The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (6 page)

The reasons for the current widespread bubble blindness by conventional investors are many. They include:

• A deep faith in “the myth of the natural growth rate” that is supposed to guarantee us continued economic growth no matter what. (The myth of the natural growth rate is described in detail in Chapter 3.)
  
• Denial: Human psychology makes it difficult to think rationally in the face of things we don’t want to be true. (Investor psychology is also addressed in Chapter 3.)
  
• What we call “The Hamptons Effect”: Conventional investors and analysts desperately need the current status quo (from which they greatly benefit) to continue; otherwise, they will lose everything: their jobs, wealth, homes (in the Hamptons, for example, for wealthy New York investors), social status, and so on. These people will fight to the end to keep what they have, even if that means complete bubble blindness. If you are counting on blind people to guide you, we suggest you keep your expectations low.
  

The deadly combination of declining productivity and the multibubble economy is giving us massive debt, massive money printing, future rising inflation and interest rates, falling assets bubbles, and an increasingly dangerous investment environment. Conventional wisdom on investing, such as the buy-and-hold value investing practiced by Warren Buffett, for example, will not hold up well under these worsening conditions. Instead of conventional wisdom, we need a new kind of Aftershock wisdom (see Chapter 3) for a new way of investing (see Chapters 4 to 11) that will guide you to and through the coming Aftershock. Ignore this new Aftershock wisdom at your peril.

The key to Aftershock wisdom for successful investing is to ignore the economic cheerleaders and stay focused on what really matters:
inflation
. Rising future inflation and future rising interest rates pose the biggest threat to the future health of your portfolio. Not too many people are worried about inflation and interest rates right now because both are remarkably low and pose no immediate threat. But rising inflation and rising interest rates will strike the final blow to the vulnerable dollar and government debt bubbles, and will send your hard-earned assets to Money Heaven faster than you can log onto your online brokerage account and hit “Sell!”

The rest of this book is entirely focused on helping you protect your wealth, whether it is $200 or $200 million. But there is only so much we can tell you in a book. This is an evolving economy and investment environment, and therefore the actions you take must also evolve over time. Beyond our books, you can keep up with us through our newsletters, or invest with us, and you will see each step we take as the Aftershock approaches. With or without our help, please understand that you must keep up with changing economic conditions in order to correctly manage and protect your assets in this increasingly dangerous investment environment.

Since the most recent update of our outlook on the economy with the release of
Aftershock
, Second Edition, in August 2011, much has happened. The most striking change is that the stock market has recovered somewhat, up about 10 percent since its low in October 2011 as of this writing in mid-June 2012. In fact, because of that recovery a lot of people have been asking us, “Do you still think there will be an aftershock?” As if all we needed to wipe out the fundamental problems with the bubble economy was a 1,000-point increase in the Dow.

We understand how tempting wishful thinking can be. People naturally hope that the bad dream is over and all is on the upswing. And it is good that people are optimistic. But that outlook simply is not realistic in the longer term. Even in the shorter term, there are big questions looming. Could this be like 2011, which started very optimistically with hopes of “green shoots” (new growth) in the spring, only for those green shoots to wither and turn brown in the summer of 2011, if they really even existed in the first place? Plus, the stock market had external shocks from Europe, Libya, and the Japanese tsunami.

The same could happen in 2012: dreams of green shoots at the start and a browning out as the year goes on, although it is unlikely there will be an exact repeat of the year before. There are certainly many potential external shocks that could further negatively impact the U.S. economy, such as from Iran or Europe or China, which we discuss in more detail later in this chapter. In addition, that economic “recovery” that everyone was hoping for, and even some declared that we already were in, simply has not materialized to much of an extent, if there is one at all.

In fact, the Economic Cycle Research Institute (ECRI), the most accurate forecaster of recessions (having correctly forecasted every recession since they were founded in 1996), still holds strongly to the prediction it made in September 2011 that the United States is heading into a recession. The CEO of ECRI, Lakshman Achuthan, further says that he has enough data since September to say it is no longer just a prediction but almost a certainty, based on the various leading economic indicators he uses. However, job growth could continue past the beginning of a recession because job growth could continue past that point because job growth tends to lag behind economic growth. Employment is considered a lagging indicator because employers don’t tend to hire until growth in demand has been more proven and they don’t fire until declining demand has been more proven.

Most importantly, the fundamental issues we discussed in both
America’s Bubble Economy
and
Aftershock
have not changed—far from it. They have only been further confirmed by recent events. In fact, so much so that it almost seems like the Fed and other central banks around the world have been reading our playbook. We said that the final bubble to be pumped up will be the dollar bubble because it’s the easiest way for politicians in the United States and around the world to solve the bubble problems temporarily. As we have said before, printing money can solve almost any financial problem—except for one: inflation. Money printing allows governments to borrow more massively, it calms nervous stock and bond markets, and it helps boost general economic activity.

