Last week I was spending some time viewing webcasts from the Milken Institute Annual Conference in Los Angeles, as I do every year. (Thank goodness they placed these videos on YouTube. Is there any reason why anybody would place videos on any other platform other than YouTube? Please Charlie Rose put your videos on YouTube!).
One highlight was an interview with Robert Rubin, the former US Treasury Secretary and Gary Becker, Nobel Laureate, Professor of Economics and Sociology, University of Chicago. Both agreed the Federal Reserve Board’s actions in what has become known as QE3 – the third round ‘Quantitative Easing’ – was less effective than QE1.
Because everywhere I look in the business press, this “fake” US market rally cannot be trusted because of central bank liquidity, euphemistically called QE3, that is driving asset values higher not supported by underlying fundamentals.
The Fundamentals are Improving!
Last July I wrote a blog called, “What is going on with the world of finance, and how do you fix it!” highlighting our Solvency Curve and recommended a policy course of action to change the solvency ratio of various economic actors in the US economy. I called for substantial tax increases with a reduction of federal spending to increase the solvency of the US federal government.
I stated in this blog,“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!
On Friday, it was reported the CBO now calculates the federal deficit through the first seven months of the current fiscal year that began in October is $231 billion less than the deficit was at this time a year ago. Also the US Treasury reported on Friday the country recorded a budget surplus of almost $113-billion in April, nearly double the surplus of a year earlier. Everyone will concede this April budget surplus and narrowing of the US federal budget deficit is because of increased taxes, which took effect on January 1, 2013 along with the budget sequestration – cutting of federal expenses.
There is a link between the US budget deficit and the stock market! It’s our Solvency Curve.
When I saw this news on Friday about the US federal budget deficit, I thought the US federal government is becoming more solvent. In other words the US Federal government is “coming up” up the left side of our Solvency Curve. (See Solvency under Key Concepts).
Here is our Solvency Curve
As the US Federal government becomes more solvent and starts to climb the severe curve on the left side of the optimal level of 0.689 (see line), the other participants in the economy will come up on the other side of our Solvency Curve, the right side.
This is how the economy works based on solvency in our view. This is why the US equity market has been so strong. The solvency fundamentals for the United States are rapidly improving. To better visualize what is going on here I have reproduced this chart from the St. Louis Federal Reserve on the US Federal Governments revenues versus expenditures since 1980.
Chart from the St. Louis Federal Reserve Board
As you can see the gap between revenues and expenditures is narrowing. This narrowing of the gap allows the other actors in the US economy, which are super solvent to feel more comfortable spending some of their savings or cash hoards on products and services thereby lifting growth and employment prospects in the US economy.
Another chart that caught my attention was this chart showing “Household Debt Service Payments as a Percent of Disposable Personal Income”.
Chart from The St. Louis Federal Reserve Board
As you can see because of low interest rates and de leveraging, service payments (interest rates) on debt as a percent of disposable income is the lowest than anytime since 1980’s. This implies the consumer has potential to add on additional debt again creating economic activity.
It’s the dynamic of all economic actors, in the US economy, becoming more efficient in terms of solvency. The US federal government becoming more solvent from an insolvent state and everybody else – corporations, individuals, state and local governments, financials – becoming more efficient in terms on solvency by spending their cash on hand or appropriately leveraging balance sheets because of growth opportunities.
In this dance around our solvency curve, the federal government had to make the first move in order for the other participants to feel comfortable initiating action. The equity markets are sensing this shifting dynamic, again led by the US federal government, and lifting equity levels in the marketplace in anticipation of increased growth and earnings prospects.
The dynamic of these economic actors that shift along our solvency curve is secular (long-term) in nature and can last 5 to 8 years. So we are in the bottom of the first inning of a virtual circle of US growth and market valuation increases that will be healthy and long lasting just as long as both sides are marching towards balance sheet efficiency at the top of our solvency curve – see above.
It has become fashionable for the business press and the “bears” to pooh-pooh this market rally. Central bank intervention by way of “QE3” is often sighted as the cause for the market rise with words like manipulation, bubble and my personal favorite “not warranted by fundamentals” thrown in for good measure. Both Mr. Rubin and Dr. Becker both agree that QE3 is having less impact than the Fed (Federal Reserve) has intended.
The reason, in my opinion, for this US market rally is the link between solvencies of the economic actors in the US economy including the federal government. There is a real reason why this US equity market is increasing rapidity. I have started blogging on this subject in of July 2012 (see links below) and have witnessed and participated in this phenomena with excellent investment results in Canada when the same conditions were emerging back in 2002.
Links to my other blogs that I have written on this subject.
What is going on with the world of finance, and how do you fix it!
What is going on with the world of finance, and how do you fix it! (Update 1)
What is going on with the world of finance, and how do you fix it! (Update 2)
Fall Over the Fiscal Cliff, Please!
S&P 500 – Why the US Stock Market is going up! (Part 2)