Eye of the Storm, Part 2

September 28, 2014

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Last week in “Part 1,” I began by asking, “What’s normal for financial markets and investing?” Together, we re-lived some of the 20th century’s incredible achievements, calamities, and triumphs. We then considered whether this new century’s version of “normal” would be similar to the 20th century – or whether things might be different now. We pondered the possibility that the slower economic growth (2.2%) of the past 5 years could represent – as Mohamed El-Erian predicted in 2009 – a “new normal” the U.S. will have to contend with for many years – or decades.

I closed “Part 1” by asking you to consider whether you really believe the notion that the U.S. is unlikely to get back to its 100-year average of +3.5% real economic growth (which would be a 61% improvement compared to the past 5 years). I presented a few quotes from leading economists citing reasons why today’s weakness may continue, including retiring Baby Boomers (Kelly) and the fact that the 2008 crash was not caused by the normal business cycle, but rather by “excessive leverage, extreme debt entitlement, and irresponsible risk-taking and credit extension” (El-Erian). I even referenced a recent video from Bill O’Reilly citing many social and economic concerns that seem to forecast a challenging future for America and the world. Of all the concerns cited, most seem highly likely (but not certain) to remain with us well into the future.

Finally, at the end of “Part 1,” I promised you that this week, “Part 2” would introduce A NEW TWIST to the “old normal” vs. “new normal” debate. I’ll also get into what all this means for normal people like you & me who simply want to prepare for a happy, comfortable life and retirement. Here’s the twist:

The “Twist”

I’m reading a fascinating new book called The Death of Money: The Coming Collapse of the International Monetary System,* by Jim Rickards. Sounds like an uplifting read, right? Yet I’m reading it – because I feel I must understand the things Mr. Rickards does (as much as I can, anyway).

Rickards is no crazy, fly-by-night, un-credentialed kook running around & shouting “The sky is falling.” If he were, I assure you I wouldn’t have time to read his book. On the contrary, Rickards is a true expert on the global financial system, and one of the most qualified people in the world to write on his topic. The book is fascinating and in-depth, albeit quite technical and at times difficult to read.

The bottom line so far, unfortunately, seems to be that a dollar crisis is very likely to occur at some point. And unfortunately, I can’t disagree with many of the problems Rickards sees in our financial system today.

Now, to be sure, the dollar has barely budged in the last 3 years. The dollar does NOT presently look like it’s teetering upon an imminent crash, at least not when compared to foreign currencies. Basically, none of us should get ahead of ourselves in clamoring that the dollar is dying tomorrow, next month, or even next year. It simply hasn’t started happening yet! Maybe it won’t happen for many years. But the book warns about underlying fundamental concerns – including things that are happening now – that could yet cause the death of the dollar.

Many experts agree if & when the dollar does start to unravel, it could happen very quickly – and have vast ramifications. Rickards says on page 1 (emphasis added):

“If confidence in the dollar is lost, no other currency stands ready to take its place as the world’s reserve currency. If it fails, the entire system fails with it.”

Obviously, becoming informed about this topic is of very high importance for investors.

I bring up Rickards’ book because in it, he adds the “twist” to the idea of markets being in a “new normal,” as follows (p. 289, emphasis added):

“Investor Mohamed El-Erian… popularized the phrase ‘new normal’ to describe the global economy after the 2008 financial crisis. He is half right. The old normal is gone, but the new normal has not yet arrived. The global economy has fallen out of its old equilibrium but has not stabilized into a new one. The economy is in a phase transition from one state to another.”

Transition?

When I first read Rickards’ assertion that our economy is in “transition” between the “old” and the “new” normal, I thought, huh, wouldn’t a “transition phase” be full of turmoil? Yet instead (as I’ve documented in this blog the last couple months), markets have been remarkably calm. If we are, in fact, in transition, it’s a surprisingly serene one.

My next thought, then, was that a hurricane is always calmest in its very center. Are we in the “eye of the storm” right now?

Rickards continues (p. 4, emphasis added):

“The world economy is not yet in the ‘new normal.’ Instead, the world is on a journey from old to new with no compass or chart.”

Uncharted Waters

Remember, even after the initial crash of 2008, economic growth has averaged only +2.2% since July 2009. This represents the weakest recovery from a major crash in U.S. history. Uncharted waters.

