The value of the US dollar, along with the value of other currencies, has been declining for over 75 years, since Franklin Delano Roosevelt suspended conversion of US Treasury Bills into gold.

The US trade deficit has been building steadily since 1971, when President Nixon cut the final ties to gold.

However, the decline of the US dollar relative to the currencies of US trading partners, only became the dominant trend after September 11, 2020, when President Bush embarked upon expensive military operations against Muslim extremists in their various forms.

If this trend is not reversed, the outlook for the US dollar as the world reserve currency, with consequent benefits to the United States, is grim indeed.

A graph that tells the story

The following Federal Reserve chart shows the value of the US dollar against currencies of US trading partners since 1995.

The War on Terror weighed heavily on the US dollar
The War on Terror weighed heavily on the US dollar

The first period of the graph, prior to 2001, shows the value of the US dollar relative to the currency of its trading partners, appreciating in value.

This was a time in which, following the end of the Cold War, the US was drawing down its military spending, while building domestic fiscal surpluses. The combination of a moderate Democrat in the White House, plus Republican control of the Congress, did the trick.

The thick red box on the graph outlines the period of the ongoing War on Terror. This has been a time of substantial military build-up, a continuing expensive US military shield over NATO countries, Japan, South Korea, and other places, and two hot wars in Iraq and Afghanistan.

The inner thick gray box shows the period of the Invasion of Iraq.

The inner thin light gray box shows the period in which the Republicans lost control of the House of Representatives, now under the leadership of Nancy Pelosi.

Finally, the blue box shows the period following the Crash of 2008 and the election of Barack Obama as President of the United States.

Except for a brief period during the chaos of the Crash of 2008, the US dollar has steadily declined against the currencies of its trading partners.

  • Period A: The War against the Taliban.
  • Period B: The Invasion of Iraq.
  • Period C: Nancy Pelosi as speaker of the House.
  • Period C: Barrack Obama as President of the US.

Although the relative value of the US dollar has been steadily weakening since September 11, 2020, the periods of sharpest decline have been during the periods in which the Democrat Party controlled the House of Representatives and the US Presidency.

Despite the relative decline of the dollar during the Bush years, the current level is still about that of 1997.

The graph suggest that by changing its military posture towards far less expensive strategies, while returning to the more conservative budgetary policies of the Clinton era, the US dollar might still be able to recover.

Whether this might be politically feasible is quite another question.

Bush’s Folly

President George W. Bush made the following critical decisions:

  1. To engage in an expensive conventional war against perceived terrorist enemies in Iraq and Afghanistan.
  2. To continue to provide a costly US military umbrella over various treaty nations in Europe, Japan, South Korea, and other alliances, despite over-extension of the nation’s military resources and without reciprocal contributions on the part of client nations so as to significantly reduce the burden on the United States.
  3. To appease domestic political opposition to these wars and the cost of defense, from both sides, by allowing Congress to engage in excessive, non-essential spending, while enacting easy credit policies that led to the Crash of 2008.
  4. To stretch US military engagement to the limit by relying on voluntary US troops (avoiding the unpopular draft) and by accepting token military contingents from most “allies” (with the notable exception of a few countries.)

The result was a successful, expensive ground war in Iraq and an initial win in the war against the Taliban in Afghanistan, in the face of falling support, both domestic and international — and the remarkable lack of appreciation — indeed, even hostility — from most countries over which US was providing an expensive military shield.

George Bush allowed Osama bin Laden to shape his Presidency
George Bush allowed Osama bin Laden to shape his Presidency

President Bush violated the military axioms learned by Dwight Eisenhower and George Marshall from that military genius, Fox Conner, back in the Panama Canal Zone in 1922:

Never fight unless you have to, never fight alone, and never fight for too long.

See: Partners in Command: George Marshall and Dwight Eisenhower in War and Peace

In order to assure continued funding for military expenditures, President Bush looked the other way when Republican legislators betrayed their own party ideals, engaging in pork barrel spending and when Democrat activists, like Chris Dodd and Barney Frank, pushed sub-prime mortgages and other populist, but unsound financial programs through Fannie Mae.

