Debt, Inflation and the Stock Market

Federal Reserve Chairman Ben Bernanke recently warned Congress:

Maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance...Unless we demonstrate a strong commitment to fiscal sustainability, we will have neither financial stability nor healthy economic growth.

The Obama administration projects total U.S. debt to increase by $1.8 trillion in 2009, with more to come in 2010. Funding of large deficits, approximating 12% of GDP for several years, poses a challenge for the dollar and for economic growth.

It should be obvious to all that we can't get out from under our mountain of debt through spending. We will simply have to go back to the old fashioned solution of hard work and productivity, cutting expenses and growing our economy until it regains its balance.

This is simple, but not easy. Yet it is not impossible, either. It takes sacrifice and commitment, but it can be done. And it has been done before. After World War II, total debt-to-GDP ratio in the U.S. was 125%, and by 1980 it shrank to 25%. America has a history of facing her problems and dealing with them (compare this to Japan, which over the past decade has consistently been at a ratio of over 150%).

Furthermore, because of the aggressive fiscal policy and expansionary monetary policy the country has engaged in recently, it appears inevitable that we will experience inflation, and perhaps a significant bout of it. With low interest rates and unprecedented levels of spending, this would be the only logical conclusion. And history shows stocks are almost alone an effective hedge against inflation. Cash and fixed income securities will be pulverized under the pressures of inflation, lose significant real buying power and not provide an appropriate protection.

Assuming we are going to face reality and respond wisely, it makes sense to stick to a disciplined investment program in equities. Consider this: Stock indices plummeted more than 50% from their peak in October 2007 to their March 2009 bottom, erasing 12 years of gains. The only time the stock market had fallen harder was between August 1929 and June 1932, when it lost some 83% of its value. It took the Dow Jones Industrial Average 25 years to climb back to its 1929 peak during the Great Depression.

Nevertheless, those who invested $10,000 in the index every year throughout that time turned a total investment of $260,000 into $1.7 million, an annualized compound return of 12.5%, which was much better than any available alternative.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at [e-mail].

Comments

[greyhound2]

The problem is confidence. I have more confidence in a Las Vegas casino than in the Wall Steet casino. At least in Las Vegas, there is strict regulations by the State of Nevada to keep casinos honest and make sure they are not cheating. The Wall Street casino does not have those same protections and gives new meaning to a crap shoot.

[higgins1990]

"We will simply have to go back to the old fashioned solution of hard work and productivity, cutting expenses and growing our economy until it regains its balance. This is simple, but not easy. Yet it is not impossible, either. It takes sacrifice and commitment, but it can be done."

One problem: There are a shortage of grown-ups in Congress who understand sacrifice, hard work, and cutting expenses. Consumer confidence has slipped, and from polling the people I know, it is mainly due to a lack of confidence that Congress will be able to deal with the debt, and in fact, continue to drive this country into the ground. Buckle up.

[Aaror]

I don't disagree with you as much as usual, which is surprising, but I want to tackle one of your points, and one of your implied points (hopefully I am not attacking a straw man here).
I am not worried about inflation until the recovery, because right now several trillion dollars were destroyed by the various crashes, and so fewer dollars are chasing goods, leading to a slight deflation at the moment. I disagree with the actions the Fed took to fix that problem (lets give the banks money to replace the lost liquidity, rather than giving it to the government to spend without increasing our debt), but I realize the slipperly slope once you allow the government to spend created money instead of borrowed money. I do admit that I expect steep dollar inflation (with certain other currencies strenghening because of it, probably the Euro most of all) once we recover, as people move money from T-bills to stocks, which I anticipate will cause a T-bill and dollar crash of some sort. T-bills are overvalued, and when they fall I expect folks who were recently burned on stocks and told that T-bills were safe to panic.
Con't

[Aaror]

con't
As for the implied question of whether the debt we are taking on as a nation is positive or negative (i.e. can we afford it?), or should we reduce spending and raise taxes, I tend to think we should keep up the deficit spending-with certain misgivings.
As a hedge fund manager, I would hope that you understand and agree with investment, even on margin, when yields are high enough and garunteed. Normally garunteed high yields are only available from folks like Bernie Madoff, but for the US government, investments in highways, bridges, and other infrastructure pay high yields in increased tax revenue from increased GDP. Likewise, investing in education pays huge yields. I am sure you can think of others.
If we run a big deficit, we can pay it back if our borrowing is for an investment like infrastructure spending.
Now if you borrow money for a fun boondoggle, whether it is a personal loan for a cancun vacation or a government borrowing for a war in Iraq, you don't get a return on that money, so you would be foolish to finance such a project.

