The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (4 page)

According to the Case-Shiller Home Price Index, while the inflation-adjusted wages and salaries of the people buying the homes went up only 2 percent for the same period (according to the Bureau of Labor Statistics), home prices shot up. The rise in home prices so profoundly outpaced the rise of incomes that even our most conservative analysis back in 2005 led us to correctly predict that the vulnerable real estate bubble would be the first to fall. (We have a lot more to say about what’s ahead for the housing market in Chapter 6, and it’s not what the economic cheerleaders want you to think.)

The stock market bubble is one of the easiest, most obvious bubbles to spot, yet so very difficult for most people to see. Stocks can be analyzed in so many different ways. We find the state of the stock market is easier to grasp by looking at
Figure 1.3
. If this doesn’t convince you that there was a stock bubble, we don’t know what will. From 1980 to 2000, GDP rose a very decent 260 percent. However, the U.S. stock market, as measured by the Dow Jones Industrial Average, leaped up an astounding 1,100 percent!

Figure 1.3
GDP up 260 Percent, Dow up More than 1,000 Percent, 1980–2000

The stock market rose almost four times as much as the economy grew from 1980 to 2000. That’s a good indicator of a bubble.

Source
: Dow Jones and Federal Reserve.

We call that a stock market bubble! It looks even more out of line when you consider that the population of the United States grew only 25 percent from 1980 to 2000. Given that population growth is one driver of GDP growth, and given that GDP growth is the fundamental driver of corporate earnings growth and therefore stock prices, we would more or less expect to see the Dow rise about as much as GDP, which was about 260 percent. A 1,100 percent rise in the Dow is a giant flag, spelling out the word
B-U-B-B-L-E
.

Shown in a different way in
Figure 1.4
, the value of financial assets as a percentage of GDP held relatively steady at around 450 percent from 1960 to 1980. But starting in 1981, financial assets as a percentage of GDP rose to
more than 1,000 percent
by 2007, according to the Federal Reserve. We call that prima facie evidence of both a stock market bubble and a real estate bubble.

Figure 1.4
Rise of the Financial Assets Bubble: Financial Assets as a Percentage of GDP

The exploding value of financial assets as a percentage of GDP is strong evidence of a financial asset bubble.

Sources
: Thomson Datastream and the Federal Reserve.

We can simplify the complex private debt bubble by seeing it as essentially a derivative bubble, driven by two other bubbles: (1) the rapidly rising home price bubble; and (2) the rapidly rising stock market bubble, which combined to make for a rapidly growing economy. In both cases, lenders of all forms (not just banks) began to feel very comfortable with the false belief that the risk of a falling economy had been essentially eliminated, and the risk of any type of lending in that environment was minimal. This fantasy was supported for a time by the fact that very few loans went into default. Certainly, at the time we wrote our first book (one year before its publication in 2006) commercial and consumer loan default rates were at historic lows.

The problem was not so much the amount of private debt that made it a bubble, but taking on so much risky debt under the false assumption that nothing would go wrong with the economy. For us, it was easy to see even in 2006 that if the value of housing or stocks were to fall dramatically (as bubbles always eventually do), a tremendous number of loan defaults would occur. We felt the private debt bubble was an obvious derivative bubble that was bound to pop when the real estate and stock market bubbles popped.

Consumer spending accounts for about 70 percent of the U.S. economy. A large portion of consumer spending is discretionary spending, meaning it’s optional (how big a portion depends on exactly how you define
discretionary
). Easy bubble-generated money and easy consumer credit made lots of easy discretionary spending possible at every income level. When the real estate stock market, and private debt bubbles began to pop and people started losing their jobs or were increasingly concerned they might, consumers began to reduce their spending, especially unnecessary, discretionary spending.

This is typical in any recession, but this time the effect has been much more profound for two key reasons. First, the private debt bubble allowed consumers to spend like crazy because of huge growth in housing prices and a growing stock market and economy, which gave them more access to credit than ever before, via credit cards and home equity loans. As the bubbles popped, that credit started drying up, and so did the huge consumer spending that was driven by it.

