The Perfect Financial Storm - Part 6: Storm Tactics Preparation

It is apparent to me that financial storms and perhaps "The Perfect Financial Storm" may be heading towards the US economy. For unseasoned investors, any sort of financial storm - whether a bear market or recession - triggers fear. Lacking knowledge and a strategic plan, they make decisions in a vacuum, reacting rather than profiting from them. Those who are forewarned are forearmed. Storm Tactics will identify three possible storm fronts heading towards the US economy, their weather conditions, and tactics to ride out the storm.

The Squall - Short Recession

The most benign financial storm front is a mild deflationary recession. It is a momentary squall that suddenly appears, wreaks havoc, and quickly dissipates. This is the scenario that Wall Street and Washington are praying for. Essentially, it is the Soft Landing scenario much talked about in the financial world.

The Tropical Storm - Stagflation

The second possible storm front is stagflation. This would result from the Fed and government using monetary and fiscal stimulus to work the country out of a deflationary recession. There is nothing worse to government officials than a deflationary recession. Assets drop, unemployment rises, the budget deficit expands while tax revenues drop.

The Perfect Storm – Inflation With Dollar Collapse or Depression with Hyperinflation

The third possible storm front is inflation triggered by a collapse of the dollar. Under this scenario an exogenous event, or series of events, erodes confidence in the dollar and the dollar loses its status as the world's reserve currency. The financial markets collapse, the economy goes into a depression, the government enacts protective trade barriers, and we get hyperinflation as a result of the dollar's collapse. This scenario could even lead to war. This storm would be a repeat of the 1930's with the exception that instead of deflation, there is inflation. It is also similar to what happened to the Weimar Republic during the 1920's.

Looking at our current economic weather conditions, there is no doubt that a storm front is on our horizon. It is not a question as to when it will arrive, but its severity. Fed rate cuts and government tax cuts will only delay its eventual arrival.

The US Dollar Is the Key

The severity of the storm will depend on the US dollar. If the dollar holds, the financial storm may create havoc and discomfort, but it will produce the least amount of collateral damage to the financial markets and the economy. If the dollar collapses, then we are talking about heavy weather. The key to surviving a collapsing dollar storm will be in preparation. No two financial downturns are ever the same. Individuals and institutions react in their own unique ways. There is no cookbook recipe that offers the best solution. However, having an understanding of the different possibilities and knowledge of a full range of tactics will allow you to position yourself to handle whatever conditions you encounter.

4 Steps to Safe Harbor

Step 1: Check Your Navigational Charts & Equipment Review Our Current Economic Conditions

A Financial Illusion - Our Financial Bubble

The first step in being prepared is to accurately assess the current environment and understand how it was created. The severity of any economic contraction is largely predetermined by the magnitude of the economic and financial maladjustments that accumulated during the preceding boom. In this regard, "The Miracle Economy", which is widely proclaimed as a new economic era, is a financial illusion. What we have experienced these last six years will become known as history's greatest financial bubble. It was a by-product of unprecedented pumping of the money supply and credit expansion by the Fed and the hype over technology, unleashing a parabolic rise in the markets.

The maladjustments created by this process have resulted in a mountain of debt by consumers and corporations, a skyrocketing trade deficit, a negative savings rate and an extremely overvalued stock market. These by-products are more reflective of a financial bubble than they are a new economic paradigm.

Watch the Money Supply

The process began during the Peso crisis of 1994 when the Greenspan Fed began injecting liquidity into the financial markets. From that point forward, each new financial crisis was met with the whir of money presses. Beginning in 1995 and until mid-2000, the economy grew by .72 trillion while overall credit expanded by .9 trillion. This outgrowth of the money supply and subsequent credit creation has been record breaking. It has resulted in all kinds of distortions in the financial system from inflating asset prices, to disfigurement of consumer and corporate balance sheets, to monstrous trade deficits.

Since 1995 the money supply has grown by .6 trillion or 60%. The stock market, represented by the S&P 500, has grown by 873 points or 190%; while total credit creation has surged by .3 trillion to .5 trillion or 54%. Essentially, it is the growth in the stock market that has given way to the illusion of prosperity.

*Article of Interest: Bloomberg News 1/8/01 US Economy: Consumer Debt Rises More Than Expected.

These pictures tell a thousand stories... all pointing to storms on the horizon.

