Default averted!
This was the headline that flooded the media on Thursday, following news of a short-term debt limit extension. But did we truly avert a default?
Is it fair to say a default was avoided when Nixon severed the link between gold and the dollar, paving the way for a system reliant on irredeemable paper currency?
Wall Street, of course, has largely ignored the long-term implications of Washington’s endless debt accumulation—along with the subtle inflationary default that Congress is orchestrating. Instead, it focused on what it does best: driving up major stock market indices.
Just a week can make a world of difference. While September brought challenges for stocks, the first week of October has been marked by optimism and gains.
Once again, Washington has devised a plan to keep financial resources flowing. It closely resembles the strategy that has prevailed for the past half-century: keep kicking the can down the road.
This approach typically finds favor on Wall Street. Increased debt—both public and private—has generally led to rising stock indices. Consequently, escalating stock prices often create an illusion of wealth among investors.
While there have been episodic exceptions, the correlation between soaring debt and stock market performance remains largely intact.
Yet this relationship is not immutable. What if circumstances deviate from the expected? What if the recent past does not mirror the near future?
What would that mean for investors?
We will dive deeper into these questions shortly, but first, let’s gain some perspective…
A Work of Genius
“The best laid schemes of mice and men / Go often askew, And leave us nothing but grief and pain, For promised joy!” Robert Burns penned these lines in 1785, albeit in a charming Scots dialect.
What Burns implied is that plans don’t always unfold as intended. Indeed, even the most carefully crafted strategies can bring about unforeseen grief. Sometimes, those plans become liabilities.
Consider André Maginot, a World War I veteran and former French Minister of War, who persuaded the French government in 1930 to construct an extensive series of fortifications along the German border. His initiative was rooted in historical hindsight rather than foresight.
The lessons drawn from World War I revealed that traditional military tactics were outdated. Static defensive strategies became the norm, a reality acknowledged by French leaders who invested heavily in the Maginot Line—the pinnacle of military ingenuity. France believed this fortification would shield them from future invasions.
However, on May 10, 1940, the same year the construction was completed, Germany launched its attack—not directly against the Maginot Line, but by circumventing it through Belgium’s Ardennes forest. France fell within approximately six weeks, and the once-lauded Maginot Line revealed its strategic futility.
“Generals always fight the last war,” it is often said. For the French military leaders of that time, the insights gleaned from World War I transformed from assets into liabilities, misdirecting their resources and attention away from effective defense.
In terms of investing, are you operating under the assumption that past financial crises provide an accurate roadmap for the future?
How to Combat the Investment Enemies Now Mobilizing
The lessons learned during the 2008-09 financial crisis have left many intelligent individuals unwittingly exposed, much like Paris in the spring of 1940. Treasury bills were a safe haven when the stock market plummeted in late 2008 and early 2009, but this strategy may not offer the same protection in the next crisis.
The Great Depression taught us that cash holds great power. The numerous bank failures and runs of the 1930s prompted the belief that hoarding cash—sometimes even stashing it in mattresses—was the way to safeguard wealth. Yet this caution proved costly for the generation that lived through the Depression, as inflation in the 1970s eroded half of their savings’ purchasing power over ten years.
Today’s retirement investors may also be fixated on the possibility of a stock market crash—and rightly so, as such an event seems increasingly likely.
Furthermore, experiences from 2008-09, the COVID-19 panic in 2020, and previous financial crises suggest that the Federal Reserve will step in to support investors. A traditional 60/40 stock to bond portfolio has been regarded as an optimal strategy for both capital growth and preservation.
But what if the Federal Reserve is no longer in a position to provide that support?
When Alan Greenspan enacted the “Greenspan put” after the 1987 Black Monday crash, financial markets were well-prepared for such intervention. Interest rates had peaked in 1981 and were still high, with the yield on the 10-Year Treasury note around 9 percent, allowing ample room for borrowing costs to decline.
The mechanics of the Greenspan put are straightforward. When the stock market experiences a decline of about 20 percent, as it did in March 2020, the Fed intervenes by lowering the federal funds rate, resulting in negative real yields and an influx of cheap credit.
This method creates two observable market distortions. First, it establishes a bottom limit on how much the stock market can fall—creating a put option effect. Second, the lowered interest rates inflate bond prices, as bond values rise inversely to interest rates. Under these conditions, a 60/40 portfolio may appear to be remarkably strategic.
Since the late 1980s, the Fed has been effectively managing a counter-cyclical monetary stimulus program in financial markets. Successors to Greenspan—Ben Bernanke, Janet Yellen, and Jay Powell—have only expanded this intervention through several programs of aggressive money printing.
The purpose of these monetary policies has been to bail out major banks and corporations while sustaining inflated financial markets and providing Washington with inexpensive credit. For the past three decades, U.S. financial markets have been largely manipulated, and there’s little indication that this will change.
However, the conditions that facilitated the Greenspan put have dwindled. The federal funds rate is near zero, the yield on the 10-Year Treasury note stands at about 1.59 percent, and inflation is steadily diminishing purchasing power.
The Fed has effectively trapped itself. In addition, the conventional 60/40 stock-to-bond allocation aligns with outdated strategies. For modern investors, it has become a liability, and those who cling to it risk being caught off guard.
To adeptly confront the emerging investment challenges, a more nuanced approach is necessary. Only full spectrum analysis can provide the tools needed to emerge victorious.
Consider the unconventional; adjust your investment strategies accordingly.
Sincerely,
MN Gordon
for Economic Prism
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