The Market Surprises: The Biggest Holders of US Debt

In my first letter of 2012, I said that there is a great chance the first half of this year will surprise us:

The New Year has begun and we’re off to a good start. While worldwide economic health remains in limbo and European woes remain, there is a great chance the first half of this year will surprise us.

Hopeful numbers will come out of the US but the economic decay in 2012 will eventually accelerate enough to overshadow any signs of hope. In order to avoid an outright economic collapse, the governments of the world, in particular the US, will once again be forced to initiate massive amounts of Quantitative Easing (QE).

So far, that one paragraph has summed up everything that has happened since the new year.

The Market Surprises

The major indices reached multi-year highs with the Dow breaking solidly through the 13,000-point barrier, the SP 500 edging over 1,400, and the Nasdaq Composite ploughing past 3,000 all in the same week. The market is now up over 30% from its October 2011 bottoms and nearly reaching 4-year highs.

When you look at technicals, the market is pointing to higher prices.

We enjoyed straight days firmly above the old highs of 1370 earlier in the week, which helps confirm the recent breakout. With the recent softening of the bond market, this technical sign may help provide the catalyst for the next leg higher.

The recent sell off in the bond market means we are likely near the end of a 30-year bond rally. Over the last 30 years, rates have been going lower making the bond market a safe and profitable haven for investors – especially with the recent economic volatility.

But rates are now bouncing up from historic lows.

That means bond investors will start losing money for the first time in a LONG TIME. As stocks make new highs, naturally bond funds will see outflows and stock funds will see inflows. This fresh money coming into the stock market could help push the market up to higher highs.

(From a timing perspective, this doesn’t mean the outflows from bonds will diverge into stocks right away. We’ve also had some surprisingly strong gains over the last few weeks which may signal a short term sell off. However, over the next few months, we may see more gains in the market up until May as predicted in the paragraph from above.)

U.S. gross domestic product (GDP) expanded an average 2.4 percent per quarter in the 2 1/2 years since the recession ended in 2009. While that means the world’s largest economy hasn’t had a smaller post-recession recovery rate since at least the 1940s, it also means there is room to climb higher when compared to past events. In the 2003 bull market, GDP rose 2.7 percent on average, before the S&P 500 surged 102 percent. In the 1982 rally, the rate was 5.7 percent with equities more than tripling during that cycle.

Does that mean we’re about to see the markets climb even higher?

When you have a market that has performed so well so fast, it’s really hard to jump in. From a psychological standpoint, there is by far a better chance for the market to head down rather than up. But from a technical standpoint, the market is looking to climb higher.

If we breach the 2007 highs and stay above there, we could be in for another strong bull market rally.

The one biggest concern scaring investors is the volume in trades that has been pushing the market higher. Trading at the New York Stock Exchange declined to the lowest level since 1999 last month, with the average volume over the 50 days ending Jan. 25 slowing to 838.4 million shares. The value of stocks changing hands dropped to $24.9 billion, a 50-day average not seen since at least 2005.

Keep an eye on bond outflows – the more this sell off continues, the greater chance the volumes in the equities market will increase on the buy side.

The Bigger Picture

The problem with our market today is that investors are reacting to daily news events. I have said this many times before. If you’re a day trader and have time to trade the news, this is the market for you.

But for most investors, waking up at the break of dawn and trading in front of a computer screen all day doesn’t work. That’s when you have to look at the big picture. The big picture is the real reason the markets are moving the way they are.

Right now, the markets are moving because of easy money and slightly better economic numbers.

The world continues to print more money – whether it’s a direct infusion of liquidity, operation twist or giving banks money at negative real interest rates.

Bernanke just told us last week that interest rates will remain at current low levels until late 2014 and that operation twist will continue. That means free money for at least another two years. While he suggests that there is no QE for now, he surely did not say there won’t be another one coming. The Fed will continue to play a major role this year.

There is so much printed money being flooded into the world and the stock market likes that type of liquidity. World money supply has soared dramatically over the past two years. Eventually, the piper will need to be paid. In the meantime, this liquidity has built a foundation under the stock market.

The IMF just said Greece will need more money – even though it just got hundreds of billions weeks ago. Brazil has promised to keep interest rates low for at least another year. Every week I stress that free money will continue to pour in around the world. But do you know how bad this situation really is?

The World’s Best and Worst Example

It took the U.S., the world’s largest debtor nation, more than 200 years for its own debt to reach $1 trillion. In the past four years alone, this debt has soared by over $5 trillion.

The U.S. is currently running deficits of over $1 trillion per year, which means this number will only keep growing. The U.S. has no way to pay this debt off – not without making major cuts that will lead to a revolt. When you consider that millions of baby boomers are now reaching retirement age and will be drawing on social security, the debt levels will continue to grow even faster than it has in the past four years.

That’s a scary thought.

If you look at U.S. total debt, the U.S. is now at about 400% debt to GDP ratio. Morgan Stanley says there’s “no historical precedent” for an economy that goes over 250% of its debt to GDP ratio without a crisis or huge inflation.

So when will it be time to pay the piper? When will this all come crumbling down? I don’t know. For now, politicians will continue to do what they’re doing. They’ll continue to patch things up by printing more money to pay for expenses, including paying the interest on their loans. They’ll continue to sell their debt to any nation that can afford to buy it.

Most people think that China is the number one holder of U.S. debt and Japan number two. Those people are wrong. The number one spot belongs to the Fed – by more than half a trillion dollars.

In the long run, all of this money printing and cheap money will devalue the dollar – especially against the purchasing power of gold.

(for now, we may see strength in the dollar relative to other currencies such as the Euro but this is based on its value relative to other currencies and not the purchasing power for assets such as gold and silver)

While gold and silver have recently experienced a selloff, these represent buying opportunities in the big scheme of things. I stick with my prediction that gold will be above $2000 and silver above $40 before the year is over.

The truth will eventually unfold. Take every opportunity to protect your wealth.

In the end, “He who has the gold makes the rules.”

Until next week,

Ivan Lo

Equedia Weekly

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Disclosure: I am long gold and silver through ETF’s and bullion, as well as long both major and junior gold and silver companies.

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