Thursday, July 14, 2011

Reality Check 2011

(Barely) time for one more reality check.

The days of extend and pretend are dwindling, with the point of recognition near at hand.  Peak Debt and Peak Stupidity are reaching their apex at the exact same time, although I believe Peak Stupidity will reinflate itself rather quickly and soar to all new highs as the Idiocracy goes into Clockwork Orange meltdown mode.  As for Peak Debt, when that ends, it will mark the end of borrowing and lending for generations.

If you ask "when" I say who knows exactly, but tomorrow is as good a time as any.  Maybe we play charades for more weeks and months, but of this I am certain - 99.99% of people alive today will be overwhelmingly affected by what happens next.  So, unless you are someone who is 100 years old and on life support, then you are in the fallout zone.

So while the Idiocrats play parlour games with the debt ceiling, it's time to make an honest assessment of the magnitude of the economic crater that is about to be created.  

To be sure, this is no game, the vast majority of Americans (and Westerners in general), will lose their job, their house and their retirement savings all at the same time.  

My central thesis has been, and continues to be that the economy is only now supported by overwhelmingly MASSIVE and unprecedented doses of Fiscal and Monetary policy.  Moreover, both these policies are running out of jet fuel and are now running on fumes, which means the spaceship U.S. economy is about to fall back to earth.  

On the monetary side, monetary policy is still being applied at near full throttle with interest rates at 0%, however there are already abundant signs that it is losing momentum i.e. the latest unemployment report, bank lending reports etc.  We have reached the quintessential definition of a liquidity trap in which no one is willing to lend and no one is willing to borrow.  Who would have thought that following two years of injecting almost $3 trillion of new money into the economy via two rounds of quantitative easing, that inflation would be contained?  Back in the 1970s we had inflation rates in the teens at a time when Fed interest rates were much higher (less stimulatory) than they are now (at 0%), and Quantitative Easing was never even suggested, much less attempted.  There was no $3 trillion of new money back then.  So any thought that monetary policy is moving the needle anymore is sheer bullshit.  The Fed is boxed in and can no longer encourage borrowing to solve a debt problem.

Fiscal policy meanwhile has gone totally parabolic in the past few years to $1.6m, now comprising 10% of the entire U.S. economy.  It has reached ludicrous proportions that were unthinkable 8 years ago, let alone 30 years ago when the deficit first became an issue.  For a glimpse into the U.S. future, cast an eye to Europe as multiple sovereigns teeter on the precipice and interest rates ratchet ever higher.  No one today honestly believes that the U.S. will be saved from the same default/bankruptcy fate, yet few ponder the magnitude of the economic impact from such an event.  10% of the fucking economy !  Gone, overnight.

Life after heroin
Herein I attempt to quantify the economic impact that will result as a result of both fiscal and monetary policy failing over the course of the next few months, years:

First the baseline and assumptions - the official unemployment rate is 9.2%, while the unofficial rate is 16%, so to be conservative, I will use 10% as a baseline.  I will also assume that each 1% drop in GDP, translates into roughly 1% drop in employment which is more or less consistent with past recessions, if not slightly conservative.  

First take out the deficit which as indicated above equals 10% of the economy.  

Now on the monetary side, imagine a run on the banks and resultant liquidity crisis culminating in a "cash only" economy in which all payments are made in cash.  Credit is the lifeblood of the economy, so imagine a situation where businesses can no longer borrow to expand.  Where consumers can't/won't borrow to buy a car, a fridge a house.  How much will that take out of GDP?  I will say very conservatively for the sake of argument, 10%, although it is likely much higher.

Now increase the savings rate, because the first thing consumers do is retrench and stop spending.  Conservatively, that could take another 5% out of the economy.

All told, that equals a 25% reduction in GDP, assuming a 1:1 economic multiplier i.e. no downstream ripple effects.  Generally when a $1 of income is added or subtracted exogenously to an economy, there is a multiplier effect as that dollar gets spent and then the receiver of the dollar spends it again etc.  

So, under the above relatively conservative scenario, GDP is reduced by at least 25%, leading to a total unemployment of (10+25) = 35%, which definitely gets us to the no job, no house, no retirement scenario for the vast majority.  Don't worry about Social Security and Medicare, they will be obliterated.  This is No Country for Old Men.

Not a Game
My point in doing this exercise was not to scare the hell out of everyone, although I am sure I did.  The point is that this is not a game.  The consequences of this current economic fiasco will be devastating to the majority of us, in our lifetimes.   Clearly the goal is to survive, not to thrive.  This blog is not intended to show the way to undiminished riches while we watch neighbour chilren eating out of our garbage cans, as we stand in the comfort of our well guarded castles.  There are plenty of blogs around telling us how to mint coin while everyone else is going bankrupt, however, I question the veracity of their claims let alone their motives.  

And the goal here is not to plan out the next 30 years, but to literally survive the next 5 years, because for most that will be the critical make or break period of time.  Those wiped out early will not "survive" economically to get to the other side of this fiasco where one could arguably begin to prosper again.  The economic consequences and fallout - health, family etc. will be far too devastating.

Survival Strategies (Invest at your own risk)

There are no guaranteed safe assets at this juncture.  I have written in detail about my preference for U.S. Treasuries, so I won't elaborate here, but suffice to say that during the deflationary phase, I still believe Treasuries to be the safest investment.  I am not advocating a buy and hold approach to any asset class, so while Treasuries may work for a while (months? years?) at some point they will fail catastrophically.  For those, who say my above default thesis is inconsistent with holding Treasuries, I say it's about a question of timing and surely making the wrong move at the wrong time could be fatal.

Holding plain hard cash is a good option, but is not viable in large quantities or to protect retirement assets and it's risky from a storage standpoint.    Some amount though makes sense.

For those who want to hedge against the stock market, one must consider counter-party risk; however, a long term put option against the stock market or ETF (e.g. QQQ) can be a good way to hedge large amounts of assets.  The counter-party risk of an option is the options clearinghouse (e.g. CME), not the moron who sold you the put option.  Just hope that the CME  does not go bust.  You also need a brokerage account to trade options.

A way to hedge 401k retirement accounts is to use inverse ETFs (QID, BGZ etc.), although these reset constantly, so in back and forth volatile markets, over long periods of time you can actually lose money, even while being directionally correct.  This phenomenon is called beta slippage.

A very good strategy for maintaining short exposure is to use leveraged ETFs in tandem e.g. 60% long QID (ultra short) and 40% long QLD (ultra long), this gives you 20% net double short exposure.  The advantage v.s. owning 20% QID and 80% cash, is that the 60:40 strategy has convexity around the buy price meaning that gains compound positively while losses compound negatively.  This is a fancy way of saying you can make a lot and only lose very little.  With this strategy, you should rebalance 60:40 after big moves, otherwise you will give up much of your gains on retracements.

Same thing for buying a put option - when you are in the money, you need to sell, as bear market rallies can erase gains very quickly leaving options worthless.

As for gold, always some is advisable.  The easiest way to play is buying GLD or one of the other gold  ETFs.  

Don't forget a multi week supply of food, as there could come a time when store shelves are empty and the supply chain breaks down; although I believe shortages will be intermittent.

Good luck, we all need it.