Market Tops Start With Champagne And End In Tears; Washington May Trigger This One

by: Michael Blair

Gridlock in Washington is nothing new. More and more, it seems like a way of life. It used to be the case that governments reflected the views of their electorate and implemented the policies they believed flowed from the mandate of their election platform. Not any more. Today the power struggle in Washington is a "take no prisoners" approach to managing the world's largest economy and the leader of Western democracies. Leaders of each party act more like the tyrants they use their military to depose and display a touch of the "spoiled brat" conduct that may have characterized some of their childhoods.

Regardless of who "wins" or "loses" the current standoff, it will not be good for investors. This bull market, now 5 years old, is more likely to go into retirement than gather steam.

The President, quite rightly in my view, will not "water down" the Presidency by allowing the Republican Congress to hold the White House hostage to demands for changes to legislation in no way related to the debt ceiling issue before the two houses on Capitol Hill. At the same time, Congressional leaders think they have not only the right but also the obligation to deny funding for the very programs both sides of the House passed as a way to bring about repeal, at least in part, of the law of the land. Accordingly, the government is shut down owing to an absence of spending approval and the country is facing the possibility of a debt default as the burgeoning government debt approaches the maximum enacted to date, the so-called "debt ceiling".

In the course of the standoff, the world economy is caught between a rock and a hard place, and the direction of the stock market will very likely follow suit.

For the past few years, investors have hoped that growth in China, India and other parts of Asia would provide fuel for continued world economic expansion, and more recently signs that Europe's economies have bottomed are seen as a bit of tailwind. But, China's growth has "tapered", India is facing currency problems, and Europe's recovery is fragile.

If the President prevails and both Congress and the Senate pass "clean" bills for both the funding of government and the authorized debt from which such funding must come, Washington will continue to spend itself silly and the debt will continue to grow virtually unchecked until lenders go on strike and stop lending. Reform of Social Security and other entitlements will take a back seat, the tax code will continue to be Byzantine but more favourable to the establishment than the man on the street, and the problems facing the United States will be pushed off to a later crisis.

If the Republicans in Congress prevail, and changes are made to entitlements and spending, the government contribution to Gross Domestic Product will necessarily fall and the lower payments for Social Security, Health Care or whatever other entitlement is scaled back will flow directly into lower consumer spending. If higher taxes are part of the deal, they will come directly from consumers spending and add to the fiscal drag.

One way or another, and despite reports that talks have broken down, the two sides will likely make a deal and avert chaos. The final deal will no doubt involve compromise but hopefully will be a longer term agreement to stop using the debt ceiling debates as bargaining chips. Regardless of the nature of the agreement reached, the markets will trundle on propelled by continued waves of "quantitative easing" (QE) for short until there are signs of inflation or unemployment drops to a 6.5% or lower levels. By that time, changes in QE will be too late to stop the inflation set in motion by the unprecedented central bank intervention. Removing $85 billion a month of demand from credit markets can only cause interest rates to rise and rise they will regardless of how "tapered" the removal is. Like a heroin addict either going "cold turkey" or beginning a methadone program, the inescapable outcome will be unpleasant - a combination of low growth, higher interest rates and very likely higher inflation.

We have seen this movie before and we know how it ends. Think early 1980's. Interest rates were in the high teens and even low twenties; inflation was at alarming levels; there was no growth; and, stock markets were trading at single digit multiples of earnings.

Unlike the 1980's, none of the developed economies have balance sheets that can stand much more borrowing and many will have trouble servicing their existing debt at higher rates, so Keynesian monetary policy will not be an option and high government spending won't get us out of the hole being dug any time soon.

Smart money will be invested in hard assets. Prudent investors will have a short book or own puts as well as a healthy cash position. And we should all think about having a backup plan for when our job disappears or when the government cuts back on its social security payments.

As my father used to say, cheer up, it will get worse. These are the good old days.

The ideal portfolio for today is one no one owns. 30% cash, 15% base metals, 15% oil & gas, and the balance a diversified mix of debt free or low debt blue chips with a history of surviving regardless of the environment. Johnson & Johnson (NYSE:JNJ), Merck (NYSE:MRK), Pfizer (NYSE:PFE), Procter & Gamble (NYSE:PG), Nike (NYSE:NKE), Microsoft (NASDAQ:MSFT), Coca-Cola (NYSE:KO), Intel (NASDAQ:INTC) and Disney (NYSE:DIS) come to mind. The absence of fixed income is intentional. Treasuries of a government unable to pay its bills are not a good option. Treasuries of a government that pays its bills by printing money are not a good option. The rest of the debt market will not find higher rates salutary.

Conclusion: This is no market for old men.

Disclosure: I am long INTC, MSFT. 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 may take positions in any of the companies mentioned on any sell off

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