"As we near the debt ceiling and fiscal cliff, be prepared once again for extreme volatility." - Nov. 4, 2012

Those new to Equedia Weekly should go back and read: A Storm is Gathering from two weeks ago to get a better understanding of what happened this week.

On Friday, House Speaker John Boehner said the talks about the fiscal cliff with President Obama were constructive; the markets rallied following a massive weekly selloff. This type of back and forth market stimulation, manipulation, or whatever you want to call it, is overplayed.

I often find myself in awe at how the market reacts to news and meaningless media events; like a child who just found out there's no tooth fairy. The outcome of both the fiscal cliff and debt ceiling debate is simple: Print and inflate, or suffer the wrath of a worldwide recession.

Long-time readers of the Equedia Letter may be tired of hearing me talk about this over the last four years. But if you look at what's happened during this time, you will see that more printing has occurred than ever before; QE1 led to QE2; QE2 led to QE3-infinity. Let's not forget negative real interest rates, where money borrowed now can be payed back later with cheaper dollars.

The US has already passed the point of no return.

No amount of tax increases or budget cuts will fix the current situation. America is in way too deep.

What Fiscal Cliff?

Last year, the big debt ceiling fiasco played out with an embarrassing standoff between Congress and President Obama. They eventually compromised and increased the debt ceiling by $400 billion in August 2011. Five weeks later, they increased it by another $500 billion; 5 months later, they increased it by a massive $1.2 trillion - using up every increase allowed in the Budget Control Act of 2011.

Signed by Obama in August, the Budget Control Act of 2011 ended the debt-ceiling debates. But the law stipulates that, unless another compromise is reached, a series of tax increases and budget cuts will automatically take place on January 1, 2013, including the expiration of the Bush tax cuts and the temporary 2% payroll tax holiday, plus new taxes related to Obamacare.

This is the "Fiscal Cliff."

If these series of tax increases and budget cuts are allowed to happen as is, the nation would undoubtedly go back into a recession; with that, the stock market would plummet.

As Former Federal Reserve Chairman Alan Greenspan said:

"The markets will crater if we run into any evidence that we can't solve this problem...If we get out of this with a moderate recession, I would say the price is very cheap. The presumption that we're going to solve this problem without pain, I think, is grossly inappropriate."

If the fiscal cliff is not avoided, it does mean disaster. However, it is largely irrelevant in the big scheme of things because it's merely an argument between political parties. Let me explain.

US government spending falls into three categories:

1. Discretionary spending consists of US government expenditures that are set on a yearly basis. This is money that members of Congress can adjust on a yearly basis such as defense budget, education, and homeland security
2. Mandatory spending is spending on certain programs that are required by existing law such as Social Security and Medicare.
3. Interest on Debt is exactly what it sounds like; interest the US owes on its debt obligations

The only thing Congress can influence is Discretionary Spending.

Here's the kicker: No matter what is decided, there will never be enough taxes collected to cover categories 2 and 3: Mandatory spending and Interest on debt.

Last year, the U.S. government spent $176 billion more on mandatory spending and interest on debt interest than they generated in tax revenue. This year, that shortfall increased to $251 billion. This means they could cut the entire discretionary budget and still be in the hole by hundreds of billions.

When you combine the three categories, the US is running a national deficit of more than $1 trillion per year, and growing (US Federal spending over $3.5 trillion per year; US tax revenue of $2.4 trillion.) Right now the US national debt sits at $16 trillion and climbing. Liabilities across the board now amount to over $1 million dollars per tax payer.

Even if expiring tax cuts aren't extended over the next five years, the U.S. is projected to accumulate more than $1.5 trillion in additional deficits, according to the Congressional Budget Office.

My point is very simple: a deal will get done between the White House and Congress, but not without pain. How the market reacts to the final decision will be based on the minute details of their agreement. Regardless of what they decide, the Fed will have to print more money.

As I mentioned in A Storm is Gathering, it's highly unlikely this situation won't be resolved. But we've seen mind boggling things from the U.S. before...

