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5 "Tells" that the Stock Markets Are About to Reverse

Allegory Regarding Investment Decisions Made On Basis Of Government’s Income Statement, Balance Sheet

Stock-Markets / Financial Markets 2018 Apr 19, 2018 - 10:05 AM GMT

By: Raymond_Matison

Stock-Markets Webster’s dictionary defines allegory as a story in which people, things or happenings have a symbolic or hidden meaning that can be used effectively in teaching or explaining difficult ideas.  Accordingly, an allegoric story is used here to explain the important difference between a government income statement and balance sheet, and its application for investment decisions in financial markets.

Simplistically, the government’s income statement records all its activity over a specific period of time during which it brings in revenues, disburses some benefits and pays some expenses.   Individual and corporate income taxes provide the lion’s share of those revenues.  When the cost of government and its expenditures are deducted from its revenues the balance is either a surplus or savings, or as has been our experience over the last few decades – there is a budget deficit.  Such deficits have to be financed, and it results in persistent issue and growth of our national debt.  In our allegory the budget deficits will be represented by a not large hole in the hull of a ship, whereas the governmental debt is represented by the accumulated flow of water in the hull of a ship.


The balance sheet of our government shows its assets, which include value for its vast holdings of land, and liabilities which should include our sovereign national debt and all unfunded liabilities.  The difference between these two values, in accounting terms, would show the net worth of the nation.  A large positive value would imply that the U.S. is a wealthy country, whereas a large negative value would signify that the country cannot honor or fully pay its liabilities and is bankrupt.

Corporations and individuals are presently required to provide accounting of their activities to the government on a quarterly basis in order that it may collect tax revenues on a timely basis.  It is noteworthy that there are two acknowledged methods of accounting; on a cash basis one only records the amounts actually received or expended during the accounting period, whereas on generally accepted accounting principle basis (GAAP) one has to recognize revenues and expenses on an incurred basis.  Under GAAP, the sale of a large project or product which provides a multi-year revenue stream, or the multiyear expenditure of contractual amounts from an agreement would have to be recognized in the year the contract was signed.

It is noteworthy that our government does not conduct its accounting on a GAAP basis -which it demands from all corporations.  It may be said, without exaggeration, that if corporations did their accounting on a basis consistent with that of government that the officers of these corporations would be jailed for fraud.  It is easy to see why this would be the case by citing one simple example: if corporations only showed the amount they expended for retired employee pensions in the present year rather than the amounts necessary to be set aside to fund future pensions for all employees they would be substantially understating their liabilities thereby fraudulently inflating the company’s net worth.  Accordingly, under its cash accounting basis, government accounting records the amounts expended for Social Security, Medicare and other welfare programs for the current year, but neither does it calculate or show the amount of the actual liability nor the amount necessary to be set aside to fully fund those liabilities. A respected professor/economist at the Boston University, Laurence Kotlikoff, has estimated that on a GAAP accounting basis our government has unfunded liabilities of approximately $200 trillion, rendering the nation unable to meet its financial obligations of the future – therefore bankrupt.

For decades our government has used misdirection, now called fake news, which keeps the populace and Congress from focusing on the real problems of governance.  Our media will focus on sex scandals or wars, while our elected officials’ fiscal spending transgressions have accumulated to levels now endangering our financial markets and the solvency of this very nation.  For this reason any means, including the use of allegory, is reasonable to bring attention to and explain in simple terms the plight of our endangered nation, and the faulty illusion of soundness in financial markets.

Investment decisions

Classical investment analysis for equities would require an informed investor to first look at the market’s investment environment as a whole.  If that environment is healthy, then there is more opportunity of profitable investment when compared to an economic environment which is weak.  One would select an industry which is stable or growing and has a good regulatory record, and then look to analyze individual companies.  That company could be small with expectations of rapid revenue and earnings growth, or it could be a relatively large company where the rate of growth is lower but it is balanced by the expectations greater stability of results.  In our allegory increased growth will be represented by a ship of state moving at a faster speed.

Equity investors are often less concerned with a company’s balance sheet as opposed to its income statement.  Supposedly, growth in revenues and earnings will fix all corporate problems.  But this is not always so.  A company developing a new product for its market uses up its cash balances in that process.  If its cash is spent before the product is available to be sold in the market, and further borrowing is denied by investors, the company is forced to close down – with prior investors losing their money. 

