at the end of this year as scheduled, even though President Obama has proposed that they remain in place for most families. Should Obama extend these tax cuts for families earning under $250,000 per year, then the deficit projections by the CBO will be too low for the years after 2010.
Another well-documented assumption in regard to healthcare was the fact that the 10-year projection period included 10 years of taxes and fees but only six years of benefits. Obama attempted to fix this by having the CBO project out another 10 years, but if the 10-year numbers are questionable, the 20-year numbers amount to little more than fantasy.
Actually, Congress has employed the strategy of immediate revenue but delayed benefits many times in the past. This was the case when Social Security was enacted in 1935, so this is nothing new with the current administration.
Suspended Reality – CBO projections must also assume present law, not expected changes or even recurring congressional actions. One good example that came out during the healthcare debate was the so-called “doc fix.” In 1997, Congress voted to reduce Medicare reimbursements to physicians. However, these cuts have never been implemented because each year, Congress has passed a “doc fix” that prevents the cuts from becoming effective.
A bill has been introduced to make the “doc fix” permanent but until that happens, the CBO will have to assume that these 1997 cost savings will be effective in future budget years. The same goes for the annual Alternative Minimum Tax (AMT) fix, which is handled by annual patches rather than a permanent fix.
Another altered state of reality exists in relation to tax revenues from various sources. A good recent example is the additional tax on investment income for high-income taxpayers in the healthcare bill. As we have seen at various times in the past with the ill-fated “luxury taxes” that have been imposed, high earners have the flexibility to alter their activities and greatly reduce expected gains from additional taxes. Just Google “Laffer Curve” to see what I'm talking about.
Legislative Stability – Closely related to the above discussion about suspended reality, the CBO assumes that the provisions of any bill they are scoring will stay static over the entire time window being projected. In other words, when scoring out the Senate healthcare bill, the CBO had to assume that only the provisions of that law would apply, and that these provisions would stay constant over the next 10 years.
This is far from a realistic assumption as major legislation is often changed in later years. In fact, many people believe that the tax on high-end “Cadillac” healthcare plans will never be enacted due to its strong opposition by unions. If this part of the healthcare bill is changed, then the savings assumed to come from this tax will never occur, greatly affecting the actual long-term costs of the legislation.
Again, it has not been my intent to cast a cloud over the non-partisan nature of the CBO. Instead, I think it's important for all voters to know that the CBO is subject to a rather rigid set of rules when projecting deficits or scoring legislation. Since Congress knows these limitations and can tweak legislative proposals to take advantage of them, we shouldn't base our opinions about proposed laws based on the CBO cost estimates alone.
I don't know about you, but I have much less respect for CBO projections now than in the past, not because they provided political cover for passage of the healthcare bill, but because any analysis they perform is subject to restrictions that cannot help but affect their accuracy. In addition, politicians have become adept at crafting bills that take advantage of the inherent limitations governing CBO projections. As long as elected officials from either party can game the system, then no CBO projection will be reliable, no matter how non-partisan they may be.
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Conclusions
It occurs to me that I have been warning about the precipitous rise in US debt for almost 30 years. Yet ever since the serious recession of 1981-1982, the US economy has surprised on the upside despite the continued rise in the national debt, and periodic recessions have been brief and relatively mild over this same period.
That is, until the subprime meltdown, the credit crisis and the severe recession of 2008-2009, which was the worst economic/financial debacle since the Great Depression. You would think that our leaders would have learned a thing or two from that gut-wrenching experience, and would be working hard to get our government on a firm financial footing.
But instead, President Bush ran the largest federal budget deficit in history (at that time) in his last year in office, a record $459 billion. President Obama saw fit to more than triple that amount with a massive $1.4 trillion deficit in 2009 and is on track to add more than $5 trillion to the national debt of $12.6 trillion in his first four years in office alone. His own projections show the national debt doubling by 2020. And keep in mind that several of his economic assumptions (such as no recessions in the next decade) are too optimistic.
Like sheep, we are marching in lockstep toward our financial and economic Armageddon. The larger our debt becomes, our options for a non-crisis solution diminish. As I warned last week, there will come a day when the foreigners who own over half of our national debt will decide that we no longer have the ability to make good on those debts. When that day comes, it's game-over for the US – and we may be much closer to it than we think, at least based on last week's Treasury debt auctions.
We had a very large response to my alarming E-Letter last week. Like the latest Fox News poll showing that almost 80% of Americans fear that another financial crisis may well lie ahead, many of you let me know that you indeed share my concerns about our nation's future. Seems I hit a nerve that is on the minds of millions of Americans.
By far the most common question I was asked was, “What do we do to protect ourselves and our assets?” I will be writing more about that in the weeks and months to come. In the meantime, you need to be thinking beyond Wall Street's conventional buy-and-hold mantra.
In closing, I very much appreciate your comments and suggestions – all of them – including the negative ones (with a few exceptions). Please remember that your comments make me think, so please keep them coming.
Very best regards,
Gary D. Halbert
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