Last year in my yearly Looking Forward piece I wrote, "Hopefully the direction that the US will take will become clearer as the nation uses 2012 to debate and then vote on its future. A referendum one way or the other would lead to resolution. Failing that, the continuation of divided government would lead to a continuation of the status quo for some time. Either way, we should have a good idea of what to expect."

Well, the people have spoken and we have a status quo decision. Nothing has changed which means what I wrote in my Looking Forward article of 2008 still holds true:

“At best we should be left with an L-shaped recovery for as far as the eye can see. Whether we have a double dip recession, or an L-shaped economy, there is no getting around the fact that we are about to hit a mountain of debt accumulation that will serve as a wall against any return to the robust growth of the last 25 years. That era is over.”

I have no reason to change a word of that forecast. After five years of stagnation, more of the same is on the way. We will have at best another two years of L, where the economy runs either side of zero by a percent or two, unemployment remains high, and the debt continues to climb. So what does this mean to investors, especially those investing in hard assets and resource companies?

It is a truism that the market is not the economy and that confusing the two leads to endless confusion. Markets around the world, including the French and German markets, are hitting 52 week highs even as tax rates on the rich were raised to 75% in France and a possible recession is being predicted for Germany in 2013. Even the S&P is up over 14% this year despite the US economy being in disarray. Austerity is the theme for 2013 the world over, and it’s coupled with solvency and debt problems galore. Yet markets go higher. Why? The reason has to do with the difference between governments and corporations. US Corporate cash balances are high. Profits are good. Auto and home sales have increased, and energy production is booming. And this is in spite of government intervention and state solvency problems. A lot of people underestimate the ability of the US economy to take a punch and get right back up on its feet. Such was the case in 2009 when Obama took America toward bigger government as he will undoubtedly do again in 2013—raising taxes to pay for even more government. Many believe that will be a death blow to the American economy.

But what were the odds that the American economy could see a depression in housing for five years with home building stopped in its tracks. Foreclosures were at all time highs, the equity in most people’s homes disappeared overnight and still the nation came out the other side mostly unscathed? America faced scary times, many lost tens of thousands of net worth in their homes while others lost everything, but during it all the market doubled and corporate profits soared. Apple became the greatest American innovator in modern history during a time labeled “The Great Recession.”

So the market is not the economy and the economy obviously does not determine the direction of the market. There are huge government solvency problems to be sure, but they do not necessarily translate into individual or company problems. America is a diverse and dynamic nation that continues to innovate and adjust. Its flexibility is one of its great strengths. To put things into perspective, household wealth in America is near its highest level in history. As of December 2012 it sits at approximately 65 trillion dollars! And that wealth is what government wants to tap into to expand its domain.

The government is broke but this nation is rich and the government aims to have a bigger piece of it. Unfortunately it wants the money to further expand government programs rather than pay its bills. This will only prolong the stagnation of the last five years.

Just as it’s important not to confuse the direction of the market with that of the economy, it's equally important not to confuse the direction of particular stocks with the stock or commodity markets. For example, while the US market is at near highs, many stocks are at 52 week lows.

Relate this fact to the run in gold where we have seen very high gold prices as gold stocks relatively underperform the metal. Costs are rising for resource companies and financing has become difficult to obtain. Some are faring better than others but have generally disappointed investors. Most gold bugs are in resource stocks because they anticipate inflation, but I doubt they expected inflation to eat away at profit gains. I chose resource stocks not as a defense against inflation, but because of increased demand for resources around the world based on world economic growth and population growth. Even though world growth has remained anemic, resource prices have risen impressively over the last 5 years and should continue to do so.

The direction of the economy will always be a factor as to where commodities and stocks go but never the determining factor. Stock prices are much more unpredictable than that. Profits and multiples are the main determinants of stock prices. And even then, look at what just happened to Apple given their huge profit margin and low multiple. In the midst of a market rally and an all time high balance sheet, Apple has fallen more than it has in over two years; which just goes to prove that any stock can break away from the trend at any time for any reason and on either side.

I specialize in resource stocks, especially the junior exploration and development companies. The fundamentals for these companies have not changed; they are simply being ignored and their stock price has fallen because they are risky in a risk-off world. But buying when stocks are out of favor is how to get the biggest bang for your buck when things turn around, so I am adding to my core position of these stocks. I’m also always on the lookout for blue chip stocks that will be competitive in the world at large.

