Global Warming Scare May Be Overblown In Short Term, But Increased Droughts, Flooding and Wildfires Are Here Today

A couple of interesting news items caught my attention today. On one hand, research indicates that global temperatures have not increased during the past 15 years. On the other hand, the drought in the Southwest has led to wells no longer producing enough water to meet the needs of the residents of Spicewood, Texas.  Long term predictions about global temperature change are being debated, while much less attention is being focused on the immediate impact of extreme weather events.

In order to gain attention and funding, climate researchers have focused attention on the armageddon-ish aspect of melting ice caps causing global flooding. The almost impossible to accurately predict impact of human activity on the global temperature change over the next few decades gets most of the attention, while the less dramatic impact of changes in atmospheric moisture content that are already being manifested gets less attention.

The research showing that temperature have not risen for 15 years indicates that the computer simulations for forecasting temperature change are flawed. Thus, the longer term predictions about global temperature are under attack. However, the shorter term predictions that flash floods and droughts would increase have come to pass. According to Dr. Kevin Trenberth,

there is a systematic influence on all of these weather events now-a-days because of the fact that there is this extra water vapor lurking around in the atmosphere than there used to be say 30 years ago. It’s about a 4% extra amount, it invigorates the storms, it provides plenty of moisture for these storms and it’s unfortunate that the public is not associating these with the fact that this is one manifestation of climate change. And the prospects are that these kinds of things will only get bigger and worse in the future.

The uncertain long term impact of global climate change was pointed out in The Wall Street Journal's editorial No Need to Panic About Global Warming. However, the residents of the Southwest that will suffer from drought this summer may not agree that there is no need to panic.

The occurrences of extreme weather is increasing. Thus, it seems a bit premature to write off being concerned about Global Warming. Perhaps more attention should be focused on measuring the moisture in the atmosphere and less upon measuring temperature changes. Droughts, floods, and wild fires are already here. It would be a relief to learn that the 16 scientists urging candidates for public office to ignore the looming threat of climate change are correct, but I'm not ready to ignore the conflicting viewpoint of NASA.

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Will Oil And Gas Drilling Activity Determine Economic Growth Rates By State and Country?

The end of cheap oil is a huge drag on economic growth for the U.S. states and for the countries that are net importers. As oil production from easy to tap wells declines and oil exploration and discovery becomes more expensive, the transfer of wealth from energy importing states and countries to exporting geographies is likely to become an increasingly important driver of economic growth. Demand for oil is predicted to continue increasing due to population growth and growing levels of car ownership in Asia. Thus, the days of cheap oil are almost certainly in the rear view mirror. Economic forecasts that do not factor in the likelihood of higher cost of oil may turn out to be badly flawed.

The high price of oil has spurred huge investments in exploration and recovery of oil from expensive new sources, including tar sands, deep off shore wells and fracking. The investment in and recovery of oil via expensive techniques is transferring more wealth than ever to oil exporting geographies.

In the U.S, the cost of energy per household increased from 7% to 11% from 2001 to 2011. Further increases in the cost of energy will depress the net incomes of households in states that are importers of energy and put them at a disadvantage versus energy exporting states. A review of employment statistics shows that this trend may already be in effect. The state with the lowest unemployment rate is North Dakota, with just 3.3% unemployment due to the Bakken drilling boom. Unemployment rates are dropping faster in states that have embraced fracking than in those that have banned it. As shown below, unemployment is dropping faster in Ohio and Pennsylvania than in New Jersey and New York.

Oil and gas drilling activity may also change the balance of economic power around  the globe. The U.S. will gain from our cheap supply of gas.  A silver lining to the economic dark cloud of higher energy prices is that  U.S. competitiveness will improve due to low cost energy from natural gas versus countries that are lacking in natural gas supplies and reliant on importing oil. However, on a net basis, our importing of 9 million barrels of oil per day will hurt the U.S trade deficit and the economy if the price of oil continues to rise.

A number of countries that have been economic power houses, including Germany, China, Japan and South Korea may all experience an increasing drag on economic growth due to higher oil and energy prices. The already high cost of oil being paid by European nations is often an overlooked factor in the cause of the debt crisis. It may become an even larger headwind in restoring growth Europe. The outlook for Germany and Japan made be bleaker than most economist realize due to the self imposed damaged to their economies caused by shutting down nuclear power plants, requiring increased imports of expensive fossil fuels.

Conclusion
For those looking to relocate, it may be appropriate to consider geographies that are likely to expand  economic activity and tax bases via increased oil and gas production. Within in the U.S, the economic future of North Dakota, Ohio, Pennsylvania, Texas, Wyoming, Colorado may be much brighter than that of states that are lacking in oil and gas drilling opportunities.

Likewise, the economic activity for countries around the globe may be greatly influenced by the oil and gas reserves that they can tap. Oil rich countries may have an even bigger advantage in terms of economic growth in the future than they do now.

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Time To Start Preparing For Expiration of Bush Tax Cuts?

The Republican Party is fumbling the ball during this quarter of the campaign season. If they don't come up with a better game plan soon they will have blown a golden opportunity to take control of all three branches of the Federal government. And if the Democrats hold on to the Senate or the Presidency, the Bush era tax cuts are likely to be allowed to expire. Expiration of the Bush Era tax cuts would lead to higher taxes on both income and investments. While the sections of the legislation impacting income tax rates and deductions may be extended, it seems very unlikely that the reductions on capital gains and dividends would be extended by a  Democratic Senate or a second term President Obama.

The two major tax cutting laws passed during the Bush era were the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Jobs and Growth Tax Relief Reconciliation Act of 2003.These two bills cut taxes for earned income, long-term capital gains and dividends. The legislation also expanded the child tax credit and made dozens of other changes and adjustments to the tax code, involving exemptions, deductions and the marriage penalty. While this post is focused on the impact of expiration of the reductions on capital gains and dividends, a review of the changes to tax rates and deductions is provided in a Forbes article on How Will The Expiring Bush Tax Cuts Affect You?

Capital Gains/Dividends
The maximum tax rate on long-term capital gains and qualified dividends was reduced to 15% by the tax cuts. The sunset provisions would return the capital gains rate in 2013 back to a maximum of 20%, and qualified dividends would resume being taxed at the regular tax rate of the filer of as high as 39.6%.

