Game Plan

by Kevin D. Freeman

  The Austrian school of economics agrees. John Paul Koning of the Ludwig von Mises Institute explains, “As money-supply growth continues and prices become more contorted, more and more ventures are undertaken that would not be undertaken in a regime without money-supply growth. When, for whatever the reason, money supply finally contracts, the artificial strength in prices that encouraged unprofitable ventures is removed, prices collapse, and large numbers of ventures go bankrupt. Thus we have the recession part of the business cycle, the simultaneous failure of many firms at the same time.”22

  Currency collapse is virtually the same as investing in hyperinflation. In Germany of the 1920s, Latin America of the 1980s, and Zimbabwe of 2007–2008, hyperinflation and currency collapse were virtually synonymous. The one difference is that a currency collapse is really hyperinflation limited geographically to either a single country or region. Owning foreign stocks, therefore, can be a good way to protect your investments. As Peter Schiff says, “Getting out of the dollar is a lot easier today than it used to be. Every time you buy a foreign stock, you’re buying a foreign currency.” In any case, even as the market as a whole may prosper during hyperinflation, the focus should be on specific sectors that have pricing power or that represent inflation hedges (like mining shares or real estate).

  Schiff actually goes further. He believes that our economy will collapse but thinks it will be good for the rest of the world: “When the dollar collapses and when the rest of the world stops wasting their resources, propping up our economy, buying our debt, selling us products that we can’t pay for, I think you’re going to have a global economic boom outside of the United States.”23

  So, what happens if there’s a cyberdisruption of the market? If a hacker wiped out all the records of the stock exchanges including backups, the effect would be devastating. Of course, a system that has been properly backed up can be restored.

  The Right Temperament

  Most stock market investors can find their worst enemy by looking in the mirror. Studies regularly find that investors driven by fear and greed jump in and out of stocks at the worst possible times. For example, if an investor bought the S&P 500 for a $100,000 in 1992 and left the investment alone for twenty years, by 2013 the investment would have grown to over $484,000. This represents a compound average rate of return of 8.21 percent per year. Yet according to a Dalbar study, the average investor jumped in and out of stocks, often at the wrong times, and ended with only about $230,000, or a gain of 4.25 percent.24 Investors tend to sell at the bottom when they are fearful and buy at the top when they are greedy—precisely the opposite of what they should do. One way to overcome this serious problem is to put a plan in place with professional help and then stick with the plan. Even with a plan, if you lack the proper temperament, you shouldn’t own stocks.

  The Ups and Downs of Stocks

  Stocks can be a great hedge against inflation. If you’re scared by the government’s printing more and more dollars, putting your money in the market is a smart play. The key is not to be in or out of the market but in or out of the right stocks. A currency collapse would dramatically increase the value of many foreign shares. That’s why diversification is so important.

  But when it comes to the possibility of financial terrorism, stocks can be hit hard. Cybersecurity is not nearly where it should be to stop hackers from taking advantage of the market—and if you’re not smart about your investments, you could watch your cash dwindle quickly.

  A bear market attack would also be bad for stocks. But not all stocks, at least over time.

  So how should you invest? The answer is to invest knowledgeably. If you know a sector well, active investment may be for you. If not, passive investment may be the best strategy. If you’re an entrepreneur or supported by a qualified professional, you may even want to think about finding some small companies to invest in, private-equity style.

  Alan Greenspan worried about “irrational exuberance” distorting the stock market. Today’s thinkers should worry about financial terrorism destroying it. Make sure that you have the temperament to own stocks and not to panic at the first sign of bad news. After all, in a crisis, the only thing standing between wealth and poverty is you.

  CHAPTER SEVEN

  What’s a Bond Bubble?

  In the investment world, the word bubble conjures images of risky investments bid to outrageous prices in some sort of mania. Think the internet bubble of the late 1990s, when investors shoved billions of dollars into the pockets of twenty-something entrepreneurs who had an idea and a website. Never mind earnings; all you needed were “eyeballs” and “clicks.” “That’s all anybody had to grab on to,” explained Shane Greenstein, professor of management and strategy at Northwestern University’s Kellogg School of Business, in 2001, shortly after the internet bubble burst. “Who would have been the skeptic?”1 The companies that went boom—and then bust—included Webvan, a company that wanted to deliver groceries at home and was once valued at $1.2 billion; Pets.com, which raised $82.5 million in an initial public offering before collapsing just nine months later; and Kozmo.com, which offered delivery of various products for free and raised $280 million before going bust.2

  Or think of the housing bubble in the late 2000s. People were buying and “flipping” un-built homes in hot markets like Phoenix and Las Vegas, pocketing big profits without ever taking ownership. Thanks to banks’ handing out loans like candy to borrowers not worth their salt—and everyone banking on real estate prices going up forever—the bust was enormous. At the bottom, you couldn’t buy a stick of chewing gum with a Vegas condo. Researchers with the Federal Reserve Bank of New York actually found that investors who used subprime credit to purchase residential properties for flipping were the biggest wrongdoers in bringing on the recession. Over a third of all mortgages given in 2006 were to people who owned one house already. “This may have allowed the bubble to inflate further, which caused millions of owner-occupants to pay more if they wanted to buy a home for their family,” said the Fed. Between November 2010 and November 2011, the median home price in Las Vegas dropped from $134,900 to $125,000.3 And that decline happened after the bubble had burst.