These policies led to no clear victory over Osama bin Laden, the loss of support for the war, the financial collapse of 2008, the demoralization of the Republican Party, and the election of an unknown, radical extremist, Barack Obama, to the White House.

Obama’s Coup de grâce

With less than ten months in office, President Barack Obama has already dealt a severe, perhaps fatal blow to the supremacy of the US dollar.

Already weakened by military spending during the Bush administration, Barack Obama has increased the chances for even faster devaluation of the US dollar, pushing massive, inflationary “spending is stimulus” legislation, with explicit and hidden taxes on small businesses on whom most new job creation depends and on large segments of the population, already paralyzed by fear into a non-consuming mind-set.

To assure lack of confidence in his measures, Obama has encouraged the introduction of extreme, radical change by brute political force (claiming the “mandate of the people”) — calling on legislators to vote on bills they have not read and written by those whom they know not.

Following economic policies that seem to combine the worst schemes of Franklin Roosevelt and Jimmy Carter, Obama’s actions portend an extended US recession even after the rest of the world has recovered.

Is this Obama's "Civilian Army"?
Is this Obama's "Civilian Army"?

Perhaps the most serious blow to confidence in the dollar, beyond the unprecedented level of deficit spending, now projected forward for decades — is the fact that these measures were undertaken without due deliberation — thousand page bills that no one had read, that no one could understand, that no one seemed to know who wrote, and that were later found to be laced with radical and revolutionary “surprise packages” — like billions available for groups like ACORN to continue subversion of the democratic process and funding for a mysterious and massive “civilian army”, smacking of Hitler’s brown shirts, set up to be as well funded and armed as the regular military — all done in the dead of night, without the knowledge of most Americans.

With regards to his “civilian army”, Obama has said:

“We cannot continue to rely on our military in order to achieve the national security objectives we’ve set. We’ve got to have a civilian national security force that’s just as powerful, just as strong, just as well-funded.”

For a President that has admirers of Hugo Chaves in his “secret cabinet” of non-vetted Czars, including several admitted Marxists, his dream of a “civilian army” suggests that he may be thinking of turning the United States into a banana republic.

In any event, why should intelligent investors in the rest of the world continue to have confidence in a country that is moving decisively to devalue its currency on a long-term basis, while seeming to move into the murky world of “banana republic” politics. Obama is not George Washington, Abraham Lincoln, or Ronald Reagan. The question is: “Is he Hugo Chaves?”

Furthermore, Obama’s vision regarding conventional US military power is clouded. Elected with (in his perception) a “mandate” to reduce US military involvement and goaded further in this direction by a Nobel “Peace” Prize — not for what he has done, by for what Norwegian socialists expect him to do — Barack Obama may, eventually:

  1. Withdraw US troops from Iraq and Afghanistan;
  2. Continue his policy of reducing US military support for countries in the former East European Soviet Block;
  3. Continue to favor Palestinian, Syrian, and Iranian interests over those of Israel, allowing Iran to acquire an atomic bomb with delivery capabilities;
  4. Reduce the US military budget, atomic arsenal, and strategic defense installations;
  5. Move towards relying upon the United Nations, rather than US leadership, NATO, or regional defense pacts, for world security.

Of course, no one can say how successful Obama will be in moving in this “peaceful”, “banana republic” direction, but signs are there to suggest that such a direction is at least plausible and are consistent with his “military background”, “executive experience”, and the totalitarian opinions of some of his most avid supporters and Czars.

The combination of reckless, inflationary monetary policies with unilateral disarmament and a retreat for the US role, adopted during the 20th century as an active, leading military power, do not seem consistent with a US dollar that can continue to be the leading world reserve currency.

In other words, the stage seems to be set for Barack Obama to deal the coup de grâce on American economic and military hegemony — formally ending “The American Century” and the role of the US dollar as the world reserve currency.

If the United States retreats from its role as “world policeman”, leaving the Japanese, South Koreans, and Taiwanese to their own devices — doesn’t it seem likely that China will move in as “protector” of these nations and that the US dollar will be permanently down-graded to secondary status in such regions?

As was seen in the days of the British Empire, concepts of military supremacy and the soundness of money, including relative resistance to inflation, are intimately linked with the notion of an international reserve currency.

