Tuesday, November 2, 2010

The Elections and the Coming of Spring

Most of Wall St. is focused on the Fed decision tomorrow. I think the election today has far more ramifications for the market than more QE which will distort asset prices but do little for the economy. Since February I have said, and written several times in various blog posts, that a huge Republican tea party led win would be extremely bearish for the markets and the economy. It seems we will get a chance to see if my thesis is indeed true. The economy at this point is a sham. The only thing propping it up is government spending and government transfers to the private sector. This is completely unsustainable but to keep the economy propped up and growing, not only do you need to maintain it but you need to grow it!!! Using play numbers but if the economy is $20 and the government spent $2 dollars the government is 10% of the economy. Next year the government spends $4 (a 100% increase) and assuming the rest of the economy stays the same causes the economy to grow 10%. (2 increase / 20) Of course that growth is very low quality growth and now the government is 18% of the economy. Well the next year all things equal (again assuming no private sector growth) the government has to spend $4 dollars just to maintain what it did previously. To have the same percentage impact as the year before the government needs to spend $6.20. (economy was $22, the government made up $4 and to get the same 10% increase needs to spend $2.20 on top of the $4 so needs to spend $6.20) Now of course that isn't all true as some of the spending may increase productivity or generate its own future growth (though most of government spending is waste) but the point is mathematically without strong productive private sector growth it becomes mathematically difficult for the government to continue to have the same impact. Add now a massive Republican win and the feel for a need of a balance budget, resisting stimulus measures, state and local budget cuts, and you are potentially looking at a massive black hole economically.

The markets are used to gridlock being good for the markets. It hasn't been gridlock that saved the economy or the market over the last several years. In fact it has been cohesion that Keynesianism is the right way to go. Think back to the fall of 2008 with the huge TARP senate bill that failed to get past. It was on all the tv networks and as soon as it failed the market plummeted. It was right before the election and many senators, especially Republicans, quickly switched their votes a couple of days later. That was gridlock and that started a collapse that was reversed. This time I don't think there would be any switch of votes to save banks and the more Tea partiers that win would ensure that. What has caused this massive market rally and extremely tepid economic recovery is massive government spending that was possible because and only because you had cohesive government to jam whatever had to be jammed through. Create gridlock and there is no more that can be jammed through.

There is an entire other aspect to this that Wall St. isn't looking at. Oversight of the Fed. Currently Ron Paul is the ranking minority member of the Domestic Monetary Policy and Technology subcommittee in Congress. What does that mean? Well he is line to take over the subcommittee chair. So what? Well that subcommittee is directly in charge of overseeing the Fed!!! So the individual who would like the Fed abolished will be overseeing it? Sounds like a friendly subcommittee. Of course Ron Paul won't be able to have the type of power to abolish the Fed but he will have the power to push certain legislation. His audit the Fed bill got gutted at the subcommittee level. Wall St. isn't talking about this at all but it seems to me to be HUGE!!!! It isn't a lock that Ron Paul will get that position. It used to be that the heads of subcommittees went directly based on seniority. Today that is still normally the case but you need to be favored by party leadership. That historically hasn't been the case for Ron Paul as he was looked as an individual with crazy views but Ron Paul's status has climbed in the last several years as he is associated with the tea party movement and is now seen as right on many topics he was previously ostracized for. This was John Taylor's take on the situation in his latest letter (Taylor is head of FX concepts - one of the largest currency trading shops in the world).

...After the Republican victory things will change. The Fed will be hamstrung, as Ron Paul, a conservative standard-bearer and harsh critic of the Fed, will head the sub-committee overseeing its actions. Liquidity expansion or new programs will probably drop sharply under his watch. Paul would argue that the Fed’s unfettered ability to “debase” the currency is about to come to an end.

This is potentially a landmark shift.

How will all this affect the markets. Well right now the markets are celebrating the idea of a split government. I don't think the markets realize how things will change. It is the absolute inverse of November 2008. Remember then the markets made a new low in March of 2009 after the elections as the markets (and me) failed to realize the implications of Obama and the democrats taking charge and the willingness to do whatever it took to get asset prices up. Even if it meant ponzism. The Democrats partnered with the Fed in an evil alliance to push asset prices and the economy up no matter what the long term costs. As a result of this faulty idea that gridlock is now good, the markets may have another day or several months of moving up on a Republican win (I personally think it will be a very short rally) but I think it will not take terribly long for the markets to realize that gridlock and a competing sheriff in town is not economic or ponzi friendly. In fact it is downright unfriendly. To keep growth going the government is going to have to continue to increase its overall spending. Right now that is not the way 2011 is materializing as state and local budget cuts take hold before the Republicans take over. Maybe the Republicans will again not act like Republicans after this election and take the free spending way of former President Bush but the influx of the tea partiers and the feel of 1994 when a Newt Gingrich conservatism swept the halls of Washington will probably keep the resistance up to the way it has been done.

This is also extremely dollar bullish as the Republicans will not be most likely making an alliance with the Fed who is hell bent on destroying the dollar. Ron Paul is as passionate about hard money as anyone around and his influence will grow as well as being joined by people who think like him.

A major shift is upon the markets. The Republicans will try to do the right thing. Unfortunately, I think currently the situation is unfixable. There were multiple chances to fixes over the last 10 years but the opportunity passed as the idea to hide it through banning short selling or changing mark to market accounting played into the current sham. On the outside chance it is fixable it means massive pain in the interim. The best analogy I can think of is some major disease. The doctor tells you that you need surgery but your chances of surviving surgery is about 10%. (If you would have surgery 3 years ago there was a 80% chance of surviving) If you don't have surgery you will live two years. That is all the time if you have left. If you do have surgery you will live for 30 more years. The democrats and the Fed are taking the route of living the year. The Republicans seem like they would prefer to take the chance of the surgery.

As John Burbank of Passport Capital said at the Value Investing Congress a few weeks ago, the United States now has to be looked at as an emerging market. No longer are the economic prospects as important as the political landscape. Washington matters much more than Wall St.

This election may just awaken the bears from a winter hibernation. For the bears, a Republican landslide may just be their spring as they stumble out of their dens from a long winter more grumpy than ever.

This has been my thesis for almost a year and it will be interesting to see if it plays out. One thing is certain. If I am right it proves yet one more time that the market really isn't a discounting mechanism at all. Just a drunk sailor where prices really carry no informational value. A far cry from what capitalism in the United States used to be.


Anonymous said...

It seems likely that the "Bush Tax Cuts", at least for the higher income levels will expire. Estimates for the drag on GDP are at least a percent.

Moreover there was the crazy story today about the Social Security Administration miscalculating average income levels for 2009 because two people used fake w2s to skew the results. Amazingly, it looked like the correction lowered average income by 1%. I have seen no discussion yet on whether the incorrect estimates fed into tax projections.

A percent here and a percent there and eventually you have a recession.

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