As these graphs indicate, the boom times of the past few years are clearly the by-product of money expansion and debt creation. The result is that mortgage debt as a percent of disposable income*, non-farm financial debt as a percent of GDP, stock margin debt as a percent of personal income, and corporate debt as a percent of equity are all at record levels. The result is that the personal savings rate is now negative and the nation is running record trade and current account deficits. Debt is not the only bubble. The P/E multiple on the Nasdaq and the Q ratio are also at new records.

Borrowed Prosperity

Record level debt is not the makings of a new paradigm. This is borrowed prosperity—a financial illusion. These graphs portray economic and financial imbalances that have been masked by a rising stock market and low inflation rates. We have seen inflation in the stock and real estate markets. A burgeoning trade deficit and statistical manipulations by government have helped to cover up consumer inflation. The excess demand created by the expansion of credit did not create inflation in the real economy because of foreign imports. Normally, when demand is stimulated above the capacity of the economy to produce, prices rise. This did not happen because of global competition and imports deficit. The additional demand created by the Fed's money pumping was absorbed by foreign imports, resulting in America's trade imbalances.

The US financial boom of the last five years has been built by piling debt upon debt. The nation's savings rate, which is now negative, has been replaced by leverage.

*Consumer debt includes borrowing on cars, mobile homes, credit cards, from banks and other lending institutions. Mortgage debt covers first and second mortgages as well as home equity loans. The graph measures the debt service on these loans and interest and principal repayment in relation to after-tax income. Debt payments now exceed disposable income and is consistent with the graph of the negative savings rate. It implies that debt service payments are greater than income which is why the savings rate is negative.

Clintonian Economics: Tax, Spend and Inflate

Economic policy under the Clinton Administration was driven by a return to Keynesian Economics. The formula was tax, spend and inflate the money supply. As this graph indicates, taxes are at the highest they have been since the advent of World War II. The government budget ballooned from .382 trillion in 1992 to .790 trillion for 2000. Money supply has grown from .16 trillion to .0 trillion in 2000. The first major piece of legislation in the Clinton Administration was the Tax Bill of 1993. Following it, we saw increased social spending and expansion of money supply. The much talked about downsizing of government occurred mainly in one area—the military.

Rising Deficit and Phantom Budget Surplus

On December 28^th, President Clinton held a news conference to extol the virtues of his economic policies. He takes credit for eliminating the deficit and paying down the nation's debt. The President pointed to the fact that the nation's public debt had fallen to .2 trillion. Yet, the December 25^th edition of Barron's listed the nation's outstanding debt at .7 trillion. The difference between the President's number and the number reported in Barron's is what the government has "borrowed" from Social Security and other retirement trust funds.

The REAL surplus is only $.7 billion! The REAL story is in the fine print.

In the Financial Report to the Citizens, updated June 8, 2000, the Financial Management Service of the US Department of Treasury states,

"The fiscal 1999 unified surplus was 4.4 billion, or 1.4 percent of Gross Domestic Product (GDP); Excluding Social Security and the Postal Service, there was a small on-budget surplus of $.7 billion."

(Requires FREE Acrobat Reader to view pdf file.)

Essentially, our government has used most of the surplus created by increased Social Security taxes to pay its bills and more recently, to pay down its public debt. This is akin to a major corporation using employee retirement contributions to pay down its liabilities and then brag about its financial health. The difference between the President's numbers and Barron's is a debt that the government owes to a future generation—a debt that will have to be repaid.

Trading Places

Even with this so-called "good" news, the nation's growing trade and current account deficits loom in the shadows. During these last five years, while the government's budget deficit was pared down by excess Social Security taxes, the debt burden has been replaced by a trade and current account deficit now running close to 0 billion a year. This burden is even more ominous. Our budget deficit is money our country owes itself and finances internally. The trade deficit, money we owe foreigners, means at 0 billion a year, we are borrowing over billion a day to finance our consumption.

The Possible Flight of Capital

Capital inflows into this country must not only finance a soaring current account deficit, but also finance swelling capital outflows. Capital outflows were 9.8 billion in 1998, 8.2 billion in 1999, and will exceed 0 billion for 2000. These capital outflows pose an even greater threat to our economy than the preceding government budget deficits. These current account deficits have transferred large dollar assets into the hands of foreigners.

At the end of 1999, dollar holdings amounted to nearly .7 trillion. Currently foreign central banks own 8 billion in US Treasury debt. These large dollar holdings by foreigners present the biggest threat to the dollar, the policy initiatives of government, and to our financial markets. A sliding dollar could cut off capital inflows into the US, thereby causing our stock and bond markets to plunge, interest rates to rise, and result in a credit crunch, and an accompanying hard landing for the economy.

