Stocks — Part IV: The Big Ugly Event, Deflation and a bit on Inflation

Deflationary Depressions and Hyperinflation

So far we’ve seen that the stock market is a wonderful wealth building tool that goes relentlessly up.  Vanguard’s Total Stock Market Index Fund (VTSAX) is the only tool we need to access it.

But it is extremely volatile, crashes routinely and most people lose money due to their psychological tendencies.  Still, if we toughen up, ride out the turbulence and show a little humility regarding our investing acumen this is the surest path to riches.

Except……

Stock Market 1900 – 2012

There, in 1929, is the Big Ugly Event.  The Mother of all Stock Market Crashes and the beginning of the Great Depression.  Over a two year period stocks plunged from 391 to 41, losing 90% of their value along the way.  Should you have been unlucky enough to have invested at the peak, your portfolio wouldn’t have fully recovered until the mid-1950s.  26 years.  Yikes.  That’s enough to try the toughest investor.

Of course, if you had been buying stocks on margin (that is with borrowed money) you would have been completely wiped out.  Many speculators were.  Fortunes were lost overnight.

Lesson #1:  Never buy stocks on margin.

Lesson #2:  If a time comes when you are reading and hearing about people routinely making fortunes in an aggressively rising market using margin, something very, very bad is around the corner.  (Joseph Kennedy is said to have known it was time to exit the market in early 1929 when he started getting stock tips from shoe-shine boys.)

Lesson #3:  If you see Lesson #2 forming it is a good time to take your chips off the table.  Very tough to do when everybody is making “easy” money.

Lesson #4:  Once the crash comes, it is too late.

So what to do?

Does the possibility of another Big Ugly Event blow a big enough hole in this idea of “toughen up and ride out the storms” to make it useless?  The answer to that has everything to do with your tolerance for risk and your desire to build wealth.  There are ways to mitigate the risk and we’ll talk about them next time.

For now, let’s step back and consider a few things regarding The Big Ugly:

1.  It would have taken an investor of exceptionally bad luck to have borne the full weight of the the crash.  You would have had to buy precisely at the 1929 peak.

Suppose instead you had invested in 1926-27.  Looking at our chart this is about halfway up on the climb to the peak.  Many, many people were entering the market in these years.  Certainly they were destined to lose all their gains, and yet 10 years later, had they held on, they’d be back in positive territory.  Although another rough stretch was coming.

Suppose you’d bought at the earlier peak in 1920.  You would have taken an immediate hit and recovered five years later.  From the collapse in ’29 you’d be back even by 1936.  Seven years.

The point is that any given start would have likely been different and yielded an outcome not as severe as the widely quoted 90% loss, peak to bottom.

2.  Suppose you were just out of school and beginning your career in 1929.  Assuming you were in the fortunate 75% that kept their jobs, you would have had decades of opportunities to buy stocks a bargain prices.  Ironically, a crash at the beginning of your investing life is a gift.

3.  Suppose you were retired with a million dollars in today’s money.  By 1932 your stash is down 90%, to 100k.  Terrible for sure.  But remember the Depression was deflationary.  That means prices fell dramatically.  And that means your $100,000, while no longer a million, now has far more buying power than 100k did pre-crash.  Plus, it is poised to grow rather sharply from this low.

4. The Big Ugly Event has happened only once in the last 112 years.  Longer actually, but that’s how far back our DJIA data goes.  We haven’t had another in 83 years.  These are really rare.

5.  Many changes in economic policy were made post-1929 that, so far, have worked.  In 2008 we came right to the edge of the abyss.  Closer I think than most folks fully appreciate.  But we didn’t tumble over.  This I find encouraging.

Looking for Balance

What is not so encouraging is that a Deflationary Depression like that of ’29 is only one of the two possible economic disasters that can destroy wealth on a major scale.

The other is Hyperinflation.

Here in the USA we haven’t had to deal with this monster since the Revolutionary War way back in 1776.  But it destroyed Zimbabwe’s economy as recently as 2008.  Hungary had the worse case of it in history and many credit the German hyperinflation of the 1920s with ushering the Nazis to power in the 1930s.

Hyperinflation is very bad news, every bit as destructive as deflation, and it is exactly what it sounds like:  Inflation running out of control.

Zimbabwe money changer

A little inflation can be a very healthy thing for an economy.  It keeps the wheels greased and running smoothly.  It is the antidote to looming deflationary depressions.  This is why our Federal Reserve has been working overtime pumping money into the system these past few years.  We very much need to get some inflation going.  But, not too much.  It is a tricky balance and once in motion it can be hard to change direction.

In a deflationary environment delayed buying decisions are rewarded.  If you were considering a new house of late you would have noticed that prices are dropping, along with mortgage interest rates.  So you wait.  You can get both for less later. If enough potential buyers join you, prices and rates drop further.  Delay is further rewarded and action is punished.  Too much of this and the market slips into a deadly spiral of crashing prices.

But when inflation is high and growing, anything you want to buy will cost more tomorrow than today.  Buy that house (or car, or appliance or anything else) today and beat the price increase.  Delay is punished with higher prices later and action is rewarded.  Buyers become ever more motivated.  Sellers become ever more reluctant.  Too much of this and the market slips into a deadly spiral of increasingly worthless currency people are desperate to exchange for goods.

“Hyperinflation is often associated with wars or their aftermath, political or social upheavals, or other crises that make it difficult for the government to tax the population.”  Mmmm.  The quote is from Wikipedia and sounds a lot like our current situation to me.

Governments love a little inflation.  They can add money to the system, keep the economy humming and not have to raise taxes or cut spending to do it.  In fact, it is sometimes called “the hidden tax” because it erodes the buying power of our currency.  It also allows debtors, like the government, to pay back their creditors with “cheaper dollars.”

Given all this, it is hard not to see increasing inflation on our horizon.  In fact, it is far more likely today than any deflationary depression.

The good news for our VTSAX wealth building strategy is that stocks are a pretty good inflation hedge, as long as it is moderate and builds slowly.  After all, as we’ve discussed, in owning stocks we own businesses.  These businesses have assets and create products.  The value of those rises with inflation.

Still, if inflation rises too far too fast we’ll want to have something that reacts more quickly. So too for deflation.

The decision every investor must make is how much risk to accept in the wealth building process.  Looking at the past 100+ years, you have to ask yourself whether it makes sense to focus on the Big Ugly or to invest for the relentless rise that dominates.

None of this is to say that Big Ugly Events are not very scary and destructive things.

But they are rare and in the context of our overriding approach —Spend less than you earn – invest the surplus – avoid debt — they are survivable.

This is the first post of the blog:

http://jlcollinsnh.wordpress.com/2011/06/02/the-monk-and-the-minister/

The more able you are to live like the Monk, the more likely you are to live like the Minister.

Next time we’ll look at specific investments to build and protect our wealth.  As I promised in Part I, you won’t believe how simple it is.

Disclaimer:  Like everything else on this blog, this is only sharing ideas.  You are solely responsible for your own choices.

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