Of Mid-Term Elections And A Sinking US Dollar
The US Mid-Term Election
Next month sees a mid-term election in the US. They lack the excitement of Presidential elections - no long drawn out campaigns, no high drama - but as is usual in the US, this one will offer the spectacle of considerable vitriolic verbiage between the two political parties.
The talk is that with Obama's plunging popularity numbers, discontent with the bailouts, the deficits and the health reform plan, and a recession (or worse) on Main Street while life returned to normal for Wall Street, that the election will see a change of majority in Congress or the Senate or both.
Bear markets seem to occur in mid-term years, with the market making its bottom in October. But the actual record is more balanced. Of 27 mid-terms since 1900, there were 15 up years and 12 down years prior to the elections.
Of those 27 mid-term elections, only seven saw changes in Congress or Senate or both. In 1910, Congress changed hands following a down year. In 1918 and 1986 the Senate changed hands following an up year. The other four times, both houses changed hands: in 1946, following a down year; and then in 1954, 1994 and 2006, following up years in all cases. The market appeared not to be a major factor in the decision to change either Congress or Senate or both, as it was up on five of those seven occasions.
On 10 occasions, no change was seen in Congress or Senate despite a down year in the markets during the year leading up to the election. On the remaining 10 occasions, neither house changed hands while the market was up. Based on these results, one can only conclude that a good or a bad market had little influence on whether the Congress or Senate would change hands.
One thing that does coincide with mid-term years is US military involvement in wars getting under way or already in progress. Examples are: 1914 (WW1, although it wasn't until 1917 that the US entered); 1942 (WW2); 1950 (Korea); 1962, 1966, 1970 and 1974 (Vietnam); 1990 (Iraq/Kuwait); and 2002 and 2006 (Iraq/Afghanistan). While involvement in Iraq is now supposedly winding down, the Afghanistan incursion continues as the 2010 mid-term approaches.
There is only one example of houses changing hands in a war year, and that was in 2006, when both Congress and Senate changed hands.
Our tables below outline the history of mid-terms, detailing who the President was at the time, the position of Congress and Senate before and after the election, the market performance the year before the mid-term, and the performance of the market the first year after the mid-term and the year before the next Presidential election. The first table covers 1902 to 1950 while the second table covers 1954 to date.
year later *
years later *
|1902||McKinley - Republican||Rep||Rep||Rep||Rep||+2.5%||-32.1%||-4.6%|
|1906||T. Roosevelt - Republican||Rep||Rep||Rep||Rep||+10.9%||-37.1%||+6.5%|
|1910||Taft - Republican||Rep||Rep||Rep||Dem||-14.3%||-10.6%||+7.0%|
|1914||Wilson - Democrat||Dem||Dem||Dem||Dem||-8.8%||+33.5%||+46.5%|
|1918||Wilson - Democrat||Dem||Rep||Rep||Rep||+14.8||+39.1%||-0.6%|
|1922||Harding - Republican||Rep||Rep||Rep||Rep||+31.3%||-7.9%||+8.3%|
|1926||Coolidge - Republican||Rep||Rep||Rep||Rep||-3.1%||+20.5%||+67.2%|
|1930||Hoover - Republican||Rep||Rep||Rep||Rep||-32.9%||-43.3%||-66.2%|
|1934||F.D. Roosevelt - Democrat||Dem||Dem||Dem||Dem||+5.9%||+49.6%||+89.7%|
|1938||F.D. Roosevelt - Democrat||Dem||Dem||Dem||Dem||+9.5%||+0.1%||-11.3%|
|1942||F.D. Roosevelt - Democrat||Dem||Dem||Dem||Dem||-3.7%||+21.8%||+29.1%|
|1946||Truman - Democrat||Dem||Rep||Dem||Rep||-9.3%||+7.4%||+11.3%|
|1950||Truman - Democrat||Dem||Dem||Dem||Dem||+18.7%||+16.6%||+19.6%|
|1954||Eisenhower - Republican||Rep||Dem||Rep||Dem||+27.7%||+29.2%||+36.3%|
|1958||Eisenhower - Republican||Dem||Dem||Dem||Dem||+23.2%||+19.0%||+6.8%|
|1962||Kennedy - Democrat||Dem||Dem||Dem||Dem||-16.2%||+28.0%||+48.0%|
|1966||Johnson - Democrat||Dem||Dem||Dem||Dem||-16.0%||+9.0%||+18.0%|
|1970||Nixon - Republican||Dem||Dem||Dem||Dem||-11.8%||+11.1%||+26.5%|
|1974||Nixon - Republican||Dem||Dem||Dem||Dem||-30.4%||+25.6%||+45.0%|
|1978||Carter - Democrat||Dem||Dem||Dem||Dem||-3.2%||+2.9%||+16.7%|
|1982||Reagan - Republican||Rep||Rep||Dem||Dem||+16.3%||+23.5%||+21.7%|
