Starting in mid 2008, the US and world economies began a serious and potentially long lasting retrenchment. This was the result of a multi-year credit and leverage expansion of extraordinary proportions. As credit was retracted, marginal demand for goods and services declined and as a result, a wide variety of asset values declined dramatically. This resulted in additional credit contraction, additional loss of demand and subsequent asset value reduction in a negative self-reinforcing spiral. As of the current date this process has not yet fully completed.
I believe today’s circumstance actually began in May of 1989. That was the start of the last major downward spasm of the Greenspan Fed. The Fed Fund rate was reduced from an interim high of nearly 10% in May 1989 down to a low of 3% in September 1992 that was then held for some 18 months. One could postulate a lagging connection between this downward rate spasm and the 1990’s tech boom (see Fed Fund chart below). The resulting liquidity fueled the internet and technology boom which in turn propelled the stock market in general and NASDAQ in particular to record heights. As the chart below indicates (basis S&P 500 Index) the market rallied to new highs in mid 2000 only to collapse following the dual blows of the bursting of the tech bubble and the September 11, 2001, terrorist strike.
What happened next was another aggressive effort by the Greenspan Fed (see chart below) to drastically lower interest rates to what were 40 year lows by providing massive liquidity to the banking system. Fed chairman Greenspan kept rates low and kept supplying liquidity for a full two years. This massive injection of money into the economy had to go somewhere. Bond yields were low and the stock market was a bust so the money bubble was translated into a 5 year housing bubble. Why housing? Because the bursting of the technology bubble frightened investors away from the stock market and the tsunami of baby boomers decided, en masse, to buy houses. Real estate, as everyone knew was a solid and stable investment destined to rise forever. Or so it was thought. That they were aided and abetted by a corrupt Congress and feckless administration does not reduce their individual culpability. Multiple homes, extreme leverage, option ARMS, no down loans and the whole raft of opportunities to profit in real estate lured the unsuspecting few and the great mass of intentional speculators alike.
As the housing bubble grew so too did the stock market. Ever rising housing values begat mortgages, home equity loans and mortgages with cash outs that were sliced and diced and sold multiple times to hedge funds, banks, private equity groups, money managers, mutual funds and anyone who could breathe without thinking. Layered on top were CDSs, CDOs, MBSs and a who’s who of alphabet soup derivatives levered one on top of the other often with no connection to the underlying asset. Eventually the good times ended and beginning in the middle of 2008 markets, credit and economies world-wide just died. The recession/depression of ‘aught 8’ had begun.
The Fed, now led by Ben Bernanke thought they knew what to do and so, as Greenspan did before him, Ben dropped interest rates to record lows and pumped massive amounts of liquidity into the banking system. Alas, his ZIRP (zero interest rate policy) has, as of the current date, had little to no known effect. Proponents will claim – without justification or proof – that ZIRP and TALF and TARP have kept the damage from being even worse. Opponents, of whom I am one, contend that ZIRP, its siblings and cousins have set the stage for even worse problems down the road.
Examining Japan's policy prescriptions we can see that their outcome was the loss of two – so far – decades of economic growth. This suggests that the US policy will produce more of the same. And why not? We have the same prescription just a different dose. Hard to believe the outcome will be any better than Japan’s.
The chart below shows the percent change, year over year, of the Japanese GDP from 1980 through 2008. Over those 29 years, the average change in GDP was +1.9% (+2.4% prior to 2008). However, over the 1992 to 2003 period, a total of 11 years, the average change was only +1.0%. The -12.7% GDP drop that occurred in 2008 is the worst Japanese GDP showing since 1974. All these average GDP growth rates, whether for the entire 29 years or the lost decade of 1992-2003 hide the effects of the 1980’s Japanese bubble and the disastrous 1990’s and 2008 crashes. All this in spite of massive injections of liquidity, a series of perhaps a dozen stimulus programs, infrastructure programs and exhortations for the Japanese people to borrow and spend. All this effort has yet to succeed. Most critically, all that government spending, all the borrowing and all the injections of liquidity have not yet translated into generic inflation. Japan is still fighting deflationary forces. Contrast Japan with Sweden.
