Update on Scenario One

July 8, 2011

Scenario One still remains the most probable of my four scenarios. However, if the government or the Central Bank deviates from the “expected” course (from a capitalist point of view) other scenarios might become more probable.

Also, here are some assumptions to consider:

1. The following chart uses the S&P500 index to illustrate this scenario because it is easy to visualize.
2. My assumption is that money supply drives the economy or GDP (and there is a lag time involved here.) Increasing GDP drives business revenues and profits which then drive stock prices.
3. Money supply will slow up beginning in June but will expand when re-election fears really kick in and new “government help” adds stimulus (money creation weather it’s spending or tax reductions unless paid for) to drive up GDP in time to help with re-elections.
4. Serious spending cuts will be postponed until after the election.

Following is a brief description of each point on the chart.


Point 1. Housing bubble bursts and banks become insolvent. The government decides to save the banks by using taxpayer money to “keep them solvent” rather than demanding that the banks try to convert their bonds into equity. Recession is underway.


Point 2. March 2010. The massive increase in money supply which artificially and temporarily increases GDP begins, but results in malinvestments or bubbles. For example:
a. Interest rates reduced to zero and held there
b. Stimulus Programs begin (over $800 billion in stimulus spending and unpaid for tax cuts) plus $1.5 trillion in deficit spending,
c. Mark-to –Market accounting rules revised (allowing banks to increase the ”value” of their mortgage bonds to boost their equity and reserve requirements,
d. Central Bank buys “toxic bonds” from the banks (QE1) increasing ”excess reserves” at banks to $1.1 trillion from $4 billion,
e. November 2010, QE2 begins ($600 billion more pumped into banks but most of it ends up in foreign banks)
f. Money supply increases at double digit rates for 28 of last 29 months (see assumption 2 above.)


Point 3. May 2011. There is a “short-term” stock market top and correction due to anticipated contraction of the pace of money supply and other headwinds including slowing global growth and debt problems. For example:
a. Stimulus ending in June
b. QE2 ending in June (a and b both will contract money supply which will reduce GDP)
c. Debt ceiling “argument” (raise limit by $2-3 trillion and get more fiscal stimulus or austerity) deadline by August 2
d. Reductions in U.S. GDP (Central Bank reduces growth rate in June) and Global GDP rates
e. Increasing inflation rates (headline and core)
f. Housing still a big problem
g. Unemployment slowly getting worse
h. Earnings (Qr 2) in July should be at or near expectations but analysts are already cutting earnings for second half of 2011. It will be a negative for the markets if companies do not confirm current growth rates for second half.

Economy and markets will become more volatile and trend lower until the government “solves” the problems with more money creation, which is what I expect. Or some kind of austerity program including reduced spending is put in place, which I do not expect. However, if austerity happens, my Scenario Two (continued decrease in economy and markets) would come into play.


Point 4. Labor Day or possibly sooner (for example by the August debt ceiling limit) depending on our central planners (government and the Central Bank) the money supply will again increase raising GDP (with a lag) and then revenues, profits and markets. This up turn will last longer (with corrections along the way.)
a. My guess, debt limit increased with promise to cut spending starting in 2013 (after next elections)
b. As economy drifts lower, the pressure will be on government to “do something.” Therefore, I expect a new stimulus program (significant tax cuts because Republicans will have to vote for them and Democrats will get their stimulus because we will borrow the money displaced by the tax cuts)
c. New QE3 program (large) so central bank can continue to buy bonds and keep interest rates low (for housing, employment, etc.) This may be called something else so it can be framed differently for public consumption.
d. Timing of new stimulus for 2012 elections will become important to allow for lag time and momentum prior to elections.

Point 5. Top of Bubble (Sept-Dec 2012 +/-) caused by the huge increase in money supply added over the years and the malinvestments that have occurred as a result of this increased money supply. This bust will cause a very deep recession illustrated by the S&P500 going back down to 600-650 area.

Point 6.January 2015. Long period of stagflation with low, real GDP growth rates of 1-2% and high interest rates due to inflation.