On The Road To The Endgame: The Farcical Cliff

by: Eric Parnell, CFA

Kick the can down the road. That has been the core philosophy of policy makers and financial market participants since the outbreak of the financial crisis several years ago. Never mind that we have mounting systemic problems infecting the economy and financial markets that left unaddressed could completely destroy our long-term prosperity. As long as we have the means to repeatedly ignore the problems we are facing today and carry on as if all is well, then we'll simply brush them aside to worry about them another day. From my perspective, this is an unacceptably irresponsible approach. But such is the philosophy we are left to live under today.

It didn't have to be this way. The circumstances that led to the financial crisis provided policy makers with a clear opportunity to take bold action in correcting the imbalances that have been building under the surface of our financial system for decades. And at the dawn of the crisis over four years ago, policy makers had vast resources and financial flexibility at their disposal to take such substantive action. But in the time since, we have seen little more than dithering responses and flawed policy prescriptions that in many respects have made things considerably worse. And the resources and capital once available to address the mounting problems facing our economy and markets have now been largely squandered. This is deeply regrettable opportunity lost.

So what happened along the way?

Let's first look at the monetary policy side. I recall U.S. Federal Reserve Chairman Ben Bernanke's appearance on 60 Minutes back on March 15, 2009. At the time, his monetary policy prescription of quantitative easing was truly extraordinary, and you could see the hesitation in taking such action and his compulsion to try to explain to the public why such drastic measures were being undertaken. The justification? We need to stop the crisis first, and once we do we can take the necessary steps to punish bad actors and put in place policy so that it does not happen again in the future. OK, this made sense at the time and I fully agreed with it. But now that we are long since back from the brink, where are we now in addressing these problems so many years later? One has to look no further than the events surrounding the MF Global scandal over the past year to find the answer. In short, back to where we were before the crisis even started. Making matters worse, the Fed has made what was once extraordinary monetary policy not only ordinary but also demanded by the markets. It has been the monetary policy equivalent of drugging someone into a perpetual high so they never have to come down and face the reality of their troubled circumstances. Unfortunately, among those that have been along for this magic carpet ride have been fiscal policy makers in Washington D.C.

What of fiscal policy in recent years? Before going any further, I have no interest in being partisan here, as there is certainly enough blame to go around on both sides of the aisle. After all, it's not as though the fiscal picture was at all pretty heading into the financial crisis. For it was just 12 years ago at the beginning of the current secular bear market when the U.S. government was running budget surpluses and the national debt was a relatively low $5.6 trillion (thanks, once again, to positive contributions from both sides). But by the time the financial crisis began to unravel in mid 2007, the national debt had exploded to $9 trillion with an annual budget deficit that had ballooned to over $500 billion, which was an alarmingly large number at the time. But these numbers now seem down right parsimonious in the context of what we are seeing today with fiscal policy. In just five short years to today, the national debt has skyrocketed to $16 trillion thanks to five straight years of $1 trillion plus annual budget deficits. Clearly, this is an unsustainable pace that must be addressed by fiscal policy makers.

The exploding U.S. debt problems require substantive debate and tangible solutions to begin to effectively address the problem starting today while still recognizing that the current economic outlook emerging from the financial crisis remains fragile.

It is to this point that makes the ongoing U.S. fiscal cliff debate in Washington so distressing. It's not that I worry about them coming to some sort of agreement at the end of the day. I've already marked my calendar for the week of December 17, to look for some half-baked agreement that's filled with a lot of fluff sound bites but postpones most of the tough decision making to a later date. Given that they left themselves with only six post-election weeks in a lame duck session to deal with the problem, such a solution is probably the right choice at this point instead of cobbling together some half-baked bill, but it doesn't make it any easier to digest.

What is more troubling is the genuine lack of seriousness tied to the fiscal cliff debate. In many ways, it seems that most in Washington simply do not at all understand the seriousness of the problems we are facing today. First, the fact that the policy debate has taken on such a predictable antagonist tone filled with all of the endlessly retreaded rhetoric from both sides is annoying enough. The American public on the most part is tired and wary. Many have been out of work for several years and economic prospects remain dim. They wanted to see solutions to their problems years ago, and they would badly like to see two sides working together to get something done to finally start fixing the problem today. Predictably mindless bickering is the last thing that people want to hear right now.

But more important than the tone is the substance of the debate. We have just gone through a period over the last five years where the national debt has risen by $7 trillion with annual budget deficits in excess of $1 trillion each year. Yet the latest proposal in the debate is to raise taxes on the top 2% of income earners today and postpones the debate on spending cuts until next year. Put simply, this is woefully inadequate and teeters on the brink of irresponsible. The government has just spent $7 trillion more than its earned over the last five years. A good portion of this is obviously new spending that did not exist before. As a result, there must be some place where meaningful cuts can be made right off the top today. And no, $1.5 trillion in total cuts spread out over some long-term time horizon is not even close to being enough. In fact, one could argue it should be five times as much. Of course, if the other side wants spending cuts to go along with increased revenue, the time is now to get out with a detailed list to say exactly what should be cut and begin arguing for it. Otherwise, the cuts simply won't happen.

A serious fiscal policy solution is essential in getting the country back on track to a more prosperous future that is not drowning under a rising sea of debt. This includes serious tax reform that increases revenue, broadens the tax base, simplifies the code and closes loopholes. It also includes meaningful spending cuts that if done properly are actually growth enhancing by increasing the operational efficiency of government so that remaining spending is focused toward initiatives that provide the most benefit to the economy. Yes, less can be more if actually carried out correctly.

