Do you remember the “Fiscal Cliff”? Or how about “Budget Sequestration”? You probably remember the words but foggy on the details. That’s OK. Have you heard of the Dow making new highs? Of course you have. Is there a connection? Yes there is, however no one in the financial press can and will put the pieces of the puzzle together. Model Price theory can connect the dots; so let me do this for you.
This won’t be the first time I have laid out this thesis. Back in a blog post in July, I outlined the framework according to model price theory for a new bull market not only for US equities but also for the US economy as well. I will quote from this blog and update the current “goings-on” adding context to these new highs.
First off a little bit of Model Price Theory
“Solvency Curve” and “Solvency Ratio” – See Key Concepts
Since the financial crash of 2008, the developed world has been in a “Balance Sheet” recession instead of a garden-variety inventory recession. So by analyzing balance sheets in terms of solvency is an important aspect on what we can do to fix the predicament the US and much of the developed world finds itself. The US Federal Reserve produces a quarterly balance sheet called “Flow of Funds” data, which encompasses balance sheet data on both federal and state governments but also data on the private sector. This data is invaluable and when used with model price theory can explain much what we have seen and experienced in the last five years.
Review of our “Solvency Curve”
Illustration of our Solvency Curve.
Model Price’s “Solvency Curve”
The numbers on the x-axis or the bottom of the chart represent the output of a formula we call our “Solvency Ratio”. Here is the formula for our ratio.
This formula can be applied to any balance sheet, individual, government and private and public companies.
Once you calculate the output from our Solvency Ratio formula, the result can be fit on our “Solvency Curve” to see where the output resides. We have labeled and color-coded the ratio output which best describes the solvency of the organization or enterprise in terms of being insolvent, solvent and super solvent. Also performing this exercise over time you can get a feel for the dynamic of how the organization or enterprise manage the solvency of their respective organizations.
US Federal Government
We can compute the Solvency Ratio for the US Federal Government by looking at the “Flow of Funds” data from the Federal Reserve Board. We calculate this ratio to be 0.135. This puts the US Federal Government on the cusp of what we call the 3rd Order of Insolvency. If any entity including the US Federal Government slips into this category this implies “Total Insolvency” if not “Total Breakup” of the entity. We have been doing solvency analysis on the US Federal Government for at least 10 years and I can say for the last 5 years this ratio hasn’t budge at all. How can this be possible you say, with all of the debt the US Federal Government has been piling on in the last 5 years? Good management of the ratio whether intended or not. As the US Federal debt level increased (P), the Treasury insures there is additional cash set aside balancing out the R in our “Solvency Ratio” equation. R maybe going up in proportion to P however it’s all with borrowed money.
Solvency Analysis of the rest of the categories in the “Flow of Funds” data
When we perform calculations on the balance sheets of the other categories besides the US Federal Government, (i.e., State and Local Governments, Commercial Banking, Nonfarm Nonfinancial Corporate Businesses, etc.), each category is either solvent or super solvent. What is interesting is over the last 10 years, especially over the last 5 years each of these categories have been shifting right – moving right along the our “Solvency Curve” to a more solvent state.
This is not surprising to us and we have seen this many times especially in our own country of Canada. As the Federal Government of any country goes evermore into debt the other participants or actors in the economy shift evermore right or become more solvent. Why does this happen? All participants know eventually they will forced to pay increased taxes and/or reduced services of their Federal Government and the US is no exception.
Therefore when looking at our “Solvency Curve” over the last 5 years in the US, the US Federal Government continues to borrow ever-increasing amount of nominal debt – while holding on to the brink of insolvency at 0.135 – with all other categories moving right building up solvency eventually knowing increased taxes or reduced services will be in the offing.
We can illustrate this point by placing “down” arrows on our “Solvency Curve” so you can visualize what is going on with all participants in the US economy.
Think about this, a similar “downward” action along their own “Solvency Curve” has been occurring in Japan for the last 20 some years. Hampering any recovery for the Japanese people for a generation.
So what is my point?