Every good mariner should take into account weather and sea conditions before heading out to sea. The above graphs and figures point to the severe magnitude of the approaching storms of economic and financial imbalances that have piled up in the US economy these last eight years. They range from huge consumer and corporate debt levels, a negative savings rate, overvalued stock markets coupled with financial leverage, a burgeoning current-account deficit and rising foreign holdings of US dollar assets. This cauldron of maladies has produced a dangerous economic mixture that is equivalent to nitroglycerin. It will take adept financial policy management to prevent it from exploding. Investors will have to exercise a reasonable degree of prudence and utmost vigilance to navigate their way through the coming storms.

Step 2: Man the Crow’s Nest & Watch the Tell-tales

Move to a Position of Observation

I have attached tell-tales along the edges of my sails. These strips flow with the wind and should be parallel with the wind's direction if I am sailing true to course. If I move off course, and they begin to droop, I know I need to adjust my course to keep my boat optimally powered. With the coming economic storms, there were will be plenty of warning signs noted by financial tell-tales, requiring a course change.

Consumer Tell-Tales

The most important player right now is the consumer. Investors should have their eye out for signs of collapsing consumer confidence, a rising savings rate, and falling retail sales. Those figures will be the first sign that the consumer is retrenching. The consumer accounts for over two-thirds of our domestic economy. Watch Christmas buying reports for the first indication that the consumer spending and borrowing binge is over. When the consumer starts retrenching, it won't be long before the economy heads into a recession.

Business Tell-Tales

On the business front, look for rising inventories, weakness in production, and declining profits. Capital investment by business is the other leg in the private sector that is holding up the economy. If profits start to disappear, capital spending will be cut back which will further weaken the economy.

Financial Tell-Tales

On the financial front, investors should watch for the stock market to reach new highs in response to rate cuts by the Fed. Failure of the stock market to register new highs in response to lower interest rates will confirm a bear market is firmly in place. In addition to the stock market, investors should be alert to widening credit spreads, tightening bank-lending standards, and rising bankruptcies. This will signal a growing credit crunch, which will dry up capital for business, thereby reducing earnings growth.

Soft or Hard Landing Tell-Tales

Whether we will face a hard or soft landing will depend on five factors. 1) Financial stress created by Fed rate hikes could cause a sharp increase in bond defaults by businesses and bankruptcies by consumers. 2) A free-falling stock market would eliminate "the wealth effect" that consumers have relied on for savings and has allowed them to overspend. 3) This could lead to an evaporation of consumer confidence, which could translate into lower retail sales and a rise in business inventories. 4) A continuation of higher energy prices could also cut into consumption causing a further retrenchment in spending. 5) Finally, there could be policy gridlock in Washington. A bitter election and partisan bickering could cause uncertainty on the political front, which would end up with an ineffective and unresponsive government. The Left is now out of power. Its greatest chance for retaking government is a major recession and concomitant bear market. Hard economic times could initiate a cry for government intervention and a takeover of the economy.

Step 3: Be Ready to Make a Course Change

The Fork in the Road

Dollar Confidence

We are now at a pivotal point in our economy and financial markets. Whether we experience a soft or hard landing or "The Perfect Financial Storm" depends on the fate of the dollar. The dollar's direction is the fork in the road. As bad as things can get here, it could get worse overseas. As long as confidence remains in the dollar and foreigners hold onto their greenbacks, the US will remain the only game in town. The US consumer is the buyer of the world's excess goods. If American consumers switch from borrow and spend to savings, foreign imports will take a major hit. Many global economies are dependent on exports to the US If the United States goes into a recession, Asia and Europe will also go into a recession. We've been the economic engine behind the global recovery.

A Policymaker's Nightmare

Nobody wants a falling dollar. A falling dollar would mean higher priced exports to the US A freefalling dollar would represent a nightmare for government policymakers on both sides of the Pacific and the Atlantic. Government officials don't want a repeat of 1985 when central bankers intervened to drive down the dollar. Once it began, it became too hard to stop, and eventually led to the stock market crash of 1987.

Policymakers within the G7 aren't ready for, nor do they want, another financial shock. Financial shocks have a way of spinning out of control, leapfrogging across institutions and markets in unfamiliar ways. The last decade has seen too many of them - Peso crisis in 1994, Asia in 1997, Russia and LTCM in 1998. The US and the Fed played an active role in containing them. What country is big enough to contain a dollar crisis?