Anticipation of an increase in the long term capital gains tax from 15% to 20% in 2013 would probably be enough by itself to guarantee that the stock market would not have an end of year Santa Claus rally in 2012. A 5% increase in the capital gains tax would lead to sales of investments with capital gains originally planned for early 2013 being pushed back into 2012. However, an increase in the tax rate of dividends could be a much bigger market mover. In particular, it would hurt the price of dividend paying stocks. The impact would vary from stock to stock depending on how much of the market capitalization was based on the dividend yield, but some stocks with high dividend yields might drop in price by 5% or more. The increase in tax rate on dividends from 15% to as high as 39% would reduce the net income available via dividends and make these high yielding stocks less attractive to investors. It would lead to 2012 being the opposite of 2011, a year in which stocks with high dividend yields led the market upward. A decline in high dividend yielding stock prices would weigh heavily on the entire stock market.

If the Republicans will be in trouble in November if they continue to:

1. foolishly focus on a class warfare message
2. turn the campaign for the Presidential nomination into a circular firing squad

The class warfare message is not going to win many voters over to the Republican cause. According to a recent Wall Street Journal/NBC poll 79% of independent voters agree with the statement that the U.S. is "out of balance and favors a very small proportion of the rich over the rest of the country." Further, the class warfare message does not exactly deliver an emotional jolt. Proposals to impose increased taxes on the rich is not exactly a call to send them to the guillotine. Heck, the majority of American voters are not going to get even a tiny bit upset about the fact that the rich may have to pay more in taxes.

The class warfare message can easily be turned against the Republican party. It falls in line with a perception  that the Republicans pander to the rich. Given the size of the budget deficit and the declining real income of most U.S. families, it won't be hard to garner populist support for a "millionaires" tax. 

The bitter attacks being made by the Republican Presidential candidates upon each other is weakening all of them. None of the current Presidential candidates will provide the rest of the party with coat tails in November. Mitt Romney was only viewed positively by 24% of Americans in a Wall Street Journal/NBC poll taken last month, and his rating may be even lower after all the press coverage and attacks upon his Cayman Island holdings. Newt Gingrich is viewed even less favorably than Romney according to polls conducted by CBS news and the New York Times. Further, a poll conducted by Fox News showed that voters who disliked Newt Gingrich outnumbered those who did like him by a two to one margin.

Conclusion

The weak campaign being run so far by the Republican party and their Presidential candidates is reducing their likelihood of taking over all three branches of government. Continued Democratic control of just one of the three branches of the federal government would make an extension of the Bush era capital gains and dividend tax cuts unlikely. Investors should prepare for how the stock market would react to this change and how it will impact their after tax income. Much can happen between now and the November election, so no immediate action is required, but don't get caught off guard by the possibility of the Bush era tax cuts expiring.

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The Small Business Exemption to the Marketplace Fairness Act Would Preserve Jobs

I am a hypocrite. While a core philosophy of this blog is that the Federal and State governments in the U.S. must shrink the size of deficit spending, when it comes to taking away a tax loophole that directly affects my business, I am an adamant defender of the loophole.

It is only a matter of time until sales tax will have to be paid by out of state customers for online and catalog purchases. There is too much tax revenue available and too much pressure from brick and mortar retailers for the loophole to remain open indefinitely. The argument that “sales tax fairness is about protecting small businesses and local retail jobs that are crucial to America’s towns and cities,” presented by said Rachelle Bernstein, of the National Retail Federation is almost certain to carry weight with legislators looking for new sources of tax revenue..

Currently, businesses are only required to collect sales tax from customers who live in states where the business itself has operations.  So, if a customer in Indiana buys shopping baskets from my Illinois business, I do not have to collect sales tax.  This gives me an advantage versus re-sellers with an operation in Indiana. Conversely, it, also puts my business at a disadvantage versus Indiana online sites competing with me for sales to Illinois customers.

The Marketplace Fairness Act, which was introduced to Congress in November, would create a federal online sales tax giving states the option to collect the sales taxes from out-of-state businesses, rather than rely on consumers to pay those taxes to the states—the method of tax collection to which they are now restricted.

As currently written, the bill provides special treatment for smaller businesses. The bill authorizes a state to require a seller to collect sales taxes only if the merchant's "total remote sales" are more than $500,000 on an annual basis. If they're less, the merchant earns an exemption.

It is challenging to quantify the percentage of online sales that will revert back to brick and mortar retailers once ecommerce sites have to begin collecting 4-9% on out of state sales. However, it is unquestionable that the burden of doing so would incur additional paperwork and software costs. Thus, small ecommerce businesses would benefit from the exemption. It seems likely that without a small business exemption this bill could be the straw that breaks the back of struggling ecommerce businesses and drives them out of business.

While collecting online sales tax would hurt small online businesses, the impact of the sales regained by brick and mortar retailers seems unlikely to be sufficient to lead to much additional hiring. Even when combining all online retailers, they only account for 15% of sales. Breaking off the small percentage of the 15% total accounted for by small sites, and spreading it across the much larger pool of brick and mortar retailers, the incremental sales gained by individual brick and mortar businesses seemingly would be too small to lead to any additional hiring. However, small online businesses closing down would result in job losses.

The key to evaluating the impact on online businesses of adding a sales tax is in determining how important the savings is in generating sales. I may be overestimating the lost sales that would result from the adding of sales tax to invoices. A couple of online retailers that I spoke with judge that their sales would not take too much of a hit. According to Ron Starr of Koffler Sales, "the breadth of products that we offer online insulate us a bit from competition with brick and mortar stores. They simply can not match our wide selection. As an example, we offer almost 1,000 different varieties, patterns, and colors of stair treads." And Tracy Anderson of InstallationTools.com judges that they have such a big cost advantage versus traditional stores that even after adding in sales tax, their prices will still be enough lower to protect their sales base.

Conclusion
The Marketplace Fairness Act offers a stark example of why it will be so hard to close tax loophole. Every loophole has backers with a rationale supporting the benefit of keeping it in place. In my case, I am a huge proponent of a small business exemption to the Marketplace Fairness Act. A benefit of this loophole is that it will save jobs at small ecommerce sites. Thus, the generalized case for closing tax loopholes makes for a great sound bite, but the  negative economic consequences to doing so makes it hard to muster the votes to actually do so..

Prediction: A Revitalized Environmental Movement Will Impact The U.S Economy

It's challenging to deny that there has been an increase in extreme weather events. All one has to do is note the increase in property insurance rates and it becomes obvious that the actuaries at insurance companies have factored extreme weather into rates. Of course, it is certainly possible that the large number of destructive extreme weather events  in 2011 was an aberration and the insurance companies are opportunistically taking advantage of an opportunity to increase rates. However, if Michael Mann, director of the Earth System Science Center at Pennsylvania State University, is correct and the "atmosphere contains 4 percent more water vapor–and associated additional moist energy–available both to power individual storms and to produce intense rainfall from them" it seems likely that the trend toward more extreme weather events will remain in effect. If so, 2012 will be another year of droughts and flash floods.

