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November 27, 2007

It's Time to Protect Your Wealth
by Charles Zentay

What if the wealth we've created (and you've earned) over the last two decades was simply us "perceiving" ourselves to be richer? What if the U.S. economy wasn't driven by technological innovation and globalization but rather it was pushed up by the increased assumption of debt relative to GDP? And what if that increased debt drove asset prices higher and made us "perceive" ourselves to be richer, causing us to spend more even as we didn't create true wealth? And what if everyone figures this out before you do?

You've worked hard to build up your wealth, but it's now under more threat than you can imagine. Why? The stock market could crash 10-20% any day now (I'll explain throughout this article), but selling into cash and holding dollars leaves you exposed to the threat of inflation and stuck in a currency that is falling 10-20% a year. What can you do to protect your life's work?

Do you remember the Wealth Effect? This was something analysts and Fed governors loved to talk about during the Dot-Com days. It made a brief reappearance during the Housing Bubble. According to Wikipedia, the Wealth Effect is as follows: "Economists believe people spend more when one of two things is true: when people actually are richer (by objective measurement, for example, a bonus or a pay raise at work, which would be an income effect), or when people perceive themselves to be 'richer' (for example, the assessed value of their home increases, or a stock they own has gone up in price recently)." Was the wealth created real or a perception?

These graphs provide some chilling answers:

Imagine what happens to the above graph if housing prices go down 10%? 20%?!!

For the last two decades, the Federal Reserve has had a clear and consistent answer to the threat of increased debt levels: lower interest rates. Unfortunately, this clear and consistent answer is now a clear and present danger.

Starting in the mid-80s, debt-to-GDP started to increase. At the same time, the stock market began to move higher and higher. By the mid-90s, the fear at the Fed was that if the market went down and the economy slowed, the large debt levels would cause a market collapse and a severe recession. So the Fed lowered interest rates and encouraged the assumption of more debt. The debt culture that ensued was evidenced in the belief that "leverage is good." To keep the debt culture going, when market conditions worsened in 1998, the Fed lowered rates. When the NASDAQ dramatically plummeted in 2000, the Fed dramatically lowered rates. Today, as the market struggles, the Fed is lowering rates.

The problem this time around (and why the market could easily drop 10-20% any day now) is that people around the world are starting to wake up to the fact that even more debt creation is the problem not the solution. Debt levels relative to economic output can only go so high before they become a problem (think 1929 or 1990s Japan).

The current problem with debt has to do with fractional banking. Under our current system of fractional banking, banks can borrow 20 times what they have in true value. So for every $100 a bank has, they can lend out $2000 in loans (mortgages, credit cards, business loans, etc.). If a debt-driven economy has pushed up asset prices to extreme levels (as it did with housing in 2005) and the banks lend out $2000 against overvalued assets, what happens when those assets fall 5% and the borrowers default. If the bank can only recover 95%, it is left with $1900 in assets. The bank is out $100. Since the bank only started with $100, the bank is INSOLVENT! In fractional banking with 5% reserve requirements, only a 5% drop in the value of a bank's assets causes the bank to be insolvent. What happened to our society? Why did we lose our sense of caution? Because of the risks inherent in fractional banking, encouraging more debt assumption (the Fed calls it credit creation) should be a last resort. It's kind of like going to war. It's so costly, so you should only do it if there are no other options. War on terror? The Fed has declared a war on my wallet!

The Fed has come to use the last resort of increased debt assumption as common practice. As long as CPI numbers (which many claim underestimate inflation) indicate low inflation, the Fed has been keeping debt assumption at its maximum levels.

The Fed's answer this time around (as it always has been) is to lower rates and encourage more debt assumption. But the market is increasingly uncomfortable with banks lending even more against overvalued assets. People are beginning to lose faith in the U.S. banking system and the U.S. dollar. Everyone is literally running from the U.S. dollar.

The problem when you get a dollar run is that inflation increases. As the dollar falls, peoples' costs go up, so they slow their spending habits. As they slow their spending habits, the economy slows and asset values drop (such as housing and stocks). As asset values drop, the banks have more trouble and need more help from the Fed. It's a viscous cycle (called a credit crunch), wherein housing and stock prices fall and your money gets destroyed, while the Fed creates more money and gives it to the banks, who are then supposed to re-lend it to you. Sound like a bad deal? It is, and that's EXACTLY why everyone is running from the banking system, the U.S. dollar, and into gold.

Will the stock market crash tomorrow? It could. But it is more likely that the Fed working with the Treasury Department will announce a major rescue package for the banks. The Fed MUST keep the banks solvent. It will be interesting to see how the market reacts if such a rescue package is announced. Will the dollar plummet? Will the stock market rally? It's hard to know. I think the Fed and Treasury have a couple tricks up their sleeves that could cause markets to spike upwards before people realize that these solutions are in fact more of the same (namely more increases in debt-to-GDP). Don't bet against the market unless you are willing to wait at least a year. My guess (and it's just a guess) is that the market may rally a little into the New Year, and sharply correctly sometime before the end of March. But it might not plummet at all, because the dollar might plummet faster. So, a better bet is that the market will fall 10-25% relative to the value of gold between now and the end of March.

Whatever happens, we are at the end of a 20-year paradigm of the Fed lowering rates to save the stock market. Such paradigm shifts can be very painful and costly. Hopefully, it wouldn't be painful and costly to you and your family, as long as you have enough assets in gold.

If I'm incorrect (which the macroeconomic data do not indicate), then gold could fall 10-20%. If I am correct, you could lose much more through inflation and a depreciation of U.S.-based assets. It's kind of like global warming. If we reduce carbon emissions and scientists are wrong, we've wasted billions of dollars (probably no more than the War in Iraq). If we don't reduce carbon emissions and scientists are right, most of our major cities are under water. Given what we know at present, which course of action is riskier? Taking steps to limit carbon emissions? Adding gold to your portfolio?

Given that I expect the Fed and the Treasury to come up with some rescue plan for banking and housing, the bet of being short financials and housing becomes less and less of a sure thing, so I'm starting to reduce these positions. I'm still short HOV (via LEAP puts) as I think they're going bankrupt.

Besides the HOV put position, it might be time to just be boring by owning lots of gold, some oil, and some cash, and simply waiting for the storm to pass. This strategy takes patience. Credit crunches are characterized by extreme volatility. Volatility means prices can spike up and down quickly. For example, a lot of traders are short financials right now. If the Fed and Treasury announced a big rescue package, these traders would be forced to cover their bets, and the stocks of financial firms could skyrocket. If that happens, many will think the crisis is over. But it wouldn't be. The fundamental issue will not be solved (debt to GDP). So use volatility in your favor.

When spikes occur, reinforce the trades that make up your macro thesis. If a single stock or the entire market rebounds 5%, don't be surprised. However, such brief strong moves should not cause you to lose faith. The fundamentals of the thesis appear valid. What is not valid is predicting the short-term movements in the market. And remember, markets can stay irrational longer than you can stay solvent.

By the same token, gold and oil could move around a lot. Don't go into gold all at once. There are a lot of traders currently going into gold and oil. If there are signs of an economic recovery and announcements of financial rescue packages (and there will be from time to time), gold and oil could plummet. Use these severe dips to buy more.

When the credit crunch does eventually subside and everyone else has little money left, you'll hopefully be able to buy stocks at bargain rates, just like someone did when no one else could in the 1970s. That person: Warren Buffett.

Charles Zentay
thinkinvest.blogspot.com

Charles Zentay is an independent business person who monitors the financial markets very closely.  Visit his blog at thinkinvest.blogspot.com.

Copyright © 2007 Charles Zentay

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