|1986||Reagan - Republican||Rep||Dem||Dem||Dem||+36.6%||+6.2%||+14.4%|
|1990||G.H.W. Bush - Republican||Dem||Dem||Dem||Dem||-7.7%||+25.7%||+32.1%|
|1994||Clinton - Democrat||Dem||Rep||Dem||Rep||+6.2%||+21.7%||+54.3%|
|1998||Clinton - Democrat||Rep||Rep||Rep||Rep||+15.5%||+24.9%||+27.7%|
|2002||G.W. Bush - Republican||Rep||Rep||Rep||Rep||-7.5%||+16.7%||+19.4%|
|2006||G.W. Bush - Republican||Rep||Dem||Rep||Dem||+15.7%||+15.3%||-22.8%|
|2010||Obama - Democrat||Dem||Dem||+10.7% **|
Source: Wikipedia for President, Senate and Congress.
** DJI to date
So where will the markets go after the 2010 mid-terms? With only seven previous occasions when at least one house changed hands mid-term, we are short on data.
First, the three occasions that only one house changed hands. Two years after the 1910 and 1986 mid-terms, as the US went into Presidential elections, the market was up. Two years after the 1918 mid-term, the market was down. One year after 1910, the market was down. For 1918 and 1986, the market was up the first year following the election.
On the four occasions that both houses changed hands, in three of them the market was higher both one year and two years later. Only in 2006 was the market up a year after the mid-term but down sharply as the election of 2008 approached.
In looking at the years following mid-terms where there was no change in either house, the odds seem to favour an up market. On the 20 occasions there was no change in either house, the market was up after one year 16 times and up after two years 17 times. (The last two years of the four-year Presidential cycle are historically the best years for the stock market.)
Based on the above, the odds appear to favour a rising market in the next two years if at least one house changes hands. If both Congress and Senate are unchanged, the odds overwhelmingly favour a rising market for the next two years.
So what is going to bring this market down, as many bears are predicting, over the next two years? There were only five occasions when the market fell over the two years following the mid-term elections: 1902-04, 1918-20, 1930-32, 1938-40 and 2006-08. Only 1918 and 2006 saw a change of hands in one or both houses.
1904 was the culmination of the "rich man's panic" of 1902-03, following an era of financial speculation that peaked in 1901. 1920 was the bottom of the stock market following a period of speculation that built up during WW1 and collapsed in 1917, coinciding with US entry into the war, the resulting steep recession, and the influenza epidemic right after the war. 1932 was the bottom of the stock market during the Great Depression, after a long period of financial speculation during the 1920s that ended with the stock market crash of 1929. 1940 saw lingering effects from the financial panic of 1937 that followed five years of speculative stock market recovery from the Great Depression; combined with war in Europe, the market was unable to recover until 1942. And 2008 was the depths of the financial panic of 2007-08 that followed an unprecedented period of speculation in housing and derivatives.
If there is a theme in the above, it is that periods of financial speculation are followed by financial panics and recessions or worse. Many of the above periods were followed a few years later by a second panic. The "rich man's panic" was followed in 1907 by what became known as the "bankers' panic". The collapse in 1917 was followed by a sharp rally and new highs into 1919, then an even more devastating collapse in 1920. The crash of 1929 that bottomed in 1932 was followed by a five-year recovery and then came the "panic of '37" that did not see its final bottom until 1942. The 2008 financial panic came after five years of speculative recovery following the high tech / internet crash of 2001-02. Can further financial panics lie ahead, given the sputtering recovery that has thus far taken place?
The sinking US Dollar
The world is at a crossroads. Financial co-operation and co-ordination and sound fiscal policy is essential if the world is to come out of the current spiral. Instead, the chosen route appears to be one of competitive currency devaluations, trade wars, more printing of money through quantitative easing (QE) and austerity programs at a time when global economies remain exceptionally fragile.
