Thursday, October 27, 2016

Prepare for deflation

I'm going to ramble on about the economy for a bit, but if you don't want to read all that then just scroll down to the advice near the bottom.

I'm not an economist, but I do sometimes stay up drinking whiskey and reading alternative sources for things like economics and politics. You get a very different signal when you move out of the mainstream. It can be hard to tell whether you're right and everyone else is wrong, or if in fact you are actually the one who is off course. But, what little investing I've done has paid off well. I bought precious metals around 2008 when they were going way up, and doubled my gold and tripled the silver (which turned into a down payment on my first house). After the crash, I knew I should buy a bunch of stock while it was low. And I bought several thousand dollars of a mutual fund right at the lowest point of the whole stock market crash. It was pretty sweet. I sold that during my time in grad school, probably for booze. So I could be crazy, but then this has worked before.

State of the economy
For those who don't really follow what's going on, our economy has been in recovery since the 2008 crash, which was caused by a collapse of the real estate bubble, for about 7 years. They say we're still in recovery, but at 1% GDP growth, that's becoming a very optimistic description. Mostly when people say that the economy is doing great, they will refer to the soaring highs in our stock market. (Go ahead, post on your facebook that Obama's economy sucks*. Watch as they come out of the wood work to lecture you on the market.)

After the crash, the Fed lowered the interest rate to stimulate the economy. For years now the Fed has kept the rate very low. When the Fed lowers the rate, the cost of borrowing becomes cheap, and thanks to fractional reserve lending, the amount of money in the economy goes higher. But more money doesn't mean more wealth. At the end of the day, the value of a dollar is the total value of the real economy divided by the number of dollars. So if there are more dollars out there (printed or imaginary debt dollars like those backing your mortgage**), the value of each will be less. This is inflation.

Does anything about this strike you as odd? There is more money being pumped into the economy, so what would we expect to happen, that we aren't seeing? That's right, inflation. While we can argue about how accurate the inflation numbers are, ultimately we are just not seeing very much. What you're probably asking is, how is this possible? The answer, I think, is that pretty much all the economic gains of the recovery have gone to the top of the pile. So those of us in our little-people economy aren't seeing more money. We're not getting big pay raises. It's all going to the top. Where are those people putting the money? Remember that interest rates are very low. So debt-based investments, like bonds, have almost no return. I think you see where I'm going with this.

The money is going in to the stock market. It has no where else to go. As money dumps in, the prices of shares go up. People who bought early enough saw positive returns, fueling them to put even more money in. The market has become less about the real value of the underlying assets, as it has become based on the trust that more money will keep coming in to raise raise the prices further. It's a pyramid scheme at this point. It is highly susceptible to a "run on the market".

What would trigger such a run? A number of things I'd guess, but the most obvious one is a rise in the Fed rate. For two reasons: (1) it will reduce the amount of new money, reducing confidence that the stock prices will increase, and (2) it will make other investments like bonds profitable again.

So the people who run our economy are in a bind. If they raise rates they could bring down the house of cards that is the stock market. If they don't, they leave no room to maneuver when the next economic downturn hits. The last one was resuscitated by lowering the rate, but the rate can't go lower. If the next downturn comes before rates have been able to return to their natural level, the whole economy may go in to freefall with no brakes left to apply***.

The advice
You don't want to be exposed to the stock market. If you have stocks, sell them. If you have a 401(k) or equivalent, reallocate them to bonds or securities. The rule of thumb for stock percentage in your investments is 100 minus your age. So if you are 40 years old, you should have 60% in stocks. I'd say subtract 20%, at least, at this point. Sell high. Sell high. Sell high. Once the market crashes you can buy the stocks back on the cheap. Bonds and securities are where you want to be. The bond rates should go up as people bail the market. Cash-backed securities will actually increase in value as deflation occurs. And we could be in store for some serious deflation. Only like 10% of US dollars are actually in circulation. The rest are sort of imaginary debt dollars. So even if the value of the real economy drops, the amount of currency could absolutely plummet. Brace for deflation.

Pay off all the debt you can. If you have $20,000 in stocks and $20,000 in mortgage you need to even that out. While you should take advantage of 401(k) matching at your company, don't put in any more than they match. Otherwise, if you have any debt, including mortgage, you should not be putting any money into retirement (some people will cringe to hear that advice) or the stock market or taking out new loans. Here's the thing about debt: it's set at a nominal value, a certain number of dollars. If the total number of dollars available becomes smaller, it will become much harder to get the same number of dollars to pay the debt. Your income will fall. It will be harder to make those payments. And if you have a floating interest rate you'll suffer a double whammy. Not where you want to be.

Good luck. Please keep in mind my advice is free and comes with a money-back guarantee.

* I don't actually like getting in the habit of blaming or crediting a president for economic ups and downs. This suggestion is for illustrative purposes only.

** By the way, if you are considering taking out a mortgage now if the time to do so. The rates are as low as they can possibly get, unless they take the extraordinary step of setting the target rate to below zero. Be warned though if you lose your job in the coming crash, you may lose your home no matter how low the rate is. Also, the price of real estate will surely fall in a deflationary event. So there's no right answer, but take advantage of the low rates if you can. Fixed-rate mortgages ONLY!

*** The apocalypse scenario. I wrote about that a while back, and I have a preppers guide I've been sitting on forever that I may finish this fall. But you can find lots information on that if you're in a hurry.

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