The Great Recession of 2008-2012 Isn't Over!

Last Updated: May 2012

Abstract:

This paper reviews some of the evidence that – regardless of US Government declarations to the contrary -- the Great Recession of 2008-2012 is far from over. In the coming year, we may move into the second “V” of a W-shaped recession. There is also serious risk of a market melt down in stocks and bonds. This is not a time to “buy and hold” equities for the long term.

Introduction:

During the winter of 2010, I received an email from a personal friend who was once our retirement investment adviser (“us” being me and my wife). It had been a while since we'd talked. In early 2008, I had allowed this adviser to cajole me into keeping a substantial part of our investments in the stock market -- despite my own strong misgivings about a serious shakeout that I felt was coming in US equity markets, due to problems with sub-prime mortgages. My adviser discounted such concerns, believing that although the US might be moving into a recession, such events are “a normal part of the business cycle” that I should “ride through”. Though he had noted the peak of the US residential real estate bubble in 2005, he anticipated that any recession would be relatively short and mild, if it happened at all.

Like most of his colleagues in the investment industry, he was quite wrong. And because he was wrong for the reasons that he was, the man is no longer my financial adviser. I made that decision despite believing him to be morally sound on a personal level, thoughtful, and highly conversant in the investment principles that other professionals in his field use in their advice to clients. I had come to believe that his advice and theirs was no longer appropriate for the financial climate that most of us live in. This paper shows why I came to such conclusions.

Between August 2008 and March 2009, the value of our retirement investment portfolio dropped by about 33%. The S&P 500 Index lost 48%. Although we were diversified enough to avoid worse losses, that minor victory felt like cold comfort at the time. As the Dow Jones Industrial Average headed south through 11,000, then 10,000... 9,000... 7,000 and lower, I wasn't sleeping well at night. Despite a lot of nonsense published in the name of “analysis”, nobody really knew where the DJIA would hit bottom and begin to turn around – or even (in our worst moments of anxiety) “if” it would turn around. I learned a lot about my tolerance for risk during those months. I wasn't nearly as risk tolerant as I'd thought a couple of years before.

Thus, in March 2009, we bailed out of the retirement investment strategy that our adviser had prepared for us two years before. As I'd been tempted to in the Spring of 2008, I took over management of our retirement plan. We re-balanced our investment holdings toward short-term, high-rated, non-corporate bonds, short-term CDs and cash (money market) reserves.

In hindsight, I must admit that I revised our investments at quite possibly the very worst time. If we had “hung on” with the original plan through the rest of the year as my adviser implored us to, our portfolio would have climbed most of the way out of the crater, much like the DJIA itself. As it worked out, the more conservative investment plan that I constructed during many nights of study and worry recovered about 2/3 of our losses. This was somewhat less than we would have experienced with the adviser's recommended plan. But I slept better, knowing that our exposure to a further market crash was more limited.

There's another bit of sour grapes from this experience. If I had followed my own instincts in early 2008 and later forced myself to set aside my concerns about the markets during the second quarter of 2009, we might have added a healthy 70% to the net value of our retirement investments. That also didn't happen -- either for us or most other private investors. It's hard to say if I would actually have taken that leap of faith at the time. In this, my investing behavior was no wiser for us than for millions of others.

What is of greater import for the purposes of this article, however, is precisely that many other investors did pretty much the same as I did and bailed out at the bottom of the stock market plunge. A lot of them are now kicking themselves for not participating in the market run-up from March through December of 2011. And now they're hearing from their government that the recession is over. Despite their misgivings, they're wondering if they shouldn't be putting money back into stocks.

That would be a REALLY bad move, in my opinion. You'll see why, in the pages below.

The Drunk Under the Lamp Post Syndrome

Perhaps you'll see the basis of my concern with this logic, if I paraphrase one part of my former adviser's email of a few days ago:

“For those who may not have [visited my website] in a while … one of the "quotes" [you will find] there is one worth repeating... Even though this is now called the Great Recession -- though the "technical" recession is over, while severe unemployment continues (which is terrible but normal):

"...The difference between this recession and previous ones is that we are in this one now..."

We have been here before. This time is not different – really.”

=========================

My former adviser is doubtless sincere in his assertion. He's neither a crook nor a fool, despite charging for financial plans that he develops for clients who have since lost money. He really believes what he's saying. But I'm also pretty sure he's wrong again – and folks who acts on his advice could find themselves in a world of hurts because of the reasons he is wrong. The recession this time really is different. We've never been here before.