While many appear to believe that the markets and the economy will pull out of the spiral, even the monetary and political authorities are now warning that years of austerity, slow growth and high unemployment are more likely than a return to the days of solid economic growth and low unemployment. For the poor, the young seeking work, the unemployed, and retirees depending on pensions, this is not good news. When even the monetary and political authorities are telling us there is a problem and that we face years of uncertainty, it has to be taken seriously.
A country's currency can be likened to the common shares of a company. A strong currency is indicative of a strong economy while a weak currency is more indicative of a country in a death spiral. Unlike a company, countries don't go bankrupt, eventually to be wound down. But they can go into the equivalent of Chapter 11 bankruptcy in the US or CCAA in Canada. Except that for a country it is not that easy, as politics inevitably get in the way.
Few countries will readily accept the IMF's strictures, which are often onerous and can lead to unemployment and social unrest. Even without the IMF strictures austerity programs can cause considerable social unrest witness in particular Greece plus strikes in Britain, France and other European countries. Further with economic stress in G8 countries it is not surprising to see the rise of ultra-nationalist parties and xenophobic politics. Further social unrest in countries coupled with "terrorism" scares could lead to suspension of civil liberties and a police state. All of these characteristics were seen during the Great Depression. And it is not just Europe or Japan, the US and Canada are not immune either.
The US dollar has been the world's reserve currency since the 1944 Bretton Woods agreement. It remained so after President Richard Nixon took the US and the world off the gold standard in August 1971. Until then, the US$ had been convertible into gold at US$35 an ounce. All other currencies were fixed to the US$ within a small trading band. The US$ is then the stock value of the United States of America. Some stock. If one had been wise, when Nixon acted in 1971 one would have shorted it immediately and never looked back.
Since the Federal Reserve came into being in 1913, the US$ has lost roughly 95 per cent of its purchasing power as measured by the CPI. When measured against something tangible, such as gold, the loss is even more dramatic. In 1913 an ounce of gold was pegged at roughly $20.64, so $1,000 would buy 48.4 ounces. Today, $1,000 gets you roughly three-quarters of one ounce. To put things further in perspective, 200 years before the creation of the Fed, $1,000 would still buy you about 50 ounces of gold. For 200 years the purchasing power of the US$ was basically stable with a few periods of exception, most notably during the US Civil War. Since the creation of the Federal Reserve the US$ has suffered a monumental collapse in purchasing power.
Many would argue that talk of the loss of purchasing power is disingenuous because technological and productivity gains have made so many things considerably cheaper over time. By that measurement, despite a loss of purchasing power, there has been an ever-rising standard of living. The future, however, is in question. Stagnant wages which have prevailed for over 20 years and rising (possibly permanent) long-term unemployment could change this.
When one measures the purchasing power of the US$ against gold, the decline has been stark. Setting aside the period of the Civil War, the major devaluations took place in 1933, when the US confiscated gold and raised the price from roughly $20.60 to $35, and after 1971, when the US government closed the gold window and set the US$ to float against other major currencies. The largest relative decline in the purchasing power of the US$ has taken place since 1971.
The US$ has also been losing value against the world's major currencies since the convertibility of the US$ to gold ended in August 1971 and currencies became free to float against each other by March of 1972. In January 1976 the fixed exchange rate system that had been in place since Bretton Woods was formally finished, and since then the US$ (and other currencies) have gone through many volatile cycles.
The most notable periods of a rising or strong US$ were seen from 1980 to 1985 and again from 1995 to 2001. The period 1980-1985 saw Fed Chairman Paul Volker hike interest rates to 20 per cent to wrestle down the inflationary 1970's. The policy caused a severe recession in the early 1980's but set in motion a period of a strong US$ and eventually a period of stronger economic growth. It ended with the Plaza Accord in 1985 that was designed to bring down the high US$ relative to other currencies. The 1995 to 2001 strong US$ was set in motion when the Bank of Japan sharply lowered interest rates and promised to bring down the then high flying Japanese Yen. That set in motion the so called Yen carry trade that resulted in huge flows into higher yielding securities in the US. The resulting inflows into the US also helped fuel the bubble in high tech/internet stocks and finance the resulting trade deficits as the US went on a buying binge of foreign imports. It all unravelled in the early part of this decade with the US recession, the attack of 9/11 and resulting wars in Afghanistan and Iraq.
