The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (40 page)

One of the easier indices to manipulate is the Consumer Price Index (CPI), which measures inflation. This figure is based on the prices of a wide variety of goods and services around the country, monitoring how they change over time. So all that has to be done to manipulate this figure is to alter the mix of goods and services in order to understate inflation, as well as using factors like “substitutability” and “quality adjustment” to massage the raw numbers. In fact, in the past couple of decades, the measurement of the CPI has changed so much that today’s CPI registers inflation at about 7 percentage points lower than it would be under the old measurement!

Another misleading factor in measuring inflation is shrinking asset prices—such as real estate or commodities—that may be due to falling demand and have little to do with the value of the currency. But because these assets represent large portions of the inflation measurement, their decreasing prices can cover up any real inflation in the measurement.

We’ve talked a lot in this book about how the Federal Reserve increases the money supply through buying bonds. Of course, everyone knows that increasing the money supply leads to inflation—though they may pretend not to in some cases—so it can be in the Fed’s best interest to understate these numbers when they might otherwise cause concern in the markets. We won’t go so far as to make accusations here, but it’s certainly possible that the Fed has done or will do what many banks and private companies (Enron, anyone?) have done in recent history: off-balance-sheet accounting. By not reporting every bond purchase openly and accurately, the real increase in the money supply can be obscured, maintaining confidence in the dollar.

And then there’s a more crude way for governments to mislead the public and stave off worries: just lie. We can be fairly certain, for example, that the government of China does this regularly, with statistics created by government employees under orders from their superiors. These lies can be spotted pretty easily by those with access to reliable information, though. For example, we can monitor the use of electricity in China—if electricity use is going down, it’s a sign that the economy is contracting, regardless of what the government says. It is likely there is some manipulation of electricity statistics but likely not as great as gross domestic product (GDP) or inflation numbers. Perhaps an even more reliable way is to look at exports to China from other countries. If exports to China are slowing, that’s a bad sign for the country’s economy. (In fact, this is exactly what has happened recently, indicating that China’s economy may be slowing even faster than the government is willing to admit.)

Granted, in most of the developed world, outright lying like this is somewhat unlikely, and would likely be ineffective. But attempts to mislead like this are not inconceivable, and it’s important that we be rigorous in finding reliable, accurate information at all times.

So if this is the case, why don’t journalists, analysts, and academics catch it and report on it? Remember what we said earlier about the motivations for continuing on the path of manipulation. The truth is that there is very little reward out there for professionals who call the government and the financial community out on its misleading or outright wrong figures. Aside from often wanting to believe the cheerleaders themselves, those who speak out are often labeled “doom-and-gloom” pessimists and ridiculed throughout the financial community and in public, possibly even blaming such people for falls in the markets. We have some small experience with this, as do some of the people we’ve profiled in our ABE Awards throughout our books.

Misleading numbers and market manipulation can go on for quite some time, but sooner or later they aren’t enough to keep things afloat. Eventually, losses become too large to hide with a little mathematical creativity. Even if the government outright lies, indicators elsewhere will eventually be too strong to ignore—just like we’re beginning to see now in China.

Direct manipulation can’t prop up the markets forever either. Once people lose confidence in the markets, it’s very difficult to restore it. Even buying stocks to prop up their price might create a short-term upswing, but the losses that follow make this tactic unsustainable in the long run. The amount of capital that would be needed to sustain prices would be astronomical, which brings us to the next failure: quantitative easing.

Expanding the money supply is always going to be a recipe for inflation. Governments do it because it’s a short-term fix, but eventually it catches up with them, and it can snowball very quickly. In the early going, investors may cheer quantitative easing and respond by buying up assets. But once inflation really takes off and panic sets in, there comes a point when quantitative easing becomes counterproductive. The inflationary response to any increase in the money supply becomes almost immediate, as the flight to safety becomes even more frantic. We’re left with no stimulus, just a devalued currency.

Inflation is really the key here. Our guess is that people will be relatively content to stick with traditional assets as long as inflation is low and the dollar remains stable. Only when inflation becomes a major concern do we expect most people to get spooked and cause the stock, bond, and real estate bubbles to pop, and pop very rapidly. With U.S. markets collapsing, expect foreign investors to pull out en masse. This is the Aftershock. And it will necessitate more dire measures than what we’ve discussed so far.

Right now, we have an oscillating market. It goes up a little, then down a little, then up more, then down more. But what we’re not seeing is significant sustained gains over time. Instead, we have a market that, left to its own devices (without continuous money printing or the hope of money printing), will trend downward. Eventually, that oscillating market will turn into a consistent down market, with losses for the Dow potentially approaching 500 points a day or more.

At this point, the government will need fast action. The old way of doing things—massaging numbers, manipulating prices, and flooding the market with capital—will not be nearly enough to stop the plunge. As it happens, there are already systems in place to shut down the stock market in this situation—often referred to as “circuit breakers.” The idea is to shut down the market for only a few hours and address whatever issue is causing the plunge in prices. In this case, we might see this initial shutdown last up to a day or two before reopening.

Of course, the problem in this case is a bubble economy. That’s not something that can be fixed overnight. So when the market does eventually reopen, the plunge continues, and the government will need another shutdown, one that will last more than a day or two.

