Wealthology

by Akinaw Bulcha

  Everything seems to be more valuable but it‘s all a hoax. Just like the O.C. women I mentioned above, the American economy has been undergoing a great deal of plastic surgery since 1982. Instead of a scalpel, our economic surgeons use a printing press to create the illusion of prosperity.

  This means that most assets in our economy are still overvalued and need to come down in price. I say this because all the liquidity that had been pumped into the system hasn‘t been taken back out. Assets are worth less than we may think because the market has been flooded with credit for a couple decades.

  “You just have to be opportunistic, and try to figure out what creates value, where the bottom is, what creates incremental value, and in what combinations.” ~John Malone.

  Ugly Investments Looking at past performance of stocks or real estate is a shoddy way to invest unless we understand the history behind the numbers. Otherwise, we might wake to find our investments are giving birth to ugly babies.

  Lots of people are suckered into buying overvalued investments by looking at the past performance of markets without understanding why it‘s done so well.

  Some think that if we‘re in the market long enough, any investment will appreciate. So the thinking is that if we held anything from 1982 until today, our investment would have appreciated, just because we put in the time.

  Well that‘s not exactly true, we‘re not in a prison system—no one gets kudos for good behavior. If we look at the Dow Jones Industrial Average, there were zero gains from 1964 until 1981. In 1964 the average stood at 874, almost twenty years later, it was 875.

  “Price is what you pay. Value is what you get.” ~Warren Buffett.

  What Every Investor Needs to Know

  Unfortunately, most investors think that rising real estate or stock prices are either good for the economy or are rising because the economy is doing well. But here‘s the thing everyone, and especially real estate investors, must understand: Rising prices of assets slowly destroy jobs. And if you know anything about real estate, jobs are the most important factor in creating the demand for real estate that‘s needed for sustainable appreciation.

  To say that when asset prices go up, jobs are destroyed seems strange but it‘s a fact that‘s been acknowledged even by Federal Reserve economists. Here‘s how it works.

  When asset prices (real estate, stocks) rise, so does our trade deficit. And huge trade deficits only mean one thing: Money and jobs are flowing out of our economy.

  When a real estate investor sees prices go up as a result of the Fed‘s below market interest rates, she should slowly (1 to 3 years) get out of the market because as the rates go down, jobs and money will flow out of our economy. As wealth flows out, there will be fewer buyers available who can afford our properties in the long term. Of course, she may miss out on some appreciation at the top but she‘ll be in position to buy back in after the crash.

  The huge trade deficit and the loss of jobs is why the real estate industry is having difficulty selling its excess inventory even though mortgage rates are at 50 year lows. Without jobs, buyers can‘t afford mortgage payments.

  When prices are inflated, the equity in our homes and stock portfolios goes way up. But that growth is really a myth. Just like a rubber band, an economy returns to its original structure once we stop pulling one of its ends. Interest rates affect the value of assets in the same way. Low interest rates stretch the boundaries of our wealth beyond its true borders, making it look like we‘ve got more than we do.

  People then spend their savings, cash out some of their stocks or use the equity in their homes like a personal ATM. Saving and investment then goes down because people may feel they‘re closer to their financial goals as the equity in their homes or stock portfolios grow.

  As a result of all this credit induced fake wealth (equity growth), our priorities shift from saving and production to borrowing and spending. The logic is this: ―If I‘ve got all this equity—all this wealth—I can take it easy for awhile. I don‘t have to save or be productive.‖ Our industries begin to be dismantled and imports go up. The numbers show this scenario. Since the early 1980s, the U.S. has run an ever increasing yearly trade deficit.

  Look at the similarity between the artificially low interest rates (above) and increasing trade deficits.

  If we put the two graphs side by side, they tell the same story. As the interest rates are lowered, the trade deficit grows. There‘s an inverse relationship between the two. That means our economy has been slowly drifting towards a day of reckoning as the effects of our loss of wealth and jobs catch up with us. We‘ve been stretching the rubber band for decades and it‘s trying to snap back to its true dimensions.

  Another interesting fact that we‘ve pointed out in an earlier letter is that our economy only improves during recessions.

  The graph above shows our trade deficit shrinks during recessions when credit contracts (shaded areas). We can also see that sharp recessions are better for our economy because the sharper the recession, the faster our trade deficit shrinks. The chart above shows that during our rather severe, current Squirrelspan recession, the deficit was cut in half from almost $800 billion per year to less than $400 billion.

  So far so good right? But we seem to have a point that argues against the one I‘m making.

  “We are still masters of our fate. We are still captains of our souls.” ~Winston Churchill.

  The Bubble Economies How come the value of all assets have gone up since 1982 if our trade deficit has been increasing (money has been flowing out) since that time? Surely, we should‘ve seen the widening trade gap, become more sober minded as investors, pulled back a bit and calmed the upswing in prices. How come the unemployment rate was so low for so long if money was flowing out of our economy? We should expect asset prices to decrease if the economy has been losing jobs.

  First, I should remind you that investors are hardly ever sober. In college, my classmates swore by a cure for a hangover: Drink more alcohol. I kid you not—people really believe that. I‘m of the opinion that Wall Street believes the same thing.