Fixed income investors are not so much interested in huge capital gains but rather in the certainty of receiving regular cash disbursements in addition to getting the original loan repaid.  This type of investor is much more interested in the soundness of that company’s assets, liabilities and its net worth.  This investor focuses on that company’s ability to repay all of its liabilities, and therefore is highly interested in the company’s balance sheet.  It should be obvious that the fixed income investor is more conservative than the equity investor.  In our allegory a lack of financial soundness is represented by the draft of the ship (the part under water) and the size of the hole in its hull that allows water to flow into the ship’s hull and endanger its eventual sinking – regardless of the speed at which the ship is moving forward.

Investors are inappropriately focusing too much on the government’s income statement in assessing the health of the economy, and not enough attention to the balance sheet part in making appraisals for the health of financial markets.  It is possible for an economy to appear sound and moving forward, even as its recognized and unfunded liabilities overwhelm the functioning of that currency and therefore its economy and all financial markets.

The allegory – ship of state

It was the people of a distant colony, a long time ago, who were under control of a country with a mighty navy which exercised global power.  These people living far away from this global power sought to be the masters of their own fate rather than remain under colonial rule.  When that control and duress grew to intolerable levels, these people revolted, which started a revolutionary war.  Although lacking weapons and war hardware and militarily outnumbered, the vision of their freedom was so vivid that they persevered and ultimately won their independence.  These revolutionaries were guided by men who “committed their honor and their very lives” to this cause, who in turn were guided by unique documents which they authored after studying all of the different governing documents of countries around the world.  These new and exceptional governing documents were called the Constitution and the Bill of Rights.  It was these exceptional documents which provided individual freedom, incentives, opportunity, hope, certitude of keeping the benefits of one’s own labor, and the sanctity of property ownership that transformed future generations of these regular ordinary people, living under these unique freedoms, into becoming exceptional.

These people built their economy over generations of hard work and innovation. Over further decades they built an economic ship of state which grew in size and stature such that it was admired by all other countries.  The quality of life in this country exceeded that of all previous countries, monarchies and dynasties.  To be clear, the government did not build that.  It was the people. It was this unique, exceptional document which limited government intrusion, and expanded boundaries of individual freedom of people which made the country and its people exceptional.

This very large ship of state had to have many officers to oversee its diverse operation safely, and was manned by elected leaders who made decisions to maximize the goods that it can bring home to its people.  These officers were called Senators and Congressmen.  This economic ship of state called on ports around the globe and brought home products which we do not produce.  It brought fruits and spices which we cannot grow ourselves.  Reciprocally, we brought manufactured goods and food supplies to these other ports which they did not have; as a result it was a virtuous cycle which benefited everyone.

Medium of exchange

Historically, the medium of exchange over centuries for this trade was gold.  Over time, because of its convenience, a paper currency which was convertible into gold took its place. This required a strong moral compass, integrity and commitment on behalf of the leaders of all governments to make sure that the currency printed reflected the amount of gold the country had in its possession.  Printing too much currency relative to the store of gold reduced the value of that currency and robbed both the country’s citizens and its trade partners.
 
Because of designs of evil people, the world was brought into two terrible global conflicts – world wars.  This exceptional country eventually participated in these wars, prevailed, and helped establish peace.  After losing two great world wars the exhausted warring nations were willing to accept the proposition that goods henceforth could be traded globally using the dollar, which was backed by gold.  At some point new generations of the ship of state officers became greedy, expanded the goals of this government and became so voracious that it printed currency for which we did not have the gold to back our global purchases of goods.  Alas, soon this government (as all governments) showed that it could not be trusted to maintain the morality and integrity of a fixed relationship between currency and gold as it continued to print more paper money.  Soon it even had to abrogate its promise to the whole world, and refused to exchange gold for the printed paper dollars at the promised rate. 

Next to the ship’s engine compartment was a little understood fuel injection apparatus called the Federal Reserve which could increase the speed of the engine.  The fuel injected was finely printed paper (called currency) which weighed little compared to the normal fuel, but it seemed to be able to create short spurts of increased speed even for this huge ship.  Increasing speed of the ship by this method almost seemed magical in its effectiveness.