Central banks in many countries (led by the Federal Reserve here in America) have embarked upon a massive experiment involving overnight interest rates near zero, long-term interest-rate manipulation via printing money to buy up government bonds, and other monetary operations. Japan, Europe, and other developed countries are all taking part in this Grand Experiment, the likes of which has never been tried. Uncharted waters.

Even El-Erian’s original 2009 rationale is that the “new normal” would be different from the “old normal” precisely because the economy was entering uncharted, unprecedented territory. Said El-Erian (to Kiplinger magazine on 10/19/2010, emphasis added):

“We think that the global economy and markets are on a bumpy journey to a new destination, the vehicle is being driven primarily by policymakers, and they have already used the spare tire.”

Rickards says this about today’s markets (p. 4):

“(Investors) have a misplaced confidence that central banks (like the U.S. Fed) can save the day; in fact, they are ruining our markets.”

Heck, even Mr. Ben Bernanke himself said (in a June 22, 2011, press conference, emphasis added):

“We have an awful lot of uncertainty right now about how much of the slowdown is temporary, how much is permanent.”

Bernanke’s statement seems to be an admission that there’s at least some likelihood that this “slowdown” could be a “permanent” “new normal” – or perhaps a “transition” phase full of “uncertainty.”

So here we are. Instead of remaining in the 20th-century “old normal” or being in a 21st-century “new normal,” perhaps we’re right in between – still trying to figure out what’s next. I have to agree with Rickards and El-Erian that we’re in uncharted waters with no compass or chart. Excessive government debt, private debt, Fed manipulation, persistently low interest rates, vast expansion of government taxes and regulation, and a growing segment of society willing to allow government to intervene in their lives all signify that this time may be different.

In the meantime, markets have been lazily, almost obliviously “melting up” instead of “melting down.” I addressed the tranquility – dare I say “complacency”? – in my Labor Day market update. What will the next 12-18 months bring? More of the same? Are we truly in the midst of some kind of “transition phase”? Is this the “eye of the hurricane”? Or will everything return to “normal” soon enough? Maybe the calm markets we’ve seen since October 2011 will prove to be the real “new normal.” (I seriously doubt it). So many possible scenarios. So few concrete answers. Speaking of which…

How to Prepare for Whatever Lies Ahead

The idea that we’re now in either a “transition phase” or a “new normal” seems likely. If we’re in a transition, what are the best investments for this phase? And what will the “new normal” be? Perhaps markets will simply return to the “old normal” (we can only hope). Or perhaps we’ll live through tremendous turmoil at some point, followed by a new global financial system that replaces our current one (and would be unrecognizable to 20th century investors). Rickards lays out several possible future scenarios, including a deflationary depression, hyperinflation, financial terrorism, and more.

Here are my insights about investing in today’s challenging environment and remaining positioned for the future:

Have a strategy in place to protect against large losses. This is Step #1 for a reason. It’s essential in any environment.
Maintain enough flexibility to seize any opportunities created by violent market cycles – while continuing to protect the vast majority of your portfolio against the risk of loss. If you read my work regularly, you know I believe this is also essential in any market.
Recognize that the strategies that worked in other market environments – like the high-interest-rate days of the late 1970s, or the boom years of 1980s and ‘90s, for example – may or may not be the same strategies that work best today.
Make sure you remain nimble enough to make changes as conditions evolve. Interest rates may increase, for example, or stock markets may collapse, and you’ll want to be able to profit from any such shift(s) – without being wiped out by the shift itself first. This is also always essential.
Remember that none of us can predict what will happen. Maybe the “current normal” will persist for many years before turbulence really strikes in a big way. Or maybe we’re on the doorstep of major upheavals even now. The best thing you can do is to stay on top of your portfolio at least once per month, using your Take Time for This monthly guide as a trusted resource to keep you on track.

Death of the Dollar?

Is now the time to batten down the hatches and prepare for collapse? I have to say, as I look at today’s markets, a collapse does NOT seem to be upon us. So I’m not predicting any immediate calamity, or even that it will ever happen. But I do think some radical shifts in the global financial system are very likely to occur at some point, and I want very much to be prepared, as well as to help as many of you as I can to prepare.

What if U.S. and global economies and markets simply continue to “muddle through” (to borrow John Mauldin’s term) for many, many years without an outright collapse? What investment strategies should you follow in that scenario?

What investment strategies would be best immediately before, during, and after a crisis?