What Next?

Negativity may be soon offset by optimism of more Obama spending and Federal Reserve printing; as it was this past year.

When the original debt-ceiling crisis was averted by increasing the debt-ceiling and signing the Budget Act of 2011, the markets fell hard: The NASDAQ, ASX, and S&P 100 lost up to four percent in value, the largest drop since July 2009. The commodities market also took losses, with average spot crude oil prices falling below $US86 a barrel while the price of gold also fell.

As a result of the debt ceiling increase, the Standard & Poor's downgraded the long-term credit rating of the United States government from AAA to AA+. This marked the first downgrade in US history. Markets didn't like that and it continued to fall.

But the fall was short lived. Despite running record deficits, continued poor economic growth, high unemployment, and record foreclosures, the market continued to thrive.

2012 started with a bang and still remains up on the year.

Will it Last?

If history does indeed repeat itself, the following chart can be pretty scary:

source: Bloomberg

This current price action in the S&P 500 is far too similar to the movement leading up to the collapse in 1987. Will history repeat itself?

Bet the Farm

Last week, I told our readers that it was time to buy farmland. Food prices are rising as a result of both worldwide monetary policy and global food supply shortage (see America's Gold Wiped Out).

The world creates more than 213,000 new mouths to feed every single day. But the availability of arable land per capita is falling each year due to development, peak production yields, loss of topsoil, and a dramatic reduction in freshwater supply. Demand is clearly outstripping supply and it doesn't take an economics professor to know what happens as a result.

Some food for thought:

Combine that with the world's political obsession of money creation:

If you can't afford to buy farmland, preferably overseas, farm stocks are worth a look.

Running out of Cash

The biggest government source of employment, the United States Postal Service, just posted a record $15.9 billion loss. That means it costs taxpayers $250 million per day to keep the thing going. It currently employs 607,400 employees.

Without action by Congress, the service will run out of cash on Oct. 15, 2013.

What Housing Recovery?

WSJ just released a very important article that flew by the radar:

The Federal Housing Administration is expected to report this week it could exhaust its reserves because of rising mortgage delinquencies, according to people familiar with the agency's finances, a development that could result in the agency needing to draw on taxpayer funding for the first time in its 78-year history.

Together with Fannie and Freddie, federal agencies are backing nearly nine in 10 new mortgages.

The FHA accounted for one third of loans used to purchase homes last year among owner occupants.

Though the agency guarantees fewer mortgages than either Fannie or Freddie, it now has more seriously delinquent loans than either of the mortgage-finance giants.

Overall, the FHA insured nearly 739,000 loans that were 90 days or more past due or in foreclosure at the end of September, an increase of more than 100,000 loans from a year ago. That represents about 9.6% of its $1.08 trillion in mortgages guaranteed.

More QE, anyone?

Gold and Silver

The sell-offs this week were apparent with some major sellers taking control right at market open for four consecutive days.

Whether it was Apple traders forced to sell winning collateral to meet margin calls, or algotraders taking control, it was clear that a group of sellers forced prices down.

Remember, gold is now being accepted to meet margin calls by many financial institutions. I mentioned this first back in 2010. Since then, gold has become a collateral standard to meet margin calls by many of the major institutions. As a result of the massive selloff earlier in the week, there's a good chance gold was forced down to meet margin call demands on losing bets.

While you should be careful as gold and silver may fall with the broader market (to meet margin calls etc.), the overall outlook remains the same.

As I said before, we're in a period of stagflation. The inflation cues are here but there's a deflationary drag pulling on the economy; that is why the Fed has been able to print endlessly without an immediate and dramatic rise in inflation.

I remain long both gold and silver. It's pointless to reflect on every small percentage drop or gain in this market. Hold tight and stay away from media manipulators; they have little clue as to the real price action of the metals.

Despite the market selloff, the Equedia Select Portfolio remains in good shape; still beating the markets, and still with room to climb.

Until next week,

Ivan Lo

Equedia Weekly