Printing of currency without the gold backing allowed the country to purchase ever more goods without consideration of its actual costs.  Thus our ship of state was increasingly weighted down with goods purchased with this printed money.  But the printing of this money required the issuance of national debt which as if by magic also weighted down this ship and increased its draft – the depth of the hull which was below water level.  Sailing through some shallow waters it ran over rocks that ripped what appeared to be a relatively small hole in its hull. It also damaged the propeller, and as a consequence the ship slowed and eventually stopped moving. The economy was dead in the water.  Ever more water started to flow into this huge ship’s hull.   The elected stewards of this ship refused to bring the ship home for repairs, but as concern overtook the country’s citizens, the people decided to call for a new captain.  Indeed the election of a new captain was a quiet revolution by voters who demanded that their views be respected by the ships officers.  It was a subtle warning that if the officers of the ship do not repair the ship of state, further ignoring the will of the people, that an event foreseen and described by one of the founders of the nation, Thomas Jefferson, could take place.  He noted that “The tree of liberty must be refreshed from time to time with the blood of patriots and tyrants.”

The new captain
The new captain was a swashbuckler who grew up in a city called New York who learned from his environment at an early age to be combative against insults, lies, and intimidation.  If you were polite to him, he was gracious and polite to you.  However, if you were not civil - to him or his people, he was an unrelenting antagonist fighting for fairness and just results.  Since this was the culture he grew up in, this experience later defined the man. 

The first thing the new captain did was to get the propellers of the ship working again so that they might head for harbor and repair.  This new captain knew a lot about how to make things run, and his enthusiasm, energy and perseverance soon got the boat moving again.  In fact the speed of the boat soon picked up such that many observers could hardly believe the results when compared to that of historical speed norms and even more strikingly to that of the previous captain.  The people rejoiced, and financial markets reflected this enthusiasm by reaching record highs.  The other 500 elected officers of this ship, while never supporting this captain’s leadership, regained their confidence such that they directed the ship to head for trade ports rather than go home to dry dock to repair the hole in their ship.  Citizens recognized that the ship’s moving again provided the right environment for their boats to be in the financial waters fishing for gains.  The investment seas seemed calm – safe for the ship of state to resume its port calls, and perfect for small citizen boats to be in the water.

By moving at such a quick speed, this huge economic ship made everyone feel that everything is fine, and that the hole in the ship could be ignored.  But in truth water kept coming into the ship, and made it more dangerous for the ship to be out at sea.  Indeed, the irony was that as the ship was increasing its speed, it actually forced even more water through hole, which continued to fill the ship more rapidly than it did before when the ship was not moving quickly through the water.  The officers of the ship called this deficit spending; it had the effect of increasing the ship’s speed and also its national debt, which increasingly weighed down the ship and made it more difficult for it to maintain its forward motion, and increased the risk of enough water filling the ship’s hull that it might sink.

Moving away from the exceptional governing document

Originally when this ship of state made its port calls, every country and its citizens were treated as equals and the trade was fair.  Over more recent decades, when the stewards of the ship and the people started to abandon the guidelines of their exceptional governing document, it started to increasingly treat others as if they were subjects to a financial colonialist – forgetting their own historical hate of the colonial overlords their ancestors fought off.  The ship’s officers started to treat the people of other nations, as well as its own country citizens in way which made them feel disenfranchised.  Hard working people could not increase their earnings, while even minor officers on the ship were earning disproportionately large incomes, often from “special arrangements”.  Over time, citizens of foreign ports and local citizens alike increasingly resented being taken advantage of, and no one cared about the state of our ship as the virtuous cycle was broken.  The people of other ports, given the opportunity, would now sometimes act in a way which would in fact help sink this mighty ship.  As more country ports embraced the same attitude, this mighty ship was increasingly less welcome in their ports and became more isolated.

Ultimately the document that made the country and its people exceptional was almost entirely discarded, and upon reflection, it was no surprise that the exceptional nation became totally un-exceptional.  As citizens took note of the actions of their ship’s officers in being ever less scrupulous, ignoring the repair of the ship’s hull, many citizens also abandoned the teachings of their exceptional governing document and became corrupt seeking welfare benefits and other free goods from the ship’s storage.  
Under the guise of bringing the concepts of this exceptional governing document to other ports, the ship’s officers were now starting wars far from its own national boundaries, rather than resolving them.  It seemed as a desperate move to seize booty – by which a larger bilge pump could be purchased and installed thereby slowing the accretion of water filling the hull.