The US$ is the world's reserve currency and as such it should be the world's strongest currency. It is not, and many are questioning its continuing as the reserve currency. The chorus against the US$ as the world's reserve currency is being led by the BRIC nations particularly China (BRIC - Brazil, Russia, India and China).
Today the world is dominated by "fiat" currencies. Fiat currency is any money declared by the government to be legal tender. It is not fixed in value to anything; it is money with no intrinsic value. Fiat money has a long history dating back even to the Roman Empire. The Romans did not use paper money, but their main form of money, the silver denarius, had its silver content reduced from 100% to barely 0.05% during its long decline. In the latter stages of the Roman Empire its people rejected the money of the time as worthless.
In August 1971, in the US, M3 (the broadest measurement of money supply) stood at roughly $744 billion. Today it is estimated that M3 is about $13.3 trillion. The US stopped reporting on M3 in February 2006 when it was estimated at $10.3 trillion. Since August 1971 it is up about 1,700 per cent, and since reporting ceased it is up 29 per cent.
US Debt growth has been even more phenomenal. According to the Federal Reserve Flow of Funds "Debt Outstanding by Sector" total debt in 1976 stood at $2.5 trillion. The latest figures available, for the second quarter of 2010, shows total debt outstanding is $35.5 trillion - an increase of 1,320 per cent in 34 years. US GDP by contrast has grown from $1,127 billion in 1971 to $14,575 billion as reported in Q2, for growth of 1,193 per cent. Debt and money growth has outpaced GDP growth. The US CPI since 1971 has gone from 40.8 in August 1971 to 218.3 today a gain of 435 per cent. Significantly debt and money growth has not only outpaced GDP it has overwhelmingly outpaced the growth in the CPI. Price inflation is not the problem. Monetary inflation is.
The US national debt is estimated to be about $13.6 trillion by year end, giving a debt-to-GDP ratio currently about 93 per cent. Many economists estimate that a ratio of 100 per cent would cut at least one per cent annually from a country's GDP. (Japan is in even worse straits with a ratio estimated to be above 200 per cent. China's is about 22 per cent.) It is estimated that by 2015 the US national debt could be close to $19.6 trillion.
Massive growth in debt and money that has outpaced the inflation rate has contributed significantly to the long-term decline of the US$, not only in purchasing power but against other currencies. But that is only a part of it. Many believe the US has entered a period of long-term decline that is also contributing to the long-term decline of the US$. Besides the growth of money and debt, the following factors are cited (11 Long-Term Trends that are Absolutely Destroying the US Economy - www.theeconomiccollapseblog.com):
- The US has been de-industrializing at a fierce pace, particularly in the past 20 years. It is estimated that over 40,000 factories have been lost since 2001. This loss of manufacturing has led to the US buying everything from everywhere but the US. The result is a global imbalance in trade where the US net imports and others - China, Japan, and Germany in particular - net export. At the same time the US has exported all those manufacturing jobs, leaving a minority of the population in high-end financial and marketing jobs and the majority in low-paying service jobs.
- The US trade deficit has grown sharply in the past two decades. At one time the US was a net exporter. No longer. Its trade deficit is running at $40 to $50 billion a month. The trade deficit with China has increased 300 per cent in the past decade. This imbalance has caused protectionist sentiment to rise in the US. Of the G20 nations the US is running the largest trade deficits while Japan, Germany, China and Russia run large surpluses. The Economic Policy Institute has estimated that if the US trade deficit with China continues it will result in further job losses. The protectionist mood is behind the US Congress passing sanctions against China to force them to revalue the Yuan upward. But the Chinese will move at their own pace. China is an export economy and a sharply revalued Yuan would hurt their exports, leaving them to encourage domestic demand to drive their economy. The US has not only passed measures in Congress against the Chinese Yuan they have also taken their case to the IMF. China threatens to take their case to the WTO. The IMF has been quite critical of G20 countries for their failure to deal with global imbalances including the trade deficits.
- The US middle class is shrinking. Wage growth for the average worker has been stagnant for over 20 years. One in six Americans are in anti-poverty programs; 15% of Americans, or about 45 million, live below the poverty line. Hundreds of thousands maybe in the millions have lost their homes in the past few years. The official unemployment rate is 9.7 per cent but the Bureau of Labour Statistics U6 unemployment rate (which includes discouraged workers and part-timers who want full-time employment) is closer to 17 per cent. Unofficial employment statistics that include the long-term unemployed are over 22 per cent according to www.shadowstats.com.