The environmental movement will be tremendously energized if extreme weather events continue to increase in frequency and severity. It is human nature to make correlations between events. Thus, regardless of whether the conclusion is valid, people living in areas experiencing extreme weather will conclude that it is due to man made pollution. Experiencing extreme weather will create converts to the green movement. It may also radicalize those that are already consider themselves to be environmentalist.

The above conclusion may seem like a jump in logic, but I serve as a perfect example of someone that has made a correlation between extreme weather and global climate change. Regardless of whether there is any causation or not, the December snow drought in Chicago has convinced me that global climate change is leading to an increase in droughts and flash floods. Given my track record of being slightly ahead of the mainstream, I am reasonably certain that others will make the same leap that I have and the environmental movement will gain converts. While I realize that there may not be any causative effect, the correlation seems strong enough that I am jumping to the conclusion that the extreme weather is due to more than just La Nina and unusual arctic steering winds.

Thus, my prediction about a revitalized environmental movement is based on two assumptions:

1. the trend of increasing extreme weather events will continue
2. extreme weather events will create converts to the environmental movement, regardless of whether or not there is scientific proof of causation due to human activity

If the environmental movement becomes energized, as I expect, large scale protests seem likely to occur. Frankly, the concept of "saving the planet" should have far more appeal to protesters than the grievance oriented message of the Occupy Wall Street movement. The news media loves to cover protests, and the publicity generated by these protests will galvanize the movement.

So, what will be the effects of a revitalized environmental movement? The primary impact is likely to be an increase in energy costs. There will be:
1) increased pressure to shut down coal fired power plants;
2) continued challenges to obtaining permits for oil developments;
3) attempts to shut down fracking;
4) further legislation requiring utilities to increase usage of clean energy
5) increased pressure on auto makers to increase fleet mileage

It is going to be tough to fight a "save the planet message". However, all of the above trends would hurt the economy.

Coal fired plants are the lowest cost source of electricity. Replacing coal fired plants with other types of fuel will increase electricity bills. Even without any additional rules, the Chicago Tribune reports that Chicago area consumers could see their electricity bills jump an estimated 40 to 60 percent in the next few years. "More than 8,000 megawatts of coal-fired generation capacity has been retired in the U.S. since 2005, according to data from industrial software company Ventyx. Generators have announced they plan to retire another 21,000 megawatts in the near future, and some industry consultant studies estimate 60,000 megawatts of power, enough for 60 million homes, will be taken offline by 2017."

Oil Project Development Will Be Slowed. The "permitorium" on drilling in the Gulf of Mexico has resulted in decreased investment. An industry source estimates that total U.S. employment has been reduced by 72,000 jobs in 2010 and approximately 90,000 jobs in 2011. Further, the delay in approving the Keystone XL Pipeline has eliminated a project that may have created an additional 20,000 U.S jobs.

Attempts to Shut Down Fracking. The battle over fracking is likely to become noisier. Environmentalist have succeeded in keeping fracking from being approved in New York and New Jersey and are would love to shut it down in Ohio and Pennsylvania and the rest of the U.S. Shutting down fracking would be an economic disaster for the U.S. Oil and gas extraction accounted for 25,200 new jobs in 2011. Producing natural gas from shale may support 870,000 U.S. jobs and add $118 billion to economic growth in the next four years according to IHS Global Insight.

Further Legislation Requiring Utilities to Increase Usage of Clean Energy - Clean energy is expensive. Wind and solar require subsidies to make them cost competitive with burning fossil fuels. Further, due to their intermittent nature, additional gas fired capacity must be developed to provide a backup source for days when the wind is not blowing or the sun is not shining. Some are estimating the current California standards for renewable energy will increase the cost of electricity in the state by 11% by 2020. It is instructive to note that Germany's wind power revolution is costing the country billions of dollars and their cost of electricity in now double that of neighboring France.

Increased Fleet Mileage Standards - Mitch Bainwol, president of the Alliance of Automobile Manufacturers, judges that new regulations covering the 2012 to 2016 model years will cost the industry $52 billion to comply. And as Car and Driver reports, the Obama administration's CAFE Fuel Economy Standards will create a fleet of tiny, expensive vehicles.


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Does Chris Christie Really Only Have A 0.3% Likelihood of Being The Republican Nominee?

Over at InTrade, a wager that Chris Christie will be the Republican nominee for President is only projected at a 0.3% chance of occurring. Interestingly, the odds of Christie being the V.P. nominee are listed at 28%.

Given that the Florida primary is winner take all the delegates, it seems likely that Mitt Romney will wrap up the nomination quickly. However, Romney has so much baggage and is so unpopular among social conservatives that if he doesn't deliver a knockout blow to the other candidates in Florida, he may be in for a real dog fight the rest of the way.

While a brokered Republican convention seems unlikely, it is definitely not out of the realm of possibility. Given how little enthusiasm Romney generates among Republicans, he might be in real trouble if there is a brokered convention. Based on the polling data, a majority of Republicans would welcome a fresh candidate that does not carry so much baggage that can easily be attacked by the Obama campaign. Today's headlines from the NY Post about Romney's Offshore $tash is yet another piece of baggage (although probably not as damaging as an ex -wife claiming a 6 year affair).

If there is a brokered Republican convention, my assumption is that Christie has a reasonably good chance of being selected. It seems almost a certainty that Romney will have the highest delegate count going into the convention. If it becomes obvious that he cannot gain the 1,144 delegates required for nomination, it seems likely that he would support his most prominent backer, Chris Christy.

Do I think there is a high probability of Chris Christy being the Republican nominee for President? Not really, but I would rate it a heck of a lot higher than 0.3%.

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Clean Energy Propagandists Obfuscate Need For Oil As Transportation Fuel

When environmentalists discuss replacing oil with clean energy, I often wonder whether they are knowingly spouting propaganda or if they are morons. The wind and solar power they espouse is barely useful as a transportation fuel. Oil will continue to be the energy source that powers cars, trucks, and planes for the rest of this decade. However, the reports about Obama's rationale for rejecting the Keystone XL Pipeline all focus on the Administration's support for clean energy. As is often the case, environmentalists are once again making a case against a domestic oil project by claiming clean energy is a better solution. An Obama ad touts "2.7 million Clean-Energy American Jobs” in promoting his record on energy.

Regardless of how much wind and solar energy is produced for electricity, the U.S. will continue to import millions of barrels of oil per day to power our cars, trucks, and planes for the foreseeable future. So far, electric cars have barely even gained a foothold. Neither Nissan nor GM could even hit their goals of selling 10,000 electric cars in 2011. Given that the average age of the 240.5 million cars and light trucks being driven in the U.S. is 10.8 years, wind and solar will not be meaningful transportation fuels until the 2020's at best.

