Financial Literacy

The Dow Jones Industrial Average and S&P 500 have both made new price highs. Hurray, we’re saved! The “wealth effect” will increase consumer confidence, people will start spending money and the economy will improve.

But if you look at a price chart that has been adjusted for inflation, courtesy of AdvisorPerspectives.com, you’ll notice that all of the 3 major stock indexes are still below their price high of 2000 and 2007. Now this isn’t actual inflation but the government issued CPI, true inflation is of course higher.

What does this mean? It means that the strength of the U.S. stock market is fake. It is a mirage created by U.S. Federal Reserve’s actions to make the U.S. dollar worth less through inflation or money printing. Since inflation is eroding the value of the currency, the prices of assets and investments are getting more expensive. The price of a share of stock, a barrel of oil, a home, or anything else is becoming more expensive when priced in a currency that is losing value, the U.S. dollar.

For you to financially tread water, your income and assets must first overcome inflation. For example, if inflation is 3% per year and your salary raise was only 2% then you’ve lost 1% in purchasing power. So even though you received a 2% raise in nominal terms, you are 1% poorer in inflation-adjusted terms. Understanding the compounding effect of inflation is an important element in your financial literacy.

First, a relevant quote from Thomas Sowell,

“When I used to teach, I would ask the class to imagine a government agency with only two tasks:
1) Build statues of Benedict Arnold.
2) Provide medications to children.

If this agency’s budget were cut, what would it do? Of course, cut the children’s medications because that is far more likely to prompt the public to get the budgets restored. If they cut back on Benedict Arnold statues, people might actually ask why they were building them in the first place.”

Example #1:
This week, the Michigan governor was told he had zero chance of increasing the gasoline tax by 17 cents to pay for road repairs and construction. He then asked the Michigan legislature to come up with a solution and they did: “Strip away all the money collected from the current gas tax that goes to education and use it on roads, then we will have a voter referendum in the fall to raise the state sales tax by 1% and we’ll say it is for education so people will vote for it.”

Example 2:
To create public alarm over the sequester budget cuts…

• The Dept. of Homeland Security prematurely released +300 convicted illegal aliens from prison
• The FAA claimed it would cut back controllers and increase flight delays
• White House tours were cancelled (saving $74,000) but million-dollar monthly vacations by the first family and vice-presidential family will continue; along with oil paint-portraits of White House administrators totaling hundreds of thousands.

In order to allow the president to make careful budget cuts where he wanted, the house of representatives offered a bill to give him that flexibility. But the president said he would veto that bill because then he would be to blame for cuts.

Sequester Perspective:
The sequester cuts are only a tiny reduction in the growth in government spending, a total of $44 billion this year. To put this in perspective, the ratings agency, Fitch said that the U.S. would have to cut $1.6 trillion to avoid further credit downgrades and another $3 trillion if the U.S. were going to start reducing the debt. Basically, the sequester is less than 1% of what is necessary to get on stable footing. If you include the $123 trillion in unfunded U.S. liabilities, the sequester is only 0.04% of a cut.

To equate this to a family’s finances, if your income were $80,000 and you had an unsustainable amount of $350,000 in credit card debt, the sequester that politicians are crying about would be like letting your credit card balances increase further in 10 years to only $405,000 instead of only $410,000. Only a politician could call that a “cut” in spending and be baffled over why their credit rating is falling!

The U.S. Federal Reserve bought junk debts from banks to bail them out and then to print money.

Bernanke says we shouldn’t worry about inflation because he can turn around the money printing in 15 minutes by selling all of the bonds he has to stop any increasing inflation.

Interesting fantasy – who is going to buy trillions of junk bonds?

The true price discovery of these impaired bonds may be near zero and so no money would be going back to the Federal Reserve so there would be no brakes on increasing inflation.

But the bonds that were bought are NOT the same bonds that would be sold – interest rates change and the expiration date is closer. Plus, the bonds that have ALREADY expired must be re-created to keep the debt level of the Federal Reserve at the same place.

As Max Kaiser says so eloquently about the Fed’s fantasy about of exiting all the debt in 15 minutes, “Just because you can eat a porcupine whole does not mean you can pull it out – the quills are now facing the wrong way.”

What keeps happening over & over?

Government spends more than it can afford.
It kills the economy.
Government refuses to cut back on spending.
It prints money to kick start jobs and cheapen the currency to payoff the debt.
Printing money doesn’t create any jobs so more & more printing is done.
Eventually the currency collapses from devaluation or hyperinflation.

When many governments are doing this at the same, the money printing kicks off a currency war. Each country needs exports to lower the unemployment so it deliberately weakens its currency to make its products cheaper. In response, other countries weaken their currency to get exports and eventually the currency war turns into a trade war with tariffs and limitations on capital and trade. Ultimately, resulting in an economy collapse where the economy can finally start anew in a sustainable manner.

This scenario has played out countless times over the last few hundred years.

Where are we today?

• Governments around the world are overspending.
• “Austerity” is defined by politicians as a speck of a reduction in the growth of         government spending.
• Governments around the world are printing money.
• Economies are weak and unemployment is high so money printing keeps            increasing.

Some details?
Japan announced in December that they were going to sharply drive their currency down to increase exports.
The Yen has fallen 15% against the dollar and even more against the Euro.
Then S. Korea weakened their currency, then Taiwan weakened their currency, Britain devalued by 25% in 2008, but since it didn’t help their economy, they are expected to devalue again soon.

It is less than a zero-sum game: mis-allocation of resources from politicians leaves us all much worse off. How? A giant problem is large global companies with expensive plants setup in countries based on raw materials, gov’t policies, and relative currency values get whip-sawed in these currency wars and trade wars. Bill Gates recently said that Microsoft is hoarding cash and cannot grow because of the currency war.

British bonds are at a 300-year high.
U.S. government bonds are at a 240-year high.

How to profit when these bubbles finally burst?

Here are a couple candidates for you to consider:

Short British gilts = ticker symbol “XUGS”
Short U.S. Bonds = ticker symbol “TBT”

It could happen in 5 months or 5 years, but sooner or later the bubble will burst and bond prices will have a long way to fall.