Rickards’ book provides tremendous analysis and insight. Recognizing that I haven’t yet finished reading it, here are some more observations on topics of interest.

Transition phase: First, Rickards elaborates on the idea of a “transition” period by using an analogy:

“When wood burns and turns to ash, that is a phase transition. There is no easy way to turn ash back into wood. The Federal Reserve believes that it is managing a reversible process. It believes that deflation can be turned to inflation, and then to disinflation, with the right quantity of money and the passage of time. In this, it is mistaken.

“The Federal Reserve does not understand that money creation can be an irreversible process. At a certain point, confidence in money can be lost, and there is no way to reconstitute it; an entirely new system must rise in its place. A new international monetary system will rise from the ashes of the old dollar system.

“Loss of confidence in a monetary system can rarely be restored.”

Death of the dollar: Rickards presents a case that many nations would love to see the dollar’s “global reserve” status replaced by an international currency, probably issued by the International Monetary Fund (IMF). He points out several incremental steps toward such a system that are already in motion, but says the real shift is likely to occur rapidly next time the U.S. has a crash or a financial panic.

Investment recommendations: Of course, Rickards discusses gold, land, other real assets, foreign currencies, and hedge funds (for qualified investors). He (understandably) stops short of making actual investment recommendations, partly because his book lays out so many possible scenarios for how the future could play out. I find his book very helpful in terms of thinking through what events could unfold, what the catalysts might be for change, and how markets could react under various conditions and sequences of events.

Signs to watch for: Rickards suggests paying attention to several signs that, should they occur, could indicate the dollar system may be crumbling in favor of a new system. Among others, signs that the risk of collapse is increasing include these:

Any major changes in the price of gold (either direction)
Major gold purchases (in the thousands of tonnes) by China and other countries’ central banks
Larger voting power for China in the IMF
Global corporations issuing bonds denominated in an international (IMF) currency instead of the dollar
The Fed’s inability to stop printing money
And so on.

By the way, Steve Forbes also has a new book on this topic, released in May 2014. Forbes’ work is entitled Money: How the Destruction of the Dollar Threatens the Global Economy – and What We Can Do About It. I’m eager to read this one as well.

So far, I’ve read only an excerpt from Money, in which Forbes says U.S. monetary policies have already led us to an era of “declining mobility, great inequality, and the destruction of personal wealth.” Remember, Bill O’Reilly also mentioned (in the video I linked to last week) that government policies have helped create – not helped prevent – income inequality. Hopefully this phase of “personal wealth destruction” will be merely transitional in nature; surely, personal wealth can’t be destroyed forever, right? Or will “the 1%” of the future be “the 0.1%”?

Isn’t There Any Good News?

Of course, in the absence of a major collapse or “the death of the dollar,” many experts continue to point to many powerful reasons for optimism. Many opportunities exist today that seem likely to prove profitable in the long run, which is why my portfolios continue to recommend a certain amount of moderate and aggressive investments.

The lead Yahoo! Finance article & video one morning last week was an interview with a very smart analyst, Brian Belski (whom I met years ago when we both worked for the same firm), in which Belski declared the stock market has another 15 years of upside remaining. Wow! Maybe things will turn out that great, and stock investors will beat inflation by 6% again. I don’t think so (at least, looking forward from today), but a lot of experts do. Brian Wesbury, chief economist at First Trust (whom I’ve also had the pleasure of meeting), contends that technological innovations like fracking, 3-D printing, smartphones, apps, the cloud, biotech, nanotech, and so on – are “changing our economy massively,” and will drive future growth “in spite of bad government policy.” Wesbury is one of my very favorite economists, and he also believes the stock market has room to run (to the upside).

Which of these scenarios will come to pass? Remember humility. None of us know. The best way to prepare yourself and your portfolio for the future is to build the vast majority of your “Retirement War Chest” (not nest egg) upon a solid foundation, while reserving a much smaller amount for “Aggressive Growth Opportunities” (preferably when the market throws what Warren Buffett calls a “fat pitch”). Meanwhile, remember that some of the “opportunities” may include assets beyond U.S. stocks – perhaps including gold, oil, real estate stocks (REITs), emerging countries investments, and so on.

* Rickards, James. The Death of Money: The Coming Collapse of the International Monetary System. New York, New York: Portfolio/Penguin, 2014.

This article is for informational purposes and does not constitute individualized investment, financial, tax, or legal advice. See additional disclosures here.