Developing clean energy will barely make a dent in America's dependence on imported oil from unreliable sources. Supply concerns inflating the price will be a major factor in the price of gasoline going over $4 a gallon once again this spring after refineries switch over to summer formulations.

While there is no question that clean energy is preferable to burning fossil fuels, its potential is often wildly over stated by environmentalist. Gail Tverberg provides a summary of the Obstacles Facing U.S. Wind Energy

Blocking oil project development is hindering job growth. As reported by The Olympian,

a study by Wood Mackenzie, an energy consulting firm, found that U.S. policies that encourage the development of new and existing resources could, by 2018, increase domestic oil and gas production by millions of barrels a day and support a million new jobs. Another study, by IHS Global Insight, estimates that returning permitting approvals to their historic levels before the oil spill in the Gulf of Mexico would generate 230,000 jobs in 2012. And these are mainly blue-collar jobs that could make a huge difference for millions of American households.

Continuing to pursue policies that slow down the issuance of leases and drilling permits, increase the cost of hydraulic fracturing for shale gas and delay the construction of oil sands pipelines are having a detrimental effect on jobs. If these obstacles are not addressed, we’ll be missing out on creating the millions of jobs needed to bring the economy back to pre-recession employment levels.

Conclusion
The environmental benefits of halting oil projects, such as the Keystone XL Pipeline, are often wildly overstated. In particular, claims that energy investments should be focused on wind and solar ignore the fact that oil is required to power 99% of cars, light trucks, and planes. At least for the remainder of this decade, clean energy is not a substitute for oil. Touting the benefits of clean energy is not a logical rationale for halting the development of oil projects.

The efforts of environmentalist to reduce the supply of oil available via North American sources is more economically damaging than environmentally beneficial. The efforts of the greens would be more productive if they focused more effort upon educating consumers on reducing demand, and stopped spouting propaganda that suggests clean energy is a substitute for oil.

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Did Expiration of Accelerated Depreciation Artificially Inflate the 2.8% GDP Growth?

Gross domestic product from October through December expanded at a 2.8% pace according to the Commerce Department's preliminary report. Most of the commentary on the 4th Quarter GDP report emphasize that a large component of the increase was an unexpected buildup in inventories. However, little attention seems to be focused on the impact of the year end expiration of  accelerated depreciation.

Accelerated depreciation of 100% was permitted for capital expenditures if the items purchased were installed by the end of the year. The accelerated depreciation drops to 50% in 2012, increasing the after-tax cost of such outlays. Businesses have worked this tax gimmick to their advantage by pulling  outlays into 2011. This created an artificial boom/ bust cycle. While the bust will not be as dramatic as that caused by the forward buying that occurred in 1999 in anticipation of Y2K, it will likely be substantial. Just as the hangover from forward buying in 1999 was a factor in dot-com bubble bursting, the forward buying of capital equipment in 2011 will big a drag on capital expenditures during the 1st quarter of 2012.

It seems likely that the growth in the U.S. economy may stall during the 1st quarter of 2012. The following four headwinds will make growth challenging to achieve this quarter.

1. The hangover from the forward buying that occurred in order to take advantage of accelerated depreciation 
2. The inventory buildup suggests businesses accumulated excess stock and did not sell as much product as expected during the holiday season. Companies are likely to reduce this inventories during the first quarter of 2012 reducing demand for new sales.
3. The slow down in Europe may cut into exports during the 1st quarter.
4. Consumers are no longer getting the benefit of declining prices for gasoline and oil has returned to $100 dollars a barrel.

GasBuddy.com

Conclusion
The decline in stock prices this morning indicates how unimpressed investors are with the report of 2.8% growth in GDP. Just as accelerated depreciation gave the economy an artificial boost in the 4th quarter, the economy now has to overcome the artificial decline in activity this quarter due to purchases that were pushed into 2011 to take advantage of the tax break. Don't be surprised if growth in GDP stalls out this quarter.

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Is The Greek Economy In A Death Spiral?

The Greek economy certainly appears to be in a death spiral, regardless of the outcome of the PSI negotiations. The 18% unemployment rate in Greece is likely to get even worse in coming months. Seven out of 10 Greek companies are expecting to go ahead with staff cuts in the next few months, according to results from the HR Pulse survey by ICAP People Solutions. Additionally, one in three firms will also be reducing wages.

Already almost two in three firms (64 percent) have adopted some form of labor cost-cutting measures. For the next few months, the most common of these will be reductions in working hours.  Giorgos Haros, managing director at ICAP People Solutions, says this trend is set to grow in the next three months.

The cuts by business combined with government austerity measures will severely reduce income. The government cuts include:

• Public sector wages to be cut by 20 per cent, and wages of state-owned enterprises to be cut by 30 per cent
• 30,000 civil servants to be put on partial pay — meaning 60 per cent of regular pay for one year

Strikes and civil unrest could further reduce economic activity. A 24-hour strike over wages and labor rights organized by the Athens Labor Center (EKA) and the Confederation of Greek Labor (GSEE) will lead to transport disruption in Athens on Tuesday.

The downward spiral in the Greek economy has been relentless. At this point, there do not seem to be any viable plans to revitalize the Greek economy. EU leaders seem to be exclusively focused on avoiding the short term problem of avoiding a default and protecting European banking interests. It is challenging to envision how the Greek economy can be saved any time soon.

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Romney Is Badly Misplaying His Private Equity Experience

Most U.S. voters think the U.S. government is bloated. They would welcome a President that would slash and burn through the wasted spending of their tax dollars. There is only one candidate for President that can legitimately claim to have experience at eliminating inefficiencies in organizations - Mitt Romney. However, the Romney campaign has foolishly tried to position him as a job creator rather than as an inefficiency slasher.

Romney's role in private equity was not to to create jobs. The goal was to improve a company’s profits and resale value, either by increasing sales or cutting costs. While some of the firms that Bain Capital invested in have created jobs, others have slashed them by going bankrupt. The claim that Romney made while running for Governor of having created 10,000 jobs is credible. The current Romney claim that “we helped create over 100,000 new jobs" comes across as puffery. It has been described by the Washington Post as an untenable figure.

It is hard to understand why the Romney campaign has drawn attention to his private equity background. They should have learned a lesson from the attacks on his role at Bain Capital by Sen. Edward Kennedy in Romney's losing race for the Senate in 1994. The ads Kennedy ran attacking Romney's job-killing record at Bain damaged the Romney campaign. Kennedy won by a landslide, with 58 percent of the vote, in the year the Republicans won back the House.