Osama’s victory

The war that Osama bin Laden and Al Queda have been waging against Christian nations and non-radical Muslims for over a decade, was brought decisively to the United States on September 11, 2020.

The United States faced a number of serious obstacles that would need to be resolved if it was to “win” this war:

  1. A Non-National Enemy: Al Qaeda is not a sovereign power nor signatory to the Geneva Convention, but rather an amorphous, terrorist group, composed of loosely associated cells of like-minded individuals. It hides in failed states, or in national regions outside the control of the supposed “sovereign”, or in friendly “rogue nations”. It has moved its primary location several times over the years.
  2. The Geneva Conventions: The Geneva Conventions are a series of supra-national agreements that impinge upon the sovereign rights of nations and citizens of those nations. The intent is to somehow make wars “more humane”. Infractors of the Conventions may be tried for “War Crimes“. Al Queda doesn’t care about the Geneva Conventions, but uses them against its enemies, by hiding operatives and weapons among civilians and by using the national “sovereignty” of the weak or friendly nations as a shield.
  3. The US Constitution: Citizen and residents of the United States are protected by the US Constitution, which makes it difficult for the government to spy on its own citizens, even for the purpose of national security. Anti-discrimination laws protect Muslims from being singled out for scrutiny by the government, which effectively raises the cost of internal surveillance of behavior beyond all reasonable bounds. Groups like the ACLU insist on captured terrorists being treated as criminals, rather than as combatants, giving Al Qaeda an enormous advantage when infiltrating the country as terrorists.

The enormous advantages afforded Al Qaeda by these legal restrictions, plus the economic asymmetry of terrorism, have placed the United States at a severe disadvantage in fighting Al Qaeda.

Unionized officials confiscate a lady's mouthwash ...
Unionized officials confiscate a lady's mouthwash ...

The long lines and personal inconveniences that US citizens must now face when traveling by air are a case in point:

  1. Universal passenger screening, rather than profiling for the most likely terrorists: I recently witnessed a TSA employee requiring a two year old child, whose mother was carrying two other infants, to remove her flip-flops and put them in a basket for screening. She then confiscated a four ounce bottle of baby oil from the mother, because it was over the three ounce limit. The mother was white, about thirty, wore a typical house dress and a cross, and spoke with a strong Texas accent. The TSA official seemed to lack the intelligence to spot Osama bin Laden if he were to approach her.
  2. Permanent, unionized screeners: In addition to insisting on universal screening (requiring far more employees than intelligent screening by profile), the Democrat Party also insisted that screeners be unionized government employees — thereby virtually ensuring that they can’t be fired, no matter how incompetent, nor that they will be fired, even after the danger of terrorist attack on airplanes passes. This means that the costs of the War on Terror will go on for generations, supplemented with government health insurance, retirement plans, and other goodies.
  3. Failure to implement pre-screening: It seems obvious that millions of Americans could be pre-screened as not being suspected terrorists, thereby dramatically reducing the cost and inconvenience of current universal passenger screening. However, this would reduce the number of government employees required (anathema to the Democrat Party) and involve “implicit profiling” (hateful to the ACLU). So all Americans must put up with the indignities of mass screening.
  4. Failure to screen for real dangers: Anyone with an ounce of sense, observing TSA officials at any airport, can come up with a dozen ways to get weapons past these bureaucrats. For example, in the same line mentioned above in which a TSA official was forcing a two-year old child to remove her flip-flops, I saw a tall, muscular woman, who seemed to have a furtive look, wearing stiletto high-heel shoes. The spikes, with a little ingenuity, could have been converted into a weapon that could be driven into the brain of an airline stewardess, but this lady passed inspection with barely a glance. (Meanwhile, the screeners were confiscating toe-nail clippers of old ladies.)

So far, based on the evidence, we must conclude that Osama bin Laden (or whoever is taking his place) is winning the War of Terror:

  1. George Bush, despite successful military campaigns, has been discredited.
  2. Barrack Obama has been awarded the Nobel Peace Prize (despite having done nothing to earn it) on the assumption that he is likely to disarm the United States, fail to protect Israel against the Iranians, and free Al Qaeda terrorists held at Guantanamo Bay in Cuba.
  3. The cost of the War on Terror, so far, has been sufficiently high to devalue the dollar relative to its trading partners and weaken the position of the dollar as the international reserve currency.

