The euro finally cracks?...
Reality seems to be finally dawning on the world's credit markets that there might be a problem with Europe's sovereign debt. European Central Bank (ECB) President Jean-Claude Trichet said the Greek situation is now "code red." This shouldn't be news to any Digest reader. We've issued detailed warnings about the nature and the magnitude of these problems. The five-day chart (below) of the Rydex CurrencyShares Euro Trust exchange-traded fund shows today's move in the euro…
Adding to the volatility in the markets was the Obama administration's harebrained move to release a large chunk of the strategic petroleum reserve, which added momentum to the U.S. dollar rally as traders fled the commodities markets. We cynically wonder how many politically connected hedge funds and banks were apprised of the move ahead of time. In any case, this was exactly the wrong time for such a move, given the uncertainly over Europe.
You need to understand one more part of the European puzzle – the question of whether or not a technical default still counts as a default. ECB officials are trying to negotiate a deal where some of Greece's major creditors (large European banks) would voluntarily extend various loans at lower future interest rates.
So… is this still a debt default? Fitch (a major ratings agency) is warning that any action that hurts creditors, even if it's voluntary, would still be a default. Why does it matter? It matters because many people have purchased credit default swaps on Greek sovereign debt. A default would trigger perhaps billions of dollars in losses for major credit default dealers... such as, perhaps, JPMorgan...
We can't say whether JPMorgan would actually suffer losses on a Greek default. But we are confident the resulting strain on the entire monetary system would cause the bank big problems. That's undoubtedly part of the reason JPMorgan's common stock fell as much as 2.4% today.
Yesterday, we promised to talk about the opportunities in this looming sovereign debt crisis. We are good for our word. Here's the rough outline – the broad overview – of what's happened so far.
First, freed from personal liability to their depositors and almost all reserve requirements (thanks to paper money and central banking), the world's largest banks (including the U.S.-backed mortgage giants Freddie and Fannie) went on a multidecade lending spree. Most of the credit eventually found its way into real estate and China.
When these debts finally soured (with the U.S. approaching a 400% total debt-to-GDP ratio), governments around the world stepped in to rescue their banks through a combination of printing money, manipulating interest rates, and issuing sovereign debt. In effect, they transferred these bad debts and impaired assets from private hands to public hands. Thus, the nature of the crisis shifted from a deflationary credit collapse to an inflationary currency crisis. You can see the nature of the crisis change by looking at the price of silver, which collapsed in 2008 to less than $10 an ounce, then rose almost straight up to $50.
We are now approaching the second stage of this massive crisis. At this stage, the governments' resolve to paper over the bad debts must be tested. The epicenter of this next crisis will be in Europe. (There's little doubt America's politicians are resolved to continue printing and spending.)
The ECB has been much more reluctant to monetize bad debts. If my thesis is correct, we'll see Europe opt for vastly more monetary inflation over the next six months in an attempt to paper over the sovereign defaults of Greece, Spain, and Italy. This should take the euro down to less than par with the U.S. dollar.
The more certain outcome is China. The country's debt expansion and its building boom cannot last. As the world's monetary system slips back into another crisis, China's investors will grow skeptical of the country's banking system, which we believe is riddled with bad debts and assets.
The chart below is of the iShares China 25 Index Fund (FXI), which holds the 25 largest Chinese stocks. About 40% of the index is made up of financial companies. Shorting this fund is not a perfect way to short China, because it includes some good companies, like PetroChina. But it's an easy trade for most people to make. We're not "chartists." But it does seem that this ETF falling below $41 is probably a bearish signal.
Finally... an interesting data point to consider for those of you interested in the tax revenue discussion we've been having in the mailbag this week. From 1951 through 1963, the U.S. maintained extremely high marginal tax rates. The lowest rate of federal income tax was 20%, and the highest equaled 91%. The tax structure back then generated revenue equal to 7.7% of GDP.
Marginal rates were lowest from 1988 through 1990, when the lowest rate was 15% and the highest rate was 28%. With that structure, federal income taxes brought in revenue equal to 8.1% of GDP. (This information comes from Alan Reynolds' well-sourced piece in the June 16, 2011 Wall Street Journal.)
The point is, the liberal Democratic policy goal of using income taxes for social engineering is extremely inefficient. It lowers tax revenues at a time when the government is deep in debt. The amount of revenue generated is only one small part of the puzzle. What goes unmeasured is the resulting disincentive to work and invest under high marginal tax rates. And yes, this second consideration is vastly more important than merely the technical detail about revenues. But the technical detail about revenue is a clearly proven fact that the tax-'em-until-they-bleed crowd can't ignore.
New 52-week highs (as of 6/22/11): Annaly Capital Management (NLY).
In tomorrow's Digest... It's Friday, which means I'll do my very best to teach you something useful that you probably won't see anywhere else. If you've enjoyed my writing this week (or if you hated it), please let me know by writing in to the mailbag. Whatever you do, don't let your subscription expire without telling us what we could be doing better: feedback@stansberryresearch.com.
In the mailbag... a few of our more kind and patient subscribers offer our friend Kris a few words of heartfelt advice. We didn't have room to print all of them... but a few choice selections are below. Now, if only he (and the millions of other Americans like him) would listen.
"Porter, I just want to say thank you for the Digest. Beyond all the diverse investing ideas your newsletters give us, the Digest is such a valuable tool for being able to see what's really going on in the financial world and what dangers are coming. I would never have known about Italy and the possible collapse of the euro if it were not for the Digest. You'll never hear about that in the media until the day happens. Proactive reporting is nonexistent in today's media, but in 3 minutes on the Digest I get an intelligent and well-informed alternate perspective..." – Paid-up subscriber Darren Nelson
Porter comment: You're welcome... I enjoy writing it. Zero-percent interest rates and a global sovereign debt crisis are like manna from heaven for financial newsletter writers. There's hardly enough time to write about all the stupidity in the world...
