by David Stanowski
22 December 2008
Recently, I was asked why I continue to report and analyze the "bad" economic news, as though everyone already knows all about it, and as if the discussion were to end; it would all go away. The answer is simple: we are experiencing a Financial Hurricane, and it MIGHT turn out to be the Category 5 variety, that comes along every so often; so everyone needs to pay very close attention to the potential dangers. As in the case of a meteorological hurricane, failure to prepare properly will expose us to more damage than necessary; possibly even financial ruin!
The plot below shows the "satellite image" of our Financial Hurricane. The S&P 500 Index formed a top in March 2000, dropped 51% into a low in October 2002, but then rallied to a slight new high in October 2007. From there it dropped 53% to a slight new low in November 2008, but, so far, it has held above the level reached at the October 2002 low.
What everything turns on now is whether or not this is the end of the move down, or whether, after a few months, the market will smash through that red line and go to much lower levels. No one can know which scenario will unfold, but this article will discuss the possibilities of what the world could look like, if this is just the first leg down, and how your business/employment and investments will fare in such conditions. Obviously, YOU have to decide the likelihood of such an outcome and whether you should make certain changes to prepare for it.
Not shown on this chart is the fact that the S&P 500 is currently trading at levels first reached in 1996. This means that if the S&P 500 is used as a proxy for the U.S. stock market, investors have now given back all their gains for the last 12 years!
More on the Stock Market
The two similar questions that must also be asked are: do the real estate market and economy have further to drop, or is this the bottom for them, too?
Even though the two declines shown on the chart above look very similar, closer examination shows that during the last four quarters of the 2000-2002 decline, the loss to the net worth of American households was $1.748 Trillion, while the losses during the most recent four quarters of the 2007-2008 decline are $7.090 Trillion. The damage from the current decline is four times worse than in 2002!
Source: Federal Reserve 2002, Page 105, Line 1
Source: Federal Reserve 2008, Page 105, Line 1
During just the third quarter of 2008, American households have seen declines in the value of the asset classes listed in the table above:
$647 billion loss in real estate
$922 billion loss in the stock market
$523 billion loss in mutual funds
$653 billion loss in life insurance and pension fund reserves!
$128 billion loss in private businesses
$2.872 TRILLION loss in TOTAL
This Bear Market began with a first-year loss that exceeds the 1929-1932 Bear, which also tends to suggest that it is probably not over!
Finally, it is estimated that the worldwide losses in stock, real estate, debt, and commodity markets are at least $30-50 trillion, since their respective peaks. All of this data tends to argue that the amount of damage already done will have a lasting effect on the nature of our economic and financial activity for quite some time, and that the downside momentum is going to be hard to stop at this point.
If should have become obvious, by now, that it is very dangerous to put your faith in so-called economic and financial "experts". The vast majority failed to foresee the bubble tops in real estate and stocks, and they were also unaware of the brewing credit crisis until it was well along its path. After it became painfully obvious that these markets were in major declines, the "experts" spent most of their time trying to "call the bottom", and to assure us that the "system is sound". The bottom kept moving lower, and the President finally admitted that our financial system is like a "house of cards".
The Conventional Wisdom was that all of these matters would be "managed" by the Federal Reserve and the federal government. They were "managed", and it is now clear how much good their meddling did; absolutely none! After following the markets and watching "experts" for over 30 years, I can attest to the fact that most are highly unreliable.
I have come to know which experts I can trust, but they all make a lot of mistakes, so the responsibility still falls on each individual to do their own due diligence, and to use their common sense. If it seems to good to be true; it is! If it doesn't make sense; don't do it. If you can't deal with risk; stay in TBills.
One of the pillars of the Conventional Wisdom that many are now wrestling with is the premise that stocks and real estate "always go up", if you just hold them long enough. If an investor bought the DJIA at the top in September 1929, it didn't reach that level again until 1954; 25 years later! And, that does not account for the companies in the DJIA that went out of business over that quarter of a century, or the lost income on the money, if it had been earning interest! If you can wait 25 years, you might always break even, but few can wait that long, so the buy-and-hold strategy becomes deadly during some periods of time! Is now one of those times?
Successful investing, during times when buy-and-hold isn't working, takes far more than intelligence; it takes a kind of wisdom, insight and common sense that very, very few possess. However, it is nearly impossible to cultivate this ability without studying the history of the markets. How can someone possibly expect to understand the potential destruction of a major bear market, or an economic depression, if they haven't lived through one; unless they study history? If you start with the belief that such things can't happen, you can't possibly factor them into your decision making process.
