The $61 Trillion Hole

June 8, 2011

USA Today had a nice piece on government accounting today.  Although it is little known to the public, corporations are required to use accrual accounting, while government entities are allowed to use cash accounting.  The difference is profound:

Corporations would be required to count these new liabilities when they are taken on — and report a big loss to shareholders. Unlike businesses, however, Congress postpones recording spending commitments until it writes a check.

Unlike a corporation, Congress (and also smaller government entities like states, counties, and cities) is allowed to make a promise to pay out something, but is not required to reserve for that event.  It is akin to an insurance company collecting your policy premiums but not setting anything aside to pay the eventual claims.  According to the article, USA Today has calculated federal finances based on standard accounting rules since 2004 using information from the Medicare and Social Security annual reports and the audited financial report of the federal government.

Once standard corporate accounting rules are used, here’s the real picture:

The $61.6 trillion in unfunded obligations amounts to $527,000 per household. That’s more than five times what Americans have borrowed for everything else — mortgages, car loans and other debt.

Ken Rogoff and Carmen Reinhart have discussed debt levels in relation to economies and point out that debt-induced sclerosis—very slow economic growth—results when the debt becomes too unwieldly to service.  Based on historical precedent, they point out that very slow growth tends to occur when debt grows to about 90 % of GDP.  If eventual liabilities are taken into account, given the US GDP for the last fiscal year was about $14.66 trillion, we are already over 400%.

An American contemplates the national debt

This is scary stuff.  Most households in this country could not readily service a $527,000 loan.  Resolution can come in a variety of ways, however: outright default, debt restructuring, repudiation of some of the future promises made, dollar devaluation, inflation, austerity, and so on.  Even just muddling along will work for some amount of time—probably.  As Mr. Rogoff points out, the timing of a crisis is inexact:

It’s very hard to call the timing of a crisis. You can see that an economy is vulnerable, and maybe even fairly reliably say you’ll have a crisis in 5 to10 years, but until it’s upon you, it’s hard to narrow the window down with any precision. Many of the people who say they predicted the crisis in a precise way had actually been predicting a crisis for years. There’s irreducible uncertainty coming from fragile confidence and political factors. The analogy is someone who’s vulnerable to a heart attack. You can go to the doctor and they can see your cholesterol is high and you have a number of risk factors, but you might go on for 20 years without anything happening. Or it might be 20 hours.

Each of the different scenarios for resolution will create very different investment outcomes.  The best way, I think, to deal with the $61 trillion dollar hole, was expressed very eloquently by Andy in an earlier article:

Investing is always disconcerting because of the real and perceived risks to the capital markets and to the global economy. Professor Rogoff’s point about timing a financial crisis based on known fundamental data is an important one. Risks may be in place to cause a crisis, but if the likely window of time for those risks to actually result in crisis range from the next couple months to the next several decades the investor is left with the decision of how to incorporate those known risks into an investment plan. It is one thing to be aware of great fundamental risks and it is another to be able to translate that knowledge into profitable investment returns.

Again, we see why pragmatists gravitate to tactical asset allocation. The tactical asset allocator accepts the reality that timing market moves based on fundamental data is nearly impossible. Therefore, the tactical asset allocator embraces the concept of reacting to trends in a disciplined fashion. It is the next best thing to having a crystal ball.

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High RS Diffusion Index

June 8, 2011

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 6/7/11.

This index has worked its way to the middle of the distribution over the last couple of months.  The 10-day moving average of this indicator is 54% and the one-day reading is 41%.  Dips in this indicator have often been good opportunities to add money to relative strength strategies.

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