"Dear Kris – It's painfully obvious to me that you've drunk the 'politics of envy' Kool-Aid. Instead of working to become one of us so-called 'rich,' you would rather drag us down to your level so we can all be equally miserable.
"When I was a kid back in the 70s, I had ample opportunity to go astray. But instead, I stayed in school, graduated with honors, went on to college and graduate school and completed degrees in finance, exited college with a negative net worth and a pile of student loan debt, got an entry-level job at a bank, paid off all my student loans early, got married, STAYED married, lived painfully frugally beneath my means, began a disciplined savings and investment plan, got laid off in the early 90s when the first big bank consolidation began, went back to school to earn the highest credentials in my field (CFA) to reinvent myself, began my own advisory practice, continued to save and invest and live debt free, and VOILA, 28 years later at the age of 52 I have a seven-figure net worth and am looking forward to retirement.
"This didn't happen by accident. It happened because I busted my a$$, lived a prudent lifestyle, and played by the rules. Anyone can do it. That is what makes America great. Your inane remarks suggest to me that you have no concept of what makes America and exceptional nation. I suggest you a little a little reading. For starters, how about The Road to Serfdom by Hayek, Human Action by Von Mises, Economics in One Lesson by Hazlitt, America the Last Best Hope by Bennett, and perhaps a few essays by de Tocqueville. Only then will you truly appreciate the blood that was spilled to form this great nation.
"Oh, and by the way, the reason that the Social Security payroll tax is capped is that the benefit is supposed to be (in theory anyway) proportionate to the pay in. I have paid in the maximum nearly every year since beginning my professional working life. The last I checked, the internal rate of return on my projected benefit is NEGATIVE! Had I been allowed to invest those 'contributions' myself, my SSI payout would have easily been three times higher. Where do I sign? I'll gladly take that risk." – Paid-up subscriber, James Martin, CFA
"Dear Kris: I read your feedback in the June 22 edition of the S&A Digest. I'd like to start by saying – I hear you. Contemporary conditions can be rugged for members of the middle class and the impoverished, and the occasional reminders of the large and growing imbalance between earnings and wealth of the very richest and those of the rest of us don't make the challenge any easier to live with. Along with you, I sometimes find it pretty easy to fall into anger toward the gigantic corporations and fat cats that seem to be thriving at the expense of everyone else. And yet...
"It is oh-so-easy to adopt a perspective that the primary corrective action is to require the wealthy to give more of their resources back to the rest of us. Make them pay more into Social Security, raise their income tax rates, expand programs for public employment and social welfare – it's so simple and seductive, and seems relatively painless. We have to consider all of the impacts of our actions, though. As Porter has pointed out on occasion, should we choose to substantially raise taxes on the rich (I recall him hypothetically considering doubling those taxes), the funds injected into our government would still be inadequate to close the federal deficit. And of course, under those circumstances, some of them would leave the country; these are generally smart, ambitious, and adaptable people, and have their own level of tolerance for how much of their resources they're willing to surrender.
"Besides that – history shows we have been pretty enthusiastic about increasing taxes, and the result has not been greater monetary stability. Annual receipts from federal income taxes in the U.S. now hover around $1.5 trillion – about 90% of the entire American GDP in the year of my birth. Yet, the level of federal debt outstanding is 53 times as big now as it was then. I'm all for a social safety net. People fall on hard times, and our culture has morphed into one where people cannot depend on the support of an extended family as regularly as they once may have. But there do need to be limits. We need to ask ourselves if we can afford to continue Social Security as a retirement plan, rather than the social insurance program it was originally designed to be (and, of course, need to implement compassionate options if the current system changes).
"We especially need to consider the two juggernauts of probable future deficits – Medicare and the military – and whether we need to restructure each one, as well as the industries tied to them, in order to provide necessary benefits in as fair and cost-effective of a manner as we can design. Always with an eye to the well-being of the least among us, we also have to attend to the level of support we are able to sustain beyond the current fiscal year.
"During the 2008 presidential campaign, Ron Paul hosted an amazing and little-heralded symposium featuring himself, Ralph Nader, Cynthia McKinney (the Green Party candidate), Bob Barr (the candidate of the Libertarian party), and Chuck Baldwin (Constitution Party). While acknowledging the substantial differences among their platforms, to a person every candidate, from far right to far left, signed on to some common principles – including bringing deficit spending under control, dismantling the Fed, and diminishing the reach of our military into the affairs of the entire globe. We should be listening to these people; the shared portion of each one's personal vision demands a transformation of the existing system, rather than moving its bricks around in a way that keeps most of the current deficiencies and corruption in place (as would a mere change of tax rates).
"There's not enough room here to lay out an entire proposal of how I'd like to see things resolved, nor do I have enough time to give the matter as much thought as it deserves. I would say, this, though: Our vision of a better future needs to support justice to everyone – rich, poor, and in-between. If we do otherwise – whether we choose our actions based on either anger toward those wealthier than ourselves, or disdain for those who are poorer – we will advance our march to calamity. I hope you, and I, continue to advance in wisdom regarding how to best address the future of our economy." – Paid-up subscriber Todd Selle
Regards,
Porter Stansberry
Baltimore, Maryland
June 23, 2011
The euro finally cracks?... Obama's dumbest move ever... JPMorgan's exposure to Greece... Opportunities in a crisis – why not short China?... A good data point on tax rates... Replies to Kris...