Theoretically, it would be possible for the United States to completely rethink the strategy for the War on Terror, to include such features as internal surveillance against US citizens and residents, black-operations against Al Qaeda cells without the permission of the host nations (like Pakistan), and regrouping of US military, bringing troops back from abroad (including places like Korea, Germany, Japan, Afghanistan, and Iraq), to beef up domestic border security.

However, there is no indication, so far, that a reasonable response to the asymmetrical warfare waged by Al Qaeda has been found.

The conclusion, therefore, so far, seems to be a victory for Osama bin Laden.

This also, does not suggest that strength of the US dollar or the outlook for its role as the international reserve currency is likely to be enhanced.


Photo credit: “Only following order” by Crashwork, from Flickr

The US Federal Reserve flow of funds accounts for Q2 2009 provide a clear explanation of the causes of the recovery in stock prices in the first half of 2009.

These statistics show a pattern of behavior quite different from that which has prevailed since 1982.

It is too early to say whether Q2 2009 is the precursor of a new paradigm in US equity markets, or whether the Stock Buyback Era will return.

The (temporary?) demise of stock buybacks

For the last twenty years, the upward trend in the US equity markets has been driven by massive net stock buybacks on the part of non-financial corporations, matched, more or less, by huge net sales of equities by US households as corporate executives exercised stock options in amounts that far exceeded net stock investments by other individual investors.

New York City skyline in 1970s, before the Buyback Era began ...
New York City skyline in 1970s, before the Buyback Era began ...

During this period, prices moved upwards, which, according to the Motivation Axiom of Capital Flow Analysis, meant that corporate buybacks were causing the upward movement in stock prices.

In Q2 2009, this flow pattern was suddenly reversed — returning to a type of behavior seen prior to 1982 when the US SEC issued Rule 10b-18 granting safe harbor to corporations that wished to manipulate stock prices in order to give value to executive stock options.

The stock buyback movement has been, essentially, a trillion dollar Ponzi scheme that required ever greater gobs of corporate cash to succeed.

The Crash of 2000 signaled the first weakening in the buyback movement, as a point was reached where buybacks could no longer be easily financed just from current earnings.

The post-2000 recovery came about as corporations began to finance buybacks by dipping into depreciation reserves and, in the last five years, by borrowing from banks.

In 2007, the collapse of the sub-prime mortgage market began to restrict the availability of credit.

By the last quarter of 2008, imprudent bank lending had reached such proportions that global financial markets collapsed, bringing what seemed to be, the end of the buyback era.

Capital Flow Analysis made it possible to predict the 2008 collapse in equity prices as far back as September 2007.

Now the pattern has changed.

Radical shifts in market behavior in Q2 2009

Federal Reserve flow of funds table F.213 shows the dramatic difference in the equity market in 2007 (before the Crash) and in Q2 2009 (after the Crash):

Federal Reserve Release Z.1 (F.213 Corporate Equities)

Green = net buyers; Red = net sellers.

US$ billions (Annual rates) 2007 Q2 2009
Issuers of securities
Domestic, non-financial corporations -790.1 88.0
Foreign corporations 147.8 148.9
Domestic financial corporations 28.1 55.0
Exchange-traded Funds 149.9 149.0
Total Issuers -464.3 440.9
Purchasers of securities
Households -794.2 288.1
Federal government 0.0 -127.9
Foreign investors 218.5 114.6
Life insurance companies 84.1 15.4
Private pension funds -217.0 -170.6
State, local gov’t pension funds -35.3 2.8
Mutual funds 91.3 225.7
Closed-end funds 18.7 -7.9
Exchange-traded funds 137.2 106.7
Broker-dealers 25.4 -30.1
Miscellaneous purchasers 7.0 24.1
Total Purchasers -464.3 440.9

This table shows a striking shift in market behavior pre- and post-Crash.

Before the Crash, Domestic, Non-Financial Corporate issuers were net buyers of securities; after the Crash, these corporations were net sellers.