[dawnone]

Increase the productivity of whom? Does cutting expenses, hard work, and increased
productivity apply just to lower level workers, or is this a call for change in the
executive class, especially in the financial industry? Cap those salaries, return those
bonuses, sell those private jets, limit the expense accounts and business junkets, etc...

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[petef59]

Think maybe it is a llttle too early for Finance Industry people to be preaching about the "hard work and productivity" we all need to rescue ourselves from the economic situation?
The stimulus programs have barely been implemented and the author is also proclaiming failure for them. Maybe the concept of honesty should be studied by the finance people. After all, the productivity gains of the majority of workers has been skimmed by the Finance industry since the erly 1970's. Better yet, they should all shut up, change careers and let newer college grads stick to the basic of fiduciary reponsiblity. Enough of 'creative financial instruments.'

[Sundialsvc4]

I firmly believe that we cannot hope to accomplish anything until we squarely address the crime in our financial institutions ... and the high crime in Congress which serves them.

[hearmeout]

So you're suggesting that the stock market lows reached in March of this year are the lows of this cycle, and that it's up from here? It seems like the data - both from 1929 and from 2009 - suggest something different: that lower lows - perhaps far lower lows - are yet to come. Consumer spending has dropped further and faster than any time since the 1930s (when it drove considerably less of our GDP), unemployment has risen faster (4+ percent year-over-year, and that's with the government hiring like mad) than it has in generations, our total debt load (government, corporate, consumer) is far higher than it's ever been (approaching 400 percent), both world trade and industrial output are plunging faster than any time since the 1930s, the banks are far unhealthier than we're being led to believe and still facing large scale defaults from commercial real estate, credit cards, option-ARMs, etc., personal bankruptcies have risen almost 40 percent in a single year and are rising at the fastest rate ever recorded (and that's with the law being re-written to make it far more difficult to declare), we have deficits that literally dwarf anything we've ever seen which will invariably put pressure on the dollar, interest rates, etc., and you're suggesting that the stock market is up from here?

Or did I just read you wrong? For your clients' sake, I hope so.

[metalpipe]

Here are my bets. GLD, UNG, PIO, SLV, BRF, UNWPX, and FDIVX. Slightly weighted towards metals in the short term. Good luck to all.

[elkabong]

I'd bet on deflation and possibly depression long before we get any significant inflation. That's why all the big investors are hanging on to most of their CA$H.

What we need is to start making things - you know, IMPORTING raw materials and EXPORTING finished goods.

We'll never find prosperity pushing more paper around.

[Hailmaryyy]

Why does it seem inevitable that we will experience a significant bout of inflation? Inflation never returned to the U.S. in the 1930's despite all of the spending for the New Deal. Deflation is a much bigger risk right now than inflation.

As detailed in How America Can Escape the New Great Depression, the only viable solution is for the Fed to be much more aggressive in printing money.

http://www.escapethenewgreatdepression.com

[vagabondvet]

A) You're wrong. Between 1934 and 37, there was inflation. http://oregonstate.edu/cla/polisci/faculty-research/sahr/pc1915ff.htm

B) Every single time in history that aggressive monetary expansion (read: hyperinflation) has been tried, it has not only failed to bring about real economic growth, it has destroyed currencies and countries. You might not believe this, but Weimar Germany, Zimbabwe, and Argentina come right to mind.

[research]

12.5%? What was the inflation adjusted gain?

Trickle down does not work. Trickle down is what giving money to the bankers is all about.

Even the stimulus tend toward large company giveaways, and more stupid derivatives like cap and trade.

We should be directly stimulating Main Street with gov order for rooftop solar and bio char. We should make sure that small companies get a large portion of that.

[in10se]

The inflation rate from 1929 to 1954 (25 years) was 1.6% so the inflation adjusted return was still over 10% ANNUALY

[Aaror]

I agree cap and trade is stupid. Obama should ask people if they would be in favor of a 10% reduction in income tax rates/collections and making up the revenue shortfall with a carbon tax. It makes sense to tax the things you want to discourage (pollution, CO2, etc) and not the things you want to encourage (income, health care, etc.).
Or we could have a carbon tax to pay for health care...