This is a continuation of the 4 Fs: Fear of a False Factor is Favourable but with an expansion of the main points.
What is really going on?
The reason that today feels as scary as 2008 is that the memory of 2008 is still fresh. But this is nothing like 2008. In 2008, credit dried up and nobody could get cash. Today, many companies and investors are sitting on huge cash holdings. In 2008, we had real problems – a credit crisis, a real estate crash, an oil bubble, and a recession. In 2011, all we have is primarily political issues.
U.S. “debt crisis”
The U.S. can easily pay its bills if it wants to. It has huge powers to raise taxes. Simply adding a GST of 5-7% would already put the U.S. into annual surpluses. Their income taxes are the lowest since the 1950s (only 14.9% of GDP).1 Of US households, 51% pay no federal income tax. 1 Their gasoline taxes are extremely low. There is no national sales tax, their mortgage interest is tax deductible and it is the largest consumer economy in the world.
The US is a massively under-taxed country.
The news makes it sound like everyone has lost confidence in the US. However, there is clear evidence that they can pay their debts:
- The credit rating agencies, who analyze finances to death, still rate the US AAA or AA+. If they were unable to pay their debts, the rating would be far lower.
- US treasury bills are still the safest investment in the world. This is why huge investors globally have been piling into them lately. It’s very ironic and revealing that fears that the US cannot pay its debts on its bonds resulted in huge amounts of money being invested in US bonds.
The U.S. budget looks quite bad because it shows lower tax revenues during their recession combined with large tax cuts. Obama also spent a lot of money on a “stimulus package” the last couple of years. Like most government spending, it was 80% wasted. Projections of U.S. debt just project the existing inflated budget deficit and assume that nothing will be done.
The statistic used to try to claim the debt is too high is that the total debt to GDP ratio is over 90%.1 This is a strange comparison that accountants and lenders rarely use. It compares debt to income. It is like saying your mortgage is more than 90% of your salary. So what? The relevant figure is your debt payments to your income. This figure is not quoted because there is no story. U.S. debt payments are lower now than 3 years ago, because interest rates are so low. Interest on public debt in 2010 was $414 billion, down from $430 billion in 2007. 1 How can there be a “debt crisis” when interest payments on the debt have declined?
The US can easily pay its debts and the solutions are not complex. Solutions will certainly involve some tax increases. It is not clear yet what it will take to give them the political will necessary, but their politicians will eventually be forced to work together and create a solution.
The real issue is political. Politicians have made it an issue as they posture leading up to the 2012 election.
Obama and the Democrats spent (or wasted) tons of money to try to stimulate the economy and create jobs in 2009-10. The vote in November 2010 that gave the Republicans the majority in the Senate deadlocked the government and meant Obama needs the support of Republicans to pass any legislation. The Republicans, including their more radical Tea Party movement, are using the debt and deficit to push for spending cuts and make Obama look bad for having spent so much on the “stimulus”.
The “crisis” is not that the U.S. cannot pay its bills, but that the politicians are rigidly stuck in their positions and will not compromise. The government is dysfunctional.
There was never any real doubt that a deal would eventually be reached on the debt ceiling, since no politician wants to explain to seniors in their district why they did not get their pension cheque. Back in May, it was obvious to us that there would be a “miraculous”, last minute deal.
You can understand all the news about the US debt if you think of it as political posturing.
U.S. Credit Rating Downgrade
Even the downgrade of the U.S. credit rating from AAA to AA+ is political. Only 1 of 3 credit agencies downgraded them and the reason given was a lack of political willingness to compromise, not the actual ability to pay. The S&P said they had lost confidence in the ability of the US government to make decisions. The S&P debt rating agency even made a $2 trillion math error, but that did not matter, because the downgrade decision was based on the state of U.S. politics.
Canada went through this 20 years ago. We were running large deficits and had our credit rating cut. There were predictions of a debt spiral. Then we implemented the GST (replacing the dreadful manufacturers’ tax), made some spending cuts and were back in a surplus. It took a few years to regain our AAA credit rating. The US can do this as well.