Hence, almost exactly as we had predicted, governments around the world have opened the floodgates of printed money (see
Figure 2.1
). According to J.P. Morgan Chase, the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan combined have printed more than $3.9 trillion since 2009. To put that into perspective, the entire money supply of the United States was about $800 billion in 2007. Discussion of an “exit strategy” for the Fed’s pulling back its printed money out of the system, which was quite in vogue only a year ago, has been
completely
forgotten.

Figure 2.1
Around the World, Central Banks Are Printing Money

In response to the 2008 financial crisis, central banks around the world, not just our Federal Reserve, have responded by printing money as shown by central bank's balance sheet growth. This is a world bubble economy.

Source
: Various central banks.

The European Central Bank (ECB) has flooded the European economy with more than 1 trillion euros of easy money loans. That has also taken pressure off the U.S. financial markets as well and helped pave the way for the stock market recovery we had in the winter and early spring of 2012.

Not to be left out of the party, the Bank of England keeps adding to its printed money pile with more quantitative easing (QE).

Meanwhile, China’s massive government-controlled banking machine continues to stimulate its economy with money printing, although at a slower rate than when the financial crisis first hit China’s economy with a baseball bat. More on China, too, later in this chapter.

Japan has also continued to increase its money supply. Japan’s exports are falling and the printed money will help drive down the value of the yen, making its exports cheaper. More importantly, the Japanese economy, which recovered smartly after the tsunami, has slowed down again, partly due to slowing European demand for Japanese exports, as well as slowing demand from other Asian countries, in particular China.

All of this money printing has helped boost economies and especially financial markets around the world. Now, it may not appear like a big boost because world economic growth is so slow. But it is working, especially on the financial markets. Without this massive money printing, financial markets could melt down. In the case of Europe, it is easy to see that bond yields on Spanish and Italian debt would have quickly spiraled up out of control without massive ECB intervention to keep them lower. Out-of-control interest rates in such large countries as Spain and Italy would rattle financial markets around the world, taking the European, United States, and Japanese economies down with them. So the money printing madness may not look like it’s helping because European, U.S., and Japanese economic growth is so slow, but it is most certainly helping keep the financial markets from deteriorating dramatically, which would have a severe negative impact on all of those economies.

But, of course, massive money printing, while supportive in the short term, is simply another bubble, not a solution. Pumping up the huge dollar bubble with massive money printing is only going to make its crash even bigger and more uncontrollable later. That’s because massive money printing eventually causes significant inflation; rising inflation causes rising interest rates; and rising interest rates will pop what is left of the first four partially popped bubbles (stocks, real estate, private debt, and consumer spending) and will fully burst the last two: the dollar and the government debt bubbles.

In the meantime, no one wants you to think about that.

As with any bubble, the key to its short-term success is
ignoring it
. If you don’t ignore the bubble, it is a lot harder to keep it going. So, part of the key to the short-term success of this money-printing madness will be for cheerleading financial analysts and economists to overlook the bubble it is creating. For help in overlooking bubbles it is always good to have some academic support. And, sure enough, as if on command, there is growing support for a new economic theory called New Monetarist Theory.

The group of economists who support this theory think that deficits are good and cannot cause economic problems. Actually, deficits help governments solve economic problems. They say governments can borrow massive amounts of money and never have to default on their debt because their central banks can always buy their debt with more printed money. But these economists don’t just believe this will help in the short term, they see it as an acceptable, even desirable, long-term solution because they don’t see any long-term problems with it. They believe that this printed money won’t cause inflation because the new money is simply a “balance sheet adjustment” in the economy. Like a magic trick, it doesn’t really count and it won’t hurt us in any way.

New Monetarist Theory is like Keynesian economics on steroids. And, to a large degree, at least in the short term, it is true. Government borrowing
does
help the economy. And, yes, the Federal Reserve, with printed money, can buy
every single
government bond Congress wants to sell if need be. Hence, there is no possibility of a failed Treasury auction and no possibility of default even if government debt became incredibly massive.

Of course, as we have been pointing out for years, there is a giant flaw in this plan. Using printed money to buy bonds will eventually cause inflation. If it won’t cause inflation, then, using the logic of the New Monetarists, the government could simply eliminate all taxes and borrow all the money it needs by selling bonds to the Fed, who will pay them in newly printed money that didn’t exist before. No taxes and lots of government spending (funded by printed money) certainly would boost the economy. And if all that printed money doesn’t cause inflation, you have created the perfect solution to any economy’s ills. It would truly be “Money from Heaven,” and it could basically move any economy in the world into hyperdrive.

But, of course, Money from Heaven does not really exist. As we have said before, Money from Heaven is the path to Hell. It is amazing that such a line of economic thought is getting increasingly greater and more serious attention. It is also a reflection of the sad state of the economics profession that this line of thinking represents cutting edge non-mainstream economists. That’s a big problem because almost all real change in economic thought over the next few decades will come outside of the mainstream. That this represents current nonmainstream thinking shows how far the field of economics has yet to go.