While 2013 should be economically challenging, what is ultimately done about the fiscal cliff we approach will undoubtedly determine the near term movements of economies, markets, and commodities. There are four scenarios regarding fiscal policy decisions we face.

The first is that there will be a compromise, probably along the lines of a short-term tax and spending fix to prevent taxes from rising for everyone and spending from falling across the board in 2013. Everything else will likely be passed on to the new congress. This is the scenario I believe is most likely. It is near term mildly bearish for gold as safe haven buying will probably recede, but bullish for the stock market in general.

Scenario number two would be a grand bargain that would include all of the above plus set up the framework to reform entitlements. This is the scenario I would prefer, but I don’t believe it is very likely.

A third possibility of course would be going over the fiscal cliff, allowing taxes to rise oneveryone, and waiting for the sequestration to kick in with government spending (particularly in defense) to be cut and taxes increasing immediately. This is the scenario everyone fears, but also the one which would reduce the deficit dramatically if allowed to occur.

A fourth alternative would be going off the fiscal cliff but with a rescue and resolution, finally passed by the newly appointed congress, probably sometime in January or February and made retroactive to January 1 to avoid higher taxes and spending cuts. This should include a deal on the framework for entitlement reform. Although no major permanent economic harm would be done in such a scenario, the stock market could easily lose a thousand points in this scenario.

The two options that would actually fix the deficit and address the debt crisis are the grand bargain or falling off the fiscal cliff. The former would be mildly bearish for gold and very bullish for the stock market, while the latter would be extremely bearish for both markets.

Whatever path we take, how will we know if we have succeeded in reaching a good deal and solving our debt problem? The standard must be the level of the deficit. We can live with high unemployment and 2% growth. We cannot live with growing deficits and debt. Debt is a time bomb capable of bringing down the entire monetary system and with it the American economy as we know it.

With all the appearances by Tim Geithner on news shows touting the Obama plan, there was not one question asked by any interviewer as to what the deficit will be next year, or the year after if the Obama plan was implemented. The standard of a successful fiscal deal should be the amount of the deficit and nothing else. If the deficit falls significantly, it is a good deal; if not any deal is meaningless. It is the deficit and accumulating debt that is the problem, not too little taxes or too little stimulus, or even the level of tax rates or the unemployment rate. The goal must be to lower the deficit and eventually the national debt.

Obama's plan calls for 600 billion in cuts over ten years, which equals 60 billion a year. The deficit is 1.1 trillion per year. If all the cuts were made Obama is asking for it will leave 1.04 trillion in deficits. But the Obama plan increases new government spending by 80 billion dollars next year.

The tax increase if implemented exactly as Obama wants only lowers the deficit by 1/2 of one percent. Yet the Obama Administration insists its plan will cut the deficit and bring it into balance over the years. How? The total of all the cuts and tax increases is chump change. Maybe Obama is naive or even stupid but markets are not. If the deficit is not reversed and credibly brought under control interest rates will eventually rise and a recession will result.

The final arbiter will NOT be Obama or the Republicans but reality.

Obama may be able to successfully out negotiate the Republicans, but he will not be able to deal with riled bond vigilantes! It is the bond vigilantes that drove interest rate to over 20% the last time they lost confidence in government and demanded it get its house in order.

The President’s men have stated that they have already cut a trillion dollars last year and that that is enough spending cuts. But we know we are being conned by such assertions as we watch the national debt increase from 16 trillion to over 16 trillion 300 billion in a matter of a couple of months. It is the new debt that tells all. Refusal to deal with it will end in economic and monetary crisis here, and around the world.

On the other hand if the government reaches a credible, even temporary fix, markets will soar. Any way you look at it, we either credibly deal with the deficit or the deficit will deal with us. There comes a point where economic laws trump political legislation. Obama may be about to learn that lesson. Keep an eye on the deficit, for that will tell the tale of the direction of many markets including the bond market, the stock market, and the commodities market.

I’m entering 2013 with an open mind. Markets may rise or fall. It’s a coin toss. I’m willing to take whatever the market gives me on the long side as well as the short side. There are always opportunities to make money regardless of what the economy is doing. Economically, look for a continuation of what we have had. But as an investor, focus on where the flow of money is headed—that is where I want to be.

Paul Nathan
Paulnathan.biz