The Next Big Showdown

Voters have spoken.

But the market has not.

And a major new showdown between Washington and Wall Street is now in the making.

So far, investors have barely begun to raise their voices. But already we can hear the anger and sense the fear …

• Investors are afraid of the fiscal cliff and trillion-dollar deficits.

• They’re impatient with gridlocked politicians.

• And they’re downright angry at anyone or anything that threatens to gut the value of their investments.

To make their mark, they don’t have to pound their fists on the desks of faceless bureaucrats. They don’t have to wait for the next election. They don’t even have to be U.S. citizens.

All they have to do is pick up the phone … or click on a mouse … and issue a single four-letter instruction: “SELL.”

That sell order, multiplied a million-fold, is the ultimate Sword of Damocles hanging over Washington.

It can make or break landmark legislation.

It can jinx or clinch the career of powerful leaders.

And it can change history.

Hard to believe? Then just look at what began to happen last week.

When President Obama drew a line in the sand, saying he would absolutely insist on raising taxes for the rich, what did investors do? They sold!

And when House Speaker Boehner said he’d absolutely refuse to cave in to the White House on tax hikes, what did investors do? They sold some more.

They sold health insurers like UnitedHealth Group (down nearly 6% for the week) … big oil companies like ExxonMobil (down more than 3%) … megabanks like BofA and JPMorgan Chase (both off 4%) … and big telecom leaders like Verizon (also off 4%) — not to mention Walt Disney, which sank a whopping 7.4% on the week.

They also sold all the high-yield junk that they’d been chasing. In a recent email, Safe Money Editor Mike Larson writes about some of the main targets:

“Investors dumped JNK, the leading junk bond ETF. Everybody and his sister have dog-piled into high-risk bonds as part of the ‘yield insanity’ trade I highlighted in Safe Money. Now, that’s biting them on the rear end. Last week, this ETF fell below its 50-day moving average and sunk below its trendline that dates back to June.

“Investors dumped IYR, the main ETF that invests in REITs — another example of the yield insanity trade that I cited. It’s now carving out a massive top, in my view, and it has also fallen below a series of technical landmarks.

“Meanwhile, widely owned tech stocks (such as Apple and Google) have been hit hard, while one of the major retail ETFs (XRT) also got smacked. That’s the last thing Wall Street wanted to see heading into the holiday season.”

The good news is that, after seemingly endless stonewalling and bickering, when the market finally speaks, Washington DOES listen — eventually.

Skeptical? Then consider these two case studies …

Case study #1
Bond Market Collapse of February 1980

The time is November, 1979; the place, the White House.

Like in November 2012, a dark financial cloud hovers over Washington — not only fiscal troubles, but also the threat of hyperinflation.

Like in 2012, President Jimmy Carter and Congress have been gridlocked for months, unable to deal with the brewing storm.

Unlike November 2012, the next presidential election is a year away. But investors don’t wait for the ballots. Nor do they have to.

They begin issuing their sell orders immediately, venting their wrath primarily in the U.S. bond market — by dumping medium- and long-term U.S. Treasury securities.

Treasury bond prices collapse, while interest rates surge.

The tipping point comes on February 5, 1980. That’s when Treasury bond prices fall so far that their yields surge above the 11% level — the all-time peak reached during the Civil War.

“Faced with a prolonged buyer’s strike,” says one bond market pro, “we decided to throw in the towel and get yields up to a level where some cash buyers might be shocked off the sidelines.”

But the next day, panicky bondholders begin unloading bonds at any price … and there are still few takers.

The selling is so intense that all except two of the largest, best-capitalized bond dealers on Wall Street — Merrill Lynch and Solomon Brothers — effectively abandon their market-making role.

Now, it’s no longer merely a case of a price collapse. It’s a market collapse in the literal sense of the word: The dealers themselves are packing up and going home!

By February 19, the collapse gathers even more momentum, as Treasury bonds lose over 5% of their face value in a single trading day!

Investors aren’t just shouting their protests from the rooftops. They are shutting down the market for U.S. Treasury securities, making it impossible for the U.S. government to borrow the money it needs to stay alive — and to avoid defaults on maturing debts.

Result: With Paul Volcker at his side, President Carter acts, announcing an anti-inflation bombshell: An unprecedented package of CREDIT CONTROLS that clamps down on virtually all forms of credit.

The U.S. economy is pushed over a cliff and into a tailspin.

Carter’s chances for re-election are doomed.

But the bond market recovers and the U.S. Treasury is able to resume borrowing.

This is the sacrifice that investors demanded in order to kill the threat of hyperinflation. And this is what Washington ultimately delivered.

Case study #2
Market Collapse Gives Birth to
Biggest Bank Bailout of Our Lifetime

Fast-forward to September 29, 2008.

Lehman Brothers has failed. Bank of America, Citigroup and many others are on the brink. The nation’s worst financial crisis since the banking holiday of the Great Depression is here.

The day begins with a reported “agreement” that Washington hopes will end the financial crisis — a massive bank bailout plan to be dubbed the Troubled Asset Relief Program (TARP).

But when the legislation is put before the U.S. House of Representatives, it fails 205–228. Democrats vote overwhelmingly in favor; Republicans, against.

A verbal brawl erupts in the Cabinet Room of the White House.

“If money isn’t loosened up, this sucker could go down,” President Bush declares.

Treasury Secretary Paulson drops to his knees. He begs House Speaker Pelosi not to “blow it up” by withdrawing her party’s support for the package.

Paulson warns that, without the massive bailout, Wall Street will melt down, the U.S. economy will collapse, and the entire world will sink into a great depression.

But despite all the warnings, gridlock continues to reign … UNTIL, that is, the market speaks:

Within a short 20 minutes during the live voting on the House floor, the Dow falls by more than 500 points. And before the day is over, it’s down 778 points, the largest single-day point drop in history.

Result: The parties panic and reach a “grand compromise.” Congress passes a nearly identical TARP bill on October 3. And it’s signed by President Bush within the hour.

Think These Are Unique
Circumstances? Think Again!

I’ve been watching the interaction between Washington and Wall Street for nearly a half century.

I’ve seen a similar series of events under Eisenhower, Nixon, Clinton and Bush.

Just last year, we saw the Dow give up about 2,000 points as the debt ceiling debate raged, putting the squeeze on Washington to at least kick the can down the road — the same can that now threatens to blow up with the fiscal cliff.

The difference between today and 20th century showdowns: The venom and acrimony are now greater; the stakes, higher; and the consequences of failure, more destructive.

My view: Ultimately, they will reach a deal!

But serious questions remain unanswered …

• How quickly will they agree? And how much will market conditions have deteriorated by that time?

• Will the agreement be a true break with the past? Or will it be like the many empty deals announced in recent years by European leaders to ward off their sovereign debt crisis — just fancy trimmings and fanfare with little substance?

• Will the deal truly reduce government spending? Or will it merely cut back projected future increases in government spending?

• Will it mark the beginning of the end of this fiscal crisis? Or will it merely set off a new chain reaction of financial disasters?

Stay tuned! We will explore each of these critical questions thoroughly over the next few weeks.

In the meantime, be sure to stay safe!

Good luck and God bless!

Martin