Launch the Life Raft

2010 will see the financial crisis become a sovereign debt crisis...

YOU MIGHT NOT spot it from the lethargic vibe coming out of the news each day. But we get the distinct feeling that we're sliding toward an existential crisis for the Nation State as a competent, solvent institution for the 21st century, writes Dan Denning for his Daily Reckoning Australia.

Enough of the carping, though. Today, we're going to begin doing something about it.

First, there's more evidence that a few of the world's governments are in over their heads. As we've said before, this is the year the global financial crisis becomes a sovereign debt crisis. It will put great strain on the bond market (rising yields, falling prices). That might be a nice boost for equities.

But before you get really excited about the breakdown of the 28-year bull market in bonds and what it might do for stocks, remember we're talking the failure of a financial model for governments here. That is no small thing. No one really knows what it will mean, particularly if some of the bigger liberal democracies face ratings downgrades.

Case in point, the United Kingdom of Great Britain and Northern Ireland now faces an 80% chance of a credit-rating downgrade if it doesn't have more credible deficit reduction plans, according to Scott Mather of Pimco, the world's largest bond fund group.

The UK is already on a "negative outlook" rating from Standard and Poor's, but still retains its AAA credit rating. The immediate problem, as for the United States – and aside from spending too much money – is central banks in both countries plan to remove their support for bond markets this year. This pushes up rates and raises the cost of servicing and raising new debt. And if your economy isn't firing on all cylinders generating tax takings, your expenses rise while your income stays stagnant or falls.

You don't have to be Nobel laureate to know that's not good for the national finances.

But the results for investors are not so straightforward. Investment analyst Byron Wein reckons US GDP will grow by 5% in 2010, unemployment will fall, the S&P 500 will rally to 1,300 in the first half of the year before closing at the same level, and that Fed funds rate will be pushed up from 0.25% to nearly 2%, giving the Dollar a boost in the FX markets and pushing ten-year yields to 5.5%.

Whew! That is a lot of predicting. But when you break it down it goes something like this: stocks up and then down, Dollar up short term but probably down long term, bonds down. Japan, so-so.

This begs the question of what time-frame you should be using for your investment decisions. Via our friend Dan Ferris we ran across an article in Forbes in which fund manager Whitney Tilson says the average holding period on the New York Stock Exchange is now six months. It used to be five years. One possible conclusion from this observation is that patience is still a virtue. Hold for longer and you'll avoid transaction costs. More importantly, you won't morph into a trader masquerading as an investor. You'll be focused on long-term value over short-term trends.

The trouble with this idea is the market might smash it in the face. Higher volatility and more uncertainty about the future are both direct consequences of government manipulation of the cost of capital (the Fed setting interest rates). Investors aren't buying and selling more often because it's trendy, or fun, or more effective. They're doing so because Wall Street and Washington have made evaluating securities and their future earnings really difficult. How?

Bad public policy and short-term corporate management have shortened the national time horizon to about five feet in front of the nation's face. That's not so good. We were discussing just this point with a wizened Uncle over a beer in the Colorado mountains last week.

An essential piece of America's DNA is its short-term memory. The country began as a home to religious radicals and those fleeing the social and economic stasis of Europe. What they got and what they created – fuelled by an endlessly expanding frontier – is institutionalized revolution: constant change.

That change – the chance to reinvent yourself by moving West and starting afresh – is what made the country so attractive to risk takers (and so ungovernable the further West you went). But that great virtue of reinvention has also led the nation to have a very short memory. And today that is a liability.

America's heroes used to be frontiersman or traders or settlers. By definition, these people were literally at the margin of the national experience, pushing the country's borders West and encountering the native peoples and generating either commerce or friction and genocide. The violence of living and the margin (the frontier) also explains something of America's attitudes toward guns. You couldn't dial triple zero if you had to defend yourself from man or beast.

But with such a short national memory, America today doesn't remember much about where it came from. Its heroes are what's on TV, mostly vacuous, over-fed, under-dressed celebrities famous for being pretty, or, even more superficially, for just being famous. The frontier of American experience has collapsed and falling in on itself. The nation now gazes at its fat belly, dirty with potato chips and barbecue sauce, and wonders where we're headed.

Of course none of this has anything to do with Australia. We apologize for the diversion today. But we were asked about it last night by a stranger at the local pub who wanted to know more about America and what Americans thought of Aussies. We told him America is cheap right now. The cost of living is heaps lower than in Australia.

But at the same time, there's a nationwide amnesia about the virtues of a free country: risk is rewarded, effort leads to results, thrift is prudent, and conspicuous consumption is wasteful. People know these things intuitively. They are just going to have relearn them from personal experience.

In any event, great changes in social mood are afoot in 2010. And we're trying to sort out what that will mean for changes in personal financial behavior. Will the Baby Boomers double down on stocks and try to rebuild the retirement kitty? Or will the evident failure of the Federal government to do anything well cause people to become a lot more conservative, favoring cash and bonds?

Our revelation over the break was that we didn't really care either way what direction public policy was headed. The main thing is to be in control of your own financial future. You have to have a macroeconomic view in order to prepare and allocate your assets correctly.

But after talking with family and friends we're convinced that this is the year you need to launch your financial lifeboat into the sea. Granted a storm is coming. But the big ocean liner we've been placidly cruising on is creaking ominously.

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