The 2007 pre-Crash flows were typical “buyback era” behavior — exactly the opposite of issuer behavior one might expect from Economics 101 in which corporations are supposed to go to the stock markets to raise capital.

After the crash, Issuers became “net sellers” and investors became “net purchasers” — which is what one would expect from Economics 101.

In Q2 2009, stock prices were rising and the principal buyers were individuals, directly as Households, and indirectly through Mutual Funds.

According to the Motivation Axiom, this means that the behavior of individual investors was the driving force that caused stock prices to rise in the first half of 2009.

By analyzing the flow of funds accounts for Households, we see that individual investors were moving out of fixed income investments into stocks, apparently due to low interest rates on short-term investments and fear of the impact of inflation on longer-term bonds.

What else can be deduced from Q2 2009 equity flows?

From the above table, other patterns can be discerned, beyond the shift of motivated buyers from domestic, non-financial corporations to households and mutual funds (individual investors).

  1. Rest of the world: Foreign corporations continue to use the US capital market as a source of funds (sellers of equities). However, the willingness of foreign investors to buy into the US equity markets has dropped significantly relative to 2007.
  2. Federal government: The US government is now a major player in the US equity markets. However, the government has not entered directly onto the stock exchanges, preferring direct deals with corporations. In Q2 2009, the government reduced their equity positions (net sellers) as companies sought to rid government from their lists of shareholders. The prices at which these transfers took place were not determined by supply and demand on the open market.
  3. Sophisticated investors: Insurance companies and broker-dealers tend to be more sophisticated in their investments than individual investors, acting directly (households) or indirectly through mutual funds. Sophisticated investors showed a reduced appetite for equities, despite rising prices. In the case of broker-dealers, activity shifted sharply towards net selling compared to their position as net buyers in 2007. This suggests that institutional investors might have been skeptical of the sustainability of the 2009 recovery in equity prices.
  4. Private pension funds: These long term investors have been strong sellers of equities since before the crash, indicating an excess of withdrawals over new investment in pension plans. As Baby Boomers retire in greater numbers, private pension funds might be expected to continue to be a drag on equity price levels.

These indicators suggest that the more sophisticated institutional investors have been avoiding US equities and that a furtherance of the 2009 price bounce may depend upon the motivation of less knowledgeable individual investors.

Risk of investment in equities increases substantially

For a generation prior to the Crash of 2008, with equity prices being driven primarily by corporate stock buybacks, investors could rely, over the medium term, in a continued rise in stock values.

The motivation the caused corporations to buyback their own stocks (at the expense of dividends and to the detriment of long-term investors) was pure, selfish greed, without a trace of fiduciary responsibility. This crass motivation proved extremely reliable, as seen by the behavior of top executives in saving their own remuneration schemes during the Crash of 2008, despite public outcries and the woes of ordinary investors.

However, if the buyback era is over — which is not yet certain — investors will have to get back to fundamentals and try to determine the intrinsic value of securities before trusting their life savings to a portfolio of equities.

This is easier said than done, since the market has changed since the days of Graham & Dodd.

Many unsophisticated investors still believe in the Efficient Market Hypothesis, as demonstrated by the continued high level of investment in Exchange Traded Funds.

Furthermore, the extreme, radical changes in the US economy being introduced by the Obama administration and the Democrat Party that controls the US Congress, with an outlook of fiscal deficits beyond anything most investors have seen in a lifetime (except in third world countries), combined with expectation of massive tax increases on most of the population (directly and indirectly), creates foreboding in the minds of most Americans (at least those who own stocks) as to the future of the country.