This well-intended professional adviser seems to be looking back through the years of his financial education and trying to fit recent events to the ideas he was taught 30 years ago. But it seems to me that he's doing so without examining a large body of evidence that some of those principles don't work well under present conditions. His approach might be an example of what is sometimes called “the drunk under the lamp post syndrome.” My reference here is to a very old joke, as follows:

--- --- ---

A lawyer is walking home one night. Along the way, he meets an obviously intoxicated citizen who stands unsteadily, bracing himself against the pole of a street lamp. He walks up and asks the drunk, “Are you all right?”

The drunk nods, woozily. “I'm fine... I jus' lost my dime, is all.”

As he holds his head back to avoid the drunk's breath, the lawyer asks politely, “Well, where do you think you lost the dime?”

The drunk waves vaguely across the sidewalk toward the large lawn of the house in front of which he stands. “I think it's over there somewhere...”

Perplexed, the lawyer asks, “Then why are you looking for it here?”

With perfect – to him – logic, the drunk replies, “Because there's more light here...”

--- --- ---

It is part of human nature that we often react to our present day human experiences by comparing them with the past – and by trying to avoid mistakes of the past. Most of the time, such responses are quite appropriate. We humans can and should learn from experience. However, there can also be a snake in this wood pile: we sometimes insist on shaping our present behavior to events that happened in the past... even when events going on right now aren't all that similar!

The thesis of this paper is that we are now seeing things in the world economy that are quite different from anything that has happened before -- with the possible exception of the Great Depression of the 1930s. Some of the similarities to the Great Depression are really alarming.

I am concerned that my former adviser may now be locked into a “drunk under the lamp post” pattern,. He seems to be stuck upon his preference for what seems familiar to him, and unable to examine a changed reality. Rules for financial success that he “knows” from years of previous training and experience, might not apply as well in present times. And to the degree that they do not, the people he advises may suffer significantly.

So what has changed in recent times, that might challenge rules of investing that my friend lives by and advises others to emulate? What factors call into question the oldest strategy of all, “buy and hold”?

Let's review some issues that greatly complicate life for people trying to build a retirement nest egg or eventually to send their kids to college. Why should we doubt that we're only going through another – even if unusually painful -- “business cycle?” What factors seem to act in contradiction to even the very slow economic recovery that government leaders are now predicting?

Problems with “Buy and Hold” Investing

I will begin our review with a short look at the most common investment advice that we hear in modern times. We are often told that it is a mistake to buy and sell individual stocks or other investments, hoping to find better performance than the equity markets provide on average. Market timing doesn't work. And this advice is largely correct.

Though conditions appear to be somewhat better than in the 1920s, modern investors still have limited access to reliable information about the operations of publicly held companies whose stocks they wish to buy directly or through mutual funds.  We know even less about the policies of large investment banks which appear to have been largely responsible for the financial crisis of 2008.  It is next to impossible to accurately know about the attitudes, risk tolerance, or gamblers' instincts of corporate Boards. If you ever needed an example of this reality, just look at Enron. Until almost the last moments before the company collapsed, even its own employees didn't know what their own management was up to. Brokerage firm stock analysts mostly didn't have a clue either.  The same has been true more recently of the bad investment bets made by officers of JP Morgan Chase Bank.

In all but the luckiest rare accidents of market timing, any number of economic studies have shown that frequent trading in individual stocks or other investments will (sometimes quickly) erode your investment capital; commissions will eat you alive. Day trading in commodity futures using purchase and sale contracts called “puts and calls” will throw your money away even faster. About ninety percent of traders who dabble in commodity futures go broke. The other ten percent aren't selling their “systems” to the public, if they have any beyond intuition and dumb luck.

So what is our alternative if we want our money to do well over time? The classic rule of thumb is to “diversify, buy, and hold” investments whose risks and potential we understand. Since few of us really understand such things, most of us pay somebody else to understand “for” us and offer investment advice. However, we are rather often shocked when we learn that our chosen “experts” seem to know little more than we do.

We're told that the investment mixture that we select should reflect our tolerance for risk. If we have time, and don't mind watching the value of our retirement funds fluctuate widely, then we can afford to buy more risky securities that are believed to have better “potential” rates of return. There are no real guarantees. The one thing we can NOT afford to do (according to this advice) is to sock our savings away as cash under a mattress. Even if our money doesn't get stolen by a burglar, yearly cost of living inflation will erode the value of cash over time.

