Investors tend not to look at, or understand the implications of long term trends and their impact. Instead they focus on what is happening right now. Last Tuesday’s (June 14) stock market rally of over 100 points had many investors feeling like the market was doing well, a great place to invest, and was heading higher.
What they failed to realise was that last Tuesday’s advance was just a rally within a longer term decline, which had started at the beginning of May and so far has declined about 7%. It was nothing more than another indication of the market’s volatility and an example of how a bear market can suck investors in. June 17th’s decline of almost 200 points (as of this writing) shows how quickly those advances can disappear.
At Cornerstone, we focus on the long term trends and understand that most short term moves are just normal volatility within a trend. Short term moves can be months long though. They can be violent and cause investors to question their strategy. That is, those investors that don’t understand the long term trends.
Like it or not, these two charts – The Federal Budget Deficit and the Federal Debt to GDP Ratio – are the two most important long term charts investors need to be aware of. They will impact just about everything going forward.
If you are wondering why you never had to consider this information before, it is because the potential economic risks have never been this bad before. If you are wondering how important these charts are, just consider that the Federal Debt to GDP Ratio is similar to, if not worse than, some of the countries in Europe that are going through major social and economic upheavals due to their fiscal problems. Today, 2 year Greek bonds hit 27% yield. That is very bad.
The solution to these issues is not painless. To reduce the deficit, Federal Spending has to be cut and taxes have to go up. This could have a very bad impact on the economy.
Think about this – The Great Recession in 2009 was a decrease in GDP of about $400 billion. How do you take $10 trillion out of the GDP over the next 10 years, without it impacting the economy very negatively? (The CBO estimates that Federal Budget Deficits will average $1 trillion per year for the next 10 years.)
So the balancing act for the Federal Government is to somehow keep the economy moving forward, while cutting hundreds of billions in Federal Spending and somehow spark the economy while piling on hundreds of billions in new taxes.
If the economy slips into recession again, the Debt to GDP Ratio will go even higher, making the US look even more like Europe.
The impact on stocks is obvious, it won’t be good for a long time.
We believe the Federal Reserve will continue on a path of debasing the Dollar and encouraging inflation. This will have obvious ramifications for bonds. Again, it will be bad, for a long time.
On the plus side, hard assets should benefit from the Fed’s Dollar policy and fostering inflation.
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