Making the Impossible Possible

This week brought new evidence, not necessarily that the stock market efficiently allocates capital to its most productive use, but that it effectively separates fools from their money.  The fool gives…Wall Street takes away.  In other words, the house always wins.

“Patience and fortitude conquer all things,” said Ralph Waldo Emerson.  Clearly, he could not have imagined the current bear market, which commenced with the opening of the new millennium.  Nonetheless, Emerson’s ultimately right, patience and fortitude will prevail.  But what good is it if, by the time they do, your retirement account’s ravaged and the money you’ve saved to cover your kids college tuition runs out one semester into their sophomore year?

Bear markets bring clarity to the world. Without the current bear market, for instance, one of the wonderful dogmas of the 1980s and 90s bull market would not have been exposed to be a farce.  What we are talking about is the great Wall Street myth that you can retire a millionaire and enjoy an extended life of leisure by buying and holding an index mutual fund.

In the year 2000, everyone knew this was true.  In the year 2011, everyone knows this is a crock.

On March 24, 2000, the S&P500 was trading at 1,527.  Yesterday, the S&P500 closed at 1,239…down nearly 19 percent over the last 12 years.  But that’s just the half of it…

Using the government’s own inflation calculator, we find it takes $1.32 today to purchase what $1 could buy in 2000.  What this means is that, on top of a 19 percent stock market loss, the money in your bank account has lost 24 percent since the new millennium began.  What gives?

We’ll offer a thought or two on this in a moment…but first we’ll pause to consider Italian bond and German bund spreads…

Bond Spread Blowouts

We’ve been over this before and we’ll go over it again — for our jaw is still agape, and our eyes are still ajar, as we gawk at the great Eurozone crackup.  Where to begin?

As we’ve elaborated, the Greek bailout was not about Greece.  It was about French and German banks, which loaned the Greek Government more money than it could ever possibly pay back.  Following the establishment of the Eurozone, credit markets came to the implicit notion that Germany’s financial resources would back other Eurozone countries should there be a risk of default.

Predictably, less credit worthy countries like Greece, Spain, Portugal, Italy, and Ireland, couldn’t handle the cheap money.  They borrowed and spent like American consumers.  Yet for every euro borrowed by Greece there was a lender.  Likewise, the repeated Greek bailouts were really just bank bailouts via Greece.

Last week the focus of the crisis shifted across the Ionian Sea from Greece to Italy.  Lenders were questioning Italy’s ability to pay their debts. Yields on 10-Year Italian bonds spiked to 6.25 percent.  When the week ended European lenders wanted to know if Italian debt was going Greek.

This week they got confirmation.  On Wednesday 10-Year Italian bond yields topped 7.4 percent and Prime Minister Silvio Berlusconi vowed to resign.  Additionally, the spread between 10-year Italian bonds blew out to 5.53 percent from German bunds.  One year ago the spread was just 1.5 percent.  Ominously, French and Spanish bold yields hit record spreads against Germany too.

Making the Impossible Possible

Back here in the new world people were lining up to buy U.S. government debt like it were funnel cakes at the county fair.  On Wednesday yields on 10-Year Treasuries fell to just 1.95 percent…practically a record low.

At first glance, this seems like a great validation of U.S. creditworthiness.  Why else would the world loan money to the U.S. government for practically free?  In reality, it’s because, for the moment, the United States is the best looking horse in the glue factory.  Something’s amiss…

The stock market’s fallen 19 percent over the last 12 years because it’s a bear market.  Bear markets happen…they are best to be left alone to correct the misallocations of the preceding boom.  But thanks to the handiwork of the Federal Reserve, and their flood of cheap credit based money to stimulate the economy and puff the stock market back up, they’ve successfully debased your savings by 24 percent.  Here’s what else they’ve achieved…

Bank of America Certificates of Deposit are currently paying an annual percentage yield of 0.35 percent.  Based on the latest Labor Department report, the Consumer Price Index rose 0.3 percent in September – or 3.6 percent on an annualized basis.

In short, in less than one month’s time inflation will wipe out almost the entire CDs annual real return.  Over 12 months the CD will yield a real return of minus 3.25 percent.

This, no doubt, is logically impossible.  Of course, it’s made possible by the heavy handed intervention of the central bank into financial markets.  The result is far worse than we know.


MN Gordon
for Economic Prism

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