Abandonment of principles contained in that exceptional governing document was all that was required to these formerly exceptional people over time also to become basically unexceptional.  They were now acting the same as people of some of those other ports which have been called leftist, Socialist, Communist, Fascist or Nazis. 

What happens to the ship of state?

History is a good and helpful guide for what happens to ships of state that do not maintain their vessels or seal the holes in their hulls.  A long time ago there was a singularly powerful empire called Rome.  Over time their captains had not maintained their ship of state in good repair, and it sank.  New generations of people reside in this geographic space, and even live good lives – but they no longer have their world-commanding ship of state.  Britain also “ruled the waves” in its time, but their ship of state also experienced both hull and engine problems created by the same problem that afflicted Romans.  British citizens still lead relatively good lives, but their ship of state no longer makes those port calls to collect the abundance of goods that they did in the past.  Other once mighty countries such Spain, Portugal, France, and Dutch had ships of state sailing the mighty seas, but they all eventually sank for the same mistakes of neglecting the maintenance and care of that ship.  It was always the same mistake, and America, the present leading country with its huge ship of state is making the same mistake.  It seems that in several thousand years humans have not yet learned the lessons regarding ship of state maintenance, even as they are aware of the same reason being responsible for the sinking of all previous ships of state.  This seems as a very special form of ignorance.

In reality this special form of ignorance actually applies to the vast majority of the public which is not well informed about the nature of money and means of its debauchment.  However, the leaders and other elites throughout history have well understood the true nature of money and how to use its artificial creation for their own benefit.  Therefore to maintain the ship of state the people must first understand money, and demand that the captain or ship’s officers do not allow uncontrolled printing or growth of money.  They must stop manipulating the economy and its financial markets.  The captain, officers, and citizens must re-embrace the values of their extraordinary governing document.  Only in this way can the destruction of the ship of state be avoided.

Investing in today’s financial markets

For the last decade, financial markets have advanced with hardly a pause, implying strong economic fundamentals, global growth, geopolitical calm, and opportunistic investment seas.  However this ebullient experience took place right after an unexpected market meltdown which almost destroyed the whole money-financial system of the world.

So how can we utilize our understanding of our government’s income statement and balance sheet and the allegoric story for investing in today’s markets?  America’s ship of state is singularly huge and powerful.  However, at times over several decades its calls to foreign ports ran onto shoals which have punctured holes in our ship of state.  That ship is still currently moving forward and most investors interpret this as the confirmation that the ship of state is sound, and that for investors there is the opportunity to make profit.  However, because the hole in the ship’s hull is under water, the amount of water already accumulated in its hull is not directly visible to investors from the shore.   Therefore, it is not obvious that no bilge pump of any size can pump enough water from the ship to salvage it, or save the ship from sinking.

There are important lessons for investors looking at both the government’s income statement and balance sheet.  Just because the budget deficits are ignored by investors, it does not mean that liabilities do not accumulate to unsustainable levels or can be paid off.  Just because the unfunded debt is not readily visible (just as the hole in the hull of the ship which is not visible because it is under the water line) does not mean that no problem exists.  The budget deficit and, therefore, the hole in the ship’s hull are being enlarged forcing more water into the hull of our most important investment – our ship of state.

Those who are sitting comfortably ignorant on the deck of this ship enjoying the ride will be unprepared for what is coming.  Those who are aware of the impending disaster should secure their life boats now.  Over a century ago a famous scientist, Mr. Charles Darwin proposed the evolution of species, from which evolved the proposition that those not adaptive or perhaps not cognizant of unseen dangers could be eliminated by it.  Darwin’s theory for investors is about to be reconfirmed through the actions of our economy and financial markets.  Make sure that you are not made extinct by the growing waves of an approaching storm while sitting on the deck of a ship whose hull is dangerously full of water.

Raymond Matison

Mr. Matison was an Institutional Investor magazine top ten financial analyst of the insurance industry, founded Kidder Peabody’s investment banking activities in the insurance industry, and was a Director, Investment Banking in Merrill Lynch Capital Markets.   He can be e-mailed at rmatison@msn.com

Copyright © 2018 Raymond Matison - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2018 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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