Second, much of our spending on necessities has a high discretionary component, which is relatively easy for us to cut back. We need food, but we don’t need Whole Foods. We need to eat, but we don’t need to eat at Bennigan’s or Steak & Ale (both now bankrupt). We need refrigerators and countertops, but we don’t need stainless steel refrigerators and granite countertops. The list of necessities that can have a high discretionary component, complete with elevated prices, goes on and on. And, of course, there is a lot of other discretionary spending, beyond necessities, such as entertainment and vacation travel.

The combined fall of these first four bubbles—housing, stock market, private debt, and consumer spending bubbles—make up what we call the Bubblequake of late 2008 and 2009. Unfortunately, our troubles don’t end there. Two more giant bubbles are about to burst in the coming Aftershock.

Perhaps the hardest reality of all to face, the once mighty greenback has become an unsustainable currency bubble. Due to a rising bubble economy, investors from all over the world were getting huge returns on their dollar-denominated assets. This made the dollar more valuable but also more vulnerable. Why? Because we didn’t really have a true booming economy based on real underlying, fundamental economic drivers. We had a rising multibubble economy. Therefore, the value of a currency in a multibubble economy is linked not to real, underlying, fundamental drivers of economic growth (like true productivity gains), but to the rising and falling bubbles. For many years our dollars rose in value because of rising demand for dollars to make investments in our bubbles. More recently, demand for U.S. dollars has remained pretty strong, especially in light of the current European debt crisis. But that strength will wane as the falling bubbles lead to falling demand for dollars, despite all kinds of government efforts to stop it.

In our effort to stop the fall of our multibubble economy, the government has created two giant “airbags” to cushion the falling bubbles. The first airbag is the dollar bubble, created by massive money printing by the Federal Reserve. The Fed has been printing massive amounts of new money through their program of quantitative easing (QE). Two rounds of massive money printing (QE1 and QE2) have increased the U.S. money supply from $800 billion in March 2009 to nearly $3 trillion in 2012 (see
Figure 1.5
). This massive amount of money printing (the dollar bubble) will eventually cause significant rising inflation.

Figure 1.5
Growth of the U.S. Monetary Base

Money printing basically kept pace with economic growth until financial crisis, when it exploded in 2009.

Source
: Federal Reserve.

In and of itself, rising inflation would not be so bad if the only consequence were rising prices and wages. But rising inflation also eventually causes
rising interest rates
(see
Aftershock
, Second Edition, for more details), and rising interest rates will have a very negative impact on the rest of the bubbles and the economy.

Rising interest rates will certainly be a big downer for the bond market (bond values drop as interest rates rise), as well as the real estate market (housing is not improving much now, even with mortgage rates at record lows).

Higher interest rates also mean consumers will buy less on credit, if they even qualify for credit cards and loans, further depressing consumer spending, on which 70 percent of the U.S. economy depends.

And, of course, rising interest rates will also mean that businesses will borrow less money, buy less inventory, hire fewer workers, and generally expand less. That will negatively impact employment, which will negatively impact consumer spending, reduce company earnings, and lower stock values.

Even without the already falling bubbles, rising interest rates would not be good for a nonbubble economy recovering from a recession. For a falling bubble economy, rising interest rates will be the beginning of the final multibubble pop. While that is still off in the future, when it finally occurs, it will not take long for U.S. stocks, bonds, real estate, and other dollar-denominated assets to drop. Many investors, including many foreign investors who now own an enormous amount of U.S. assets (see
Figure 1.6
) will not want to hold on to these declining investments. Foreign investors don’t have to all run away at once to cause a big downward drop in dollar-denominated assets. Even a significant decline would do the trick. And, of course, domestic investors will not want to stick around either.

Figure 1.6
Growth of the Foreign-Held U.S. Assets

Part of what fueled our bubble economy in the 1980s and 1990s was massive inflows of capital from foreign investors, which grew from less than a trillion dollars in 1980 to $22.78 trillion in 2010. We remain highly vulnerable to their continued support.

Source
: Bureau of Economic Analysis.

With inflation and interest rates rising, and even more money printing likely in the future as the Fed tries to support the falling bubbles with more quantitative easing, it is only a matter of time before the big dollar bubble pops.