In 1933, Franklin D. Roosevelt declared a national bank holiday in order to shore up the problems that had been leading to runs on banks throughout the country. During that time, the Emergency Banking Act was passed, and when the banks reopened the following week, depositors came rushing back with renewed confidence. Likewise, when the stock market has to be shut down, the government will be frantically looking for whatever reform it can implement to send investors rushing back to stocks.

But without being able to assuage fundamental investor fears about the economy and the markets, the name of the game here will be finding ways to encourage purchases and discourage sales. Brokerage firms will have no qualms about playing along, and what we might see for some time is that clients who want to sell their stocks have a difficult time getting past their broker’s secretary or voicemail, while those who want to buy will get top priority. Whatever happens, the government and the financial industry will surely go to great lengths to prevent anyone from selling stocks when the market reopens.

What we will
not
hear from the Fed, or from most of the financial industry, is that stocks and other assets have been in a bubble all this time, that the implosion was inevitable and irreversible. Instead, we’ll hear all kinds of excuses, perhaps blaming the crash on culprits such as high-speed trading, which may have irresponsibly flooded the market with sellers (since they do more than half of the trading on the market and they do it quickly, they will clearly be involved in any crash). Another likely target will be the short sellers, among the favorite scapegoats from 2008.

In addition, we’ll almost certainly hear that it’s a temporary irrational panic, and that everything will be fine once people come to their senses and bet on the U.S. markets again. Anything to convince the public—and themselves—that it’s just a temporary crash and not a bubble economy popping, will be discussed and praised at length.

This might sound unimaginable in 2012, not to mention horrifying, that the stock market could just close down for an extended period. But what we’ll probably find, when the market can’t stay open without huge losses, is that the public will be surprisingly content with this action—or rather, with
any
action that might stop this downward spiral.

Meanwhile, bonds and real estate will have their own shutdowns. But that won’t happen because of government action. With soaring interest rates that the Fed can no longer control, lending will dry up, and the bond market will effectively shut down on its own. When the bond market shuts down, there’s no mortgage money available, and thus essentially no real estate market left to speak of.

The one oddity will be the gold market, which will behave in exactly the opposite way. With assets tanking across the board, people will rush to what they consider the intrinsic value of gold and precious metals. This is the last thing the Fed wants, and so measures will have to be taken to discourage gold purchases. A prohibition is possible, but more likely we might see a punitive tax on proceeds from gold sales. The Fed might even prohibit the redemption of paper gold, such as through gold ETFs, into physical gold. The idea is to prevent investors from leaving traditional assets and rushing to gold instead. But again, once investor confidence is lost, it’s very difficult to gain it back. And the reason why discouraging gold purchases won’t be successful is the same reason shutting down the stock market won’t be successful: The United States is not the only country in the world.

The U.S. government can pass all kinds of regulations and restrictions on market activity, but it can’t do much to prevent those same transactions in overseas markets. Gold, of course, will be easy to buy and trade elsewhere in the world regardless of what the U.S. government does—in fact, restrictions in the United States would just send the price of gold up even more.

Even if U.S. stock markets are shut down, U.S. stocks will still be readily traded overseas as well. And this is why it will be clear to anyone who’s paying attention that U.S. stock prices are plummeting even while the market in the United States is on a holiday. Remember what we said about the limitations of lying.!

We can’t say exactly how long the stock market will be closed, but it could be months, not days. It can’t last forever because at some point many of the people who got caught holding on to their stocks when the market closed will need to sell their stocks. They may need to cover unexpected expenses, a lack of cash flow, or any of the other problems that come up that force people to sell their assets no matter how low the price may already be.

When the market does finally reopen, it will look dramatically different than it does today. It’s not just a matter of losing all the bubble value that’s been building up for 30 years. Investor confidence will have been devastated.

Will the financial industry—or what’s left of it, anyway—admit at this point what the problem really was? We’re not optimistic. The problem will continue to be things like irrational fear, political mistakes, and other nefarious forces. It’s the earlier prices that were the correct ones, if only everyone would realize it. Expect that drumbeat to continue for a long time.

But, sooner or later, people will understand what happened: We had a bubble economy and it’s not coming back. And the road to recovery will be a long and difficult one. It won’t be fueled by low interest rates and overextended debt, but by slow and steady growth driven by real productivity gains—the same way we built the U.S. economy into the most powerful in the world.

In case we haven’t made this clear yet, let’s say it one more time: The key is to
get out early
. You may often hear about opportunity costs and kick yourself when a stock rises after you’ve sold it. But it should be clear by now that any potential short-term gains are nothing compared to the cost of staying in the markets too long. The fall is likely to be sudden and unpredictable, and it’s easy to get trapped. Those who wait until things have already started to collapse will find themselves surrounded by a massive sell-off, and everyone cannot fit through the exit door at the same time.

For those who do get out early, though, life can be prosperous for years to come—much more so even than before the Aftershock. Think of all the people who put their assets into gold during the 2008 crisis when it was below $800/oz. They’re pretty ecstatic right now, and gold will only go up faster when times get truly tough for other investments.

If you think you are alone in being nervous about the stock market, you are not. Enormous numbers of individual investors are leaving the market. Remember the chart on the massive continuous outflows from stock mutual funds over the past few years despite the big rebound in the market? Many people say this is stupid money leaving the market. As we said earlier, this is not stupid money leaving the market, as stock cheerleaders would have you believe. It is people who aren’t investing OPM (other people’s money) so they really need to protect their capital and be careful—not just keep their high-paying money management jobs by investing in a stock market that is not performing and has increasing risks of a long-term downturn.