Stock Market Sees Return of Risk, Volatility

The potential and perhaps inevitable meltdown of the EU speaks directly to the reasons that volatility has returned to U.S. markets.
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By Robert Barone of Ancora West Advisors



) -- Yesterday's action in the equity markets tells me that risk and volatility have returned. The potential, and, perhaps, inevitable meltdown of the European Union due to the overpromising of entitlements and habitual deficit spending speaks directly to the reasons that volatility has returned to U.S. markets. After all, hasn't the U.S. made similar promises?

During the Greek debt crisis, precious metals have moved to the upside toward historic high prices as a flight to safety. My view is, and has been, that the U.S. is not immune from similar dire consequences of its own profligacy. In fact, the country may have already passed the point of no return with regard to solutions. The uncertainty surrounding the long term direction of taxes, fiscal policies and monetary policies in the U.S. makes the flight to safety and to precious metals a rational response.

The financial industry generally ignores academic studies and conclusions. But every once in a while, a study based on well documented historical data, reports conclusions so compelling that they cannot be ignored. Reinhart and Rogoff's 2009 book,

This Time Is Different: Eight Centuries of Financial Folly

made an impression on some business savvy folks regarding the fallacies of the use of debt to resolve a financial crisis.

Now comes along another study, this one relatively obscure, by Cecchetti, Mohanty, and Zampolli of the Bank for International Settlements entitled

The Future of Public Debt: Prospects and Implications,

March, 2010, which concludes that the current and future state of fiscal policies and accumulated liabilities, along with the lack of political will, make future inflation and devaluation the most likely future scenario.

Under the following three sets of assumptions about future fiscal policies (which exclude the huge underfunded liabilities in almost all state and local pension plans), the structural deficits now built into the U.S. budgets will move the debt/GDP ratios to levels similar to or worse than those now causing issues in Europe.

If non-age related spending/GDP stays constant at 2011 levels, the age-related entitlements will push the debt/GDP ratio to over 150%;

If the U.S. follows its current plan to bring the deficit down to 4% of GDP by 2015, the age related entitlements push debt/GDP toward 300% by 2040;

If age-related spending/GDP is frozen at projected 2011 levels, the debt/GDP ratio still approaches 150%.

Conclusions and Investor Implications

Yesterday's market volatility may be partially related to the recognition that the fiscal problems confronting the U.S. and other industrial economies are more serious than have heretofore been recognized. Ask yourself how confident you are that the U.S. Congress could soon accomplish any one of the three sets of assumptions, i.e.: 1) hold non-age related spending at 2011 projected spending levels; 2) follow the plan to reduce the deficit/GDP ratio to 4% by 2015, especially in the face of high structural unemployment; or 3) freeze the age related spending/GDP ratio at projected 2011 levels, especially given the new health care legislation.

Given the spending track record of Congress under both Republican and Democratic leadership since 2001, one should have little confidence that 1) or 2) could be accomplished. And 3) would take political will not seen in our lifetimes. Yet, even if any one of these is accomplished, the authors conclude that the U.S.'s debt/GDP ratio would still reach at least 150%.

It thus appears inevitable that the dollar will lose purchasing power (even if it doesn't fall

vis a vis

other currencies due to those countries' debt/GDP ratios) against hard assets. Finally, history shows that it is politically more palatable for politicians to choose inflation, rather than higher interest rates, as the solution. Increased portfolio allocations to inflation hedges (precious metals), then, would seem to be the rational long-term response. Yesterday, the markets began to recognize this reality.

-- Written by Robert Barone in Reno, NV

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