However, several aspects of such investing rules of thumb are not obvious. High on the list is that such a strategy works best in times when our economy is working well and generating consistent rates of return in dividends. This condition does not occur all of the time. In fact, during the past 20 years, it has tended to be the exception rather than the rule. Market volatility (unpredictable changes in prices) can throw a major monkey wrench into such a strategy. And such price changes often seem to be caused by political events and public perceptions, rather than by long-term economic fundamentals.

If you believed in “buy and hold” in 1928, then you might have invested in a balanced portfolio of the 30 stocks that then made up the Dow Jones Industrial Average. As Black Friday and the market crash unfolded, your adviser would probably have told you that the large “blue chip” companies you'd bought shares in were among the safest investments in the equity market. Such stocks wouldn't have been included in the DJIA if they weren't sound. So you should hang on and wait for better times. It would have been tough advice to follow, as you watched your investment value drop by 90% from 1928 to 1933. Something that your adviser couldn't have known in 1929 was that you would need to wait through 25 years and two wars before you broke even again. By then, you'd have been a lot older, if no wiser.

So “buy and hold” is not always a reliable investment strategy over time, despite its popularity as a principle among many advisers. In fact, such a strategy can be a disaster in the real world, if you happen to invest just before a significant market peak, only to watch your investments depreciate for a couple of years thereafter. A lot of people who get caught in such an event, never seem to recover their losses. This reality is not hard to understand, however difficult it might be to live with.

Let's say you owned $100,000 dollars in stocks in August 2008. The S&P 500 Index at that time had edged down from its summer 2007 peaks, to about 1300. If you hung onto these stocks and their average prices tracked with the S&P all the way down to the March 2009 bottom at 683, then your stock value dropped by about 48% -- to $52,000 dollars. Quite a roller coaster to find yourself riding, wasn't it?

As we know – even if we don't entirely know why – the S&P climbed back out of that pit during the next nine months. What rate of return do you think you would have needed from your reduced assets, in order to climb back to the August 2008 value of your stocks? When we do the calculation, we find you would have needed a 90% total return on the reduced investments you held as of March 2009 -- just to break even. Your rate of growth had to be twice as high as your earlier loss rate.

In the last nine months of 2009, the S&P bounced back from a low of 675 to 1115 on December 31 – a gain of 65%. That's a really phenomenal overall gain – but you're still not back to break-even. How much would you want to bet on the S&P 500 index moving all the way back to 1300 in 2010? Relatively few investors were willing to make that bet, though the index did make it back into that territory in the summer of 2011.  Since that time, the index has gyrated between 1130 and 1400 -- a volatility that seems to have been promoted (if not created outright) by extremely short-term algorithmic trading which now dominates the stock market.  

Unsecured Government Debt

Our leaders have been trying since 2008 to stimulate the US economy out of recession by spending money we don't have in Federal“Budget Deficits. The deficit for 2010 was over $1.5 Trillion dollars, and it stayed in that range in 2011 and 2012. However, our economy is already far more burdened with unsecured Government debt than at any previous time in our history. By “unsecured” I mean “backed only by the full faith and credit of the US government” – in other words, backed by nothing more than our willingness or capacity to pay future taxes. Given that we already have over $16 Trillion dollars in previous Federal debt – more than a third of US yearly Gross National Product -- I'd have to say that our willingness as well as ability to pay are seriously in doubt.

On top of our present mountain of bills, the Obama administration plans to add even more Trillions in debt for the foreseeable future. Their intention is to keep our banks stable, "stimulate" our economy and create domestic jobs. However, we have also for the first time in recorded US history, doubled the amounts of US currency and bonds in circulation.  Such huge expansions of negotiable currency instruments have never happened before and they create dangers that have never happened in this country before.

The long-term consequence of flooding an economy with more purchasing power than it has goods to buy, has historically been price inflation. By that term, we mean that prices of purchased goods creep (or sometimes race) upward because there's more money chasing the same amount of products. So far, serious inflation hasn't happened in spite of the huge amounts of money pumped into our economy by the US Federal Reserve. But the reasons why it hasn't happened seem at least as dangerous for our future as inflation may be.

To put the case bluntly, we aren't seeing inflation because banks aren't lending out the money they've received in government stimulus, to people who would spend it buying consumer goods. Instead, this mountain of dollars is going elsewhere (I'll tell you where, shortly). Especially for owners of small businesses – which generate 90% of the activity in our economy – new credit has been effectively frozen for more than three years.