  Those American bubbles pale in comparison to Japan’s combined real-estate and stock market bubble of the late 1980s. The Nikkei stock index nearly quadrupled in less than five years. At one point, the land surrounding the Imperial Palace in Tokyo was rumored to be more valuable than the entire state of California.

  Perhaps the most famous bubble of all time was in Holland, where people speculated on the price of tulip bulbs. From 1634 to 1638, the price multiplied many times over. People mortgaged homes and borrowed against their businesses to buy bulbs. During that time, people traded one thousand pounds of cheese for a single specimen of the rarest tulip bulb. But then people lost faith in the value of the bulbs, and the bottom dropped out. In 1638, in an attempt to stop the bleeding, the government said that tulip contracts could be fulfilled by paying a mere 3.5 percent of the originally agreed purchase price.4

  Bubbles are usually associated with risky investments and greed. Yet fear has produced a bubble in what has been considered the safest investment in the world, U.S. government bonds.

  To understand how the bubble has formed, you must understand bonds and how they operate. Bonds are essentially loans. Those issuing bonds are borrowing money, and those who buy them are lending money. The bond explains the terms of the loan. How is the loan to be repaid? What is the rate of interest? Who is the borrower? How long will the loan last? U.S. government bonds are merely bonds issued by the government. Bonds can be traded, just like mortgages; typically, someone trades a bond when he believes that the bond is not going to be repaid at the rate promised or would rather have cash now than repayment later.

  Because bonds represent loans, they are considered safer than stocks. In the event of a company’s failure, bondholders are paid first, and if there is anything left over, the shareholders divide the scraps. Companie
s pay bond interest before issuing dividends. Unlike stockholders, bondholders are assured the face value of the bond when the time expires, as well as a promised rate of return. Over time, bonds are more stable than stocks.

  Borrowers with excellent credit ratings can offer lower interest than those with less stellar ratings. This makes sense. Assume that Lindsay Lohan comes to you with a bond offering. You wouldn’t trust her to repay the loan, so you’d want her to pay a high rate of interest pretty quickly to ensure you get some money out. But let’s assume that Warren Buffett wants to issue you a bond. You’d be willing to accept a far lower interest rate, since it’s a pretty solid bet that Buffett will pay you back.

  Borrowers can be companies, governments, or foreign nations. Interest rates reflect the perceived riskiness of the borrower, as well as the general level of interest rates in the economy. Essentially, there is an interest-rate premium added to the “risk-free” rate. (The “risk-free” rate represents the interest rate that would be charged to a hypothetical borrower who would be certain to make every payment on time. There would still be an interest rate charged to compensate for inflation even though there would be no risk to the loan.)

  Understanding Bonds and Interest Rates

  A high-risk borrower will pay a big premium to borrow money, just as Lindsay Lohan would. A lower-risk borrower may pay a small premium. The lowest-risk borrower of U.S. dollars is generally believed to be the U.S. government, and the German government is perhaps seen as the lowest-risk borrower of euros. During the twentieth century, the interest rate on U.S. Treasury bills—loans that are repaid within a year—was just 0.9 percent annually. Because of the short term of the loan, Treasury bills are generally seen as risk free, a perception reinforced by the government’s ability to print money if it needs to.5

  There are some terms that will be useful to know in our discussion of bonds. The maturity of a bond is the date on which its term ends—that is, when the principal of the loan is due. Callability is the ability of the issuer to pay off the bond before it matures. Put provisions allow the bond buyer to sell the bond back to the issuer before the maturity date. Secured bonds are bonds backed by collateral; unsecured bonds don’t have any collateral backing. Government bonds are considered unsecured, since they are not backed by anything physical.6

  There are some elements of risk that play into the value of government bonds, however. There is legislative risk—the possibility that the government will change tax rates to hurt income from bonds; call risk—the possibility that the government will exercise a call option early; liquidity risk—the possibility that it will become difficult to sell bonds because of low demand; credit risk or default risk—the possibility that the government won’t pay you back; and event risk—the possibility that some intervening event interferes with the ability to pay off the bond.7

  The economic climate is another variable that influences interest rates. If inflation is low, the cost of borrowing will be low—the lender will get his money back without its being devalued by inflation. If inflation is high, rates will be high—you’ll want more cash back in order to give a loan in the first place. In addition, investors will look into the future with their expectations and set rates for longer terms. Charting the rates over different time periods for a similar borrower gives us what’s known as the yield curve. Imagine a graph with time on the X axis and return on the Y axis. As the time lengthens, the return must go up.