In addition to positioning Romney as an inefficiency slasher, his campaign should be focusing more attention on his success at organizing the Salt Lake City Winter Olympics. He helped erase a $400 million deficit and put together the one of the best organized Olympics. His successful leadership of the Salt Lake City Olympic Committee serves as a strong credential for a role as President. And Romney's management capabilities demonstrated as CEO of the SLOC certainly stand out in sharp contrast to the disorganized campaign of Newt Gingrich.

Conclusion
Mitt Romney has missed an opportunity to position himself as an inefficiency slasher. Doing so can be supported by his experience as Bain Capital and at the Salt Like Olympic Committee. His claims to be a job creator have opened him up to attack as a private equity "vulture". His campaign seemed tone deaf to how despised the private equity field is in the era of Occupy Wall Street. However, responding to the attacks on his private equity experience provides Romney an opportunity to reposition his role at Bain Capital. A positioning as an inefficiency slasher would play much better than his current claims of being a job creator.

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The Greek Economy Is Collapsing - Bond Swap Negotiations At Best Will Simply Get Greece Off Front Page For A Few Weeks

The jobless rate in Greece climbed to 18.2% in November, up from 17.5% in October and 13.5% the previous year. Given that the economy is falling apart and the government is running a huge deficit, it may make the bond swap negotiations meaningless for long term holder of Greek debt. The country needs to find a way to fund its ongoing 21.6 billion euro annual deficit. The declining economy will make it even more challenging to shrink the deficit. Greece is going to run out of money and when it occurs all their sovereign debt will head toward zero in value. Analogies to rearranging deck chairs on the Titanic seem entirely appropriate.

Obviously, for short term traders and hedge funds holding Greek debt and CDS's looking for quick profits on their positions, the PSI negotiations will have a major impact. However, my guess is the long side of Greek debt trades will be a challenging way to make money, even for short term traders looking to flip their positions.

55,000 Greek businesses are going to close down in 2012 according to forecasts by the National Confederation of Greek Commerce. If this forecast turns out to be accurate, then the pace of business failures in Greece is picking up steam, as approximately 30,000 businesses shut down in each of the past two years.

With over 45% unemployment among 15-24 year olds, the danger of social unrest is rising. If social unrest leads to rioting or events that scare tourists away, it could speed up the collapse of the Greek economy.

It is hard to foresee any outcome for Greece other than freeing themselves from the Euro. While the short term consequences would be nasty, the long term benefits of a devalued drachma might be the only way to revitalize the Greek economy.

The collapsing, insolvent Greek economy will not be fixed simply by forcing bond holders to take a haircut on their holdings. Even if the PSI negotiations come to a successful resolutiona

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Extreme Weather Events - The Headwind Missing From Financial Predictions for 2012

In reading financial predictions for 2012, the two biggest wild cards in forecasts are usually: 1) will Europe muddle through; and 2) will the Fed launch QE 3 and if so when. However, I would like to suggest that there should be a third wild card added to financial projections for 2012, and that is the impact of extreme weather events. My guestimate is that extreme weather events will have a significant negative impact on worldwide economic activity in 2012. Flooding and droughts will lead to the 2012 predictions of most economists being overly optimistic.

There will be more flooding and more droughts in 2012. Events such as the supply chain disruption caused by the shortage of hard drives from Thailand may be experienced again in 2012. Drought and flooding will lead to an increase in food costs. Property insurance rates will increase again in 2012. Florida is overdue to be hit by a hurricane. Texas may suffer from cutbacks in electricity.

According to TexasVox "If the drought persists into the following year (and the State Climatologist has predicted that it is likely much of the state will still be in severe drought through next August with even worse water shortages), the Electric Reliability Council of Texas (ERCOT – the operators of the electricity grid) has warned that power cuts on the scale of thousands of megawatts are possible."

The only economists that seem to be publishing information on the increasing costs from extreme weather are the team from Munich Re. Their Natural Catastrophe Review should be required reading for anyone that is skeptical about the increasing costs of extreme weather.

Extreme weather events caused over $55 billion in damage in the U.S. during 2011 and may cause even more damage in 2012. The snow drought this year is badly hurting skiing and snowmobiling destinations. Flash flooding has wrecked havoc on Houston. The Alaska town of Cordova has received 176 inches of snow and 44 inches of rain since November 1. Thus, 2012 is already on pace for another year of record setting costs from extreme weather.

So why is the frequency and damage from extreme weather increasing? Here are four theories (with not all being equally plausible):

1. The earth has been going through warming and cooling trends for millions of years. We are in a warming trend and the natural increase in the earth's temperature is causing the extreme weather.
2. Man made impacts upon the environment are causing global climate change and the increase in extreme weather
3. Higher levels of solar activity and the sunspot cycle, as reported by NASA, is causing the extreme weather.
4. Our solar system is passing through an interstellar cloud of electrical energy and this is causing the extreme weather according to astrophysicist Alexei Dmitriev.

Conclusion
Whether the frequency and damage from extreme weather events is increasing due to man made or natural causes is an unresolved issue. However, it is undeniable that extreme weather is becoming more common and costly. Extreme weather is a headwind that should be included in financial projections for 2012. It may reduce worldwide GDP by as much as 1-1.5 percent.

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Fed Claims Inflation is Subdued -- Oh Sure, As Long As You Do Not Have To Buy Food or Gasoline

The claim by the Fed in a report released Wednesday that "inflation is subdued" seem ludicrous based on a trip to the gas station or grocery store. The increased cost of gas and food is hurting consumers and reducing their capacity for discretionary purchases.

Gasoline is up by $0.242 cents a gallon versus the record setting start of year prices of 2011, and is almost certain to go over $4.00 per gallon in the spring when refineries switch over to summer formulations.

The cost of food-at-home (grocery store) prices rose by 4.25 to 4.75 % in 2011 according to the FDA and is projected to rise by another 3-4% next year. Anecdotally, based on the cost of bread, milk and other staples, my perception is that food costs increased by even more than 5%.

There are three factors that are putting inflationary pressure on the cost of gasoline and food:

1) the end of cheap oil
2) extreme weather reducing crop yields and killing livestock
3) increased demand from Asia

The end of cheap oil is due to the annual decline of 3 million barrels per day from existing fields and increased automobile ownership in Asia. Tom Whipple explains, "Despite all the hype concerning new oil finds and technological breakthroughs in oil production, these developments still are not contributing enough new oil to offset the annual increase of 1 million barrels per day of new demand. The bottom line among those following this issue is that global oil production likely will start to decline in the next one to five years as depletion gets ahead of very-costly-to-produce new sources of "oil."