Thus it is not accidental that small businesses aren't hiring many workers these days. They don't have the credit they need to expand and they are greatly in doubt concerning their own economic future. Significant numbers of businesses are still on the hairy edge of going under, despite recent “improvements” reported in US GNP. Again to be blunt, too many of those “improvements” are mere transactions on paper, rather than real. Too much GNP “growth” is in our financial services sector rather than in actual production of goods.

Structural Unemployment

US government unemployment statistics indicate about 9-and-a-fraction percent of us are still unemployed, many of us for over a year. Unfortunately, even these statistics come close to being outright lies. When we include people who are so discouraged that they are no longer looking for work, plus under-employed people who have taken part time jobs, plus others who have taken full time jobs at much lower wages, what we see is a crisis of proportions unknown since the Great Depression. Easily 20% of us across the Nation are out of work or only partly employed. For some rural counties in places like South Carolina, the numbers are closer to 30%.

It is common for economists to speak of unemployment as a “lagging indicator” in re-building national prosperity after a recession has occurred and then eased. The idea is that during the shrinkage in production that defines a recession, employers are forced to lay people off and improve production efficiency in order to stay in business. It then takes a while after businesses are profitable again, before higher demand can tease employers into hiring back these laid-off workers. But how long do we expect to wait for jobs to return?

A big problem with the concept of lagging job returns, is that jobs can also outright disappear from the economy -- permanently. If jobs are quickly replaced by other work at similar or better pay, then we don't notice the dislocations as much. But unfortunately, this isn't what is happening in America today. Instead, we see rising “structural” unemployment due to the out-sourcing of US manufacturing into cheaper overseas labor markets. It is not accidental that shoe and textile and clothing companies have fled from unionized US labor rates, to open new plants in India and China and Malaysia -- where the same work on many of the same machines is performed for a third of US labor cost.

US corporations are surviving financially by becoming the generators of prosperity for OTHER countries, at the expense of our own.

A fact that might hurt us even worse in the long run, is that most computer manufacturing and nearly all high-tech hardware technical support have fled off-shore for the same reasons. Software development is going the same way. Thus US “low-tech” job losses are not being compensated by newer “high tech” job gains. The US services industry -- where many of our low-tech and high-tech unemployed are ending up -- pays wages close to those of high-tech overseas, but well below those of skilled craftsmen formerly working in US heavy industry. So even our employed folks are becoming poorer.

The shakeout in the US automotive industry during 2007-2009 displays a lot of the same character. The automotive industry suffered through a serious world-wide reduction in output during 2009. The US industry seems to be coming back from that dip.  However, Koreans and Japanese laborers can now manufacture cars and trucks that are both cheaper and more reliable than comparable US products. Thus their economic recovery may be significantly stronger than ours.

The knowledge needed by our competitors to accomplish this new industrial revolution was provided to a generation of their kids who attended US colleges and universities in the 1980s and 90s. Those kids also frequently out-perform US native English speakers, who are not accustomed to working nearly as hard at academics. Such students have taken their knowledge back to the countries where they were born, and are using it. The US now ranks below 20th in the world, in the skills of its graduates for math and science.

Falling US Incomes Cause Rising Mortgage Foreclosures

The average weekly wage of US workers has been stagnant or fallen for a generation, as overseas wages increased. Combined with fraudulent practices by both the US Government and the US financial sector, this reduction of effective income has wide-reaching consequences for the distribution of personal wealth in the US. Almost all of US income growth in the past 20 years has occurred among the wealthiest five percent of our society. Although it is estimated that over 3.5 million US households now hold in excess of a million dollars in assets each,¹ other thoughtful commentators have gone so far as to suggest that the American Middle Class is in danger of disappearing. ²

Note that I have stated unequivocally that the US Government has been guilty of fraudulent practices. Although the story can be confused by telling it with a lot of complexity, it reduces to something basically very simple. Americans have been living beyond their means for at least 20 years. As part of that pattern from 1996 to 2005, several key figures in our government created the sub-prime mortgage crisis that popped the long-prevailing US real estate bubble and started our current recession. And they did so by committing or allowing outright fraud.