Furthermore, the are technical barriers to a continued recovery in stock prices, including:

  1. Over-hang of executive stock options: Corporate executives are still holding huge quantities of under-water stock options (perhaps on the order of a trillion dollars) that will be triggered if stock prices ever get back to 2007 levels.
  2. Rising interest rates: Sooner or later, the Federal Reserve will have to give up on trying to artificially hold down interest rates. When inflation kicks in, interest rates on money market funds will rise substantially, as happened in the Jimmy Carter years. At some point, investors will opt out of risky long-term investment in equities and move to tangible returns in the form of high interest rates.
  3. Persistent high unemployment and tight credit: Motivation towards increased personal savings are stimulated by high unemployment and tight credit. As seen in Q2 2009, personal savings rates have already risen substantially, causing savings to be channeled into equities, in lieu of extremely low interest on money market funds and bank time deposits. However, once interest rates start to rise and inflation kicks in, these savings may be moved out of equities into what is perceived as safer investments.
  4. Tendency to cash out of equities, once pre-Crash levels are reached: Most individual investors saw their net worth decline by twenty percent or more in the Crash of 2008 and many of these are approaching or are in their retirement years. Chances are that if stock prices ever get up to pre-Crash levels, these investors will be strongly tempted to cash out — placing a barrier to further recovery in prices.

In any event, uncertainty as to the future of equity prices has risen to the highest levels in a generation and uncertainty is just another name for risk.

We’ll see …


The Federal Reserve flow of funds accounts for US Households (Table F.100) clearly reveal the forces that drove the recovery in equity prices in the first half of 2009.

By comparing the flow of funds in the year 2007 (at the top of the bubble), with the flows in Q2 2009, a dramatic shift in investor behavior is evident.


Briefly, continued high levels of personal income, combined with lower taxes and historically low interest rates caused by Fed policies, along with fear of hard times to come and the need to save, resulted in a massive shift of funds out of fixed income investments into equities.

These statistics seem to contradict the dismal picture painted in the mass media.

However, by using commonsense and the Fed flow of funds statistics, the forces that influenced equity prices in the first half of 2009 are revealed.

Populist stimulus measures encouraged savings rather than spending

Both the Bush and Obama administrations pushed small amounts of money directly into the hands of consumers in an attempt to revive the economy in 2008 and 2009.

No Great Depression, despite political fear-mongers
No Great Depression, despite political fear-mongers

The theory, apparently, was that the public would spend these tiny payments, which in turn would cause businesses to produce more to meet demand, leading to rehiring and increased employment.

However, the public, frightened by rapid collapse of securities and real estate markets in 2008, and by dire warnings from the White House of a coming Great Depression — the haranguing of political operators not constrained by any need for historical accuracy — logically concluded that the prudent course would be to not spend money, but to save it for worse days to come.

The Federal Reserve, for its part, decided that lowering interest rates to almost zero would somehow encourage businesses to invest and create new jobs — presumably ignoring the terrifying behavior of a Congress that approved trillion dollar spending bills, without reading them, while favoring programs that would impose higher taxes on small businesses — the principal creators of jobs in the United States.

Rather than create new jobs, businesses became more productive, getting rid of marginal workers and holding on to the best.

Despite the success of the economic fear-mongers in getting the Democrat Party into the White House — the first president without any palpable executive experience — an over-whelming majority of Americans still had jobs and were willing to work harder to keep them.

Increasing the minimum wage resulted in sky-rocketing unemployment for young people — in the case of young black males reaching 50%!

The collapse of credit markets in the last semester of 2008 and the need for banks and other financial intermediaries to de-leverage as quickly as possible, restricted the flow of capital to business — despite the low interest rates.

Here are the figures that show household income, taxes, and savings in 2007 and Q2 2009:

Federal Reserve Release Z.1 F.100 Households and Non-Profits
US$ billions (Annual rates) 2007 Q2 2009
Household income 11,894.1 11,986.8
Personal tax 1,490.9 1,083.9
Effective tax rate 12.53% 9.04%
Personal savings 178.9 545.5
Savings rate 1.50% 4.55%

Here we can see that the tax savings doled out in the various stimulus packages did not result in greater spending, but in greater savings.

Only about 10% of the tax stimulus went into consumption — the rest was saved.

Furthermore, despite rising unemployment, household income did not shrink compared to 2007.

Switching from fixed income investments to equities

Not only did individuals save more in Q2 2009, but they shifted funds away from fixed income assets into corporate stocks.

