Forced to Accept Risk

Even before the financial crisis of 2008 arose, there were signs that the operation of a centrally managed fi at currency system was creating stress.

Consider the dilemma of retirement. On one hand, many might not have saved much, because throughout life government had stepped in to take care of every need from health care, elder care, child care, tuition, or even to make unaffordable mortgages affordable.

With fallbacks like these where is the incentive to spend within one’s means? But putting aside these and other reasons why one might have saved only a few percent of income annually (as is the national average), what circumstance were baby boomers in by the turn of the last century? Someone with a salary of $100,000 might have saved $1,000 each year early on, rising to perhaps $10,000 annually or more near retirement.

With compounding, that might have produced a nest egg worth $ 200,000, assuming no taxes (FV30 of $1,000 at 7% equals $94,000). What would one have done with this upon retiring? Investing in safe CDs would provide only $10,000 of annual income at 5 percent. But then twice in the last decade the central bank has dropped interest rates to nearly zero. Bonds would yield only a little bit more.

So without much income, stocks would have been the best alternative, because studies of long – term total return suggested 10 percent was obtainable.

However, the first decade of the new century is likely to close with having provided a negative return, regardless of whether the consensus opinion that economic recovery would lift the equity market in 2009 or 2010 pans out.

Moreover, there is inflation to consider. The persistent printing of money, which averaged about 7 percent since the founding of the Fed nearly 100 years ago, accelerated to over 8 percent since Nixon went off gold in 1971.
Besides converting what would have been organic deflation into manufactured inflation of roughly 4.5 percent on average from 1971 to 2008, generally this increase in bank money has pumped up the value of assets, especially real estate and equities. Moreover, the value of stocks was pushed higher by expanding the presence of the financial sector within the S&P 500 to nearly 40 percent of earnings, clearly an unnatural phenomenon.

The expansion of credit to unheard of levels tended to inflate earnings per share through putting the economy on steroids and from machinations such as share buybacks. Looking at a longer time frame, equity investors were cautious after a similar debt bubble was pricked by the end of the 1930s, demanding dividend yields in excess of long dated bonds in the early 1950s. By the turn of the century, yields were down to near 1 percent.

The bottom line for those who might retire is that manipulation of the money supply first drives the populace (and the pensions held by investment managers) to not hold cash due to taxes and inflation. Then it presents an unappetizing alternative of low-yielding bonds that similarly are ravaged by these two factors.

Finally it pushes everyone into equities in desperation. Excessive money supply growth distorts the earnings the underlying corporations achieve and puffs up the valuation of those same earnings, a double whammy that magnifies risk.

The aftermath is now ugly, with nest eggs reduced, taxes increasing, inflation probable, and the risk of a generational depression palpable but now downplayed by a financial community whose forecasting and analysis blows with the latest breeze.

Consider the risk that no one wishes to discuss, which is the failure of the U.S. government. Today the only safe haven is investing in debt obligations of the U.S. Treasury, which define the risk-free rate. This solidarity has been unquestioned since the passage of the Sixteenth Amendment in 1913, which granted the Treasury Department unlimited power to confiscate the private property of its citizens.

With $ 2 million of government GAAP liability per household to be borne by the few tax brackets held responsible for generating the nation’s tax revenue, the government itself may have reached the end of its ability to pick up the tab for the products of the moral hazard it has encouraged.

The fiat era was successful as long as government had capacity remaining in its credit line. When the Great Depression hit in the 1930s, government would quench an ailing economy’s need for liquidity as easily as if it were filling an empty glass with a bottle of Coca-Cola.

After the go-go years of the 1960s and the increased spending for the Vietnam War and Johnson-era programs, it could pour the soda into a half-filled glass. The high tax rates of the 1970s similarly would not bankrupt the system yet, because growing into unused debt capacity produced inflationary gains for holders of assets, which would be deferred of taxation.

After the Internet bubble, pouring in the Coca-Cola produced much fizz and displaced little emptiness. Today, correcting the failure of a second or third tier investment bank is a tedious exercise of trying to finish filling the cup to the brim without causing a mess all over the table.

Bear Stearns and Lehman were large, but not dominant forces in 2008. Their failure at any other time would have been easily contained. Some 38 percent of total deposits nationwide of $7 trillion were uninsured because they exceed the $ 100,000 limit, yet less than 15 years ago only 23 percent were.

With the passage of TARP, the ceiling was reset at $250,000, but this leaves 27 percent of depositor funds unprotected. With money market funds losing assets, it is possible that new deposits above the limit could enter the banking system.

Since the Great Depression, credit grew relative to GDP by an order of magnitude. Private debt was just 57 percent of GDP in 1944, with only 14 percent of this being mortgages. By 1954 it would be 71 percent, with 28 percent of this financing residential dwellings.

These statistics would not skip a beat in the 1970s, despite a shakeout in the stock market, because inflation would be raging. By 1984, private debt rose to 140 percent of the economy; you could trend-line it right up to over 300 percent by 2007. If during the 25-year or so final blow-off stage one decided to bet against the house, figuratively or literally, one would lose.

If one plunged in to buy real estate at any time during the upswing, chances are he would feel pretty good about his investment. Anyone with a sense of caution would have kicked themselves for having delayed a purchase of this essential building block of life.

Although so far this example deals with real estate, partly because it is so vital to everyday living, the same could be said for stocks; during the great bull market any delays to buy were fatal errors.

You would be told to buy on dips, to dollar cost average. Academics ranging from Roger Ibbotson to Jeremy Siegel would assure you that over the long run, stocks would outperform every other asset; the mean annual return of large company equities was over 10 percent from 1925 to 2007, with a standard deviation of just 20 percent. Small company returns were even plumper, but there was more risk.

Regards,