  Secondly, Americans have been spending their savings (real wealth) without knowing it. It‘s taken Alan Squirrelspan that long to get us to waste our store of nuts. We didn‘t recognize we were losing money and jobs because we started with a large amount of savings.

  Thirdly, economies can go a long way by continually expanding credit. We don‘t always see the effects right away. We can go for years before an eventual bust.

  Fourthly, even if one bubble bursts, we‘ve learned to roll it over into new ones in other areas of the economy. After the dot com bust, for example, the money that flowed out of technology flowed into the real estate market (and other sectors). Wherever the ghost of bubbles past goes, it creates a new, false sense of economic growth. That false optimism creates jobs in that sector. Lots of jobs were created during the dot com bubble and millions more were created in the real estate industry before the eventual bust.

  So even though we were, in reality, losing jobs for a long time, the credit bubbles have concealed that fact. Our economic bubbles created fake jobs on credit to compensate for the real ones we were losing. The longer we go without creating real jobs, the bigger the bubble gets. It all has to come back down to earth at some point. The excess credit can‘t shift from one bubble to another, building mass forever without popping. The longer the credit inflation continues, the bigger the eventual bust.

  “I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.” ~Friedrich Von Hayek.

  The Last Bubble Government spending is another bubble that‘s been created to prop up our credit addicted economy. All the excess liquidity that‘s been building up since 1982 has now been transferred to the government‘s books. It has nowhere else to go. This is the biggest bubble of them all but it‘s a bit different than other bubbles. It can actually go for decades without
bursting.

  The government can go on spending beyond its means much longer than a homeowner is able to. The government is different because we are its equity. We are the State‘s collateral. All our work, joy, pain, hope, laughter and love can be crumbled up like wads of paper and thrown away because the reality of the matter is as long as our future can be borrowed against, we‘re all slaves.

  If our lives, our future earnings and future standards of living can be collateralized like a home equity line of credit by the State, what else are we but slaves?

  Sooner or later though, even the government must have ugly babies. We‘re at that point in Squirrelmerica. Social unrest is increasing and the government doesn‘t know what to do. They can kick the can down the road but not forever. The longer they postpone the inevitable, the worse our problems will become.

  “Emancipate yourself from mental slavery, none but ourselves can free our mind.” ~Bob Marley.

  Uncle Sam’s Schizophrenia Now let me show how completely contradictory the government‘s actions are. You‘ll clearly see what can happen if you start a train of economic reasoning on false assumptions. In order to reduce the $13 trillion federal budget deficit, the government needs to collect more taxes; but it can only do so if jobs are being created. So, we can assume they want to create jobs. But they‘ve got a problem. Real jobs can‘t be created if we‘ve got annual trade deficits of $700 billion.

  The problem is that the Fed, as Plastic Surgeon In-Chief (and silent partner with the Federal Government), keeps lowering interest rates to make the price of assets look higher, which then causes consumers to spend trillions on imported goods. In this way, the government is fighting against its own goal of creating jobs! The Fed should in fact be increasing interest rates to stop the outflow of jobs and money.

  Look at the first graph above again. You can see that our economy is caught in something called ―a debt trap.‖ The interest rate graph looks like stair steps going down, always finding a new low. When the Fed tries to take the credit out of the system to avoid inflation, there‘s a recession and the central bank is again forced to pump in more money and the cycle is repeated. Remember that the Fed has created addicts (refer back to the ―Central Dealer‖ part in the letter on entrepreneurship) but now wants to outlaw drugs.

  “Losing an illusion makes you wiser than finding a truth.” ~Ludwig Borne.

  Why the Fed Wants Higher Asset Prices Our Fed Chairman, Ben Squirrelnanke, knows that allowing the economy to go into a deep depression will quickly cure all our economic problems but he‘d be out of a job. All the debt we‘ve accumulated can be liquidated. He doesn‘t want that to happen. Why? Well, because the Fed seems to only have one goal: Making asset prices appreciate (as if that meant there"s more wealth in the system) even if that contributes to an eventual loss of jobs, inflation and the destruction of our economy.

  I know this sounds strange but these are the facts. It doesn‘t sound so crazy when you remember that the Fed is a private organization created to serve big bank interests. The interest of banks since the beginning of time has always been to increase the amount of debt in circulation because the more that‘s lent, the more interest they can collect.

  They must have such an ulterior motive because anyone can see how crazy it is to think an increase in the paper value of our assets means we‘re wealthier. From 1994 to 2004, the total net worth of American households doubled from about $23 trillion to $46 trillion. Was that real wealth creation or was it a result of ultra low interest rates that inflated prices beyond their real levels? That huge jump in the value of household wealth coincides with historically low interest rates (look at the graph again). It wasn‘t real. What were real were the bank profits all that fake wealth produced.

  When you really think about what the Fed is really doing by basically shipping trillions of dollars to China and other Asian economies, you get the nagging suspicion Easy Al Squirrelspan and Ben Squirrelnanke are Chinese spies. After all, the correlation between money outflow and low interest rates is very obvious.