Federal Reserve Release Z.1 F.100 Households and Non-Profits
US$ billions (Annual rates) 2007 Q2 2009
Net flows (annual basis)
Checkable deposits and currency -68.5 217.3
Time and savings deposits 422.7 -183.2
Money market fund shares 232.3 -147.8
Credit market instruments 468.3 -647.6
Sub-total (Fixed income and cash) 1054.8 -761.3
Corporate equities -794.2 288.1
Mutual fund shares 244.4 683.0
Sub-total (Equities and Mutual funds) -549.8 971.1

This table shows a remarkable change in the behavior of ordinary American investors between 2007 (before the Crash of 2008) and in Q2 2009 (after the Crash of 2008 and the introduction of Obamanomics).

The investment behavior in 2007 is easily explained, since it fits a pattern observed since 1982:

  1. In 2007, corporate executives were selling huge amounts of stocks (over $ 794.2 billion, annual rate) in order to take profits on their stock options. The main buyers were corporations with buyback programs approved by the executives themselves. See: The Great Misleading, a critical essay on the stock buyback movement.
  2. After the Crash of 2008, stock buybacks dried up due to lack of corporate funds. Stock prices fell to the point that most executive stock options were “under water”. Consequently, equity sales related to the exercise of options virtually ceased. There always were individual purchasers of equities, even in the buyback era, but the amount of such purchases was hidden by massive sales due to executive options. By Q2 2009, without executive options, 288.1 billion in net equity purchases became visible. The flow of funds accounts don’t indicate whether this amount was greater or less than underlying equity purchases in 2007.
  3. Bad credit and inflation threaten securities markets
    Bad credit and inflation threaten securities markets

  4. In 2007, individual investors still trusted Standard & Poor’s and believed that money market funds were safe. The table shows that in 2007, investors were taking money out of demand deposits and cash to buy longer term credit instruments.
  5. In Q2 2009, investors no longer trusted the credit standing of longer term issuers, moving money out of agencies, municipals, corporate bonds, and money market funds, into government guaranteed bank deposits and cash. Extremely low short-term interest rates encouraged this transfer.
  6. Massive, undisciplined spending authorized by the Obama administration in January 2009 cast serious doubts on the future of the US dollar, with a high probability of inflation. Individual investors acted rationally by moving away from medium and long term debt, in anticipation of the coming inflation.
  7. Individual investors, having suffered massive paper losses in equities in the Crash of 2008, held on to their long-term mutual funds, moving additional funds from fixed income into equities in the expectation of a market recovery. In part, this reflected continued belief in the Common Stock Legend, and in part a speculative reaction to the extreme lows of the Crash of 2008.

Increased savings, plus the above factors, go a long ways towards explaining the stock market bounce in the first half of 2009.

Is the 2009 bounce sustainable?

The flow of funds accounts for Q2 2009, extracted above, also suggest the reasons that the early 2009 bounce is not sustainable.

  1. The Obama health and cap-and-trade programs contain elements that will result in substantially higher taxes, direct and indirect on the American people. This will lead lead to higher unemployment and perhaps greater incentives to save for coming worse times.
  2. Sooner or later, the “spending is stimulus” programs of the Obama administration will result in higher inflation, raising interest rates on short-term money market funds and crashing medium and long-term bond markets. Inflation also tends to favor lower price-earnings ratios in equity markets, resulting in falling stock prices, at first.
  3. Corporate executives are still sitting on huge quantities of stock options that will become valuable if stock prices rise. If stock prices continue to rise to pre-Crash levels, executives will start selling stocks into the market. If credit continues tight, corporations won’t have the cash to support executive options with stock buybacks. This places a ceiling on continued equity price recovery.
  4. Baby boomers, with equity portfolios already severely damaged by the Crash of 2008, will be anxious to sell stocks as soon as prices begin to reach pre-Crash levels.
  5. The anti-capitalist slant of the Obama administration and the Democrat-controlled Congress, in the final analysis, is not conducive to a long-term rise in stock prices. Obama shows no indication, so far, of “moving to the center”. Although the President’s popularity is falling rapidly, the earliest date at which the current administration can be out of office is 2012.

If the Obama administration insists on continuing current policies, portending high inflation and increased unemployment, the United States may indeed be in for a Great Depression.

However, fortunately, unlike in the 1930s, a US President is now subject to term limits and the majority of voters are not union members.

We’ll see …


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