A more recent example of the buy-and-hold approach gone bad is still going on in Japan. The Japanese Nikkie Index peaked in 1989, and it is still down 82%! Prices are currently trading at the same levels that were first reached in 1983! Anyone who bought the Japanese Nikkie Index in 1983 would have now given back all of their gains achieved over the last 25 years! (Click on chart for larger image).
The most successful professional investor in the world, Warren Buffett, has seen his portfolio decline 51%, peak to trough, over the last 14 months, and one of history's greatest geniuses, Sir Issac Newton, lost 20,000 Pounds investing in the South Sea Bubble, in 1720. When asked how someone so smart could have made such a huge mistake, he said, "I can calculate the motions of the heavenly bodies, but not the madness of people."
Sometimes it seems overwhelming and hopeless if the "experts" often fail so badly, but an amateur with a knowledge of the history of the markets, basic measures a value, and common sense is better equipped to make good decisions than most "experts"!
What Caused This Problem?
Many books will be eventually be written examining all of the gory details, but the simple answer is that our country created a Golden Age of Affluence after WWII, but then as it peaked and began to decline, between 1965 and 1970, citizens and governments continued to accelerate their spending, even as real income declined; we made up the difference with debt.
Recently, the debt that was used to push up asset prices (stocks, real estate, commodities) became unsustainable, so the defaults began. This lead to banking and business failures, and falling asset prices. This process will continue until all the bad debt is flushed from the system, unless the Federal Reserve is able offset all of the bad debts with "new money". If they are successful in bringing about a reversal, as they did in 2002, hyper-inflation is very likely. If not, the collapse of the debt structure will probably continue for a few more years, and may end with the stock market, and real estate prices at much lower levels.
The Total Credit Market Debt as a % of GDP stood at 170% at the 1929 stock market top, BUT it currently measures 356%; more than twice as high (see graph below)! This is a whole lot of debt to unwind!
Either of these scenarios will spell an end to the type of economic conditions and "prosperity" that we have grown used to, and will require many painful adjustments in the future. Those who are prepared and forewarned will do much better than those who are uninformed and surprised.
What is the solution?
The solution is very simple; we need to do the opposite of what we did to get into this mess. We need to stop spending, start saving, and invest our savings in productive industries; NOT in residential real estate!
All of the "solutions" currently being advanced by the Federal Reserve and the federal government are harmful and counter-productive!
When we need to stop spending and start saving, they send us "tax rebates" to try to encourage us to spend more. When some businesses made bad decisions and failed; the government gives them money to stay in operation!
All that bailouts do is to shift the losses from those who have caused them to those who are profitable and productive; which further weakens the economy, and rewards bad behavior. If the government allowed them to fail, their assets would simply be purchased by new owners who would make more productive use of them. This is the "creative destruction" of capitalism. Finally, the "money" that the government gives to failing enterprises does not come from "the magic money tree"; it represents future tax liabilities that profitable enterprises and productive people will have to pay.
The more that the Federal Reserve and the federal government meddles in this economic mess, the worse things will get, and the longer it will be until we hit bottom!
The consensus among the "experts" is that the government bailouts are working, and that we will hit bottom in the near future, enter a new bull market in stocks, real estate prices will rise, and the economy will recover in a few months. If that makes sense to you, you may not need to make any adjustments. However, even if this does happen, it is difficult to see how conditions will be "normal" again, for quite some time, because the world will still have to adjust to all the current losses.
The minority opinion, to which I subscribe, is that we are nearing a bottom, BUT after a few months of relief, the next leg down will begin which will carry the DJIA down to around 4,000; and real estate prices will drop much further, too. If something like this does come to pass, anyone who does not make major adjustments, will probably face severe losses, or even total ruin. I will be publishing, "The Case for the Super Bear", in the near future, to explain why I think this is more likely than a recovery from this level.
No one knows what will happen, so you will have to use your common sense to see what seems most likely to you! However, don't be fooled by not considering possibilities that are outside of the realm of your personal experience. Just because you haven't seen something happen, doesn't mean it can't. Study history. It does repeat itself with some variation each cycle!
Surviving the turmoil.
The key to surviving in a deflationary economy is de-leveraging and downsizing. In other words, get out of debt and reduce your overhead. Most people have far too much of both.
What businesses will do well?
It is difficult to tell specifically, but generally businesses that supply necessities as opposed to luxuries should do better than most. Unfortunately, since we have been living in a fantasy so long, many think that some luxuries are now necessities.