The droughts and flooding around the world caused by extreme weather in 2011 reduced food stocks going into 2012. Further, based on all the weather weirdness already experienced this winter, including the snow drought in the lower 48 states and the drought in South America, extreme weather may lead to even greater food price increases. Additionally, the high cost of oil increases food costs through more expensive fertilizer and transportation costs in getting food to market.

Conclusion
The Fed may claim that inflation is subdued, but rising prices for gasoline and food will hurt consumers. However, the Fed needs to maintain the perception that inflation is subdued in order to keep interest rates low. Based on the low interest rates for U.S. Treasury bonds, the Fed seems to have convinced the financial markets that inflation is subdued, at least for now.

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The 5 Factors That Will Crush 401K Rates of Return

Conventional wisdom suggests that the rate of return of a 401K is typically around 6%. However, anyone that is calculating the size of their retirement nest egg should be extremely cautious about assuming that they will get a 6% rate of return on their investments and 401K's during the next few years. The stock market is likely to go sideways at best and most investments paying a 6% or higher interest rate include a risk premium that may make them unsuitable for a retirement account.

Here are five factors that will depress the rate of return on investments over the next few years.

1. The Euro zone debt crisis
2. The debt crisis that will hit the U.S., the UK and Japan sometime within the next few years
3. The end of cheap oil
4. Extreme weather events
5. Retirees and the underemployed liquidating assets

Euro zone debt crisis - The so-called plans to fix the Euro zone debt crisis do not address the fact that the size of sovereign debt is growing ever larger. The solutions that are being implemented simply keep the cost of financing sovereign debt from skyrocketing to rates that are obviously unsustainable. As shown in the projections shown below, the deficits will increase the indebtedness in most Euro zone countries in 2012.  Thus, the size of Euro zone sovereign debt will be even larger by the end of 2012, and debt problem may be even worse. Further, if Europe is entering into a recession, the size of the deficits this year will be larger than shown in the OECD's optimistic projections provided below.

The austerity measures being proposed are not tough enough to balance budgets, yet will likely sting enough to stymie economic growth. The Euro zone is in a vicious cycle of misery that will spiral downward for years. The U.S. economy will be damaged by fallout from the declining European economies. 

Sovereign Debt Risk Scores By Country 

(based on OECD reports as of 1/1/12)

Unsustainable budget deficits in U.S., UK and Japan. - The disconnect between the size of a country's deficit and the interest rate required to fund its debt will undergo adjustment. As shown above, the U.S, UK and Japan are all projected run budget deficits of greater than 8% of GDP in 2012. Yet despite the huge size of the deficits, the interest rate on sovereign debt is under 2% in the U.S. and the U.K and under 1% in Japan.  The huge deficits are growing the debt to unsustainable amounts, and at some point within the next few years the interest cost on the debt will increase to levels that will suck up a huge proportion of tax receipts. Either taxes will have to be raised or spending cut, either of which will damage economies. And the inability of dysfunctional U.S Congress to pass budget acts is a wildcard that may hurt the markets.

The End of Cheap Oil - The world is running out of easy to find, easy to pump oil. The high cost of production from new sources of oil makes it unlikely that oil will ever drop down below $70 a barrel again for a sustained period of time. Demand for oil to fuel the growing car culture in China will lead to consumption outpacing production from new oil fields. When the cost per gallon of gas goes over $4 again this spring due to refineries switch over to summer blends, the hit to consumers pocketbooks will hurt the U.S. economy and the markets. The price of oil will stay elevated simply due to the high cost of production, even if there are no shocks to the market from events in the Mideast. The post Do 2012 Economic Forecasts for U.S. Foolishly Discount High Cost of Oil? includes more details on this subject.

Extreme Weather Events - The frequency and severity of extreme weather events is increasing. The U.S. will be lashed by more hurricanes and more economically damaging weather. In particular, Florida is overdue for a destructive hurricane. The occurrences of droughts and flash floods will increase. Extreme weather will lead to crop damage, higher food prices, and increased costs for property insurance. The post Will Extreme Weather Events Batter the Insurance Industry in 2012? includes additional information on this subject. 


Further, the increase in extreme weather will energize the environmental movement. The Green's will become noisier in their efforts to block economic development. Their success in delaying a decision on the Keystone XL pipeline provides an example of the Green's efforts to block economic development. They will continue to use lawsuits as a tactic to delay the development of new energy sources and oil fields. The political pressure from environmentalists that led to the shutting of seven nuclear plants in Germany (with the lost electricity being replaced by burning more fossil fuels) shows how the environmentalist agenda can damage an economy.   


The combination of extreme weather events and environmental activism may lead to the cost of diesel fuel increasing even faster than the cost of oil and gasoline. As the reliability of electricity production around the world falters due to droughts that are reducing hydro power, coal fired and nuclear power plants being shut down, and the difficulty of obtaining permits limits the building of new power generating facilities, the demand for diesel generated backup electric power has surged. 

Liquidation of Assets By Senior Citizens - The baby boomers are hitting retirement age. There will be 10,000 baby boomers in the U.S. reaching age 65 every day for the next 19 years. The new retirees will begin liquidating assets instead of acquiring them. This will put pressure on the prices of single family homes, stocks, and bonds. While the $132 billion that was withdrawn from stock mutual funds in 2011 may be due more to investor discontent and transfers to ETF's than to a liquidation of assets by retirees, these draw downs  are likely a precursor of a trend toward increased redemptions. Further, the weak job market is forcing many of those that are out of work to sell assets to pay their living expenses.

Conclusion

The stock and bond markets are likely to be flat or decline during the next few years. The 6% rate of return that is built into many retirement and 401K calculations is likely to be wildly optimistic. Investors should review their plans for building their retirement accounts using realistic assumptions. 

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Will Extreme Weather Events Have A Measurable Impact On The Economy in 2012?

The extreme weather in 2011 is having a lasting negative impact on the U.S. economy.

• Thailand flooding has led to a shortage of hard drives hurting technology companies
• There is a shortage of seed corn due to last year's drought
• Snow drought in December is hurting ski and snowmobile destinations this month
• Property insurance rates have been raised due to high cost of last year's damage
• The USDA indicates that food at home costs increased by 4.25-4.75% last year and are projected to increase by another 3-4% this year. Much of this increase in costs is extreme weather related.

Hopefully, last year was just an aberrational year for extreme weather events. During 2011, there were 12 weather-related disasters in the USA with damage over 1 billion dollars each. The total damage from these disasters exceeded $52 billion with additional costs from smaller disturbances. These disasters included hurricane Irene, blizzards, tornadoes, drought, flooding and wildfires.