In the late 1990s, during the Clinton administration, un-named policy wonks seem to have decided that the Democrat party as well as the economy in general would benefit if everybody who wanted to “own” a house, could get a mortgage. Where they got this silly and self-defeating idea is not recorded. However, the Clinton Administration and its Congress got together to pass a series of bills and regulatory guidelines intended to force banks to broaden their lending to inner city families. They then poured hundreds of Billions of dollars into residential real estate, through Fannie Mae (FNMC) and Ginny Mae (GMNC). As new money came into the market, housing prices rose – sometimes at more than 5% per year.

Naturally the smell of money brought many alert Wall Street operators (also known as “predators”) out of the shadows. With the prompting and assistance of various movers and shakers in Wall Street, Senator Phil Gramm shortly after the election of George Bush in 2000, quietly slipped a large piece of almost unnoticed legislation into a major appropriations bill. Titled, the Commodity Futures Modernization Act, this 262-page time bomb effectively repealed the Glass-Steagall legislation of the 1930s which had separated banks and investment brokerage houses into different businesses and regulated their financial practices. Wall Street had a green light to go after the commissions and fees associated with the huge volume of new mortgage loans.³

Pretty soon (2003-2004), the new managers of this lovely cash cow ran out of credit-worthy home buyers to give new home loans. So banks and finance companies started passing out loans to people who had about the chances of a hailstone in hell of ever repaying the money. Investment companies further up the food chain started looking for ways to hide the increasing default risk that such poor loan oversight inevitably created.

The finance folks figured out new ways to do this magic hat trick – again with the complicity of Congress, the Securities and Exchange Commission, US Treasury, Federal Reserve, and key figures in the Bush Administration. Wall Street created new classes of complicated investments called “Collateralized Debt Securities” and “Credit Default Swaps”. Pooling “good” mortgages with “below prime” (high default risk) mortgages, such securities paid returns to their investors from the interest paid by mortgage holders. Investors were supposedly protected from defaults of sub-prime borrowers by the addition to the investment pools, of less risky mortgage debts of truly credit-worthy borrowers. Credit Default Swap arrangements supposedly provided a form of “insurance” against loan defaults. However, the net result was that “good” mortgages got corrupted by “bad” ones, and nobody could figure out what these pooled investments should be “worth” or what their real risks of default were. At that point (2007-2008), the sub-prime market collapsed.

We might reasonably ask why such morally upright people as our bankers and finance folks would allow themselves to be caught up in such a transparently fraudulent Ponzi scheme. There were two main reasons. First, the government either implied or outright told lenders that anybody who refused to lend to borrowers in US inner cities (poor people, illegal immigrants, even unemployed day laborers!), would be prosecuted for red-lining and racial discrimination in housing. So those who resisted such risky practices should “get with the program” or suffer legal consequences.

However (second), many bankers and loan brokers actually welcomed being told to lend out this money since they got paid on the front end of these deals. Loan commissions and closing costs were making them very, very rich. Finance companies that made and then bundled and re-sold a $200,000 dollar loan on the same day got at least $1,000 to $2,000 dollars in up-front service and handling fees. They packaged and resold larger bundles of these loans to other companies that hoped to thrive and pay investors by collecting loan payments and interest. Multiply these commission numbers by millions of mortgages, and you can begin to see how tempting it was for bankers and loan brokers to ignore what they knew in their greedy little black hearts: the whole mess was a house of cards, waiting to fall down in any healthy breeze.

Although there were many early signs of potential trouble in the sub-prime mortgage market and the derivative “investments” built up around it⁴, as long as the handlers of these transactions didn't believe their own propaganda and actually dare to OWN these loans, they were relatively safe. To everybody's lasting regret, a large investment company named Bear-Stearns wasn't that smart. They and their investors got caught in a liquidity crisis when billions of dollars of sub-prime mortgages defaulted, dragging even more “good” mortgages into unknown waters.

The breeze at last blew in and the house of cards collapsed. The lame-duck Bush Administration then stepped in with hundreds of Billions of dollars in bail-out money, designating such companies “too big to fail” without bringing down the entire global finance system.  Bank executives got their million dollar bonuses, and the tax payer picked up the bill for their malfeasance and fraud.

Ironically, as far as anybody knows, not one of the government people who created this mess is presently in prison for fraud. If it were up to me, most of these greed-crazed idiots would reside in Leavenworth Prison for twenty years or so – if they weren't stood up against a wall and shot to save tax payers the cost of their imprisonment. Of course, it isn't up to me. At present, the inmates are still in charge of the asylum. Wall Street firms continue to pay multimillion dollar salaries and bonuses to the same people whose greed and complicity in fraud led our economy into the deepest decline since the Great Depression. And the Wall Street Elite continue to have lunch with their friends who serve inside the Obama Administration. It's all very civilized.

