The Bernanke Bubble

The stock market continues to rise, albeit with some volatility. We have been cautious for months and have raised cash while also keeping exposure to stocks. It appears to us that most investors have the same information about the economy but some are bullish and some are bearish. When one looks at the data everyone seems to be right but it is all about timing.

The third quarter seems to be the turning point of the recession. Government stimulus drove auto sales and new home purchases. The Federal Reserve has orchestrated low interest rates and the capital markets have opened to large companies. Banks have increased their capital and their liquidity but have not dramatically expanded their loan portfolios. In the depths of the Great Recession, the consumer stopped shopping and businesses slashed staff while production halted. When panic subsided as the markets were rising, consumer confidence rose a little and businesses began to replenish inventories. All this contributed to the 3rd Quarter GDP growth.

With low interest rates, the dollar has been sinking. This has lead to a rising stock market but it is definitely climbing a Wall of Worry, as it should. Commodity prices, oil, and gold keep climbing and a weak dollar will exacerbate that trend. Unfortunately, government debt continues to bloom. Debt is everywhere from the consumer, to business, to real estate, to all governments globally. As long as rates stay low, investors are predicting economic activity will improve and the U.S. government can finance their needs cheaply.

So far, all investors agree with the above scenario, whether one is a bull or a bear. The other key factor driving some growth is China. China holds the cards to not only global growth but low interest rates in the U.S. Now we must highlight where the two camps may differ.

China is still growing at high single digit rates but the U.S. was a driving force to their exports. Bears are concerned that China is spending tons of capital to build domestic infrastructure which may be creating its own bubble if their standard of living doesn't improve. They have also been driving commodity prices through large purchases in order to fill their domestic manufacturing needs. Those purchases have been kick starting the growth of many natural resource economies. What happens if China can't maintain this growth?

China holds many of the cards. If their growth slows, so does most of the world's. The U.S. would likely suffer immensely. What is more troubling is the amount of U.S. debt China holds. China has been a big buyer of U.S. treasuries for many years. If they suddenly decide to stop buying or worse they become sellers, the interest rates in the United States will begin to rise. Our fear is that those rates may reach levels that will be extremely damaging to our economy.

Furthermore, the towering government debt will grow significantly when we add in healthcare, medicare, and social security funding. How can the United States pay all this debt off? We are seeing the beginning trend in the dollar as the answer to that question. We believe the dollar weakness is due to the Federal Reserve keeping rates low and concerns with the growing debt balances in the U.S.

Given these concerns, how can stocks keep rising? Low interest rates may persist for a while longer as the Federal Reserve floods the markets with liquidity. Inflation has been tame because the velocity of those additional dollars is low. This velocity may not accelerate if employment stays high and lending is curtailed. If the economy actually kicks into high gear, the Fed will have a new juggling act to perform to keep rates low. This scenario will lead to rising inflation. Bullish investors expect rates to stay low, dollar weakness to be positive in the short-term, the economy to be strong in 2010, and unemployment to improve next year.

Our concern is that the Government Stimulus has been a big driver of recent growth and low rates created by the Federal reserve is a catalyst for the weak dollar and improved capital markets. Eventually, markets will need to act on their own and the results may not be pretty. The Federal debt is high and getting higher. State and Local Governments are bleeding huge deficits. The answer in many cases is to raise taxes. Can the consumer or business afford more taxes? The bottom line is that bubbles are being built in stocks and bonds and as long as rates are low, maybe that trend will persist. We remain cautious because we know there will be a day of RECKONING. It is not If, it is When. We are just trying to figure out how to protect our assets. Gold will clearly be a beneficiary but U.S. assets will have to be devalued and interest rates will likely skyrocket in order for the United States to fund its enormous debt.