Wednesday, December 15, 2010

2011- The year reality hits Government

2011- The year reality hits Government

The November election fostered a wake up call to Washington. The markets which already had been rallying from the QE2 announcement in August have continued to climb to the current DOW 11,457. I’ve been wrong about the strength of the current rally. It seems all that QE2 has added fuel to stocks while doing the opposite to bonds. The 10 year bond was trading around 2.50% when QE2 was announced but has since fell to 3.52%. What would have happen if the FED wasn’t buying billions of dollars of bonds everyday?

There have been a few positives as the dollar has gotten stronger and it looks like tax rates will remain the same for the next 2 years. However in the passage of the bill they loaded it with billions of giveaways. On the negative side our budget deficit is increasing and interest rates are moving higher on that debt. States like Illinois are likely to default. Our government has successfully managed to sell out of some banks and GM but Fannie and Freddie remain dark clouds. The attitude of no one can fail as the government will bail you out hopefully end as the good government investments get repaid while the remaining ones struggle to pay or default causing a wave of negativism toward government bailouts.

What remain big concerns going forward into the coming years include-

1. Banks still marking to model
2. Special tax breaks
A. McDonalds doesn’t have to pay for the new health care plan. (Along with 100 others)
B. GM getting a 50 billion tax break from Congress (being able to use bankruptcy tax losses)
C. Giving Ford a 12 billion tax break after giving GM a break.
3. Foreclosures being delayed with “Extend and Pretend”
4. States defaulting
5. Congress keeps spending while the FED keeps printing money.
6. Weak Housing as high real estate taxes pressures any appreciation.
7. Over confident that FED will bail out any market sell off.

The day of reckoning of the government gone spending crazy is approaching in the next few years. The only difference between our budget shortfalls and Greece, Spain, Ireland is that we can print money. Our fiscal responsibility concerning the deficit of 13 trillion and counting is all talk. Congressmen blame it on the other side and claim they want to lower the deficits but their actions sharply differ from reality. When Senator Mitch McConnell came out and stated that his goal was to make sure President Obama has only one term this statement shows how Congressman really think about solving any problems like the deficit in the next few years. Hopefully all these bums get voted out during the next few elections. As long as the attitude in Washington remains in spend mode our country remains on the cusp of disaster.

The Fed’s liquefying the system has created “free money “for many companies. Companies that couldn’t raise a dime 2 years ago now raise millions with ease. The corporate bond offerings are at records. What will happen in 3-5 years when they have to payoff the bondholders? We have seen a 3 standard deviation move in the 10 yr. bond even with the government’s QE2. What will happen if 10 yr. rates move above 4.5%? This bond market crash would devastate not only bond holders but our government debt interest payments will surge killing off the current recovery. Corporate bonds would also get hit but big multi-nationals would be the safe haven away from government bonds and will out perform in the upcoming years.

As for the stock market DOW 11,550 -11.632 and SPX 1247-1260 are lines in the sand for changing my bearish stance. The above levels need to be breached for 3 days for me to change to a bull. The downside is ugly with a minimum 10% drop (more likely 30-40%) likely during the first half of 2011. The risk to the downside is scary more so now than in 2008. All the programs that our government has pursued like “cash for clunkers”, tax credits for buying a house or a refrigerator have done nothing but postponed the upcoming washout.

What will trigger the collapse? How about some of the scenarios taken below as loading the gun –

1. Bonds rates surge as our government cost of funding the deficit spins out of control
2. Current bullishness as measured by market sentiment is at 2007 levels
3. The US dollar drops 10-20% over a 2-3 month period.
4. European countries default.
5. China’s slowdown accelerates as property values fall (also in Hong Kong)
6. Banks need to mark to market
7. Massive foreclosures hit the market sending down prices.
8. Cities and states default
9. Congress fails to reach a long term budget that reduces the deficit in a meaningful way.
10. Interest rates for housing go to 6%
11. Riots in the street like in Europe spread worldwide.

Bottom line is one should keep close stops as a “mini crash” 8-12% in one day is possible. Also markets don’t crash at the highs rather a crash could occur after a pullback of 5-10%. The panic won’t happen until the DOW breaks 9850. The “extend and pretend “pattern is about to run into reality in 2011.

On a funny note it amazes me how stupid the government can look. The treasury made over 1 billion of the 100 dollar bill until they realized the error which can easily be seen. Excuse me but 1 billion NOT just a couple hundred bills until this flaw was realized? This error cost over 120 million. I’m sorry but you add the postal system, Amtrak, Fannie and Freddie to the equation you end up with one costly messed up system and that’s not even considering all the pensions problems. The economy needs a cleansing of the current system even if it does mean a double dip. It could take a few years to evolve and run the course but for the long run it would be a winner. The government’s “ponzi scheme” is about to be discovered by the average investor. Extreme caution is warranted. Stay in cash and short-term investments. The housing drop is in the latter innings but still has 15-30% to fall. Gold is due for some pullback and higher interest rates will cause a sharp pullback in gold to the $1150 area. Other commodities are also expected to correct from their recent surge. China’s cost of $5.50 for a gallon of milk on a $350 month salary adds up to rioting in the street. Believe it or not China’s stock market is down over 10% this year and over 25% from it peak while our market is up 10%. Something doesn’t add up here.