Imbalances at a critical juncture

Across both old and new media, there is a war of words raging about the direction of the market.

On one hand, you have the optimists, who are jetting around the world from party to party, claiming this time is different (see http://www.safehaven.com/article-4104.htm). This time Current Account Deficits and Inflation don't matter. There is a new world order that explains why the dismal scientists, the economists, are wrong.

On the other hand, the economists are locked away in their sanctuaries of study, claiming all is not right in the U.S. of A., and that we face a unprecedented set of imbalances, that either threaten to throw us into a surge of inflation or a contraction of deflation - but either way, threaten the fabric within which we have wrapped our wealth.

In my humble opinion, we are at a critical juncture in the market that will test the various hypothesises that are being put forth, and thereby help us to divine the direction in which we may be headed. In short, $55 Oil, $500 Gold, and 1250 S&P are key lines that the market has drawn in the sand. If those lines are crossed, I believe, a clearer trend will emerge.

Going back for a second to the concerns of the economists, the basis of their discomfort stems from the massive imbalances in the economy, the most pronounced of which is the U.S. Current Account Deficit. Today, that deficit is greater than 6% of U.S. annual GDP. That is tremendous. To put it in perspective, it means we have to import more than $2 billion in investment capital per day just to keep the U.S. Dollar valued where it was the day before. To date, foreign investors have been happily lending us these amounts, and then some. The concerning question is: for how long will they do so? According to Alan Greenspan's comments today, the answer is "not indefinately."

The other source of concern for some is somewhat related to the U.S. Current Account Deficit: the level of indebtedness of the U.S. consumer and the U.S. government. In total, the U.S. consumer has over $11 trillion in debt. The federal government has about $4.5 trillion in debt, while state and local governments owe another $1.7 trillion (not to mention all the Social Security and medical liabilities the government has!). The worry is that there are two paths out of this indebtedness: (1) to have the federal government print a lot of money to pay for it, which of course has the unwanted consequence of inflation; (2) to slow consumption and increase savings, which has the unwanted consequence of a slower economy, with less growth, fewer jobs, and possibly deflation.

To the optimists, all this worry is silly. Debt is at a record high, but so are assets. The net worth of individuals (assets minus debt) in fact has never been higher. The counterpoint is that asset prices have been inflated by low interest rates, and once interest rates go up, the true overwhelming nature of the debt will be revealed. Who is correct? It is difficult to say.

With such complex arguments being put forth, how can an individual investor know which extremity will win out - or whether we will just muddle along with moderate growth and moderate inflation. To make matter worse, the level of complexity described above is just the beginning. In this globalized world, to truly understand the trends in an economy, one must also examine competing economies and currencies. How Japan sets its interest rates or how fast China decides to grow its money supply, all will effect the economy in the U.S. For now, let's just stay with the simple case, and we'll explore the other factors in future posts.

While it will take years for the true path to reveal itself, in the short run the three previously mentioned indicators should be helpful. The first and probably most important is Oil. Oil has been on a long run-up. It is hard to believe a barrel of Oil was trading in the low teens in the 1990's. Since reaching that low, it has skyrocketed, exceeding almost all analysts' projections. Several weeks ago, Oil set a multi-decade high of just over $70 a barrel. Since then, it has come down to around $58 a barrel, where it is today.

Because Oil is such a vital and worldwide commodity, some, including me, see it as a possible indicator of larger trends, such as how fast inflation is growing in the U.S., and what effect foreign economic and money supply growth will have on U.S. inflation. In other words, if Oil is in an even longer term run-up, the more dire predictions of massive inflation are more likely to come true.

To determine the long-term trend of Oil, it is important to see over the next two months whether Oil breaks below $55 a barrel, or stays above it. If it breaks below $55 a barrel, then the trend has been broken. This is no guarantee that the trend will not resume, but a fairly strong indicator that at least for the medium term, the price of Oil will remain somewhat contained. If, however, it fails to go below $55 a barrel, then it will likely retest its high of $70, and at that point, we should all watch the $70 mark carefully. If it can break that, then we may be in for real trouble.

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