Good Afternoon Everyone,
Keep in mind that finance is complicated precisely because of the profit opportunities that can be derived in this complexity. (note: derived leads to derivatives)
Whether you are an accountant, lawyer, doctor or financial planner, the less your client understands, and the more they are dependent upon you, the more profit that can be made.
European and Asian markets foreshadowed a 1,000 to 1,500 Dow decline on Monday January 21, 2008 (US markets closed). This brought an emergency 0.75% Fed cut.. All the Fed action accomplished was to delay, not eliminate this drop.
Notice how quickly we went from no recession talk, to denying a recession, and now to looking past the recession. All without the requisite actual, factual earnings decline that must accompany a recession. Surely a great many companies will be priced higher two or five years from now but some will and must be squeezed out during the next six months. The inability for anyone to predict with 100% accuracy which companies will be good and which will be bad is precisely what will lead to future devaluation in all companies. The larger indexes must reflect this uncertainty, a delay is not prevention.
The Fed’s and Congress’s moves just save some financial companies from bankruptcy and will also feeds inflation. In fact, they haven’t changing anyone’s income statements, individual or corporate. Just as with the Smoot-Hawley Act in 1930, which has been universally acknowledged as exacerbating the depression, political Machiavellianism can sometimes be economically short sighted.
But what makes this Fed move Machiavellian? First, ignore the obvious political uses of delaying the actual stock crash until after the election. The real money is in looking at the money.
Lets examine the situation of a new retire with three million invested and retirement income of a pension and Social Security that is sufficient to cover 125% of their current retirement costs.
In their investment portfolio rapidly decreases, lets says over the next ten days, to only two million (33% drop, typical bear market), while at the same time prices for basic goods like oil and food fall to allow their pension to cover 150% of their expenses. Not only will their standard of living go up but they will be able to put 50% of their excess income toward purchasing investments at a the new, immediately lower, prices.
What’s really happening?
Let’s look at this same individual with the same decline in their investments from three to two million, but over two years instead of ten days. Let’s also add inflation which changes the impact on their standard of living. Rather then covering 125% of their cost of living, their retirement income will only cover 100% two years from now and then 50% in ten years and 25% in fifteen years. This sixty-five year old who retired with $3,000,000 will become insolvent in 2010 and bankrupt in 2032 at eight-nine years old.
Of course this assumes 10 percent inflation per year due to continued “easy money” in the future. This also assumes that the CPI continues to grossly understate inflation and subsequently under-adjust CPI pegged retirement benefits.
Actual Inflation over the last two years
Oil up 19% per year, 38% totals from $65 to $90
Gas at the pump up 25% per year, 50% total from $2.30 to $3.00
Gold up 35% per year, 70% total from $515 to $890
We all have observed inflation in our own lives, from milk to eggs, and beyond to college costs. The street is crying that deflation is bad, and it is for those that owe money. Deflation is good for those that own don’t owe money; middle-class Baby Boomers anyone??
The wisdom to know the difference between what should be done and what will be done has never been more important.
Have a nice day.
PS The video below is a good mockup of 2007’s Irrational Exuberance