Government Bubble Targeted with S&P Outlook

Jason Kaspar — Tue, 19 Apr 2011 20:16:00 GMT

Washington has been placed on notice that it’s reckless spending and unfathomable fiscal debt is not immune to the censure of Wall Street.

To recap, Standard and Poor’s issued a press release yesterday announcing that it had cut the United States outlook: “The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years."

The markets reacted violently. Europe quickly dropped an additional percent, the Dow Jones Industrial Average opened down over one hundred points, and the gold price took off again, continuing its assault on $1,500 (reaching an all-time high of $1,498.60). Asset prices were extremely volatile during the first hour of trading, with currencies and commodity prices getting whipsawed.

On the one hand, the news doesn’t particularly matter; on the other, it is the only market news that matters.

The typical reaction from pundits was one of confusion: "The whole thing makes no sense to me," said Aaron Gurwitz, chief investment officer at Barclays Wealth in New York. "I can't tell a consistent story that explains all of these facts. My working hypothesis is this whole thing is ephemeral—people were looking for a reason to sell stocks today."

On the surface, I tend to agree with Mr. Gurwitz. The “press release” was really a non-event, especially considering the recent stream of legitimate “black swan” events (i.e. Japan’s tsunami) to which the markets have been largely impervious, even downright bullish. It is no secret that America’s financial situation has been deteriorating, or that Helicopter Ben has been experimenting more like Miley Cyrus than a conservative risk-averse central banker. Do investors really need a rating agency – an agency that has lost much of its credibility over the last several years - to inform them that America “may” be in a dire financial situation “within two years”? Hardly. The markets seemed predisposed to a sell off, and it was used as an excuse for many investors to pull the bid from the market.

However, on a philosophical level, it was a public relations blow to Washington and its fiscal irresponsibility, as well as an overt warning to all about the nation’s current debt crisis. The government’s initiative to transfer risk from the private sector to the public sector has created an all-encompassing bubble. I refer to this new bubble as the government bubble, the last of all major market bubbles. The overvaluation in asset prices is essentially a mispricing of risk. Like the equity bubble and the private debt bubble preceding the current government debt crisis, risk has been mispriced because of the Pavlovian response that government debt carries no risk. This response distorts the price of every other asset.

Practically, the government bubble implies that government agencies will continue to expand to the inevitable point that the country can no longer afford the federalization of the private sector and the socialization of risk. The S&P downgrade portends this fatal scenario and alerts investors to the mispricing of equities.

Since World War II, debt issued by the United States has been consider the triple-A above all triple-As. Wall St. uses US government debt yields as the “risk-free rate” for their valuation models when pricing assets. Even an otherwise “simple” mention that the outlook has been downgraded is a warning to investors about the potential for erroneous underlying assumptions.

While the S&P’s press release was in reality a non-event, its implication is highly relevant. The government is the last entity supporting everything below it. When the government bubble inevitably pops, the mispricing of risk will have a profound impact on asset prices regardless where these assets are in the capital structure.

Can Dollar Weakness Mean Equity Weakness?

Jason Kaspar — Fri, 15 Apr 2011 17:52:00 GMT

Are there any dollar bulls left? Inflationists across the web are crying ‘victory’ as the dollar sinks and certain asset prices (especially oil prices, food prices, and the gold price) mushroom higher. To the level headed, you should exercise extreme caution against assumed fixed correlations like “weak dollar” means “asset price increases.” Correlations can quickly change.

A mentor of mine consistently preaches that the market will always do whatever it can to make the most investors look foolish. Contrary to conventional wisdom, there is a case that investors should at least consider: that an accelerating decline in the dollar could turn asset prices negative, at least in the short term.

The 1987 crash is an appropriate case study. The cause of that October market crash, when the S&P 500 lost 20.5% in a single day, has never been thoroughly explained. No major event could be credited as the catalyst for such a monstrous and rapid decline.

Portfolio insurance, rapidly rising long term US interest rates, a series of preceding market declines during the week leading up to the crash, and a weakening US dollar are all mentioned as possible triggers. In truth, it was likely a confluence of these and other factors that ultimately pushed the market to a tipping point.

One macro factor stands out among the rest: the rapidly weakening US dollar leading up to Black Monday.

Beginning in late July of 1987, the dollar, after already falling to a seven year low just a few months prior, began a steep decline. A much wider trade deficit than expected was thought to have accelerated the dollar’s descent.

US Dollar: 1987

Over the long term, all things being equal, it is logically sound to conclude that a weakening dollar must cause assets priced in dollars to rise. However, in the short term, markets are not always logical and can anticipate the next move by world bankers. In 1987, the U.S. dollar lost 10% in roughly three months. During the same time span, the equity markets lost close to 30%. Such a move contradicts today’s accepted wisdom.

Though the Federal Reserve has approached its dollar policy with the same restraint as Charlie Sheen at Happy Hour, we should avoid approaching every scenario with broad generalizations, regardless of one’s long term view on the dollar. In the financial markets, nothing goes in a straight line, and correlations tend to break down if certain asset classes move too violently.

US Dollar: Last Twelve Months

While the last twelve months have been unfavorable for the dollar, and while assets have benefited from the Federal Reserve’s currency abuse, correlations do seem to be diverging. Over the past year, the dollar is down roughly 8% and the S&P is up about 9%. But the market has begun reacting more coolly towards a weakening dollar as oil prices have accelerated higher. In fact, in the past two months, the dollar is down 4.25%, and the S&P 500 is down 1%. In the last two weeks, the dollar is down 1.45% and the S&P 500 is down about 1.1%. These moves are in stark contrast to the performance of the past year, so the trend is clearly weakening.

I might worry that if the dollar begins a sharp move downward, the Fed may be forced to approach dollar policy with greater restraint, which could instigate a strong market reaction.

I am fairly agnostic on the dollar’s next move, and I am unsure how that next move will correlate with asset prices. Furthermore, I do not intend to predict an imminent market crash. I simply revisit this history lesson to emphasize a few broader points:

Long term correlations do not necessarily equate to the same correlation in the short term.
In the short term, crashing asset prices can - and often have - occurred alongside a crashing currency. (This occurred in Europe last year.)
Investor sentiment against the dollar is heavily skewed, which should make market observers nervous.
The Fed may desire a weaker currency, but it is in their best interest to keep the decline orderly. If a dollar decline were to become chaotic, it would force a Fed reaction that could be unfriendly to the market.

Extreme dollar bears (and asset bulls) should be cautious. The markets do not move in straight lines, and the only certainty in volatile markets is uncertainty. A handy life jacket is worthwhile if the boat flips.

Kaspar's Comments

Government Bubble Targeted with S&P Outlook

Can Dollar Weakness Mean Equity Weakness?