KICKING THE CAN DOWN THE ROAD

In the last few weeks, the hands-down winner for the most used, hackneyed cliché in financial and political speech with respect to the federal debt and deficit has been “kick the can down the road” which is a folksy way of saying procrastinate. The expression probably derived from an old children’s game and appears to be the one thing that both Republicans and Democrats agree on, that they don’t want to be accused of doing. It seems that many politicians would rather be accused of emulating DSK rather than be called a can-kicker. DSK’s behavior has been seen before in DC.

The children’s game has been described as an active, energetic, happy game played by a few children at the same time, while the verb to procrastinate means “to put off until tomorrow what we could do today.” During this period leading up to reaching the nation’s debt limit, the anti-can kickers all want to be seen as serious men and women. They’re thinking of our grandchildren they tell us, forced to make the hard austere decisions that will bring tears to people’s eyes; profligates no more. Cutting benefits, yes, we must do that; raising taxes, no, we will never do that, better to kick the can on that one. Even President Obama joined the conversation declaring that he too would kick no can down the road and suggested he would kick something else in an attempt to get something passed.

All the posturing is the attempt to fashion a complex, long-term “permanent” solution to America’s operating deficit and outstanding debt problem, appending it onto immediate legislation that would extend and raise the ceiling imposed annually by Congress on the amount of US Treasury debt that can be issued and outstanding at any one time. The debt ceiling problem is an immediate one – Secretary Geithner claims that the Treasury cannot function and pay America’s bills after August 2nd.

Some Republicans, especially those representing “Tea Party” backers, including Michele Bachman, are opposed to any extension of the debt ceiling. In her new campaign ad she declared that she would not now nor ever vote for any plan to raise the limit. Many view the date of August 2nd as just a ploy by the administration to raise a false alarm. One senator contended that even without Congress raising the debt limit, the Treasury would have plenty of cash available to pay interest to bondholders first, and then could delay without consequence, Social Security, Medicare and other benefit payments, and government salaries. The dystopian view that bondholders must always get their interest paid before retirees or veterans or even soldiers can get their checks sounded like Marie Antoinette’s famous “let them eat cake” moment..

There are two issues at play – one an immediate problem, the other long term - and both are poorly served by a false linkage done for political leverage for both parties going into the 2012 elections. In my opinion, the debt ceiling extension is mandatory, immediate and must be passed. Without it, I believe that we risk a catastrophic event potentially equal to the market crash and enduring financial crisis that began with the major miscalculation by Secretary Paulsen that led to the Lehman Bros. bankruptcy filing. Extend the debt limit, I say urgently, and kick the the longer term problem down the road.

Realistically, no worthwhile, decent legislation can possibly be debated, understood and passed by the two branches of Congress before August 2nd. A poorly constructed long-term spending bill will be like the healthcare bill, controversial, reviled and propagandized from the start. The best outcome for the American people at this time would be for this can to be kicked and re-kicked down the road until the 2012 elections are over. After the elections, we should have a clear picture of true voter sentiment and political power in the country, whether it’s from the likes of an extreme Michele Bachman, a moderate Mitt Romney or Jon Huntsman, or the neo-centrist President Obama.If power shifts after 2012, any legislation enacted today will certainly be renegotiated or repealed

The consequences of Congressional inaction, of kicking the can, could, in fact, be quite beneficial and result in a balanced budget by 2015 says the CBO. I will repeat what I said: If Congress does nothing, the budget can be balanced in 2015 based on legislation currently in place. Surprisingly, this has not become part of anybody’s debate, probably, I guess, because it doesn’t serve the political strategy for 2012 of either party. It would by definition be kicking the can.

A few weeks ago on June 23rd, the CBO (Congressional Budget Office) issued its 2011 Long-Term Budget Outlook. The extensive report is fact-filled with accurate, non-partisan information and is generally considered to be reliable. Readers can access the report at www.cbo.gov .

The CBO presents the long-term budget outlook under two scenarios that embody different assumptions about future policies governing federal revenues and spending. Neither of the two scenarios is offered as a prediction of future events, since each scenario depends on a specific course of political action and prospective legislation that may be enacted. Following are the two scenarios:

In The Extended-Baseline Scenario, if current law is permitted to stand – which means that there is no repeal of the healthcare legislation; no further extension of the “Bush tax cuts” which have already been extended once and are scheduled to expire at the end of 2012; no repeal of the current health care legislation; and no new fiscal legislation - there is no immediate crisis. The budget deficit would disappear beginning in the crossover year of 2015 and continue balanced to 2035. In the CBO’s words: “That significant increase in revenues and decreases in the relative magnitude of other spending would offset much – though not all – of the rise in spending on health care programs and Social Security.”

This scenario offers the best reason in the world to kick the can down the road: A balanced budget with no new legislation. Adjustments can be made down the road as political conditions improve and events dictate.

On the other hand, the alternative is not so good. Under The Alternative Fiscal Scenario, the situation becomes “much bleaker” according to CBO. CBO assumes that there will be tax cuts, (changes to existing law such as a further extension of the tax cuts due to expire); the “reach of the alternative minimum tax will be restrained;” and that Medicare payment rates to physicians will remain at present levels rather than be reduced as called for under current law.” The CBO concludes that the “explosive path of federal debt under the alternative fiscal scenario underscores the need for large and rapid policy changes to put the nation on a sustainable fiscal course.”

