TMFDeej (99.46)

Cross of Gold / A permanent 60 per cent across-the-board tax increase?

June 01, 2009 – Comments (8) | RELATED TICKERS: UDN

Always listen to your parents.  While this is probably a bad rule of thumb for most adults, after all stupid people can reproduce too...often in greater numbers than smart people (see Travis Henry's 9 babies with nine women for an example of what I mean), this is one of the most important lessons that I will take away from the recent financial crisis.  Many of you who have read my blog in the past know that my retired father (he still does some consulting) is very involved in commodities and follows the stock market very closely.

He did not see the implosion in the stock market coming from a mile away, like some people such as Gary Schilling who have been preaching about the coming bout with deflation for about oh a decade or so (even a broken clock is right twice per day).  However he did sell the majority of his common stock holdings late last year and shorted S&P futures contracts to hedge his remaining holdings. 

Fast forward to March and he became extremely bullish on the markets.  He has been buying stock just about every day since then.  Dad's no gold bug.  Instead he has been playing the inflation angle using things like EWZ, Potash, pipelines, and a whole host of commodity, particularly ag and oil, related names.

I personally was skeptical of his bullish view of the market and as a result I did not pile into common stock.  I deployed most of my available cash in the amazing opportunities that I have ever seen in corporate bonds at the end of the year.  I did catch some nice moves in bank stocks, Wells Fargo and B of A that I have since cashed out, but I have been using most of my money to build up a solid cash cushion in case my wife or I lose our jobs in this terrible economy.  After all, my family is more important than anything and I must be able to protect them.  The only common stock move that I made lately is I increased my exposure to my favorite CANROY (Canadian oil & gas E&P company).  That's worked out pretty well.

Overall, my portfolio in real life has performed very well lately.  Even with the recent rise in interest rates, the value of my corporate bonds has increased tremendously as the credit market has thawed.  My dividend paying preferred and common stock as done well, too.  I still remain somewhat skeptical about the recent move in the markets.  I don't see how many of the companies out there stick at this level when their likely disappointing earnings and slow growth become evident.  Oh well, at least my conversations with my father convinced me not to short the market like I did with the Mexican airports, credit card companies, and restaurants in real life last summer.  As the old saying goes, the market can remain irrational a lot longer than you can remain solvent.

Anyhow, I mention my father because of a conversation that we had this morning.  In our talk he brought up William Jenning Bryan's famous “Cross of Gold” speech.  I am sorry to say that while I love history and read about it all the time, I was not familiar with what some consider to be the most famous speech in American political history.

In short, in a speech at the 1896 Democratic National Convention Bryan proposed eliminating the gold standard and shifting to one where the value of the U.S. dollar was pegged to silver.  The idea behind this move was to lower the value of the dollar and spur inflation that would make it easier for farmers and other debtors to pay off their debt.  The move also would have combated the deflation that the United States experienced from the Panic of 1873 through practically the end of the century.  The most famous line from the speech is the following:

Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests and the toilers everywhere, we will answer their demand for a gold standard by saying to them: You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.

My father's point in mentioning this speech was that the government debt is so large in the U.S. right now that the only way he sees us getting out of this mess is to inflate our way out.  Many other people support this theory as well.  I personally have been in more of the deflation, followed by a slow erosion in the value of the U.S. dollar camp rather than the immediate inflation camp, however when my father talks I listen.

On the subject of inflation, last week the Financial Times published an interesting Op-Ed piece on by Stanford's John Taylor.  Here are a couple of interesting pieces of information that I took away from it:

Under President Barack Obama’s budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America’s ability to service it. The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years...

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?...

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.

Here's a link to the FT article for anyone who's interested: Exploding debt threatens America.

We are really in unprecedented times.  I doubt that anyone alive has seen markets and an economy like what we are currently experiencing, not even the grizzald vetrans of the investing world.  Life is dynamic.  No one knows for certain exactly what is going to happen in the future. 

As an investor, I like to keep an open mind and be flexible.  I also have become more conservative in my old(er) age.  I have constructed a portfolio of high yielding corporate bonds (around 10% YTM) that have reasonable maturities (7 years or less in most cases) to protect my portfolio in the event of deflation.  At the other end of the spectrum, I own stock in a number of companies that will benefit in an inflationary environment such as oil and natural gas.  I also own common stock in several dividend-paying international companies that sits somewhere in the middle of these two extremes.  Lastly, I am working on building up an even lager cash cushion to act as an emergency fund.

Deej