Everyone would like to have a crystal ball, but how can someone see into the future? I believe that the future, and specifically the future of the US financial markets, is predictable to a certain extent. However, to be able to predict what will happen in our financial markets in 2013, you have to understand who the major players are, and what motivations they have. The intersection of actions of the major players will determine the future course of the markets.
Who are the major players? What are their motivations? A short list of the people who have true power and are likely to exercise it in 2013 is presented below.
The Major Players of 2013 and Their Motivations
The Federal Reserve
Many market participants have developed an image of the Federal Reserve as a cash cow whose role is to pump the stock markets to the moon so that they can profit. While many have made paper gains in the markets over the last few years, this is not the role of the Fed. The Federal Reserve System is a quasi-governmental organization tasked with a dual mandate of price stability and full employment. Of course, as anyone who has taken an economics course is well aware, these two goals are mutually exclusive. Thus, the Fed must undertake a never ending balancing act of keeping both of these values within ranges it deems as reasonable and achievable, to the best of its ability. Since 2008, the Fed has made minor progress. The main thing it has done is to drive down rates and push money into risk assets. The Fed has also taken some toxic assets (MBS) off of bank balance sheets in an effort to improve the health of American financial institutions. However, to perform this quantitative easing, the US debt must be increased. The Treasury must issue debt securities, which are purchased on the open market, and which the Fed prints dollars to buy. Ultimately, the cash winds up at the Treasury and is used to pay for government expenses. The Fed's function is this scheme is simply to ensure that the price for Treasuries remains high and thus the yield remains low.
If the US debt cannot be increased, the Treasury cannot continue to issue new Treasuries in excess of repayment. Thus, the Fed cannot continue to reasonably buy them, and the government's spending cannot be financed by QE. Thus, if the debt ceiling is not lifted, the Fed's QE program could be forcibly ended as early as the end of next month. If the Fed continues to buy Treasuries regardless of the shut off of new supply, full steam ahead, then Treasury prices will shoot to the moon, and the Fed will be forced to buy from the market at a large premium. Thus, ironically, the debt 'financing cost' may actually go lower in the event of a "default" as holders of Treasuries become unwilling to sell them to the Fed at current prices in anticipation of much higher prices, and force the Fed to bid them up. If, however, the Fed acknowledges reality and ceases buying Treasuries, the market will collapse and yields will shoot to the moon. The Fed is unlikely to continue QE in the face of a debt crisis, as they would in essence take an even bigger loss on the huge position in Treasuries they have been accumulating. Even the threat of a debt crisis has to give the Fed pause in regards to buying more and more Treasuries, because they will take a bigger and bigger loss on any eventual unwind. Even if the debt ceiling is increased and the Fed is able to continue buying those Treasuries, it is starting to move in the direction of ending purchases, as it must balance the support it can provide for the economy now with the costs, both to itself and to the economy as a whole, of an eventual unwind. I believe that the Fed will not accept perpetual debt monetization and the US becoming a second Japan (according to my calculations they have averaged -1.6% annual real GDP growth from 1995 to 2011 - not a pretty fate), so a halt to purchases will certainly come sooner or later.
The Treasury is something of a wild card because of the possibility of something called Platinum Coin Easing. The concept is that the Treasury can use the old technique of seigniorage to avoid the debt ceiling by printing money in as raw and naked a fashion as possible. Of course, if the US were to mint a 1 trillion dollar coin, why not mint 100 or 1000? I believe that this action would cause a total collapse in confidence in the currency and lead to hyperinflation and the ultimate end of the US dollar as a fiat currency. The economic consequences of this would be worse than a full sovereign default. Tim Geithner, the Treasury secretary, is retiring before the 2013 debt ceiling debate. Any replacement would be subject to Senate confirmation - and I do not believe that even a Democrat controlled Senate is willing to utterly destroy the US dollar. Still, this is a potential time bomb that could wreck the world economy beyond repair for many years, and it is possible that the people in charge are unable or unwilling to see this. It might well be able to keep the US moving for another year or two, but it would truly be curtains after that. The smart people that are advocating for the minting of the Trillion Dollar Platinum Coin understand that there might not be an immediate collapse in the short term, but I do not think they fully appreciate the long-term consequences of starting down that path.
Congressional Republicans are angry and thirsty for payback after being forced to raise taxes without spending cuts. It is a certainty that they will refuse to raise the debt ceiling without sufficient spending cuts being enacted. Expect defense spending cuts to not figure much into the Republican package and social spending cuts to weigh in heavily. It is likely that the Senate will refuse to pass any measure the House puts forth and that it will require a genuine crash of the financial markets for the government to start to work towards a compromise package. Even then, if one side simply refuses to budge sufficiently, there may not be a compromise package. In this scenario, the sequester would be enacted, the government would shut down, and the US would default.