For example, in the retail sector, it should be better to be more like Walmart and the Dollar Stores, and less like Tiffany's and Nordstrum's.
Currently, pawn shops are making a lot of money. Discount auto parts, used auto parts and auto repair are doing well as people see the need to keep older cars running. Some believe that in the coming years people who can repair a variety of products will be in demand when new items are not affordable. Bankruptcy-filing services may be a booming business, too.
Leisure, travel, recreation, and entertainment.
If a new Age of Frugality is truly upon us, there will be massive changes in this sector. During the Age of Affluence, more and more time and money could be funneled into leisure time, but that trend should be reversing sharply.
For example, the restaurant business peaked in early 2004. People will still go out to eat, but they will do it less often and will look for better deals. The restaurants that will do well will find ways to deliver more value for a lower price. Customers may be very happy to do away with the wait staff, and order "at the counter", if it saves them 20+% in tips.
Other businesses, in this sector, are showing the strain. Hotels are overbuilt, airlines are struggling
and the once invincible gambling industry is feeling the pinch, too. Second homes will become a luxury that fewer can afford. These trends will probably accelerate over the next few years.
There is a lot of wishful thinking that our new President will save the economy by undertaking a massive infrastructure building program. The country can certainly use some new infrastructure, but these programs usually become contests about who can bring home the most pork, so the money doesn't go to where it will be most productive.
Of course, the other problem is that it will cost a lot of money; money that we don't have, because we have squandered it over the past 30-40 years.
Much of it is locked up in residential real estate. If someone could only figure out a way to get the capital back out of residential real estate for productive uses, we'd be in much better shape! It's hard to say how much capital is locked up just in the 18 million+ vacant homes in this country. Since there is no way to retrieve this capital, the federal government will just borrow more money; but that's how we got into this mess!
Many say that upgrading the country into new Green technologies and energy-saving schemes will save our economy. However, there is a problem with this idea. When oil was at $100-150 per barrel, many Green technologies could still not compete on price. If oil stays down below $50 per barrel for 2-3 years, due to deflation and demand destruction, Green solutions will be even less competitive. This means that if Obama mandates the use of Green technologies, it will be a big drain on the economy when we can least afford it.
There is a very good chance that we have hit the point of Peak Oil, but unless and until a Green technology is developed that provides cheap energy, any meaningful shift in this direction may only come when we are forced to do it, due to dwindling oil supplies; which will not propel our economy into a new Age of Affluence.
Doing Business Local:
There is a new movement to transact more and more business on a local basis. This is a good idea when it is more efficient and less costly, in the times ahead, but otherwise, it will just be a net drag on the economy.
Many of the arguments in favor of going Green and focusing on the local economy may have non-financial benefits like cleaner air and water, and less use of scarce resources, but when times are tough, these will be regarded by many as luxury items that we cannot afford.
History never repeats itself, exactly, but it does come close enough to be very helpful in looking at the future.
A few months ago, only those of us who are outside the mainstream, in this business, began to write about the parallels between the 1930's and what we are probably facing at this time. Now that the stock market has dropped much further, it seems that almost everyone is comparing today with the 1930's! The most common reference is that many economic indicators are "at their worst levels since the 1930's". What many don't yet see is that many indicators are already at more extreme levels than they were in the 1930's!
However, most people still think that it is impossible for us to go through another Great Depression. They argue that today we have all kinds of institutions that won't allow that to happen! Of course, many, like the Federal Reserve, were instrumental in causing the mess we are in, so that argument is rather meaningless. Those who are waiting to see bread lines to recognize the similarities need to check the data showing the rising food stamp applications, and food pantry visits.
It is also difficult for many to imagine the worst hardship that occurred during the Depression repeating itself; 25% unemployment. The "official" government measure of unemployment, U3, will probably not get that high, but the more accurate barometer, U6, which includes discouraged and underemployed workers is already at 12.5%! It isn't hard to imagine that, if the market goes lower, U6 could hit 20% next year!
Going through a crash like the one in 1929-1932 is bad enough (the DJIA dropped 92%), but the prospect of living through another New Deal is horrifying! The market bottomed on 7 July 1932, and FDR wasn't sworn in until March of 1933, so the recovery was well underway when he took office. That didn't stop him from trotting out every socialist-inspired program he could dream up to "fix the economy"; which kept stifling the recovery of the private sector. What should have been a 3-4 year Panic, as they used to call them, became a 16-17 year Depression.