Two Key Assumptions

In the end, confidence in the dollar is paramount, resting on two key assumptions. The first is the supremacy of the US economy and all that entails. It means confidence in our financial markets, our financial institutions, and in the performance of the American economy. The other key assumption is complete confidence in America's military might. An unforeseen event that shakes confidence could spark an unstoppable decline of the dollar. It will be financial or it will be military. It could be a derivative blowup that results in the bankruptcy of a major financial institution that ripples through our financial system. The other possibility is a terrorist attack against US military assets or a geo-political event such as a Chinese move on Taiwan, a North Korean invasion of South Korea, or war in the Middle East where we are powerless to stop.

Step 4: Take Precautions

No matter what kind of storm or series of storms buffet the US economy, it is time to take precautions. Whenever I head out to sea, I run through a list to ensure my safety and that of my crew and vessel. I review the forecast looking for signs of inclement weather. I look at tide tables, navigational charts, sea conditions, wind direction and intensity, and barometric pressure. I make sure my safety gear is onboard and functioning. I’ve been out to sea too many times when forecasted weather changes, equipment breaks down or I run across a hazard not of my own making.

The key ingredient for success whether at sea or in the market is being prepared and vigilant for the unexpected. Storms are coming. Whether a momentary squall (Soft Landing) or more severe condition (Hard Landing) or the Perfect Storm, there are steps you can take now. By preparing for the worst, the occasional squall can be an opportunity to learn and get ready for the big one.

Taking Stock

The first of the year is an excellent time to review your personal financial picture. Year-end statements help to pinpoint where you are. Familiarize yourself with the key tell-tales discussed above. Knowledge of where you are, where the economy is, and where you're headed is imperative. Develop a long-term investment strategy. Over 95% of traders, investors and fund managers are only interested in a quick buck. Surviving these storms is going to take intestinal fortitude. We live in a world of no moral absolutes. The same holds true for the investment markets. Develop a strategy, adhere to it, and ride out the storm.

Get Out of Debt

You can start right now by getting out of debt. If you have a margin account, look at how you can close out your position. If you have credit card debt, start to pay them off. If you have too much mortgage debt, consider downsizing. The important concept to understand is that having too much debt is dangerous. It's like having too much cargo onboard or too much sail, which can overpower a vessel and sink it. Debt is dangerous. It is time to get rid of it.

Increase Liquidity & Savings

The next step you can take is to build up your savings and increase your liquidity. This will give you flexibility and room to maneuver, if your financial condition or the market environment should change. Having cash can be a godsend if your job or business is in jeopardy. Cash can also enable you to take advantage of buying opportunities. If the markets plunge, it is far easier to maneuver from a position of cash, than it is to sell out a losing position.

Become Informed

You'll need to pay more attention to global political affairs since foreigners own an increasing share of our securities market. What they do will have as much influence as the Fed or Washington. Fine-tune your news sources. If you depend on network news or the daily newspaper, you're looking at the world and financial markets through a rear-view mirror. Take off the media blindfold and search for forward-looking news sources.* Look at what's ahead, rather than what's behind.

Future Installments

The next two installments of Storm Tactics will include investment strategies for a deflationary or inflationary economic environment. Before heading out to sea, mariners take a barometric reading. Before fighting a battle, a general surveys the battlefield. Before investing, a wise investor seeks to understand the investment environment. It's time to do your homework. Prepare for the storms—they're coming.

References:

The Richebächer Letter, December 2000, p. 4
The Richebächer Letter, December 2000, p. 4
https://w3.access.gpo.gov/usbudget/fy2001/pdf/hist.pdf
Barron's, December 25, 2000, p. MW70
https://www.fms.treas.gov/ note this report is no longer available. https://www.federalreserve.gov/boarddocs/hh/2000/July/ReportSection2.htm
Barron's, December 25, 2000, p. MW69

Reading Recommendations

The Intelligent Investor by Benjamin Graham
Security Analysis by Benjamin Graham and David Dodd
How to Think Like Benjamin Graham and Invest Like Warren Buffet by Lawrence Cunningham
The Research Driven Investor by Timothy Hayes
Reminiscences of a Stock Operator by Edwin Loevre

Notes for Readers:

CAUTION: This article is for information purposes only. It is general in nature and does not take into consideration any reader's personal circumstances and/or investment objectives or needs. Therefore, it has limitations and you should be aware of this. You should always seek competent, experienced professional advice before acting on anything you are unsure about. Few forecasts or strategies are ever one hundred percent correct. Most every consideration, action or strategy involves a particular or unique type of risk. Seldom is anything really a sure thing. No specific individual advice is implied or offered to any reader. This article and others on this web site deal with possibilities and unfortunately, not certainties.

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