Japan, in the late 1980’s and early 1990’s had a real estate and stock market bubble that burst. They followed that with bank bailouts that are roundly credited with creating a series of zombie banks that were technically insolvent but permitted to survive. It wasn’t until sometime in the early 2000’s that Japan finally closed and/or merged the zombie banks out of existence. The United States appears to be following the Japanese playbook instead of the Swedish playbook. The Swedes took the financial bull by the horns, nationalized troubled banks, closed others down, reorganized their financial system, and sold the cleaned up banks back to the private sector. Did it hurt? Yeah, but it seems to have worked.
If, as I believe, the US is following the Japanese financial playbook, then our stock market is equally likely to follow the Japanese market, not in lock step but very likely in the same general pattern. The chart above vividly shows the Nikkei hitting a record high in 1990 and then (with some inter-period rallies) selling off until 2003. There followed a rally, like every other national stock market until mid 2008 when the bottom fell out all over again. A global financial bubble had burst.
So what is an individual investor to do? Here’s what to do. I conclude that the stock market is not the place for an investor. A trader can perhaps do well, but not an investor. Since I am attempting to determine how to invest I must look beyond the stock market. I have chosen two areas: (1) private equity and (2) bonds. Both of these options require explanation.
I am a small investor so the usual hedge funds and private equity groups will only sneer at me. However, I can follow similar principles by purchasing a small business. Is that risky? Sure, but then again, so is doing nothing. A buy and hold investor would have lost anywhere from 20% to 40% of their investment last year. Even well diversified portfolios suffered substantial losses. Buying a well run small business on the other hand allows the owner to have a direct role in the success or failure of the enterprise. I can buy a million shares of GE (about 10 billion shares outstanding) and never have a single word on how it is run. But I can direct my small business as I see fit. But that’s not the place for 100% of my portfolio.
The second area of investment is income oriented. Or, more properly it is a mix of money market and bond funds. Given the potential cash requirements of a small business a reasonable amount of cash must be readily available. The banks won’t lend it after all. The balance of my portfolio will go into a mix of Vanguard mutual funds: intermediate-term investment grade corporate bonds (VFIDX); intermediate-term high yield corporate bonds (VWEHX); and a cash reserve in the prime money market fund (VMMXX). The two bond funds currently provide a combined yield of 7% or better. But what about the potential for loss of principal when interest rates soar? And clearly interest rates must soar as a result of the inevitable inflation that simply must follow the recent series of stimulus plans; liquidity injections and massive government borrowing? Don’t they?
First, what inflation? All the official talk is about deflation not inflation. Not that I believe government officials. But once again look at Japan. Did they have inflation? Well, they had a little. Too little actually, since they’ve spent the past twenty years trying desperately to re-inflate their economy. Yes, I believe inflation is a monetary phenomenon. Yes, I believe that the US will eventually suffer a serious bout of inflation. But when it will suffer I do not know. A recent comment I read was eye opening. First, we have to accept that inflation is a monetary phenomenon that results from too much money chasing too few goods. Anyone noted too few goods lately? Not really since demand, world-wide has diminished significantly. But suppose demand begins to rev higher? As that writer pointed out there is ample capacity for goods producing in China and all of Asia (Near-East, Middle-East and Far-East). The US and Europe too have room for that matter. I do not belittle the prospect of inflation. I lived through the gas lines and price controls of the 70’s. I had an 11% mortgage in the 80’s. I do assert that at this point in time, and probably for the next few years, inflation will not be the primary economic issue that worries many of us. Further, most of us are on high alert in case inflation rears its ugly head. So we are less likely to be taken by surprise as happened in the 1970’s and 1980’s.