For readers who have time and a desire to understand more of the details of the sub-prime swindle, I suggest a documentary program by National Public Radio in 2008. “This American Life: The Giant Pool of Money” won a Peabody Award for its clarity in reporting of complex issues. The program transcripts are worth reading and are available on the Internet.⁵

The most important idea to take away from this summary is that the mortgage crisis is a LONG way from over, and US real estate markets are a very long way from safe harbor. A 2010 study for the Brookings Institute found that approximately $13 Trillion dollars (about 15%) of all US wealth evaporated from the US residential housing market between mid-2007 and March 2009. Due to widespread reductions in home prices, about 25% of all US homeowners presently owe more on their home mortgages than their property is worth in resale. ⁶ Likewise, although home sales recovered slightly in the Fall of 2009 due to government first time buyer programs, prices overall remain much lower than the 2005 peak, and may be headed even lower in 2012.

As these insolvent owner/tenants try to sell their homes in the future, one of two things must happen. Either they will be forced to come up with money they don't have to pay off the banks (which shouldn't strike any sane reader as very likely), or the banks will be forced to write off major loan losses in short sales and foreclosures. Consequences of this second alternative will almost certainly include the discovery that a large number of US banks have more non-performing liabilities than performing assets on their books. They are insolvent, even if present accounting rules allow them to create the pretense that they are not.

In 2009, just over a hundred US banks failed and had to be taken over and resold after liquidation by the FDIC (Federal Deposit Insurance Corporation). Most of those were relatively small. Even with this advantage, the FDIC had to request additional funds from Congress to meet its obligations to insured savers. What are we going to do when the numbers of failures become hundreds in a year, and some banks that go under are truly large?

This dilemma is one of the ways in which current conditions alarmingly resemble those of the Great Depression of 80 years ago. Although it is popular among financial advisers to remind us that our banking system is much better regulated and protected from failure now than in the 1920s, that reminder distinctly rings hollow in the face of the facts. One of the influences which created the mess we are in now was bank “deregulation” under the Bush administration, which stripped away several of the legal firewalls built in the 1930s between banks and investment firms. The dismantling of such regulations was a key factor in allowing such firms to become “too large to fail”. Although we still have more banking oversight as well as deposit insurance that wasn't available in the 1930s, this “oversight” did not keep our bankers from stealing us blind with the active cooperation of our government. Nor is our deposit insurance system at all adequate to cope with a truly major collapse of thousands of our now much larger banks.

Even the pending bank failures don't tell us the whole story of our folly. Just as Americans for a generation bought larger and more expensive houses than they could afford, they also furnished those houses by using their credit cards rather than their shrinking earnings or savings. It is not at all accidental that US bankruptcies are now at an historic high and rising or that credit card defaults are also. Consumers have simply run out of current income to maintain their unsustainable life styles from paycheck to paycheck.

Bankruptcies are linked to yet another indicator of US national insolvency: mortgage foreclosures. During 2008-2009, approximately two million private homes were foreclosed and their former tenant-owners evicted. As the year 2010 began, about five million more households were in early stages of foreclosure proceedings. No less an authority than the Wall Street Journal estimates that 25 million properties may go through this process in the next ten years.

Will somebody please tell us where buyers for these properties are going to come from, in an economy where 20% of us are unemployed or under employed? Likewise, how we are going to negotiate the collapse of thousands of banks whose books will no longer balance in the face of such short sales? This debacle begins to sound a little more like the Great Depression every day, doesn't it?

Lagging Employment May Impact Bond Markets

Unemployment in the private sector has multiple effects on the Government sector of any national economy. As widely reported on our US television news, falling income tax receipts put pressure on State budgets that must be balanced by their constitutions and laws. Such pressure reduces government services and causes layoffs of employees considered untouchable in normal times. A lot of this sort of thing has already happened. Until State income tax receipts recover, we still seem to be a long way from turning such trends around.

Less noticed by the public, however, such pressures may also impact the ability of State and local governments to pay the interest due on municipal and State bond issues. The State of California -- with 13% of US Gross National Product – is only one of the more visible tips of this iceberg. Lacking a robust recovery, many other US States may also be forced in the second half of 2010 (after April 15) to choose between honoring their existing debt obligations versus enduring major new layoffs of public employees, and further shrinkage of their economies. There is real concern that defaults on State bonds could bring on a Bond market shake-out even more painful and possibly more rapid than the stock market crash of January to March 2009.

