Getting Ready for the “House of Cards” to Fall

by Michael Lombardi, CFP

If a company takes on too much debt, and then needs to borrow money to pay back loans, or worse, borrows money just to make interest payments on its old loans, what eventually happens to that company? Yes, it goes broke, because at a certain point, lenders will not lend to the company. Add falling revenue to the mix and the company is surely headed for bankruptcy.

Is the overall state of America’s finances really any different from the above example? We know revenue for the government has fallen off quickly, as corporations and individuals pay less tax because they are making less money. While money coming in (tax revenue) is decreasing, costs of the economic bailout and two ongoing wars have risen.

For the first time in history, the U.S. deficit has surpassed $1.0 trillion. The government’s fiscal year ends October 31, 2009, and the deficit is expected to hit $1.8 trillion by then. Think about it: we are taking in $1.8 trillion a year less than we pay out. That’s $5.0 billion more a day that our government spends than it takes in. How long can this go on for? When will the proverbial “house of cards” start to come apart?

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Going back to my example of a company following the same path, at a certain point, losses will be unsustainable. The best-case scenario (and what we all hope for) is that the economy turns around, the costs of the economic bailouts decline, and tax revenue picks up. My concern is the cost of other major projects being considered, such as a revamping of our medical system and the “going green” initiative. Where is the money going to come from for these new costs?

As I have written many times, there are several risks we are running with this high-deficit policy. We are risking the status of the U.S. being the world’s reserve currency, we are risking foreigners not wanting to buy our bonds and, ultimately, we could be setting ourselves up for higher interest rates. The stock market loves a lower U.S. dollar, but it hates higher interest rates.

I’m doing my best to monitor the house of cards for my loyal readers, as there will be risk and opportunities in the months ahead for investors who are prepared for higher interest rates. My readers will not be caught off guard.

Michael’s Personal Notes:

Last week was the best week for stocks since March. Many of the major market indices like the Dow Jones Industrial Average and the S&P 500 were up 7.0% for the week. Better than expected earnings reports from companies like IBM, Google, General Electric Co., and the banks caught many investors off guard. Second-quarter earnings reports are 16% better than analysts had expected (according to Bloomberg).

The stock market is rallying again and the positive economic forecasts are also starting to roll out again. Not so fast, I say. The economy is still on very shaky ground. The government itself expects the unemployment rate to hit 10%, banks are not lending to business like they use to, and home foreclosure rates continue to rise. We are far from being out of the woods.

Where the Market Stands:

The Dow Jones Industrial Average, which was up 7.0% last week, is now close to the breakeven point for 2009. The media was quick to credit last week’s stock rally to better than anticipated earnings reports form large U.S. companies. Yes, earnings reports for the second quarter are coming in at an average of 16% better than analyst expectations, but please remember that the market always does the opposite of what is expected of it. Two weeks ago, most analysts had been calling the bear market rally that started March 9, 2009, as over. The stock market is delivering the opposite.

What He Said:

“When property prices start coming down in North America, it won’t be a pretty sight, because consumers are too leveraged. When consumers have over-borrowed so much that they have no more room in their credit lines to borrow more, when institutions start to get tight on lending, demand for housing will decline and so will prices. It’s only a matter of logic, reality and time.” Michael Lombardi, in PROFIT CONFIDENTIAL, June 23, 2005. Michael started warning about the crisis coming in the U.S. real estate market right at the peak of the boom, now widely believed to be 2005.