A picture is worth more than all my words, so following are two charts prepared by the CBO that graphically depict the two scenarios.



The air of political uncertainty and constant talk of debt crises in Europe and the United States is infusing the stock markets with a sense of uncertainty. Fears of a double-dip recession are back on the front burner as growth slows. Yet, in spite of the psychological climate, the markets have produced gains for the year. Through June 30th, the S&P 500 is up 4.9% for the year to date, while the narrower Dow Jones Average is up 7.2%. In the second quarter, the S&P was down by 0.4%, while the Dow rose by 0.7%.

Much of the slowdown in second quarter economic activity can be attributed to shortages caused by the Japanese earthquake; a continued slowdown and double dip in housing sales; rising gasoline prices; rising local and state taxes; and slower consumer spending arising from continued high unemployment. Additionally, I continue to see correlation between consumer spending and stock market performance within the investing/savings class i.e., a rising stock market enhances economic activity; conversely, should the market decline if the debt limit is not raised, a new recession or worse may could begin.

A year ago (June 26, 2010), I wrote a piece called Reckless in which I expressed concern that political sentiment was pushing Washington towards austerity on a grand scale and simplistic assumptions by an uninformed public were pushing Congress towards a premature deficit reduction program. Unfortunately, it appears that the Federal government is aligning with the states and cities and beleaguered European countries in broad austerity thinking at a time when we need spending and stimulus. Today’s report of a rise in unemployment to 9.2% is throwing a chill on expectations. It is very interesting that at this same time last year, the economic problems of Greece, Portugal etc. and trading in the credit default swaps were in the headlines and rankling the markets, just as they are again this year. This is the story that keeps on giving. No CNBC day would be complete without worry for Greece or Portugal, and one year later, we’re still talking about the same things with neither a resolution nor catastrophe having taken place.

It is very difficult to maintain an optimistic short-term investment posture amid the complications of election politics at its worst and constant media focus on the direst outcomes. Aside from the very real possibility of political miscalculation, and financial accident, I am confident that the debt ceiling will be extended. Who could possibly believe that our political leaders would play games with the credit standing of the country? Through it all, I remain positive about the investment potential in our great country and I think the best way to approach capital growth and preservation in a zero-to-low interest rate climate and an inflationary future is to pursue equity investments in growth industries through what is now known as single-stock investing.

I continue to be optimistic about investments in health care. We are entering a period of personalized medicine using genetic identification to design of medicines and treatments on an individual case basis. This change could bring about smaller, shorter and thus cheaper clinical trials that will finish sooner and benefit the patient, the sponsor, and the public by reducing time and costs. Separately, human health needs are growing at a rapid rate: results of a recent study of diabetes showed that the present estimate of diabetics in the world now numbers 350 million, and accelerating rapidly, compared to just 250 million in the last study done just a few years ago. I and clients are invested in a publicly-held company that is awaiting final FDA marketing approval on an ultra-rapid acting mealtime, powdered insulin for both Type 1 and Type 2 diabetes delivered to the patient via a miniature inhaler (about the size of the pinkie finger): faster, unobtrusive, disposable, convenient and inhaled rather than injected. Its global potential could be significant. We also are invested in a publicly-held company, one of the pioneer stem-cell research companies that has recently received FDA approval and commenced human clinical trials using stem-cells to treat spinal cord injury and concomitant paralysis. The same company is conducting Phase II clinical trials of a novel peptide-drug conjugate that attempts to deliver anti-cancer drugs across the blood-brain barrier to enable the treatment of primary brain cancers and metastases. The blood-brain barrier prevents most medication from delivering to the brain.

I continue to be interested in the growth potential of electric-hybrid vehicles, and the stimulative effect the adoption of these vehicles will have on expansion of the power grid. Electricity usage is rising from the widespread growth of rechargeable gadgets, devices and autos. Hybrid electric vehicles available now can offer as much as a 100 mpg equivalent or even more depending on driving conditions.
One final thought: It is virtually impossible for the economy to attain an acceptable growth rate and satisfactory employment levels until housing begins to recover. It’s my feeling that the Financials are gearing up to become more proactive in dealing with foreclosures and seeking to work things out with troubled borrowers. We may see improved news in the next months.

Current consensus estimates of 2011 earnings of the S&P 500 companies are around $99.00 per share, placing the price/earnings ratio at roughly 13.5 times, and the earnings yield at 7.4%. Both measurements compare very favorably to the 10-year Treasury bond yield of 3.1%. The S&P 500 has risen 28% from 6/30/2010 to 6/30/2011 when I published Reckless. I concluded then as follows: “Investing in this economic maelstrom is as difficult as at any prior time in my 47 years in Wall Street. However, I do believe in a long term and I do believe that equities rather than bonds are the way to participate in the evolutionary process towards that long term. The continuation of a low-interest rate policy provides low income returns and I continue to believe that selling short-dated covered calls against an underlying quality equity portfolio is a low risk method of income generation. In retrospect, it was a good call last year and with caveats for unforeseen political accidents, I’ll stick with it again.

Peter Mack
July 8, 2011