Our current investment trauma marks the end of an era of excesses in credit and real estate markets, of course.  But it also denotes that the United States is undergoing a far more general and significant transition - not only to a new government with a radically different agenda, but more lastingly into a whole new climate for investments. 

Gone is the era of wind-to-the-back investing powered since 1982 by continually lower interest rates and the virtuous influence of the baby boomer demographic bulge working its way through the U.S. economy with its high spirits, sense of entitlement, the confidence that it can and should change everything to suit its own needs, its increased demand for goods and services, and its great labor force to help produce them. 

Welcome to the new world of wind-in-your-face investing as short term rates can only go higher from this point (with long rates to follow soon enough) and baby boomers each year becoming a greater economic albatross - consuming social security, medicare, and other services that must be provided by a declining number of working Americans as the boomers increasingly stop working.   

America must now adjust to lower asset values, a lower rate of consumption, and a higher rate of savings. That doesn’t mean we can’t have a pleasant life and a return to a stable, growing economy eventually.  After all, even at the bottom of this downturn some 85% - 90% of Americans who want jobs will probably have one.  But it means the rich cannot continue to consume a growing share of the GNP since the need to fix the yawning federal deficit will eventually require higher taxes on the wealthy, and since the past era’s unconscionably high executive compensation may be ending, and since executive options are no longer providing windfall profits.  It also suggests that America’s free lunch whereby we exchange paper for the world’s goods is not likely to continue for too long.  

The key word in the above paragraph is “adjust.”  Anyone who’s experienced an important loss understands adjusting.  The painful and much analyzed “stages” of adjustment - popularly recognized as denial, anger, acceptance, etc. - are now about to unfold.  We seem to be part way through denial at this point - people know that times are tougher but they think the pain will pass fairly soon, which may not be the case.  It would not be surprising if the anger stage led to more war.  One commentator recently opined that WWIII has already begun.  Past global economic dislocation has led to important wars. 

An appropriate (if unoriginal) metaphor for the investment implications of our transition is the ship on a stormy sea. While a storm is raging passengers stay off the deck, they “batten down the hatches.”  In investing terms they go to cash.  Storms sometimes have “eyes” and a ship passing through the eye can think the storm is abating although it really is not.  For investors these eyes are called bear market rallies - of which there can be many.  We have seen many such rallies already since the bottom fell out after August.  Who knows how many more false rallies will come?  

We all want to know when the “all clear” signal will sound.  We can easily be convinced by false rallies that the skies have cleared.  But the true end of the storm will be determined only by the real economy, which nobody can predict at this time because of the risk of deflation.   

Deflation

The Energy Investment Strategies web site has not focused on energy much lately.  Rather, I’ve been writing about deflation (here, here, here and here) because whether or not the economy falls into deflation will determine the duration of the present investing storm.  If we avoid deflation, a recovery could happen in 6 - 18 months.  If we get real deflation, the storm could last much longer for two simple reasons. 

First, if deflation takes hold it becomes a self-perpetuating condition that is extremely hard to defeat.  Deflation implies a vicious cycle - a negative feedback loop - that can cause continually increasing amounts of economic pain as lower prices lead to less profit, lower employment, lower consumer and capital spending and back again to lower prices. 

Secondly, during a deflationary period it makes perfect economic sense for investors to hold cash because cash is the one asset that gets more valuable in a deflation as the prices of goods, services and assets decline (the definition of deflation).   Therefore, the fact that a huge percent of investment assets is sitting in cash during a period of deflation is not necessarily short term bullish for stocks; that money can stay in cash for a long time.  Thus stock prices that are falling can tend to continue to fall, further contributing to the negative feedback loop of deflation.

Economists disagree on where we are now and what will happen but some of them think deflation is already baked in.  Here’s what John Mauldin said in his most recent letter: ” For a very long time, I have been adamant that deflation is in our future… For now, deflation is the economic factor that the Fed and central banks will be battling. And believe me, it will be a very large and controversial battle.”

We now see some deflation.  The prices of assets - houses and stocks - have been declining for many months.  Americans  are cutting  back their spending and increasing their savings, which causes deflation because less spending leads to lower prices. The price of labor is starting to decline as people give up bonuses, agree to work fewer hours for less pay and start to compete among themselves for the remaining jobs that cannot be outsourced overseas to even cheaper labor markets.  Companies like Gannet are simply calling time out and putting employees on unpaid furloughs.  

Here’s a report from the field that I heard of just yesterday.  A friend advertised on Craig’s List for a part time file clerk at $15 per hour in San Francisco, not a low-cost-of-living venue.   Within two hours he had received…sit down…over 800 responses.  That story defines the time in which we are just starting to live, and those times are starting to look like deflation.

There is one other and even more pernicious component of deflation: expectations.   When everyone expects prices to continue to go lower such expectations cause people to hold off purchases in the reasonable belief that prices will be lower later.  They buy only at the very last moment when they must have something. We’re not there yet, I think. We don’t yet have a pervasive expectation of lower prices.  But we’re not far away, I would guess.