Inside today’s Daily Journal…

Editor’s note: Porter turns today’s Journal over to Tom Dyson, investment director for Bonner Private Research, who steps back to share his perspective on The Big Picture…

Here’s Tom…

The U.S. government is broke and its finances are spiraling totally out of control.

There is no way out. We are hurtling toward a worldwide debt crisis. This cannot be anything but bearish for stocks, especially coming when valuations are as high as they’ve ever been on Wall Street.

But first the money. As my colleague Bill Bonner says, when the money goes, everything goes. Paper currencies are backed by Treasury debt. We are in the final act in our experiment with unbacked paper currency. We’ve been calling it the greatest financial experiment of all time.

I’ve spent my entire adult life studying this experiment. But at the end of my reading and thinking, I came to the humbling conclusion that the whole experiment simply rests on rising asset prices. Specifically, the credit markets only function – including the U.S. government, its $40 trillion debt and $2 trillion yearly deficits – as long as stock prices go up. Whenever stocks stop rising, the system starts correcting violently. Why?

Asset prices, especially the S&P 500, are the collateral backing the U.S. government’s credit and therefore the entire experiment itself. I didn’t make the rules. It’s just clear that the stock market is the pivotal asset, and when it falls enough, it triggers a doom loop of margin calls, defaults, profit warnings, bankruptcies, lay offs, and then more selling. If not addressed forcefully with massive inflation, workers lose their jobs, the tax base shrinks, the government’s obligations soar and the Treasury quickly starts to look insolvent, triggering even more doom loops.

Meanwhile, a rising stock market generates capital gains taxes for the government. The last time the U.S. government budget showed a surplus was 1998 through 2001.

There were two reasons for this (not Bill and Hillary Clinton). First, Social Security actually ran a surplus in those years. Contributions from payroll taxes exceeded the cost of benefits going out the door. It was an unusual demographic “sweet spot” that accounted for most of the surplus. But the stock market helped. During that four-year period, capital gains taxes were roughly double their percentage of federal tax receipts. The dot-com boom generated big tax cash for the Feds. The stock market crash – when the major valuation metrics we follow at Bonner Private Research were last this high – wiped out capital gains taxes.

That will happen again. And when it does, you’ll get a double whammy. Falling asset prices will reduce demand for U.S. government debt, pushing up interest rates. And capital-gains tax receipts will plunge. The $2 trillion annual deficit will grow even wider – this time because Social Security is now running annual deficits, where the cost of benefits exceeds the income from payroll taxes.

Inflate or die.

It’s easy to get blinded by the flashing stock quotes, emergency headlines, and earnest news reports of modern speculative finance. But once you strip away all the complexity and pizzazz, you see our experience of the last fifty years has really just been a self-reinforcing cycle of rising asset prices and expanding debt, spiraling higher and higher, year after year.

Or said another way, it’s been an epic credit inflation (as described by the Austrian school of economics.)

The credit inflation must now deflate. The most rational investment strategy is to get as far away from overvalued markets as possible. We call this position Maximum Safety.

In the past, a super defensive investment position would have simply meant holding cash, especially the dollar, which you could always count on to be a store of value in a crisis or panic,

That’s no longer true today. To repeat: falling stocks mean a falling demand for the dollar and U.S. debt. Higher interest rates might make the dollar attractive to some foreign investors. But they will have to consider the risk of default/inflation by a U.S. government that simply cannot stop spending money.

The Feds understand the contagion risks. They have concluded that the only way to head off these Minsky Moments is to move fast… and go large. To prevent a massive asset sell-off, the Fed will become a big buyer of stocks and bonds again.

In fact, I bet they’re already prepping the next hero’s dose of stimulus. They simply cannot risk a chaotic collapse in asset prices. If the Fed is forced to choose between allowing a stock market crash – negative for all the reasons I’ve shown – or allowing a great inflation through the paper currency system, it’s not a mystery. They will use the currency as a release valve rather than let stocks crash. The resulting inflation and the increase in your cost of living… is just the price you’ll have to pay. It boils down to using the paper currency system as the release valve for losses… by debasing the currency.

All this means holding cash is no longer risk-free. In fact, it’s quite risky.