With the “Fiscal Cliff” and the “Budget Sequestration” the US Federal Government made a serious down payment on reversing this negative action along their “Solvency Curve”. President Obama’s stated goal is to have $4 trillion in a combination of increased revenue (taxes) and reduced spending over the next 10 years. These two actions – “Fiscal Cliff” and “Budget Sequestration” – the President and Congress has achieved $1.5 Trillion permanent savings of the $4 Trillion goal. THIS IS BIG! This is progress even though the media will tell you the Republicans and Democrats are not doing anything. The political parties are at each other throats! Don’t believe it.
Change the direction in our “Solvency Curve” – Welcome to the new bull market!
If and when the US Federal Government stabilizes its solvency picture or better yet reverses course to a more solvent nature – increasing our “Solvency ratio from 0.135 – guess what happens? You guessed it. The other participants and actors in the economy start spending their money. Growth starts to happen. Consumers and businesses starts to borrow money again believing expansion and business creation have a high probability of success. Have a look at our “Solvency Curve” and notice the different direction of the arrows – see chart below. As the US Federal Government becomes more solvent the economic actors or participants will start to invest in assets (Houses and businesses), companies will reduce record cash balances – see blog October 11, 2012 – (build plant and purchase equipment, hire additional staff, and start returning cash to shareholders) as economic growth begins to pick up.
CHART – Up Arrows
Model Price’s “Solvency Curve”
The US equity markets are sniffing a secular change occurring in the solvency of the US economy. The “Fiscal Cliff” and “Budget Sequestration” negotiations provided a meaningful and permanent shift showing the US Federal Government is getting its act together and starting to improve its solvency position and the equity markets are taking notice.
This is why the equity markets have been so good lately. This is why new highs have been achieved on the Dow Jones with the S&P 500 not far behind. The US equity markets are sensing a secular shift in solvency driving a better economy and higher stock prices.
I wrote this in my July 17 blog, “What is going on with the world of finance, and how do you fix it!”
It is the US Federal government that is driving the other categories down the other side of the curve. In other words, the solvency of the government is the issue. Therefore, in my mind the President, or whoever, must layout a fiscal plan to at least balance or close the gap in the fiscal deficit. When and if, the federal government starts to climb the left side of our solvency curve, the other categories will start to move up the right side of the curve. The debate of raising taxes or cutting expenses is not the choice Americans have at this present time. It’s both! Taxes will have to be raised and expenditures have to be cut substantially in order to rectify the situation. Once everyone sees the plan and its implementation, the other categories on the right hand side of the curve, especially corporations will start spending their records amounts of cash on hand. Why? The right side of the curve “categories” can see sustainability in the future of the federal government. They can see a limit in terms of taxes and/or reduced services. This will give them confidence in the future and they will spend money on long-term projects, igniting employment and giving confidence to other groups. And so on.
You mean substantially increase taxes and the economy will boom – absolutely! You mean substantially cut federal spending and there won’t be a depression – absolutely!
The New Bull Market
Yes, there will be a new bull market – when? Simple, when both sides of the solvency curve start to move closer together as opposed to further apart. No, when as in timing? I don’t know. But I will know it when I see it!
Well folks with “Fiscal Cliff” and “Budget Sequestration” of the last few months, I’m beginning to see it!!!
The other observation I can make, is when we do enter this new bull market, it will be bigger than any other bull market we have ever had. Why? The extreme nature of where we are now on the solvency curve. Obviously, US Flow of Funds data is not available for the Great Depression of the 1930’s (at least not to us), however the extremes on both sides of the curve, as it is today, haven’t occurred certainly in my lifetime. So when today’s extremes start to stop and reverse course there will be a lot of “Rocket Fuel” for the next bull market.
Are you hearing any of this in the financial press? I THINK NOT!
P.S. Just to be complete and tie together Part 1 and Part 2 of this blog, if S&P 500 has a positive transit of EBV+3 this will be an important indication the market will be comfortable with the secular turnaround in the solvency of the US economy and start of a new secular bull market in US equities.
P.P.S. Also see my blog on Fall over the Fiscal Cliff, Please!