Hundreds of Billions of dollars in various “bail-out” packages disbursed by our government in the past three years were financed by debt, rather than current tax receipts. Most of this debt is short term – an unsurprising result, given that US government interest rates are now at zero percent. Thus, State and municipal bond problems might be further complicated by a huge volume of US Treasury short-term notes maturing within the next year and competing for funds from investors. The Feds are too busy trying to roll over their own debts, to send more debt-financed bailouts to the States.

A record $3.5 Trillion dollars in T-Bills and other US Government bonds were scheduled to mature (come due) in 2010.⁷ Under prevailing economic conditions, there was simply no way the majority of those bonds can be paid off.  In large part, the only thing which saved the US government from a massive default in that year was the purchase of rolled-over bond debt by the Chinese government.

A large fraction of US debt is also now held by the Chinese government. The Chinese have recently moved to raise their own interest rates, to attract new capital into their ongoing industrial revolution and 8% per year growth curve. However, every Euro or Ruble or Yen that goes into China, is a unit of currency that does not help with the massive roll-over of US Government bonds.

Thus US government now faces yet another dilemma. To attract new foreign investors in competition with China, the historical government response would be to raise interest rates. But to raise rates now will place further downward pressure on the economy. Increases in Federal interest rates will reduce the market values of Federal and other bonds. In general terms, for each percent increase in interest rates, the value of bonds tends to drop by a multiple of one percent. This multiple is roughly equal to the number of years remaining before the bond matures for payment. When interest rates rise, the value of long-term bonds can drop seriously.

The Securities Industry and Financial Markets Association estimated in 2010 that the average maturity of US Corporate bonds was about 10.5 years. ⁸ Thus, if the Feds raise interest rates by even half a percent to attract more foreign investment, we could see a 5% drop in the market value of wealth stored in US corporate bonds. Who owns those bonds? Many are held by large mutual funds and insurance companies – the managers of our 401K plans and IRAs. Thus, if bond values drop in any general way, many personal retirement plans and college education funds will drop a good deal more with them.

The total wealth stored in US government and corporate bonds is presently on the order of $30-35 Trillion dollars⁹ Though not all bond values may be affected equally by rising interest rates among Federal bonds, the down-side risk to national wealth should still be obvious.

High Unemployment Impacts Social Security Benefits

Prominent people in US government these days are talking about economic recovery getting underway. However, they almost all warn that recovery may take a very long time to generate jobs. In this context, yet another effect of prolonged high unemployment has largely been missing from recent public discussion.

Many older wage earners unable to find work during the past two years have taken unplanned early retirement on Social Security Insurance. SSI outlays for these “early birds” will be lower over the long term than they would have been if the beneficiaries had waited until full retirement age to take this step. Beneficiaries will also find themselves somewhat poorer in the long run. However, there is a near-term impact from these early retirements: namely, higher than expected outlays of Social Security benefits are occurring at a time when SSI tax receipts are reduced. 

Thus, the point in time at which SSI taxes collected are exceeded by SSI benefit payments paid may be moving forward from earlier predictions in 2016.  I don't personally know the exact statistics here. But my intuition is that by the end of 2013, the Obama Administration may face a Hobson's Choice. To continue paying current levels of SSI benefits, the Government will need to issue even more short-term Treasury debt – for purchase by increasingly resistant foreign purchasers. The only other real alternative is to begin reducing SSI benefits, in order to maintain the system within its existing tax base. 

Raising the SSI wage cap can postpone this decision for a few years. But raising Federal income tax rates to meet SSI obligations out of general funds would be almost sure political suicide for any politician who is idiot enough to vote for it.  

Combined with increased taxes hidden in the so-called health care "reform" package, such contractions in disposable income will run directly contrary to any expectation of economic recovery. Reduced social security benefits could also prompt widespread populist, independent, and third-party revolts at the polls, driving liberal Democrats and centrist Republicans out of office in droves. The term “Independent” may be about to take on a meaning which is entirely new in US politics.

The Great Recession Isn't Over!

The factors outlined above, when viewed in combination, point very strongly not to an economic recovery (even a slow one), but to very high equity market volatility and serious risk of (another) market melt-down for both stocks and bonds. Although stock markets have run up by more than 50% in nine months, it is clear that much of the run-up is a consequence of new money coming into the market, rather than any real improvement in the underlying values of the stocks themselves. Price-earnings ratios are far too low to justify the flood of buy orders that has occurred since last March.

