The U.S. government is facing a staggering amount of unfunded liabilities in 2010, around $3.5 trillion. As I described in my commentary on the Greenspan/Guidotti rule, the only way the government can make the interest payments on this debt (a good deal of which has been acquired in the past 12 months) is by printing money.
This situation is, without a doubt, the single most important financial trend in the world. It will not only affect the bond market, it will come to greatly affect the stock market, too.
You see, what most people don’t understand about the huge bull market in stocks over the last 30 years is that it was mostly funded by debt and powered by falling interest rates.
Earnings were driven by growth in GDP, which was fueled by the greatest expansion in public and private debt in history. Keep in mind, over the last 30 years, America went from being the world’s largest creditor to the world’s largest debtor. At the same time, the interest on our debts fell every year, nearly in a straight line. This is the best recipe you can script for soaring asset prices.
Consider how these factors worked in your own neighborhood. As interest rates fell, more people could afford a bigger mortgage. And as more credit became available, more people were competing to buy homes. Prices rose. Rising prices allowed more credit to become available. As more credit was available, interest rates fell more. The cycle continued.
In the stock market, falling interest rates increased earnings because companies spent less maintaining their debts. At the same time, consumers had more money to spend. Not only did earnings rise, but more importantly, the value of equities rose in terms of earnings multiples.
When interest rates are very high, fewer investors are interested in stocks. But as interest rates fell, more and more investors had to buy stocks to earn an acceptable rate of return.
Rather than trading for 10 times earnings or less, stocks began to trade at 20 times earnings or more. At the peak of stock valuation in 2000, the S&P 500 was trading at almost 45 times earnings. Today, the valuation is still high – around 20 – because interest rates are still very, very low. If interest rates on U.S. bonds go to more than 10 percent, stock market valuations will plunge. At the height of the last interest-rate cycle in the early 1980s, the S&P 500 traded at around seven times earnings.
It will happen again. But right now, few people believe it’s possible. It’s instructive to note who does think this risk is real…
Hedge-fund billionaire John Paulson says he no longer trusts the dollar as his reserve currency and has put a huge amount of his fortune into gold. The world’s biggest bond investor, Bill Gross, recently posted this on his website: “We caution that the days of carefree, check-writing leading to debt issuance without limit or interest-rate consequences may be numbered for all countries.”
And in August, Warren Buffett himself wrote an op-ed to the “New York Times” warning about inflation:
The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects.
For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself… the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.
He told CNBC the government’s efforts to paper over the banking crisis “are potentially very inflationary… worse than the 1970s inflation.”
As a stock investor, what should you do to prepare? I’d avoid conventional growth stocks… the kind that carry P/E multiples in the 20-40 range. Contracting multiples are particularly hard on these sorts of stocks. They have the most value to shed. Make sure to own the best businesses you can find… stalwarts like Verizon and Johnson & Johnson. Ideally, you’ll want to buy them for less than 10 times cash flow (a metric similar to earnings).
Also, you’ll want to skew your stock holdings toward commodities, like energy and precious metals. These sectors do well when inflation is rising, when the government bond market is correcting, and when earnings multiples in the stock market contract.