Hi Everyone,

As we get started with 2010, I want to give you a little different prospective on the coming year than you commonly hear over the airwaves or written online and in newspapers.

As mentioned several times before, I believe that the stock market has gotten way ahead of itself and is certainly overvalued looking at the economic fundamentals.  I think one of the reason why the stock market has been performing so well is that there is no other place to put your money, since you earn just about zero with the current interest rates.

An interesting phenomena with government bonds is that the yield spread between the two year and ten year bond is at an all-time high, and is still increasing.  That means that something has to give at some point and the market is telling us something.  I believe what will happen is that short term interest rates will go up, maybe only a few month after Ben Bernanke is fully confirmed by the Senate.

This extremely low interest environment cannot be sustained as we are creating the mother of all bubbles, United States Treasuries, and I believe our government knows that as well, even though it suits them perfectly for now.  This is also an election year, and during mid-term election, people older than 50 years tend to vote more than other age groups.  The 50 over age group has been hurt the most by the no return on your money policy that feeds the bankers and the government, and the health care reform is not appreciated by that age group.  Time will tell, but interest rate increases are closer than many believe and might even have a political twist.

What will be the side effects of the increase in interest.  The dollar will appreciate, especially against the European currencies.  The EU is currently quite a bit sicker than the US, and the overvalued Euro is not reflecting that, but should come down to Earth once interest rates go up.  Gold might also trade more sideways this year than in the past few years, and might not resume its secular bull market until interest stabilize at a somewhat higher level.  The stock market is a wild card, but has likely more down potential than up.

Higher interest rate will put a damper on the economy that has not cured its cold yet, although the flu has subsided.  Our government has to rein in spending on its own, or it will be forced so by the markets by demanding higher interest rates and the ramification will be much worse then doing it now.  Overall, we will likely see a fairly slow growth environment and stubborn high unemployment by US standards, but the faster we face reality not matter how painful it might seem  It will be less than what we will have to face in the future, and prosperity for all of use can return on a sustainable path.

One last thought.  If we continue on the current path, the one Japan has been on for about 20 years, the economic ramifications will be much more severe than anything we will experience now by dealing with the problems and living within our means.  Our government debt to GDP ratio is about 70-80%, in Japan it is over 200%, something never seen before by a large economic power.  20 years ago, Japan’s ratio was similar to ours now, and I believe Japan’s day of reckoning to approaching fast with ramification to the world economy that no one knows.  After all, Japan is the planet’s second largest economy, soon to be overtaken by China.

In the coming weeks, I will look at the individual issues in more detail and I will also give you a tax update in the coming days.

As always, please feel free to comment.

Patrick