Some analysts claim that they are unsure why stock prices have inflated so sharply. But a plausible reason for this outcome is about as plain as the noses on our faces: money pumped into the Finance sector by government bailouts hasn't been spent in new credit to business expansion and production. Instead, it has been “parked” in stocks and bonds, in the form of about $1.5 Trillion dollars in excess bank reserves. And it is staying there while Finance sector and government leaders dither and wring their hands over conflicting policy messages about fiscal and budget policy, higher taxes, and higher interest rates.

As the sub-prime mortgage collapse should have reminded us and apparently did not, uncertainty is one of the most effective assassins that destroys markets of all kinds. When we can't predict what the price will be tomorrow for a commodity or security that we buy today, no prudent person will buy the investment. Instead, we flee to (apparent) safety in other uses of our money.

Prospects for serious and sustained economic recovery seem to me to be overshadowed by the risk of new and major economic dislocations during the coming year. Almost any serious slip-up in government economic policy could set off a stampede in equity markets that tramples a lot of small investors in its wake. Likewise, much of the liquid cash that seems to have gone into the present stock market bubble is expected to dry up. Our Government will no longer be able to stimulate our economy with “cash for clunkers” or “first time homeowner tax rebates” or jaw-boning about fictitious “shovel ready” projects for infrastructure. In this changed climate, how many of us are willing to bet on further increases in stock prices? Without sharply increased domestic employment in sustainable industrial production, a reasonable person would have to say that the trends are much more likely in the opposite direction: downward.

Apparently, a fair number of investors in gold, silver and commodities agree. After moving side-ways or a little downward in 2008, the price of gold has ramped up to historic highs in 2009. Whether it will move higher than the present $1,100 dollars per ounce, nobody can really predict. And this is true regardless of the ignorant pontifications of various “hard money” advocates and investment gurus who will be happy to send you their advice in Internet investor newsletters for a $100 dollar yearly fee. They're making a lot of money for their advice, but I often wonder if they actually follow it themselves.

Claims very similar to those of present prognosticators and so-called “technical” analysts were made by the gold bugs in 1980-81. Gold was expected to rise from $500 per ounce to $2,000 or higher. But it didn't happen 28 years ago. If it doesn't happen quite that way now, there might be a lot of poorer but wiser investors after their blood gets cleaned up from Main Street.

Whether or not gold and silver offer hope for preserving your wealth (if you have any), is a speculation. What seems to be much more than a speculation, however, is that economic fundamentals are unusually fragile as we begin the year 2010. The uncertainty that such conditions generate will not be good for investment markets or your 401K. The economy does not look good for any of us -- not even the relatively well-off or rich.

Unlike previous deep recessions, this time around the US largely lacks an industrial engine of recovery.  We have out-sourced millions of manufacturing jobs into cheap labor markets overseas.  Recovery certainly won't happen if we rely upon the Services sector to generate it.  Nor are so-called "Green" industries going to take the place of automobile production and residential construction.  Neither solar nor wind power can offer more than a marginal contribution to our energy future.  They can't generate enough energy per acre of ground footprint, to operate efficiently. Both will remain significantly more expensive than coal, oil, or gas. Corn-based ethanol alternatives to foreign oil in our gasoline have also already peaked and are falling off – though not before having driven food prices significantly higher in the process.  Thus, I doubt we will see a serious recovery for SEVERAL YEARS.

Meantime, efforts continue by China, to displace the US currency as the primary world Reserve currency and the currency in which all oil exports and imports are traded. Their intent is to replace dollars with a basket of their own and other currencies from economies that are growing at rates better than ours.  Combined with the excess of US currency being pumped into our economy, Chinese initiatives have contributed to an ongoing fall in the value of the dollar against foreign currencies, creating a near-term potential for sharp rises in US energy and food costs.  For the most part, these factors do not appear likely of being compensated by increased US exports, despite our relatively "cheap" dollar. 

In this economic climate, moving any large amount of your savings into US stocks is NUTS! This is not a time to bet the farm or go out on an economic limb, in expectation of a lot of new jobs being created very soon.

Thus, if your broker or financial adviser calls you with advice on stocks to buy, then maybe it's time for you to say something like this:

“No thanks. The Great Recession of 2008-2009 isn't over yet!”