An additional point in regards to spending cuts - they simply cannot, CANNOT, be of the "$4 trillion over the next 10 years" variety where most of the spending cuts are back loaded when whomever else is running the country at that point in the distant future can simply vote to cancel these cuts down the road. Instead, an approach of gradual revenue increases that are conditional on meeting spending cut targets is an absolute must. And these spending cuts must include entitlement reform. Otherwise, policy makers will continue to repeatedly postpone making the tough decisions until they have absolutely no other choice. After all, is it much easier to say "yes" than "no" to those on which you are lavishing spending.

Some of the blame for the lack of seriousness among fiscal policy makers rests at the feet of the Federal Reserve. Dating back to the summer of 2010 prior to the launch of QE2, the Fed had the opportunity to hold the feet of fiscal policy makers to the fire. But instead of forcing the President and Congress to take on the tough decisions to deal with a rapidly deteriorating fiscal problem, the Fed keeps letting them off the hook by repeatedly implementing stimulus program after stimulus program. The launch of QE3 in September is only the latest example, and look for more juice from the Fed when it meets again in mid December. It is often said that fiscal policy makers need a sharp stock market correction to get their attention and force them to the negotiating table to agree on real solutions. But if the Fed never allows the stock market to correct, fiscal policy makers will never feel compelled until things are so dire that not even the Fed can sweep things under the rug anymore.

All of this brings us back to financial markets. We have a U.S. economy that is rotting at the core. And the global outlook is arguably worse in many parts of the world. Such conditions argue for a stock market that is at minimum in decline and more realistically in sharp correction. But thanks to the monetary pushers at the Federal Reserve, the stock market is threatening to break out to new post-crisis highs after having already rallied so strongly over the last three-plus years.

Such gross market distortions are absolutely maddening for those accustomed to sound fundamental analysis actually meaning anything. But such is the market environment under which we are operating today. We may not like what the Fed is doing. I for one strongly disagree with it. But regardless of how we feel about it philosophically, as investors we must react to how it is most likely to impact the markets.

So where are we likely to go from here? The impact of QE3 that was launched in mid September has yet to be felt by the markets to this point. This is due to the fact that despite $184 billion in MBS purchases by the Fed under QE3 to date, only $28 billion in net new liquidity has flowed into the financial system. And these injections have come in two weekly blasts for the weeks ended October 17 and November 14. Otherwise, the markets have been operating under fairly sober conditions since mid September. But the drip of liquidity is likely to increase fairly dramatically into a sustained flow as the MBS purchase program takes full hold. And if the Fed adds Treasury purchases at the start of the New Year as expected, we could see up to $85 billion if not more flooding into the financial system on any given week. The more this liquidity flows into the financial system, the more likely stocks are to levitate beyond all reason.

The next major stop to the upside for stocks is clearly defined. And depending on how events play out over the coming year, this could very well be the final post-crisis peak before reaching the endgame where the long overdue economic and market cleansing process finally gets under way. This level is the 1550 to 1575 range on the S&P 500 Index, which represents the previous two stock market peaks first reached in March 2000 and then revisited in October 2007. Stocks failed miserably after reaching these past peaks, and they will have their work cut out for them to break out of what has proven most stiff resistance over the last decade plus. And an eventual descent back toward the bottom end of this long-term trading channel certainly cannot be ruled out as the financial system fully cleanses itself. But with all of this being said, if stocks are hopped up on a QE high, it's not outside of the realm of possibility that they may simply levitate through this resistance when least expected. If this were to happen, don't be surprised if it's on some holiday shortened trading day when volume is light and the exchange floors are relatively empty. After all, this is how the market just broke decisively back above its 200-day moving average during the Thanksgiving week.

The fact that the Fed is acting so aggressively to jump start the economy cannot be ignored. Unfortunately, the Fed has the power to lift asset prices to previously unimaginable heights through its policy actions, even if these gains are in total contradiction to the underlying economic realities. This, after all, has been the primary reason why stocks have rallied so sharply from their lows several years ago. If Fed stimulus has brought stocks this far, they likely still have the ability to elevate prices that much further with even more stimulus. This will be particularly true if the European Central Bank and the People's Bank of China join with balance sheet expanding policy stimulus measures of their own in the coming months, which is a distinct possibility.

A variety of allocations make sense in positioning for this outcome. An allocation to stocks (NYSEARCA:SPY) is certainly warranted, but should be considered as part of a broader hedged strategy. And an allocation to higher beta positions that stand to benefit most from Fed stimulus such as the S&P Mid-Cap 400 (NYSEARCA:MDY) and Emerging Markets (NYSEARCA:EEM) such as China (NYSEARCA:FXI) and Brazil (NYSEARCA:EWZ) are warranted. Individual commodities stock names like Occidental Petroleum (NYSE:OXY), BHP Billiton (NYSE:BHP) and Potash Corporation (NYSE:POT) also stand to receive a measurable boost from QE3 as it increasingly flows into the markets. Allocations outside of the stock market make just as much sense if not more. These include High Yield Bonds (NYSEARCA:HYG) and the precious metals complex including gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV). My preference for maintaining these precious metals exposures in an exchange setting is Central GoldTrust (NYSEMKT:GTU), the Central Fund of Canada (NYSEMKT:CEF) that blends gold and silver exposures, and the Sprott Physical Silver Trust (NYSEARCA:PSLV).

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long FXI, EWZ, BHP, OXY, POT, CEF, EEM, GTU, HYG, MDY, PSLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.