Collective Insanity, Baseball and Apple Pie.

August 2, 2011

Citigroup economists last week stated that a U.S. default triggered by the failure of politicians to agree on raising the debt ceiling would be an "act of collective insanity." Further, the Citi economists explained the severe impact a default would have on asset prices, as well as the global economy.
Collective insanity? As prevalent as baseball and apple pie.
But first, the facts.
While the deal is yet to be approved, Congressional leaders reached bipartisan agreement to raise the debt ceiling by at least $2.1 trillion. This will serve the nation's needs into 2013.
The deal consists of cutting $917 billion in spending over a decade, raising the debt limit by $900 billion, and tasking a special committee with finding another $1.5 trillion in deficit savings by the year end.
Next, they must sell their respective parties on the deal. And they've left a lot of time to do so. Tonight. Midnight.
The prospective compromise will probably soothe the financial market's immediate concerns about default. But, "this relief will be short," said Mohamed A. El-Erian, chief executive officer of Pacific Investment Management Co., the world's largest manager of bond funds.
El-Erian, during an interview on ABC News "This Week," explained that if Standard & Poor's "sticks to what it said, it will downgrade" the U.S. debt following the deal.
Further, the agreement "does nothing to restore household and corporate confidence, so unemployment will be higher than it would have been otherwise," he said. "Growth will be lower than it would be otherwise."
After everything that's just transpired, how could anyone be completely soothed following this five-till-midnight embrace?
Both parties have forced the world to watch a game of chicken on a global scale. Ratings agencies, sovereign wealth funds, and everyone in between will have a difficult time seriously considering our economic dynamic when its stewards cannot agree on the weather.
And while I admire the moxy shown by some in an effort to use this event as leverage to contend with the larger deficit issues, now is hardly the time! Nine percent unemployment. Falling productivity. Lower wages. Declining asset values.
Yet, these issues deserve more than a shouting match on C-Span. Collective insanity will be the mood du jour when we realize what it is going to take to rectify our fiscal problems.
According to one pundit speaking at last week's Agora Financial Conference, "100,000 average Americans would have to work the next 330 years at today's average salary to pay off what Bernanke and company have added to the national debt this year alone."
That's a lot of overtime.
When this deal is struck, and both parties hold their press conferences, enjoy a scotch and smoke their post-battle cigars, remember this:NOBODY SAVED THE WORLD TODAY.
In fact, this story correlates more closely with that of the pyromaniac who lights the match only so that he can take credit for putting out the fire.
Our politicians got us here. They'd better damn well get us out.
Now, the investment implications.
Consumer and investor sentiment concludes that the market is ready to crash. And the market's short-term reaction to the deal, or a lack thereof, will be derived from emotion. A collective exhalation or exasperation.
But, the markets mid- to long-term direction will ultimately be driven by valuation. And right now, the S&P 500 has a forward-looking price-to-earnings ratio of 13 when one considers the current price of the S&P against its aggregate earnings projection of 98. The median historical P/E ratio for the S&P is nearly 16. By historical standards, this market is not overvalued. One could conclude that its rather inexpensive.
Any correction could represent an opportunity to put some investment capital to work--albeit in strategic corners of the market where one may calibrate some of the risk which continues to be inherent in this environment. Market returns exist, but they are like earthworms in July--one will have to flip a lot of rocks to find them.
This current victory--assuming it comes to fruition--will be short-lived. Another crisis may lie just around the corner.
Why? This short-term crisis of D.C.'s own making may have passed, but the indebted global economy continues to de-lever, growth continues to slow, and the patients continue to run the asylum. Stay tuned...

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