- The Gini coefficient, a measure of income inequality, increased from 0.37 in the mid-1970s to 0.468 in 2009. The Gini coefficient is a measure of wealth concentration and ranges from 0 to 1, where 0 represents absolute equality and 1 represents absolute inequality. Current levels are higher today than they were in 1929. The lowest levels were achieved in the US in the 1960s. The Gini index in the Euro zone and Canada is in the low 30s. This puts the US in the top one-third in the world. Of the G20 countries, only South Africa has a higher Gini coefficient.
- There is a growing retirement crisis. Over half of all US workers have $2,000 or less in their retirement funds. It is estimated that the 100 largest corporate pension funds in the US were underfunded by $217 billion in 2008. It is undoubtedly higher today. US states are estimated to have $5.2 trillion in pension obligations but only $1.9 trillion in their pension funds. US Social Security and Medicare programs are estimated to be short by about $46 trillion over the next 75 years, based on present value and benefits committed versus current revenue streams. (There are similar problems to varying degrees in all G8 countries as this is not just a US problem.)
There are many other problems as well. America's infrastructure is crumbling, yet even as funds are needed for domestic needs the US has spent over $1 trillion on the wars in Iraq and Afghanistan. Many US states and municipalities are in effect bankrupt. California is furloughing workers while many municipalities have slashed costs by laying off police and firefighters, amongst others. Measures to slash costs and increase revenues such as California's Proposition 19 a measure that would effectively legalize marijuana are being considered at the upcoming midterm elections. The Proposition is expected to pass.
Home foreclosures continue at a record pace, although that may soon come to an abrupt halt as concerns about foreclosure procedures have forced the banks to suspend foreclosure in many states. This has transferred the risk from the homeowner to the banks.
If that is the case, it is the banks that would now have a problem as they could be forced to revalue their mortgage portfolios down sharply. This would result in many of them becoming bankrupt. Already this year the US is on pace for more bank failures than in 2009. There are over 900 banks on the FDIC watch list - 10 per cent of all banks in the US - and many of them could go bankrupt.
The FDIC itself is bankrupt and has had to be bailed out by the US Treasury.
The chart above shows the long-term decline of the US$. Except for the period of 1980 to 1985 and again from 1995 to 2001, the decline has been relentless. Currently a breakdown under 76 could project a decline in the US$ to around 54, although there is potentially considerable support at 76/77 and again at the 2008 low of 70/72. As the US$ approaches these zones expect to see increased volatility.
Competitive currency devaluations and rounds of QE, coupled with deliberate low interest rates in order to stimulate the economy, are a race to the bottom where all currencies will fall. This is unprecedented and can only end badly. This then is the biggest threat to the US and the world economy. The reality is that "beggar thy neighbour" policies were a proven failure during the Great Depression and they should prove to be a massive failure once again. It raises the spectre of defaults and is an attempt by governments' particular the US to inflate their way out of the debt problem.
The initial reaction to low interest rates and QE is a rush into all assets: commodities, stocks and bonds. But apart from gold and gold stocks, the rush into stocks and bonds should also end badly when it sinks in that the policy will turn into an economic failure. These are the best of conditions for gold, as gold, currency for over 3,000 years, would be the only safe currency albeit an alternative currency and one not necessarily used for financial transactions. The recent break out over $1,300 has set the tone for a potential run to targets currently near $1,500 and higher. There will be set backs as the "currency wars" ebb and flow but ultimately as a result of the "currency wars" gold should go higher.
The end result of all of this is undoubtedly years away and will be years in the making and may require the global economy to get worse before the ability to resolve these imbalances become absolutely essential. Economic friction can result in wars as well if past history is any guideline. The rise of ultra-nationalist parties and xenophobic politics as previously noted is also a potential reality. Eventually the solution to the crisis may see a revival of "Bretton Woods" with another period of fixed exchange rates and money once again backed by gold. It may be the only ultimate solution. How soon that might come is probably dependent on the speed with how the global economy deteriorates.
History tells us that mid-term elections are normally bullish for the markets. But it may not be the case this time. The race to the bottom with competitive currency devaluations is destructive and could ultimately end badly for everyone.