Of note, tropical storm activity in the Atlantic has been elevated during the last three years, but only one hurricane has struck the U.S. mainland since 2008. An increase in hurricanes hitting the U.S. is particularly worrisome. Also, the lack of early winter snow could foreshadow another year of expensive droughts.

The impact of weather on the economy is reinforced by a  research study that indicates that routine weather events such as rain and cooler-than-average days can add up to an annual economic impact of as much as $485 billion in the United States. The study concludes that the influence of routine weather variations on the economy is as much as 3.4 percent of U.S. gross domestic product. Obviously, extreme weather events adds to the cost of weather variations.

Conclusion

Few financial forecasts factor in the potential for another year of extreme weather events to harm the U.S. economy. However, another year of extreme weather could easily cost the U.S. the loss of 1% or more of GDP. Extreme weather events may be another head wind faced by the U.S. economy in 2012.

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Will The Trillion Dollar Deficit Prop Up The U.S. Economy If Europe Falls Into A Deep Recession?

The biggest area of disagreement between the bulls and the bears is over whether the U.S. economy can decouple from Europe. The bullish case is that the an European wide recession will only shave a couple of points off GDP, and the limited damage won't halt the ongoing recovery in the U.S. However, it is hard for me to comprehend how the bulls can so easily overlook the fact that the only reason that the U.S. economy is growing is because the Federal government is providing a trillion dollars stimulus per year via the deficit.

Have the bulls already forgotten all the hand wringing last month over the debate on whether to extend the 2% payroll tax cut. It was widely estimated that failure to extend the payroll tax cut would slice 1-1.5% from U.S. GDP in 2012. The projected cost of the yearlong payroll tax cut is $112 billion. Given how much importance  economists assign to this tax cut, which will only account for an amount equal to about 10% of the deficit, it makes it fairly obvious how critical the additional 90% of the deficit spending is to propping up the fragile U.S economy.

If Europe falls into a deep recession, it will impact the U.S economy via:

1. reduced exports to Europe
2. declines in the earnings of multinational corporations with large European operations
3. losses by the financial institutions with exposure to Europe

The first two factors above, exports and earnings from Europe, are probably enough by themselves to halt the U.S. recovery.

The third factor above, the impact on U.S. financial institutions, is much harder to project. However, U.S. financial institutions have so much exposure to Europe that a meltdown of European banks would be extremely damaging. The losses incurred by U.S. financial institutions would ripple through the entire economy  and lead to a nasty recession. According to Commodity Online ,"US banks have an exposure of $767 billion to the European debt market as per recent data by the Bank of International Settlements (BIS). This includes $518 billion in Credit Default Swaps (DCS) and $181 billion in direct lending. With these banks stating that their exposure has been covered, it raises the question who insures the insurer"?

Conclusion
The growth in U.S. economic activity in 2011 would not have been possible without massive stimulus via deficit spending. Even with the trillion dollars in stimulus, the U.S. economy is too fragile to grow in 2012 if Europe falls into a recession. And it certainly looks like Europe is already sinking into a recession, with Spain, Portugal, Italy and Greece on the verge of falling into an economic depression.

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Will U.S. Economy Suffer Hangover From Boost Provided By Expiring Business Tax Credits

The buzz provided by drinking too much alcohol leads to a nasty hangover. Similarly, providing the economy with artificial stimulus leads to a hangover once the stimulus is removed. The strong performance of the U.S. economy during December may in part be due to a rush to take advantage of expiring business taxes.  According to The Institute for Supply Management,  "Manufacturing is finishing out the year on a positive note, with new orders, production and employment all growing in December at faster rates than in November, and with an optimistic view toward the beginning of 2012 as reflected by the panel in this month's survey".

As pointed out by Mike "Mish" Shedlock, "Expiring tax incentives provided a nice, but unsustainable pop in manufacturing. Notice how prices and backlog of orders did not follow. Regardless of how much tax credits affected the ISM numbers, the global slowdown will take a toll on US manufacturing".

Here are three examples of artificial stimulus leading to a nasty hangover:
1) Y2K - Business and government may have spent as much as $100 billion in upgrading hardware and software to avoid problems from the turning of the calendar to the double zero year. Slowing technologies sales was a key factor in the dot-com bubble popping.
2) Cash for Clunkers - Following the August expiration,September’s new car sales were only 746,000 units, compared to 965,000 a year earlier.
3) New Home Buyers Tax Credit - After the June expiration of the credit worth up to $8,000, sales of existing houses plunged by a record 27 percent in July

Conclusion
Do not read too much into the strong December performance of the manufacturing sector. The hangover may result in weakening January results. Also, the slowdown in Europe will ;provide additional headwinds.

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Why The European Debt Crisis Will Worsen in 2012

The debt crisis will worsen this year because European countries will spend more than they generate in receipts in 2012. Thus, the government debt that has to be funded will be larger by the end of 2012 than it is now. Even under an optimistic scenario, the projected government deficits in 2012 will be greater than the rate of growth in GDP. The so called solutions to the European debt crisis seem to do little more than reduce the imminent risk of a government default or widespread bank failures. Given that the government debt auctions next year will have to fund even larger amounts of debt than the auctions in 2012, the increasing weight of the supply of government debt requiring funding will make the debt problem even worse.

A solution to the government debt crisis can only be found if government receipts grow faster than expenditures. This is not going to happen it 2012, as illustrated by the chart below showing projected government deficits and change in GDP by country.

Projected Government Deficits and Changes In GDP

(Source - OECD)

All the counties listed in the chart above are projected to run deficits that are greater on a percentage basis than the expected growth in their economies. If a European recession does hit, the impact on government debt    will be even worse than shown in the above projections.

The austerity plans being proposed across the Euro zone are half measures that continue down the path of deficit spending in 2012. These austerity plans envision reaching balanced budget status via a multi year process. As examples, France is targeting having a balanced budget by 2016 and Italy by 2013.

There are two reasons to doubt that the proposed austerity plans will really lead to balanced budgets across the Euro zone by 2016 (and certainly not by 2013 in the case of Italy).

Overly Optimistic Revenue and Growth Projections if Europe is Headed Into a Recession
If the economies of Europe are headed into a recession, as is widely expected, then tax revenues will decrease and deficits will widen.

The Unpopularity of Austerity Measures May Lead to the Downfall of Governments That Support Them.
It seems unlikely that the voters in all the countries of the Euro zone will have the political will to support austerity measures beyond 2012. Support for balanced budgets is likely to wane over the course of this year and in at least a few Euro zone countries politicians may be elected that turn the spending spigot back on.

Conclusion

The Euro zone leaders succeeded in kicking the can down the road in 2011. It will be even more of a challenge for them to avoid a financial meltdown in 2012 with even more debt to fund.

