THIS TIME GRIDLOCK IS NOT GOOD!

In a post last June, I stated that further fiscal stimulus on the order of $300 to $500 billion might be necessary to keep the economy from lapsing into another recession. I also believed that Bernanke's and Paulson's success in "scaring straight" Congress into passing TARP quickly, along with later fiscal stimulus by the Obama administration, had kept the recession from morphing into a depression. Unfortunately one can't prove a negative--one can't say with certainty what would have happened without these steps. In this mid-term election, Republicans have claimed that fiscal stimulus and the Fed's quantitative easing have done little to free the economy from its Slough of Despond. After all, 2% real GDP growth in the third quarter is only a third to a half the growth that occurred when the economy emerged from the prior comparable recessions of 1973-4 and 1982. Republicans have criticized the heavy debt burden resulting from these attempts, with no apparent significant benefits. After all, unemployment still remains close to 10%. Hendrik Hertzberg of the New Yorker said it eloquently, "The presence of pain is more keenly felt than the absence of agony".

We are now faced with a Republican-controlled House, a slim Democratic majority in the Senate, and a Democratic President--what Wall Street describes as "gridlock". Wall Street has always embraced Congressional gridlock because it means less interference with Adam Smith's "invisible hand". NOT SO THIS TIME!

In previous posts, I have pointed out ad nauseam that: 1) the borrowing binge in the U.S. economy that persisted for fifteen years must be reversed, i.e. deleveraged: 2) according to the Economic Cycle Research Institute (ECRI) during the latter years of the debt binge, economic growth actually was lower than normal and recessions were more frequent: 3) during the deleveraging period, growth should be lower than during the leveraging period; and 4) no one knows WHEN deleveraging will reach a level where consumers and businesses will feel confident enough to resume normal spending, without additional government help. This return to normalcy is known in economic circles as "escape velocity." Escape velocity may take several years to happen, or could happen soon. Since the leveraging process took about fifteen years, if one believes in symmetry, then the deleveraging process still has a ways to go.

I believe strongly that some time in the future the government must reduce the deficit as a percentage of real GDP; but, and here is the rub, NOT UNTIL THE ECONOMY REACHES ESCAPE VELOCITY! Republicans want to attack the problem of increasing deficits and debt burden immediately. Until escape velocity is reached, further fiscal stimulus is likely to be necessary just to keep the economy in slow growth mode!

With a gridlocked Congress, any effort to stimulate the economy is left to the Federal Reserve. Today the Fed will announce what is known as "quantitative easing 2", which is simply printing more money to buy Treasury securities. The Fed hopes that by lowering interest rates on longer maturity Treasury debt, investors will be coaxed into buying stocks, and consumers and businesses will be persuaded to spend more. Also, the dollar might decline more than other currencies, which should stimulate our exports.

As one economist put it: if there are fifteen ways to stimulate the economy, quantitative easing ranks fourteenth or fifteenth in effectiveness. However, the others must go through Congress, thus the importance of gridlock. If quantitative easing fails, and Congress is loath to pass additional fiscal stimulus, we may face the dreaded deflationary spiral--lower prices, a consumer who reduces present spending because prices will be lower in the future, more layoffs, and an ensuing vicious cycle. If that occurs, the S&P 500 Index, now at 1193, would drop to roughly 840, a 30% decline. While normally a less than 5% probability, due to the deleveraging process and a recalcitrant Congress, I am raising that probability to 30%.

The most probable scenario is that the U.S. economy muddles through with 2% real growth until escape velocity occurs. In that case, the S&P 500 would slowly appreciate until normal growth resumes. At that point, the enormous flow of mutual fund money into bond funds over the past few years should be reversed. The ten year Treasury note would quickly jump from a yield of 2.6% now to 4 or 5%. Money would flow out of bond funds into equity funds, creating a stock buying panic or meltup! The S&P 500, which in my opinion is currently roughly 12% to 31% overvalued, depending on normalized earnings growth and interest rate assumptions, would quickly become much more overvalued.

In late 1999 I submitted an article to Barron's, which was published in the Other Voices column on December 27, the last issue before the new millennium. In it I argued that, at 29 times earnings and a 1.2% dividend yield, the S&P 500 Index, at 1435, was vastly overpriced relative to the almost 7% yield one could receive from zero coupon Treasury securities with maturities from 5 to 25 years. I suggested that pension funds sell the S&P 500 Index funds and buy the zeroes. While the current situation is not the exact opposite of 1999, I believe that over the next ten years the S&P 500 Index, even at its current overvalued level, will provide a 6% total return point to point, outperforming Treasury bonds' meager 2.6% yield -- more than justifying the incremental risk.

However, the road will be bumpy. There will be several bear markets during the period. While I want to be exposed to equities during this period with a core equity position of 30% of my financial assets, I feel that I can trade around that position. I am currently holding an equity exposure of 40%, down from 60% late last year. If the equity buying panic ensues and bullish sentiment reaches an extreme, I will sell another ten percent and protect the remaining position by buying at the money or out of the money puts. If the economy lapses into another recession with an accompanying bear market, I will take the equity risk exposure back up to 50% or more by dollar cost averaging into weakness The remainder of my financial assets are in 90 day Treasury bills, which yield zilch. Once escape velocity occurs, I plan to switch from these bills into ten year Treasury notes, hopefully with a 4% to 5% yield to maturity.

On another subject, since I started my blog in early 2007, I have written more than thirty posts. They are not equally spaced in time. I am only interested in writing a new post when I change my asset allocation or when I feel that events have occurred that are worth discussing.