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Business Observer Friday, Jul. 19, 2013 5 years ago

Market bears unacceptable risk, bond market crash possible

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The market continues to set records weekly with the Dow now over 15,000 points.
by: George Rauch Staff Writer

The market continues to set records weekly with the Dow now over 15,000 points. Interestingly, the fervor among the investing public we have witnessed the last 40 years when the market hits new highs simply does not exist. To the investing public this new Dow Jones Industrial's record is no big deal. Since the last time the market exceeded 14,000, with inflation, the market would need to be around 17,000 for purchasing power to remain even with its “last record.”

The dollar has lost 10% of its value against international currencies during that time, too. The market would therefore need to be 19,000 points to be even with international values. So this new “record” really is “much ado about nothing.”

The idea that the stock market remains a great opportunity to make money is no longer valid. The DJIA is currently way overpriced with low, low cash yields of 2.3%. Should the market be selling at an average Dow cash yield of 4.2%, instead of being 15,200 points, the Dow would be about 8,300 points.

There is too much risk associated with current market values to view the market as a future moneymaking opportunity. Through all the bubbles we have had the last 40 years, the biggest, most dangerous bubble of them all has been built since 2005 in the bond market. The last three years of the Bush presidency created a combined deficit of more than $1 trillion, for a total national debt of $8.5 trillion. The Obama administration has doubled that national debt to $17 trillion thus far. Projections for the next three years indicate continued huge deficits. Unstated obligations upon which the signature of the United States exists include all the bad Fanny Mae, Freddie Mac, and “government sponsored businesses” paper out there that add at least another $6 trillion to U. S. taxpayer obligations.

The government currently prints new money for 43% of every dollar it spends. The money is literally borrowed this way: The Fed (controlled by the government and a small group of private institutions) runs a printing press until the desired amount of money is printed.

The Fed hands the money to the federal government, and the federal government hands back a note to the Fed promising to pay back the money that was just transferred into its account. That's it.

For as long as that obligation is outstanding, a string of interest payments goes back to the Fed, all paid by the American taxpayer who had absolutely no control over the obligation that has been created. The taxpayer will now pay interest on the debt for the rest of their lives. Those interest payments find their way back into the spending stream through the banks.

Congress has little inclination to stop this cycle as a significant part of the funds, created out of nowhere, go to paying for the congressmen's, senator's, and the president's campaign contributions. Keeping the Democrats and Republicans in office is a very expensive proposition for the U. S. taxpayer, particularly, because both parties are responsible for our deficit spending and the huge obligations we pass on to future generations.

Where did the money go? ALL of the money went to welfare. Only 60% of working age adults work. 100 million people, 30% of our population, are dependent on government for some type of income support. In 2007, 23 million people received food stamps. Now it is up to 47 million people. Oddly, all of our military engagements since Vietnam could have been financed out of general tax revenues. War, most responsible for historic government bankruptcies, is currently being replaced by welfare costs driving governments to the brink of disaster.

This large buildup in obligations is because our government is living beyond its means — a trite statement when one must print new money to meet 43% of government expenditures. Most importantly is that increasing government debt will negatively affect the stock market. In addition to all the other economic factors mentioned above, government represents 40% of our GDP. That is not sustainable, especially with our existing obligations, let alone what's coming down the road.

What is important from an investment point of view is to realize that sooner or later we will have a crash in our bond market, coupled with far greater decreases in the dollar's value than the inflation we have so far seen. Only a handful of companies will be able to persevere through this financial disaster.

The likely future scenario is what is called a bond market crash. A bond market crash occurs, because people who own bonds cannot sell them without drastically reducing their price. A reduction in the price of bonds increases the percentage of cash yield an investor receives, so for 10-year treasury bonds one now receives about 2.2% interest annually.

Private economists believe that if the Federal Reserve System had not been manipulating interest rates down to virtually nothing for so many years, and the free market was allowed to work, those same treasury bonds bear enough risk that they should yield at least 6%. That would mean the 10-year bond price would go from $1,000 to $600, and the cash yield annually would be $60 from that bond, instead of $22 a year.

When there is a vast price reduction in bonds (and these reductions occur when the public finally realizes how much risk is associated with their investment), banks that hold bonds have a large reduction in the value of their investment portfolios. Bond investments comprise a significant part of the capitalization of the bank, so now the bank has a problem.

The bank's capital just shrank dramatically. That “paper value” the bank lost has been used to lend out money that the banks cannot now collect. Banks can't collect because customers who have obligations to the bank have to sell assets to meet their obligations. They cannot sell assets at a price high enough to meet the obligations because prices have crashed, and so the cycle continues.

A bond market crash sets off a chain reaction making it difficult for most debt obligations to be met. One then resorts to a barter system, which is what has happened in all bankrupt countries over the years: Russia, Germany, Yugoslavia, Chile, Argentina (numerous times), Spain, Greece and Portugal to name a few.

The failure of every one of these systems was mostly the buildup of costs in their welfare system and the subsequent creation of debt to support the politicians who ran those states. Politicians and bankers are not producers of wealth. Industrialists, businessmen and farmers create wealth.

Our government is taxing the wealth away, redistributing that tax revenue through welfare payments, and placing the country in a position where bankruptcy is eminent, all in collaboration with the Fed and banks that are “too big to fail.”

Caveat Emptor.

For an examination of the mathematical impossibility of our situation, go to gwrauch.com and read the last Market Watch article entitled “No Clear Path.”

George Rauch, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.

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