>Quarterly Commentary: What Can’t Happen, Won’t

>The following was mailed to my clients about three weeks ago:

There is a saying, though for the life of me I can’t figure out who said it, “What Can’t Happen, Won’t.” Though perhaps understated it communicates a powerful truth. Let’s take for example straw, it cannot be turned into gold. No matter how hard we try, you cannot spin straw into gold (trees on the other hand are another story once they are turned into pulp, then into paper and eventually money issued by a government…..you can buy gold with it….thus, trees can be turned into gold, at least temporarily). What is my point?

First, let me point out a few facts (via www.usdebtclock.org):

National Debt $12.86 Trillion
Projected National Deficits through 2020 $7 Trillion
Present Value of Social Security Liabilities $14 Trillion
Present Value of Medicare and Medicaid Liabilities $94 Trillion

Added together these liabilities of the United States represent a total of over $120 trillion or nearly $400,000 per citizen.

The Peter G. Peterson Foundation has a different estimate. According to the foundation, only about $62 Trillion or only $200,000 per citizen….only. The difference between the two is likely the use of different time frames.

Keep in mind this excludes other off-balance sheet items like the guarantees that will need to be financed from losses at the FHA, Fannie Mae, Freddie Mac and the Federal Home Loan Banks. Nor does it include state and local debt or the deficit many state and local pension plans face. Don’t forget the costs of the new health care reform just passed into law, despite the rhetoric and regardless of your support or opposition, it will eventually add to the deficit and national debt.

Bottom Line: The United States cannot continue on its present course, nor can most of the western (and eastern for that matter) countries. We have created a financial structure that we cannot pay for.

We can argue all day long about whether we should be providing the promised benefits, but at the end of the day the facts are we cannot pay for these benefits, at least not as currently structured. The amount of growth that would need to take place to fund all the promised benefits has never happened in history and there is no reasonable belief it can happen in the future, even in the great nation of America. The fact is we can’t grow our way out of this problem. We also can’t inflate our way out of this problem.

The national debt is projected to approach and probably pass $20 Trillion by 2020. While this is a massive number and history has clearly shown it to be very dangerous, if this was all we had to deal with I am confident we could dig ourselves out of the hole, though not without real pain. Even if we couldn’t we could go back to the age old ploy of inflating the currency so that our debts become worth less to those who hold them. Since the Federal Reserve came into being in 1913 we have done just that, inflating our currency so that a $1 today is worth the equivalent of 5 cents in 1913 dollars, a 95% devaluation. This would be devastating to people receiving a pension with no inflation benefits (in fact it used to be considered treason). This is not to say we won’t try to inflate our way out, but our other liabilities (entitlement programs) are in real dollars, meaning the less our dollar is worth, the more our liabilities increase (in direct relation). Thus, inflating simply won’t work.

If we can’t grow our way out of the problem and we can’t inflate our way out of the problem, what can we do? I don’t have the answers anymore, I wish I did. Simply becoming more fiscally responsible is not enough. Without massive entitlement reform there is not an answer.

Remember, in order to finance our deficits (and rolling over of current debt) we must sell bonds (or bills). There are only three entities that can buy these bonds – foreigners, citizens (and their agents) and the Federal Reserve (though technically not directly). At what point will foreigners and citizens demand a higher rate than they are receiving now? Is there a point at which the world (or our citizens) would stop buying our bonds?
It is entirely possible and as each year passes with our fiscal condition deteriorating the probabilities increase. This would leave only the Federal Reserve to buy our debt, effectively monetizing (printing money to finance our deficits) our debt. This eventually leads to hyperinflation and a collapse.

I don’t say all this to scare everyone, only to point out what we already know to be true, “What Can’t Happen, Won’t” – I’m beginning to think I heard this phrase from John Mauldin. If we can’t pay back our bonds or the interest on our bonds and if we can’t pay our entitlement costs – we won’t. This doesn’t mean we will immediately default, it just means we will eventually default (I consider the Federal Reserve monetizing the debt to be a default if they are the only buyer). The scenario’s that play out will almost certainly be different than any of us predict, but the end game will be the same – not enough money to pay our liabilities.