At least on the first trading day of 2012, investors in U.S stocks seem to be ignoring the risk of contagion to the U.S. economy from European problems. However, it seems unlikely that the European debt crisis will stay out of the headlines for long.

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A Scorecard For Ranking U.S. Treasury Debt Risk Versus Other Countries

This post provides a scorecard for ranking the risk of the U.S Treasury issued debt versus that of the government issued debt of other OECD nations. There is a simple way to evaluate the risk that investors assign to the sovereign debt of countries in the Euro zone. The yields on the governments' 10 year notes indicate the amount of risk buyers assign to the country's debt. However, inflation rates are such a driving factor in the interest rates for sovereign debt that comparisons between countries outside the Euro zone require evaluating additional factors.

As shown in the chart below based on a proprietary scoring system developed by Doom or Boom the debt risk score for the U.S. falls in between that of Belgium and France. However, as a caveat to evaluating the scores shown below, the inputs are based on  projections from the OECD, and for the most part, the OECD has a very rosy view of likely economic results for 2012.  As shown in the "Change in GDP versus 2011" column below, the OECD  is projecting growth in GDP for most of the OECD countries in 2012. If Europe and/or the U.S. enter into a recession in 2012 (as many expect to happen), the Debt Risk Scores will increase, as the inputs will be higher. My expectation is to that significant deterioration in these scores as will appear as the OECD updates their projections for 2012 once actual data is available.

Sovereign Debt Risk Scores By Country 

(based on OECD reports as of 1/1/12)

There are four factors utilized in calculating Boom and Doom's sovereign debt risk scores.

1) Gross Government Debt as a Percent of GDP
In evaluating the risk of a sovereign default, the metric that typically receives the most attention from the main stream press is the percent of debt to a country's GDP. However, while this metric is a good measure of the size of a country's debt relative to its economy, it does not provide a full indication of the risk of a country's debt burden. The best example of this metric by itself not being a good indication of sovereign debt risk is provided by Japan. With debt that is projected by the OECD to reach 219% of GDP, the low interest rate on Japanese 10 year notes (0.99%) demonstrates that at least for now, Japan is able to sell government debt at prices that do not include any risk premium. However, while Japan is the exception, the Euro countries with debt equal to 120% of GDP or more have experienced increases in interest rates required to sell their debt.  The U.S. seems to be on course to reach this dangerous level of debt to GDP within just a couple more years.

2) Government Debt Interest Payments As A Percent of GDP
The interest cost of paying for government debt (4th column above) may be the most reliable single metric for determining sovereign debt risk. As shown in the case of Japan, total government debt (3rd column above) does not correlate to risk. Governments do not have to pay off their debts— all they need to do is ensure that debt grows more slowly than their tax base so that they can role over the payments. The U.S. debt from World War II has never been never repaid and most likely never will be; it just has become less of a drag on the economy due to inflation and growth in U.S. GDP and increased tax revenues. 


However, the interest payments required to fund government debt eat into the revenue a government has available to pay for services, defense, medical benefits, and pensions. The larger the slice of the revenue pie eaten up by interest payments, the less available for other types of spending. As shown in the above chart, 7.3% of Greece's GDP is projected by the IMF to be required for interest payments. Greece is buckling under the high cost of making these payments and if its debt is not restructured the country will almost certainly default. Keeping debt as a percentage of GDP at reasonable levels is critical a country's solvency.


3) Projected Deficit As A Percent of GDP
It seems absurd that huge deficits of the U.S., Japan, and the U.K., countries are seemingly being ignored as a risk factor by the credit markets based on the interest rates of the 10 year notes. While these countries with their own central banks can print their way to solvency, the inflation risk of loose money policies has magically evaporated.  Thus, deficits as a percent of GDP is only utilized as a minor factor in scoring debt risk as the market does not seem to be giving this factor much weight.


4) Change In GDP
The changes in GDP as the OECD updates their projections is probably going to be the  factor that most contributes to the debt scores being dynamic and changing during the course of 2012. I suspect the OECD's projection are incredibly optimistic. Given that these estimates are suspect, change in GDP is only utilized as a minor factor in scoring debt risk.


Evaluating the Debt Risk Score for the U.S.
As indicated by the low interest rates on U.S. 10 Year Notes of 1.88%, the Treasury is currently able to fund our debt without having to pay a risk factor. The U.S. debt is sustainable for now due to the interest cost of U.S government debt of 2.2% of GDP. However, if the U.S. deficit continues to grow by a trillion dollars per year or if the interest rates required to fund the U.S debt double, then the U.S will join the Euro zone nations in facing a sovereign debt crisis. The +9% deficits as a percentage of GDP that the U.S has been running since 2009 is probably not sustainable for more than another couple of years. The interest expense of funding the U.S. debt could be launched into an upward spiral by either total debt continuing to expand faster than GDP or by an increase in interest rates being required by investors in order to continue funding U.S. debt.

Which Is A Bigger Threat To U.S. Stock Market - Declining Earnings or a Shock From Europe or Iran?

Now that the Santa Claus rally has failed to materialize, what's next for the U.S. stock market?. The latest reports on retail sales, the housing market, and auto sales all provide support for the widely espoused predictions that the gradually improving economy will lead to an upbeat year for stocks. However, the following factors all suggest that it may be tough sledding for the stock market over the next few months:

1. Earnings contraction due to pressure on profit margins and slowing sales to Europe. Nearly a fifth of the companies in the S&P 500 have already warned that fourth-quarter earnings will be lower than expected.
2. The high cost of oil. Most of the economic downturns in the U.S. since the 1970s have been preceded by increases in crude oil prices. Oil prices above $80 a barrel serve as a huge tax on both consumers and businesses.
3. Money being withdrawn from the stock market. Investors withdrew $35 billion from equity mutual funds in 2011 with funds outflow for 34 of the last 35 weeks. The drumbeat of bad news, enormous volatility, and a generally flat market is scaring retail investores away from the stock market.

Thus, my expectation is that the U.S. stock market is headed downward due to declining earnings even without the occurrence of a "Lehman" like event. The wild card in predicting the direction of the stock market in January and February is the potential for a shock to the financial system due to a crisis in Europe. So much sovereign and bank debt that must be raised between now and the end of February that bid failures may be a likely outcome during the next two months. While less likely, a conflict with Iran could also roil the market.

My opinion is that shorting the U.S. market will be profitable during 2012 even if no crisis occurs. However, patience may not be required for short sales to become profitable in the event of a shock to the financial system. I expect that the S&P 50 will be at 900 by May. While it may be premature to short the market during January due to risk that the market will be able to levitate a bit longer, this short term risk is compensated for by the potential reward of a shock to the financial system occurring at some point during this month.

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