Deficits Don’t Matter.

Former Treasury Secretary O'Neill said he tried to warn Vice President Dick Cheney that growing budget deficits, expected to top $500 billion …posed a threat to the economy. Cheney cut him off. "You know, Paul, Reagan proved deficits don't matter.” Well, that’s the thing we are going to find out because President Bush plans to make the tax cuts permanent. Bush’s thinking is that lower taxes will grow the economy, and with a growing economy we will have more revenue. But Alan Greenspan has already testified to Congress that the loss in revenue from tax cuts has not, so far, been made up by economic growth. And I took his reading of the situation to mean, that it won’t be made up in the future, either.

The administration’s ambitions and commitments make deficits a fixture of our future as far as the eye can see. Old time conservative Republicans don’t approve. But Bush has a war to fight. And he just gave corporate American $140 billion in tax cuts. He signed one of the worst pork highway bills in history, and he has a drug benefit coming on stream. Not a single veto.

My take: he’s going to borrow and borrow and borrow until someone tells him he can’t borrow anymore. So far, our "Liberty Bonds" have been bought in great quantities by the Chinese and Japanese. I have thought for some time that the break in the damn will come in the bond market. A treasury offering with bids only just covering the issue amount, instead of the usual 1.5 to 2 times the issue amount. This could occur if the Chinese decide they need the money they’ve been lending to us to build a highway network, or start a space program, or extend some health benefit program to their people, then there will be that much less money to lend the USA. When that happens, then our interest rates will have to go up to attract that same money.

Overseas investors can see that the administration doesn’t care about maintaining the value of the dollar (because they’ve said that a declining dollar is good for exports). And they may very well decide that a declining dollar makes their investments in the U.S. not so attractive. Especially for bonds. If you’re earning 4%, and you may lose perhaps 10% on the currency transaction, you’re going to think twice. You say 10% is outrageous, but the dollar has already lost 30%-40% of its value against the Euro in the last few years.

If the dollar suffers a precipitous loss, and declines say another 25% of its value in a short period of time, then the administration may be cornered into taking the issue of taxes and spending seriously. In which case, they may be forced to revise tax policy, and Mr. Bush may finally have to veto a spending bill. But anyone expecting this to happen in advance would be in Never Never Land. It cannot happen if Mr. Bush is to execute his radical plans with regard to taxes and Social Security.

The Europeans Don’t Care.

Many of the major finance ministers in Europe have said they can live with a higher Euro, and why is that? It is because oil denominated in dollars means that it will be cheaper for them. And since oil is such an important component of an economy, it will make their costs more reasonable.

And if Europe doesn’t care about a higher Euro, and the administration doesn’t care about supporting the dollar, then it is clear as day that Warren Buffett’s huge European currency purchases are going to work out very well indeed. It doesn’t take a huge amount of brain power to figure that one out.

Further, gold, which has been in the doldrums since the 1980s, has recovered its monetary status and recently goes up on whichever news seems to help it most: a declining dollar or higher oil prices. Most recently, it hit a new 16 year high when oil had backed off, but the dollar had declined.

Happy Surprises.

There well may be happy surprises that will unseat the dismal prospects in sight. Mark Hulbert, who tracks investment advisers, has reported for some time that the most reliable advisers have been predicting a higher market for some time.

Peace may break out in the Middle East. Yassir Arafat is gone, and new leadership may want to cut a deal. Greenspan is trying his best now to raise interest rates, so that if things go awry, he will have something in the cupboard to get things going again.

Bush may show fiscal restraint, which would help the dollar, but so much is already baked into the cake we find that unlikely to help much.

Investment Advice.

Well, gold seems a reasonable bet against the currency and energy prices (read trade inbalance). It may go as high as $500 this next year. But it may also drop back precipitously. In short, it will be volatile, but most likely with an upward bias. Probably some of the oil stocks will work out, with oil perhaps hitting $70 sometime during 2005, but it, too, will be volatile. We will go on record about our oil stock choice, Suncor. Of course, some stocks will have great prospects on their own, and will go up, if you can figure out which ones they will be. Hint, Taser has already had a great run with a PE of 100. And so has Google, already at a PE of 200. You’ll need to find another. Check out the Products and Services Watch under PICKS.

Christmas doesn’t look that special. Retail sales at Wal-mart have tended to 2% increases year over year, and with winter coming on and heating oil prices now expected to be 37% higher than last year, there will be a few less presents around the tree.

We think that the Bush Re-election Market will subside after the first of the year, and after that the market will trend down some more. If there is a sudden loss of confidence, and sharply lower prices, then we may then get some fiscal restraint. But the usual tools it would use to drive the economy, lower taxes and lower interest rates, can’t be used. Why? Because they’ve already been exhausted. No one will lend to us at low rates because we haven’t shown we intend to pay them back in any reasonable time frame.

If interest rates go up, then people can’t afford to buy the same amount of house, and we think some of the air in housing prices will ooze out. If stock prices may go down, and housing prices may go down, then we think cash will be a good thing to have.

November 16, 2004