The parallels between the last election and 1932 are very clear. In both cases, a very unpopular "conservative" Republican President didn't have enough common sense and patience to let the markets sort out their excesses quickly and decisively on their own. They both made futile attempts to intervene and halt a stock market crash. Like Hoover, Bush is being replaced by a popular far-left candidate who sees the New Deal as a blueprint for success.
This means that if the market does make lower lows, hopes for a quick recovery are very slim. Looking back at the chart of the DJIA (top of article) clearly shows the low in July of 1932, eight months before the New Deal started, but with the drag it created on the economy, the 1929 high was not reached again until 1954!
The Japanese have spent the last 19 years doing everything that the Federal Reserve, Congress, and the Bush administration have been doing over the last few months, and their stock market is still down 82%! If the Japanese experience with intervention and bailouts, to delay the inevitable, does not convince you that this won't work in the U.S. markets; nothing will!
A few have also raised the similarities of current events with the 1860 election. A rising star out of Illinois bursts on the national scene to "unify a nation" that is struggling with two great issues; one social and one fiscal. In 1860, it was slavery and tariffs; in 2008 it is the Culture War and using income tax to "spread the wealth around". As in 1860, these battles are still regional in nature, with North versus South, and the West Coast throwing in with the North, and the Central West more or less aligned with the South.
It is not hard to imagine that if economic conditions deteriorate from here, and unemployment soars; just as in 1860, we are going to have anything but unity! How much things heat up will also depend on how far Obama pushes social wedge issues like the Fairness Doctrine and gun ownership, and extreme disparities in income tax rates using class warfare.
Worst Case Scenarios:
The ideas explored in this article are far from the worst-case scenarios being discussed by those of us who study historical parallels and cycles. Economic, financial, and social conditions similar to the 1930's and 1860's often lead to wide-scale wars, great social upheaval, scarcities, totalitarian governments, and pandemics.
Roughly 22 civilizations rose and fell long before the American Experiment: the Aztecs, Incas, Romans, Greeks, Babylonians, Phoenicians, Egyptians and so on, so we should not be arrogant enough to think that we will last forever. Economist Milton Friedman once pointed out that the fall of each civilization was preceded by a vast increase in the size and power of government. With a lot of evidence that we have already made the same mistake, the road ahead is quite uncertain; but we will leave those discussions until we see if there is another leg down in this Bear Market.
"The future is uncertain, and the end is always near." Jim Morrison.
A New Paradigm:
As I sort through the daily reams of "bad" economic news, I am constantly looking for potential business and investment opportunities, and ways to adapt our lifestyles to survive and prosper in what may prove to be difficult times ahead. The themes of reducing debt, cutting expenses, and saving instead of spending are behind every sensible option.
One of my fellow Bloggers, Charles Hugh Smith, is convinced that many small businesses will be forced to make a dramatic paradigm shift as they are crushed by the high overhead of operating out of today's brick & mortar storefront model. He argues that the cost of commercial real estate leases, utilities, taxes, and other local business fees will drive many into home-based operations, flea markets, and Internet sales. Charles believes that merchants and cities that adapt quickly to this new reality will prosper and survive, and those that don't will wither and die. This makes sense to me, and I am exploring a number of ideas and options along this line.
The Rise of Informal Businesses
The reason that bad news is so good is because it should motivate people to get ready for POSSIBLE troubles ahead, and then, if they come; the damage will be much less for them than for the unprepared. The possibilities explored in this article are still far from Mainstream, or part of the Conventional Wisdom, but if they should come to pass, it may be too late to act, if you wait for them to become part of the consensus opinion.
As I wrote on 03 March, "If you aren't scared, you don't know what's going on!" These are scary times, and it is difficult to know what to believe or who to trust, which is why you must do your own due diligence and basic research and then decide what choices you can live with. I will continue to share the information and ideas that I uncover, and welcome hearing from my readers, because no one has "the answers". We can all learn by discussing a wide range of ideas.
The people living through the 1930's did not refer to their experience as the Great Depression. They called it Hard Times. Until historians coin a name for our current "troubles", Hard Times may be the best term to use. Hopefully, our Hard Times will be the beginning of shift away from our addiction to consumerism and a return to a more productive America.
It would NOT be wise to take action based on this article alone. Use it as a way to consider all the possibilities and to develop your own Fail-Safe points; events that will alert you that it is time to act! Finally, watch the interview with Nassim Taleb, author of the Black Swan. One of the few experts who got it right long before current events caught everyone else by surprise.
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