This downgrade is not really relevant to investing anyway. The huge investors around the world are piling into US treasury bills (even though the interest rate is almost zero) because they know it is still the safest investment on the planet.
Debt in Europe
The problem in Europe is also primarily political. The Eurozone has provided one currency, but there are still 17 countries with their governments trying to hold onto their identity and power to make budget/fiscal decisions. These 17 governments are the problem. They need to give up more power, move toward a more complete political union and not allow themselves to spend more money than the taxes they bring in.
As usual, governments need a crisis before they act, which is why we have had a series of crises in Europe. We will likely continue to have a series of small crises in Europe until the governments are forced to act, but we believe that all will be resolved. The European Union will definitely support all its member countries through each crisis. Why?
There is a deep 60-year commitment to the European Union. American news questions whether the Euro will survive, but as usual, Americans are out of touch with the rest of the world. The extreme nationalism that resulted in the 2 world wars made it clear to Europeans that they need to work together.
Europe dominated the world in the 1800s, but US economy is almost as large as all of Europe combined now for one main reason – they have 50 countries vs. 1 for the US. Wealth is created by the free movement of workers, money and products. Until the European Union was created, all the country borders were a massive drag on growth. Even now, Europeans hesitate to leave their country and the Eurozone is only 17 of 50 countries in Europe.
Europe is slowly moving to financial and political unification, and the Eurozone continues to add countries. These “financial” crises are speeding up this process.
We expect more crises in Europe, but we expect all to be resolved.
As usual, the media exaggerates a story. Our fund managers are all forecasting economies to only slow down a little. The US economy will grow a bit slower for the next few years – probably 2-2.5%, not the 3-4% we have been used to.
There is often talk of double-dip recessions, but they almost never actually happen. There is only one case of 2 back-to-back recessions in history (early 1980s). Another recession is usually predicted after a recession, but double-dip recessions are actually very rare.
This is again only partly relevant to investing. Despite what you hear, the stock market is not really correlated to the economy – either short term or long term. The stock market usually rises during recessions, just as it does during economic growth.
Companies are in great shape
The real news that is not getting proper coverage is that companies are in great shape:
- Profits at record highs: The consensus forecast for earnings in the S&P500 is $100.07 for 2011 and $113.43 for 2012 – both are all-time record highs.3
- Markets are cheap: The forward P/E ratio for the S&P 500 is 11.52 4, which is 28% below the historical average of 16%. This is the lowest since 1985. Low P/Es are usually associated with high interest rates. If you exclude periods of high interest rates, then this is the lowest since 1954.
- Balance sheets are strong: Company balance sheets are financially more solid than they have been in decades and many have mountains of cash. There is no “debt crisis” for companies either.
The US can easily pay its debts and will eventually find the political will. Europe will likely continue to have crises, but the Eurozone will stand behind all its members and the crises will all be resolved. We are not having a double-dip recession and our financial system is not falling apart.
The stock markets fear many things now, but we believe NONE of them will happen.
This is why stock markets are the cheapest they have been for decades. Unlike the end of 2008, company profits are at record highs. Company balance sheets are financially more solid than they have been in decades and many have mountains of cash.
For long term investors, this is what great buying opportunities look like – overly pessimistic markets combined with very strong company fundamentals. “Be fearful when others are greedy and greedy when others are fearful.” 2
The current price of stocks is based on what most investors think will happen. There is a buying opportunity when the market is too fearful of things we are confident will not happen.
The long term growth of the stock market will continue to reward those that have faith and patience.
Remember the 4 Fs: Fear of a False Factor is Favourable.
2 Warren Buffett
4 Wall Street Journal
“Disclaimer: Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Opinions expressed are the personal opinion of Ed Rempel.”
About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching. If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com. You can read his other articles here.If you would like to read more articles like this, you can sign up for my free weekly money tips newsletter below (we will never spam you).