Market Overview

Trail Risks And The Debt Trap

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July 31, 2011 (FinancialWire) (Via Investrend Forums Syndicate) (By Craig Drill) -- FinancialWire(tm) contributor Craig Drill offers perspectives relevant to the entire market spectrum, represented by bellwether-type ETFs such as the Health Care Select Sector SPDR ETF (NYSE: XLV), the Market Vectors Agribusiness ETF (NYSE: MOO), the SPDR Gold Trust (NYSE: GLD), the iPath Goldman Sachs Crude Oil ETF (NYSE: OIL), the iShares Dow Jones US Real Estate ETF (NYSE: IYR), the PowerShares Global Progressive Transportation Portfolio ETF (NASDAQ: PTRP), the Claymore U.S. Capital Markets Bond ETF (NYSE: UBD), the Technology Select Sector SPDR ETF (NYSE: XLK), the Industrial Select Sector SPDR ETF (NYSE: XLI) and the PowerShares DB US Dollar Index Bullish Fund (NYSE: UUP), to name a few. To that end, here is Drill's latest entry:

During July, of the many "tail risks," it appeared that the 20-month old euro-zone debt crisis was taken off the table, for a while. Frightened political leaders extended a second and aggressive bailout package to ring fence a "selective default" in Greece and contain contagion.

But the package was complicated and fears have already returned to markets, pushing the ten-year bonds of Italy and Spain down to the levels before the rescue plan was leaked. As Vince Lombardi said, "Confidence is contagious. So is lack of confidence."

In the U.S., a polarized political environment has turned increasingly acerbic, personal, and uncompromising. This is further dampening consumer and business confidence, and reducing faith in government.

The legislative requirement for the debt-ceiling increase has turned into a political showdown of sharply different visions of the fiscal future of our country. It has provided leverage to 87 freshman Republicans in the House (many of whom were elected with Tea Party support) to advocate for a smaller federal government. They are profoundly against spending even more on top of a gaping 9% fiscal deficit relative to GDP.

With positions hardening and the parliamentary process complex, it appears that Congress will not raise the debt limit until after the August 2 "deadline." Conservative Republicans believe that there is some "loose change in the sofas" at the Treasury and the possibility of asset sales, so that the drop-dead date may not be until August 11 or later.

At some point, the Treasury, to avoid a technical default, would be forced to "prioritize" its payments. The reality of the Treasury choosing among Social Security recipients, Medicare and Medicaid providers, defense vendors, soldiers operating in Afghanistan and Iraq, veterans in hospitals, and the Departments of Agriculture, Homeland Security, Commerce, Interior, Transportation, State, Education, and Justice would be chaotic. Public reaction and global media focus would be intense. The markets may have to put more pressure on Washington.

Without a credible and comprehensive bipartisan "Grand Bargain," U.S. Treasury debt will likely be downgraded to AA from AAA. The downgrade of this "safe haven" will ripple through financial markets, both domestic and international, undoubtedly with unexpected dislocations.

Meanwhile, the U.S. economy is clawing its way, ever so slowly, out of a deep hole. Real average weekly earnings continue to decline. Housing continues to be depressed, staggering under a heavy overhang of debt and a large inventory of foreclosed or otherwise distressed properties, and weak demand.

The labor market is crushed. The shift in income from workers to management and shareholders is unprecedented. There are hundreds of millions of trainable workers in the world whose pay is a fraction of U.S. pay equivalent.

According to reports this morning, the economy grew only at 1.3% in the first quarter and 0.4% in the second. Even if growth in the second half accelerated toward 3%, the much weaker expansion in the first half means that growth in 2011 as a whole will only be 1.5% or so, a generally unstable growth rate.

In this challenging environment, monetary and fiscal policies have turned less accommodative, perhaps prematurely. The so-called "QE2" has ended and, although the Fed stands ready to act again, if necessary, the situation today is more complex, with rising inflationary expectations and core inflation.

On the fiscal side, stimulus programs are tailing off and attention is on cutting spending, not increasing it. But debt is credit, and credit, debt. In our modern economy, total growth of credit must more or less parallel GDP growth.

As Al Wojnilower wrote in his latest piece, "Stormy Weather" (see http://www.investrendsyndications.net/content/drill/2011/06/14.php), Treasury borrowing and spending have been offsetting the gap in private activity. If the reduction of public sector credit growth is not offset by a rise in private sector credit growth, the risks for the economy are asymmetric: toward a new recession rather than a boom.

Well-intentioned actions to reduce the fiscal deficit may actually widen it. This is the classic "debt trap."

But, while the U.S. economy struggles, growth in corporate profits and free cash flow is robust. Almost half of the sales of the companies in the S&P 500 are coming from outside the U.S. In addition, unit labor costs (about two-thirds of total business costs) remain stable, while revenues rise. The cost of capital also remains low.

The U.S. stock market is selling at a P/E near 13X bottom-up consensus EPS of $98 for 2011 and at 2.2X current book value. This valuation is compelling taking into account prevailing interest rates and inflation, dividend yields, strategic and private market value, and preferential tax treatment for long-term capital gains and qualified dividends.

Moreover, cash-rich corporations are returning money to shareholders through share buy-backs and dividend increases. Shareholder value is further benefiting from mergers and acquisitions, as well as debt reduction and restructuring.

Interest rates will also remain low for an "extended period," and that extended period will keep getting extended. The monetary punchbowl remains on the table, and it is "Happy Hour" for the pricing of drinks... for those who want to drink.

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Source: Craig Drill Capital (http://www.secinfo.com/$/SEC/Name.asp?X=craig+drill+capital%2C+l%2El%2Ec%2E); This and all original content authored by Craig Drill is subject to proprietary trademark, intellectual property and copyright Laws. Copyright (C), Craig Drill Capital; All rights reserved.

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