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Thursday, 17 September 2009

The two reasons it’s time to short U.S. stocks

By Martin Hutchinson, MoneyMorning

The stock market is up 51% from its March 9 lows. The leading economic indicators have turned sharply positive, showing gains for each of the last four months. Manufacturing is on the rebound. And banks are promising to pay record bonuses, as their earnings have rebounded.

With this recent rush of upbeat economic news, it’s no wonder commentators are trumpeting the rebound of the U.S. economy.

But I think it’s time to short U.S. stocks.

Shocked?

Don’t be.

What most experts see as a strengthening U.S. rebound, I see as an increasingly dangerous false dawn for these two key reasons:


An overly expansive monetary policy that’s almost certain to spawn inflation.
And a record-level budget deficit that will cause interest rates to spike, crimping economic growth.
A Foundation for Trouble

U.S. policies that were intended to combat the financial crisis that broke last year, as well as the recession that’s been plaguing us since December 2007, have actually inflicted a lot of weakness upon our economic system.

For instance, the federal government has made $11.6 trillion in financing commitments, many of which will saddle us with debt for generations, some of it forever. Outlays of that magnitude in a $14 trillion economy are bound to have lasting implications: Think of the consumer who has a series of maxxed-out credit cards - he’ll make the minimum payments, but the actual balance will never get paid down.

And the foundation for this financial fiasco was actually constructed several years ago.

After the bursting of the 1996-2000 dot-com bubble, the U.S. Federal Reserve re-inflated the money supply. That caused stocks to resume their upward march, and as we now know, also inflated a housing bubble of such enormous size that it caused a general financial-system crash when that real estate bubble burst in 2007-08.

This time around, the Fed has been even more expansive. The benchmark Federal Funds Rate was 1.0% in 2002-04. This time it is 0.25%. What’s more, this time around we’ve had a $2 trillion expansion of the Fed balance sheet, a doubling of the monetary base and $300 billion worth of direct central bank purchases of government debt. Given this orgy of Fed expansionism, it’s likely that the onset of inflation, whether it’s in consumer prices or asset prices, will be correspondingly worse. In fact, we’re already seeing that gold prices are once again making a run at their all-time high. And crude oil hovers at about $70 per barrel, a level that would have been unimaginable before 2004.

Now that he’s been nominated for reappointment, U.S. Federal Reserve Chairman Ben S. Bernanke says he will tighten monetary policy in good time. But why should we believe him? If he tries to tighten significantly, he will incur the wrath of the Obama administration and the Democrats in Congress.

Even back during the 2001-04 time frame, when there was an administration in place that claimed to believe in monetary stringency, the Fed didn’t tighten. Bernanke himself was among the most aggressive opponents of tightening. Back in 2002, in fact, when inflation was running at a perfectly respectable 2%, Bernanke actually spun myths about the imminent onset of deflation.

Given what we know, it seems that if the current economic bounce shows even the slightest signs of faltering, Bernanke won’t tighten; he’ll pump even more money into the U.S. financial system. Rest assured that the administration, Congress, and much of the media will be cheering his move.

Borrow Now, Hurt Later

If an overly expansive monetary policy was the only problem we faced, it might not be so bad. Unfortunately, there’s more.

Lots more.

Unlike in 2002 , in fact, unlike any other time in U.S. history, this country now has a budget deficit in excess of 10% of gross domestic product (GDP). For fiscal 2009, that was forgivable: We’ve had a major recession, and a shattering financial crisis, which the federal government has tried to battle with aggressive bailout programs.

Here’s the problem, however: The projected deficit remains above 10% of GDP for fiscal 2010, even though no additional bailouts are contemplated and the Obama administration is projecting a modest-but-steady economic recovery.

The result is harder to predict: this country hasn’t travelled down this particular path before. This strategy bears some resemblance to the position Japan found itself in during its so-called "Lost Decade" of the 1990s. But even Japan’s deficit never reached this 10% threshold.

In Japan, the effect seems to have been the gradual abandonment of small business finance, and the resulting starvation of the most critical factor in economic growth: entrepreneurship.

The small-business sector creates most of the new jobs in the U.S. economy. But in a challenging environment, it’s easy to see why this sector gets overlooked. Without political connections or large contracts to hand out, the small-business sector ends up being last in line in the financing queue when the economy faces strong headwinds. Why should banks or other people lend to small businesses when the U.S. government bond market stands as such as huge, safe parking place for their cash?

Interest rates will also become an issue. With the inflationary pressures we expect to see from the overly expansive monetary policy we’ve described, long-term interest rates are likely going to rise anyway. As was the case in Japan’s decade-long malaise, these forces will combine to spark high default rates in the banking system, low or zero economic growth, and a general downward trend in the stock market.

All of this will make it tough for small businesses to obtain the cash they need to grow, meaning this key job-creation engine will have to sputter along.

It’s still early in the game, and there are many factors to consider, so the future economic picture remains a bit murky right now. But my guess is that the bubble in asset prices will be largely confined to commodities, that economic growth after this current initial burst will relapse, and that U.S. stocks will prove to be the same generally unattractive investment that they were in 1970s, the era of the so-called "Nifty Fifty." If the stock market bubble gets even more exuberant from here, the relapse will be correspondingly more painful.

Profitable Pockets

Despite this dour backdrop, three things are worth remembering:


First, all U.S. stocks are not created equal. Although I’m saying it’s time to short U.S. stocks, and I see tough times ahead for the key indices, there will always be individual stocks worth consideration, such as the "Alpha Bulldog" stocks I highlight in the Permanent Wealth Investor service.

Second, the best way to play this looming downdraft, either as a direct profit opportunity or as a way of hedging your current portfolio, is through the use of what I like to call Stage 3 investments. An example of one such investment is long-dated put options on the Standard & Poor’s 500 Index, which trade on the Chicago Board Options Exchange. If you buy these options when they are way out of the money with a strike price far below the current price, in a real bear market (like that of 2007-09), you will see them really zoom up in value as the S&P drops down closer to the strike price, or possibly even falls below it.

And third, understand that my pessimism about the U.S. market doesn’t apply to every other market around the world. While the monetary problems are more or less global, the budget-deficit problems are not. For instance, you might want to consider investments in Japan, where a recent election should spawn the kind of economic changes that will benefit savvy investors. Germany, too, looks to have avoided the contagion of stimulitus, which is why its economy is now viewed as one of the healthiest in Europe. Consider the iShares exchange-traded fund (ETF) entry for each of those two markets: The iShares MSCI Japan Index Fund (NYSE: EWJ) and the iShares MSCI Germany Index Fund (NYSE: EWG). They each warrant a look.

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