When this will happen is anybody’s guess. Some believe the end is very near, like next month, others believe it could take years, even decades due to the position of the United States as the world’s reserve currency. I do not know the timing, nor the trigger, I only know that if we can’t pay our debts, at some point we won’t.

This forecast of sorts shouldn’t be taken as a prediction of impending doom, though I would never discount that possibility either.

We all experienced 2008 and while most have tried to forget, our 20% unemployment rate is a good (actually bad) reminder that our problems still continue. If the probability of a financial collapse occurring was just 5%, would it not be worth your time to prepare for such a collapse – especially if the cost was negligible?

The stock market has been booming lately and it may continue, I don’t know. What I do know is that using the Shiller valuation measure PE10 (if you really want to know more about this measure call me and we’ll talk) is overvalued on a historical basis (see chart above).

We learned that bubbles allow stocks to become overvalued and that this condition can last for many, many years, but eventually the valuations revert. The Federal Reserve’s Zero Interest Rate Policy is having the desired effects – waning risk aversion. This risk aversion has pushed stock prices up with no relation to the underlying economy and has removed the margin of safety that existed a little over a year ago. Who would have predicted that a volcano eruption in Iceland could have a such a huge impact on the world? It wasn’t something that could be predicted, but what could be predicted is that something unexpected would occur (Goldman Sachs lawsuit filed by the SEC) and that could have a serious affect on overvalued stocks.

It is for these reasons that I continue to be defensive in your portfolios in general. I understand the frustration that occurs when the stock market is up 1% and your risky assets don’t follow. But the days when the market is down 2% and your risky assets aren’t down nearly as much (which is what I am happy to report is occurring) this feeling trumps the other. Our goal is to take risks when it appears those risks will be aptly rewarded. This doesn’t mean we won’t lose money or experience fluctuation, but hopefully we will lose less and experience less fluctuation.

Many of you have been asking me about Gold and Silver lately and would I advise you buy it? The answer is somewhat ambiguous. I’m not convinced we will experience inflation (though I can testify that I am experiencing it) as deflationary forces appear to be settling in. Thus Gold and Silver in the short term could fall a lot. My answer to you is that you must be prepared for substantial losses if you buy Gold and Silver (at least in the short term). Gold could easily go to $2,500 per ounce, it could also just as easily fall to $600 per ounce. I’m not positive it won’t hit both at some point. So if you buy it you should do the following:

• Prepare for a wild ride

• Own it physically (not via an ETF or mining stocks)

• Hold it in your safekeeping, not a bank safe deposit box (it has been illegal to own gold in the past)

• Silver is easier to trade than gold because it costs less

• Don’t go overboard, but having a small percentage of your net worth in gold or silver shouldn’t hurt you long term

Please don’t take this as recommendation to buy Gold and/or Silver, only a suggestion that if you do, the above is how you should do so.

I do want to encourage you about the long term. I am writing this quarterly commentary on my brand new iPad (Apple). I love the iPad. The iPad is ushering in a new era in connectivity and computing and represents something entirely new. Decades from now we will look back at this little device as the start of a computing revolution. I also believe the world is on the brink of a technology and bio-technology revolution – the likes of which will change our world forever. Our world will look very different 30 years from now than it does today (not exactly a prescient observation) and while we face enormous struggles and uncertainties the ingenuity of free people will continue. The irony is that while our financial picture looks bleak, the potential for scientific leaps forward is huge. Perhaps these future leaps will allow us to dig out of the hole we dug ourselves into, but then again that wouldn’t be a very good lesson to learn.

P.S. Just read Thomas Donlan’s recent Barron’s article in which he found the original of my commentary title – Herbert Stein. Stein’s Law states “If something can’t go on forever, it will stop.”

Scott Dauenhauer CFP, MSFP, AIF

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