Obama is unwilling to engage in significant spending cuts to cherished Democratic programs without a concomitant increase in taxes. The liberal base feels that Obama caved far too easily on the Fiscal cliff fight, and he will experience pressure not to cave in again on this point. He has stated that he will refuse to negotiate on the debt ceiling, while Congress has stated they will insist on it. This sets up a game of chicken from which it is very possible that neither side will back down. The question becomes how long Obama will hold out when the US has gone into default and the world financial markets have crashed. After the world has paid that kind of price, I do not believe that Obama will settle for anything less than trying to make an end of the Republican party. If the US defaults, both the Republicans and Democrats will have to hold fast to their positions, and it is uncertain who will suffer more politically.
Financial Institutions will see all of this coming. In fact, they have seen it coming. It seems that every other week I hear of massive layoffs from another bank. The banks are starting to buckle down and prepare for the inevitable outcome of what is coming. There will be a lot of talk about the new bull market for the next month or so, and when it starts to fall there will be a lot of exhortations to "buy the dip." The "dip" will be caused by institutions starting to unwind their positions in the markets. Institutional ownership of all securities will begin to drop. Big positions take a long time to distribute. This selling will be slow at first, but it will accelerate to a frenetic pace when it is clear that the government is truly headed for a collision course. The only way financial institutions will retain current massive ownership of the equity markets is if they expect first support and then later hyperinflation from "The Coin" instead of sovereign default.
I don't think that the basic economic situation has improved at all for 99% of Americans over the last several years. The financial industry has done great, and there have been a few winners and losers, but overall things have remained lousy, as you can see from the chart below.
It should also be telling that the one thing Americans have been buying up over the last 4 years (besides gold and silver) is guns and ammunition. Ruger and Smith and Wesson have been true multibaggers, and you cannot buy a box of .223 rifle ammunition or an AR-15 rifle in most stores today, because they are simply sold out. Part of that is because of Sandy Hook, but part of it is simply because a very broad swathe of America is very tired of the "new normal" and convinced that all hell is about to break loose. Profound unease is in the air.
I believe that Americans are right to be afraid. People like to complain about how rotten politicians are, but in truth our politicians do reflect our will as Americans, and the truth is that our will is ugly and it is divided in the face of deprivation and want, and lack of hope for the future. The bear market started in 2000. It was held at bay, first by private debt and then by sovereign debt. But now, debtors are at their limit. The next time the market falls, there will be no such save available. It will simply continue to trade down and down and down with no relief in sight. It will only recover this next time when there is a genuine economic recovery in the absence of more than trillion dollar annual deficit spending. But I believe that even this is a better outcome than to become the next Japan, and experience an average real GDP contraction of -1.6% annually forever. Because that is in fact about how things have gone for them since 1995. Barring "The Coin", cash will be king, and we will experience massive deflation beyond even the powers of the Federal Reserve to arrest.
And the truth is, there is not much that can be done to stop this. The problems in our economy really aren't about debt at all, they are about a society that has lost its way. That is why our government is so divided. Not because Obama is a madmen hell bent on destroying the country, and not because the Republicans are crazed lunatics. But because almost everyone has abandoned responsibility in some way. I believe the future will be very ugly. No more than a few thousand people will read these words, and I do not expect them to have a great impact. But I would quietly urge those who do read them to prepare. I do not feel that any long equity position is safe past February - and you can never tell when the downtrend may start. Bets for volatility, against US treasuries, against US equities, against gold, against oil, and for US dollars will all do well in the absence of the madness of the Coin.
I will leave you all with an inflation-adjusted chart of the Dow that I made. CPI-adjusted, 1913 to present. The prices are annual average prices. What I find truly amazing about this chart is that it seems to obey support and resistance levels, even over a century. You can see that there is an upper trendline which acted as resistance in 1929 and 1965, but actually became support in 2009, having been broken through in 1995. There is also a lower trendline which represents an absolute level of support, having been tested 5 times thus far since 1913. There is no denying that 2013 is likely to be messy. The banks are talking it up out of one side of their mouths and firing their staffs out of the other. The hope I have is that that upper trendline continues to act as support, and that we don't have a dip in the Dow below a yearly average of 10,000 in 2013. This could mean a brief retest of the 2009 lows. In my view, that is the best possible long-term outcome we can hope for at this point.
Never use any one source of information (including this article) before making an important investment decision... but realize that the factors that have caused the big inflation-adjusted moves on the Dow that you see in the chart above are more significant than a 3% beat on a housing number or a 1% miss on a jobs number. The minor stuff going on with the economy right now is, in my view, noise. I believe that the big trends are going to come to the forefront very soon. However, if the US government continues to print more and more money and engage in more deficit spending, and the debt ceiling is not fought over, the Dow may gain some this year. However, I believe that continued encouragement of malinvestment because of market distortion, continued failure to allow market forces to restructure the economy to be competitive, and continued support of a culture of irresponsibility will guarantee a trip down to that lower trendline. This would be an annual average on the Dow of about 3,000 in current inflation-adjusted terms. Of course, if we go the route of The Coin, the nominal Dow value might just hit that famous figure of 2,000,000 well before 2099.
Nobody likes to be a bear. No one wants to expect that the future is going to be terrible. And no one wants to tell everyone else that the future will be terrible. But that is all I can see in the macro cards. I welcome comments and debate, and would love to be convinced that I am wrong, and that everything will be peachy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: I am long volatility.