  There are many different types of yield curves. A normal yield curve slopes upward, just as I have explained—a bond with a longer maturity gives you a higher yield. You’re going to demand more money back in order to lend money for a longer time. A steep yield curve occurs when there are a lot of borrowers looking for cash. They must compete for loan dollars, and competition drives up the return curve. A flat yield curve indicates that the yields for bonds of multiple maturities are close to one another. That usually happens when there’s no risk of inflation or when there is deflation—everybody is happy to lend money for long periods of time, knowing he will get his money back with interest. The humped yield curve occurs when short- and long-term interest rates are closer together than medium-term rates. That happens when there’s a sharp spike in demand in short-term bonds because of a fear of inflation but also faith that the economy will eventually recover. Finally, an inverted yield curve, where longer-term interest rates are lower than shorter-term rates, indicates that people are frightened of an economic collapse; they demand high returns for short-term loans and believe that the economy will bottom out, resulting in no demand for long-term bonds.8

  As you may have noticed from this discussion of yield curves, inflation plays a major role in the market for bonds. When investors expect increased inflation, they will demand higher interest rates to compensate. While it is fairly easy to guess the short-term inflation rate, it can be very difficult to predict the inflation trend over thirty years. As an example, annual inflation rates ranged from -0.34 percent to 13.58 percent in the thirty-year period from 1980 to 2010. That was a relatively stable period, too. The legacy of the Carter economy was high inflation in the early 1980s, forcing the Federal Reserve to raise interest rates on bonds. Higher rates stimulated demand for bonds, encouraging people to put money back into the government. The result was a prolonged period of higher unemployment (money removed from the economy went to the government by way of bond sales) followed by the greatest peacetime boom in American history after inflation had been tamed.

  In the last few years, the government has dramatically increased the money supply, yet inflation, strangely enough, has remained low. Though interest rates have been at record lows, the market for bonds has stayed strong because the economy has been so fragile. At some point, though, inflation will return. When it does, the government will have to pay higher interest rates, driving down bond prices, and bond investors will lose money. So much for the so-called safety of bonds.

  Bills, Notes, and Bonds

  When it comes to government bonds, there are several types. You hear about them on CNBC and in the Wall Street Journal, but it’s important to know the difference between them.

  •T-bills: T-bills are bonds issued by the U.S. Treasury Department that mature in no more than one year. They are short-term bonds designed to give short-term injections of cash to the government. Investors buy them in order to hedge against deflation, for example. The T-bill market is very liquid, allowing you to buy and sell easily. You would typically buy a thousand-dollar T-bill at a discount—at $990, for example—and then hope that inflation doesn’t outpace the bond.

  •Treasury notes: These are intermediate-length bonds from the government, sold with maturities of two, three, five, seven, and ten years. You would buy these for long-term expenses, like college tuition or retirement. It’s the kind of bond Grandma might have bought you for your First Communion or Bar Mitzvah. Interest is paid every six months.

  •Treasury bonds: These are long-term securities, over ten years. Right now, they’re issued with thirty-year maturities, and interest is paid every six months.9

  The Role of the Federal Reserve and Monetary Policy

  As you noticed in our discussion of gold, the Federal Reserve plays a major role in setting monetary policy. Some believe that the Fed sets interest rates for America, but it is more accurate to say that the Fed is the greatest influence on rates. The Fed influences rates several ways.

  Banks don’t individually set the interest rates at which they lend money. The Federal Reserve controls the supply of money and therefore controls interest rates. Federal law requires banks to keep a certain amount of money on deposit with their regional Federal Reserve Bank—deposits known as “federal funds.” If a bank has extra money in its federal funds account, it can lend that money to other banks that are temporarily short in their accounts at the “federal funds rate” of interest. That rate is negotiated by the banks involved, but the Fed sets the permissible range with its “target federal funds rate.” If bank
s don’t comply, the Fed can intervene through what are called open-market operations.10 The target federal funds rate influences the interest rates for business and consumer loans throughout the economy.

  The Fed also influences interest rates with its “discount rate”—the interest rate “charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility,” as the Fed describes it. In other words, when banks come up short on the amount of money in their deposit accounts, they can borrow money directly from the Federal Reserve Bank at a given rate—the discount rate. The Fed’s credit programs come in three types: primary credit programs, which are short-term and given to sound financial institutions; secondary credit programs, which are also short-term but for less stable banks; and seasonal credit, given to small institutions that vary in their monetary needs based on the season (for example, banks in tourist or agricultural communities).11

  The Fed can also take extraordinary measures to move interest rates up or down. In an operation known as “quantitative easing,” the Fed increases the money supply—and, in the view of many, risks setting off inflation—by electronically increasing bank reserves and using that money to buy securities, including government and corporate bonds. When banks sell these bonds for cash, the money supply increases, and interest rates go down because banks have more cash on hand to lend, increasing the “supply” of capital and thus lowering its price. Quantitative easing has been a staple of monetary policy during the Obama years.12