  I recently read an article by an economist who was surprised to find out that a possible way to reduce our trade deficit and strengthen our economy was to lower the value of the equity in our homes. He shouldn‘t have been surprised.

  “A great deal of intelligence can be invested in ignorance when the need for illusion is deep.” ~Samuel Bellow.

  The Credit Addiction Will End As long as our economy is awash with credit, investors who don‘t understand how that affects the value of their long term investments will wake up one day with lots of ugly babies.

  And when that happens, the plastic surgeon‘s response will be to perform even more surgeries to fool more investors. The only way to stop the ugly baby epidemic is to put down the scalpel—stop the money printing press. At least then, we can better predict what kinds of babies we‘ll have.

  When I think about what‘s going on behind the scenes of our economy, I‘m reminded of the story of Howard Hughes. When he was young, he was well kempt, dashing and dated the most beautiful movie stars of his day. But after suffering massive injuries in a nearly fatal plane crash, his life changed.

  He slowly became addicted to pain relieving drugs. As the addiction grew, it also worsened the obsessive compulsive disorder he‘d partially kept under control until that time. For years, he locked himself away in dark hotel rooms, at times sitting naked in one spot for months. His hair, nails, beard all grew long and mangled.

  When he died, the autopsy revealed a bony, scraggly, disheveled old man whose body was full of dope and whose arms had multiple needles broken off in his veins.

  That‘s a picture of what‘s happening to the American economy. Our drug of choice is credit and that drug triggers our compulsive disorder— spending. The spending in turn makes us even more dependent on more credit. And that transfers even more wealth to foreign economies as our trade deficits continue to grow.

  For years, it was thought cheap, overseas labor was the reason our trade deficits kept increasing. Those two graphs above prove that the problem is our own. We‘re one of few nations running a trade deficit with China, they‘re not to blame.

  “Paper is poverty….it is not money, but the ghost of money.” ~Thomas Jefferson.

  What Can a Brotha Do?

  Kidus, here are a few ways to use this information for investing purposes if you get to the States:

  Understand that real estate appreciation depends on job growth and that huge trade deficits slowly ship money and high paying manufacturing jobs overseas. For this reason, the real estate problem will continue for years. So it doesn‘t matter if rates on mortgages stay below 5%; if jobs aren‘t being created, you can‘t expect real property appreciation. Think about investing in real estate overseas. Find partners, investment vehicles (such as REITS) and deals in China, Mexico, India, etc.

  Stay out of the real estate market until Uncle Sam leaves it alone. Recently, there was a huge drop in real estate sales as the ―Bribe Buyers at the Expense of Renters‖ tax credit program ended. We shouldn‘t be surprised of course because when you give buyers an incentive to buy now rather than later, you‘re simply carrying demand forward. There‘s always a limited amount of buyers in the marketplace at any given time, when you upset that ratio through tax credit schemes (easy credit does this as well), quick up and down price swings is the result. Who knows what the government will come up with next? Like most real estate investors, I want to flip properties but it‘s too risky, so I‘m doing something else.

  Don‘t buy domestic stocks. Stocks of U.S. based companies are overvalued and will be so as long as the trade deficit continues to grow and interest rates continue downward. Trade deficits are a better indicator of our economy‘s health than the price of assets. As long as the government pushes people to spend instead of save and invest, our economy will slowly sink into a pit. If I could ask you to remember one thing from this letter, it‘s that spending is at the root of our problems because most of what w
e buy comes from overseas.

  Invest your money overseas or in commodities. Massive amounts of money will be printed to sustain artificially high prices of assets in the U.S. as Ben Bernanke will do his best to ruin our economy.

  Don‘t invest in U.S. Treasuries or government bonds. If rates stay down for a long time, remember that inflation and the collapse of the value of the dollar will be the inevitable result. If the Fed acts responsibly and rates go way up to calm inflation, the price of bonds will collapse.

  Stay away from investing in most industrialized nations as they‘ll experience much less growth than their Asian and Latin American counterparts. Comparing the two is like placing the young, dashing Howard Hughes alongside the long bearded, mangy, drug addicted one. Debt has a way of destroying wealth. Europe, Britain and the United States are in the middle of a debt crisis because they‘ve slowly become credit addicted welfare states.

  Make sure that your investment perspective is at least 10-20 years out. It can take a long time for us to see the consequences of government action. It took us 25 years to feel the consequences of credit growth. Knowing what things are worth takes a little bit of detective work and it‘s easy to fall in love with that beautiful investment. Therefore, understand that it‘s possible that our economy can go through another ―decade of zero growth.‖ Fed chairman Ben Squirrelnanke is doing his best to stop our economy‘s recovery by injecting more drugs (credit) into our economy‘s veins.

  Be skeptical but optimistic. Nietzsche once said that if you stare into an abyss long enough, it will stare back at you. In a similar way, I‘ve found that if I focus on what the government and its central planners are doing to our economy, I‘ll find the truth about what things are really worth. That makes me a better investor. We can‘t be great investors without understanding how the economic policies at the top affect our livelihoods.

  You can still make money by quickly getting in and out of the market. If you‘ve got the cash, you can still buy and sell real estate to make some money. You can‘t get greedy and you‘ve got to be quick.