Investing in the Inevitable

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Economists tell us that the nation's GDP must climb at 3 percent in order to create enough jobs to accommodate population growth, more than that to boost consumer demand (which creates more jobs, somewhere) and much more than that to make a meaningful dent in the roughly 8 million jobs lost since the recession began. Anything less than 3 percent will cause unemployment to rise (or the labor force participation rate to fall) and substantially less than 3 percent will eventually cripple the economy because jobs ultimately drive the consumer demand which generates approximately 70 percent of it. The issue then is how much the economy is going to grow in the coming years.

Mainstream economists predict that the US is likely to achieve what they refer to as its "historical average" of 3 to 4 percent growth, a consensus upon which government agencies are content to base their various projections. Others, however, predict that US growth is more likely to average around 2 percent, or what John Mauldin has coined "the muddle through economy." The difference between 4 percent and 2 percent, in terms of investment strategies, is considerable. In the first scenario investors can afford to be relatively aggressive - riding the markets higher for the next few years, placing bets on a global recovery, etc. - while the latter scenario calls for a more cautious, defensive posture. Knowing which prediction is correct could mean the difference between profit and loss as the decade unfolds.

While no one can predict the future with absolute certainty, and we should never underestimate the hyper-Keynesian antics of the world's central banks, predicting GDP growth is fortunately not all that difficult. The most reliable method is to simply analyze historical data in order to determine the trajectory of its progression. If, for example, we'd like to predict the average annual rate of growth for the present decade (ending 2019) then our first step would be to determine the average annual growth rates of prior decades. Since the Great Depression was arguably anomalous - growth in the 1930s averaged a paltry 1.3 percent - and the Second World War was obviously anomalous in the opposite sense – US GDP surged at more than ten times that rate between 1940 and 1945 - a reasonable point to begin our analysis might be with the first full decade of the post-war era. Six consecutive decades of background data should give us a pretty fair idea what the present decade is likely to yield.

average annual US GDP growth rates, per decade

1950s (1950-1959): 4.17 percent
1960s (1960-1969): 4.44 percent
1970s (1970-1979): 3.26 percent
1980s (1980-1989): 3.05 percent
1990s (1990-1999): 3.2 percent
2000s (2000-2009): 1.82 percent

A crude visual representation of the data would look something like this:

The red trend line above suggests that US GDP will grow at an average annual rate of around 1.75 percent from 2010 to 2019. According to the data, in other words, the expert consensus is incorrect. Less than 2 percent growth will effect a net loss of jobs which no amount of quantitative easing can prevent from eventually eroding aggregate demand and stifling the economy's alleged recovery. And while no one can predict the exact timing or precise mechanism of the next economic downturn, this added uncertainty is all the more reason for investors to adopt more defensive strategies before the inevitable comes to pass. Another rationale for the cautious approach is that the data presented above, as dismal as it may seem, is arguably much too optimistic. It's only when we insert it into its historical context that we can begin to fully appreciate its genuine severity.

During the 2000s, Mortgage Equity Withdrawals [MEWs] reached stratospheric levels as home values skyrocketed. At the peak of the bubble, in 2006, MEWs were equivalent to a staggering 70 percent of GDP growth; subtracting them from the entire decade's growth, moreover, would reduce our 1.82 percent average to a measly .7 percent. While we may be reluctant to do that considering that some of the cash that Americans were so voraciously extracting was undoubtedly used to purchase foreign goods - meaning that it was already subtracted from GDP - this doesn't alter the fact that the largest housing bubble in US history basically was the economy in the 2000s.

How do we know that? Because the decade's tally of losses in household real estate equity from the ensuing collapse - $7.5 trillion from early 2006 to late 2008, up slightly since then but once again falling - was $2 trillion more than the entire decade's GDP growth. We lost trillions more from the bubble, in other words, than our economy created in the first place. One might even argue, if one were so inclined, that US GDP growth in the 2000s had there been no housing bubble could easily have been less than zero. Merely subtracting MEWs is arguably conservative.

We could probably say much the same thing for the 1990s, which, lest we forget, were super-sized by the largest stock market bubble in US history. How much of that 3.2 percent growth was simply a farce subsidized by the ever spiraling insanity of our overblown equities markets? Should the trillions that vanished when that bubble burst be somehow factored into the official statistics? What would the growth rate in the 1990s have been without the largest stock market bubble in our history? Half of 3.2 percent? Or is that still too generous? Envision, if you will, what a revised chart of US GDP growth might look like if we sought to neutralize the ephemeral effects of these recent financial perversions:

Whether the reader appreciates this revisionist experiment is beside the point, which is simply that US economic growth in recent decades has been wildly exaggerated by two of the largest financial bubbles in our nation's history literally back to back and anyone who thinks this is normal or healthy or even sustainable might just be crazy enough to work at the Fed. The epic cycles of boom and bust which have commandeered the US economy since the early 1990s are simply not comparable, qualitatively or ultimately quantitatively, to the sustained economic growth that the nation experienced in the post-war era. Considering our recent history, projections of 2 percent growth seem borderline delusional. A more realistic estimate would fall somewhere between the official data and the revision above - around 1 percent, perhaps. And since this won't be nearly enough to prevent very bad things from happening, the investor is advised to plan for the worst...

The basic principles of investing for the inevitable

#1 As the Fed seeks a return to business as usual - i.e., to inflate whatever asset it can in its attempt to spawn yet another pseudo-growth bubble - the more active investor will no doubt exploit short-term profits from all the fun. It is essential, however, especially as the relief from the recovery escalates into euphoria (if indeed it gets that far this time around) not to get too caught up in the festivities. The investor should remain as liquid as possible in such precarious, uncertain times.

#2 The more the media celebrates the rising stock market (euphoria is a definite plus in this regard) the more resources the wise investor should align against it. Either by shorting the most highly leveraged companies directly, or by purchasing ETFs such as ProShares Short S&P 500 (NYSEARCA:SH) which short an entire index, profiting from the inevitable crash will be vastly preferable to the alternative which will no doubt befall the masses.

#3 In a word, gold. As equities advance the price of gold generally declines. While still expensive (historicallly speaking) at present levels, wise investors should progressively increase their positions, either directly or through ETFs (many to choose from) as the price erodes. For this much we know: when equities collapse - and they will, as the center of the mock recovery can no longer hold - the price of gold will soar to new heights.

#4 A stock market bubble, of course, is merely an opening act for the main event: the dreaded bond market crisis. Long before our national debt reaches $20 trillion (by mid-2016, according to the CBO) the cost of funding it will very likely soar. Acutely aware of the effect that rising interest rates will have upon the fragile housing market, wise investors will avoid being caught in the crosshairs of this inevitable calamity. As long-term rates begin to overshoot their historical norms, however, they will venture against the herd to purchase government debt because they know that as bad as the crisis gets, it will eventually subside. Austerity measures will be taken if for no other reason than they must be taken and when the carnage finally passes interest rates will invariably fall. By then the wise investor will have secured a high rate of return for years to come which, if nothing else, will provide an excellent hedge against inflation.

#5 Perhaps the most important principle of investing in the inevitable is simply information. Rejecting the homogenized propaganda spoon-fed by the mass media, wise investors will continue seeking alternative sources of information upon which to base their informed decisions. They will carefully consider what other investors have to offer, distilling their own perspectives from the myriad sources readily available on the greatest information network ever devised, the internet. Message boards and websites such as our very own Seeking Alpha have become essential tools for the modern investor. And in the treacherous years which lay ahead, we could each use all the help we can get.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.