Good morning! Today I am happy to welcome Troy from The Financial Economist for the second time, he will talk today about how the economy affects the market, and your retirement nest egg. His blog is full of in-depth articles of this kind, so feel free to see his latest post at The Financial Economist. And if you want to read his previous guest post about mistakes he made when he started investing, please click here.
I will be over at Make Money Your Way with a post on how to make money at parties. Enjoy!
When I asked Pauline about writing a second guest post here, she suggested I talk about factors that will affect the average investor’s retirement nest egg. So in this post, I’ll be discussing the various economic and historical conditions that will affect investors in the medium tern (1-5 years) and long term future (5 to 10 years out), and how you can prepare yourself when each of these conditions hit.
Inflation
Without going into the arcane and pointless details, I’ll explain QE (quantitative easing) in good ole’ plain English. QE is the Federal Reserve’s way of printing money, thereby injecting more and more liquidity (money) into the financial system. Bernake (Fed Chairman) believes that this will pull the American economy out of the muck for good, and right now, whether this is working or not is still questionable.
HOWEVER, quantitative easing does have a problem – the printing of money theoretically speaking should cause inflation. But since QE first began, inflation has been virtually non-existent. How come?
According to theory, printing money causes inflation. BUT, what the economy has been experiencing post-recession is a deflationary environment. The economy isn’t doing too well, and prices should be declining. But with the Fed’s printing of money, the deflation is negated, resulting in zero inflation.
However, sooner or later (probably sooner, along the lines of 1 – 2 years) inflation is going to (finally) pick up. Why? Think of it this way. Deflation has always existed, and the Fed’s printing of money has been negating this deflation. However, soon that negation will be over (when the inflation is sufficient enough to totally negate the deflation), and the printing of money will finally cause real inflation.
So what do you do when inflation hits? Historically speaking, investors think that inflation is bad for stocks. That’s a huge misconception. This misconception only exists because stocks went flat in the 1970s when inflation was huge. HOWEVER, the 1970s were an anomaly – we experienced stagflation, when inflation was coupled with a sagging economy. In most cases, inflation occurs in a growing economy (or in today’s case, a nominally growing GDP). I believe that this time around, the recovery is real and that we’re not going to experience stagflation.
Hence, I think that buying stocks would be great when inflation hits. When inflation comes around, currencies get devalued and nominally speaking stock prices rise, leading to greater returns for equity investors.
Devaluation
Devaluation is closely linked to inflation – when governments print money, the real value of their currencies becomes devalued. Whenever currencies get devalued, all hard assets such as stocks and commodities shoot up in price. Speaking of commodities…
The Once in a Lifetime Opportunity
People believe that precious metals are a hedge against an economic downturn. Again, that’s a misconception. When the 2008 recession hit, precious metals (gold and silver) actually fell the hardest. This misconception originates (again) from the 1970s when a crappy economy was coupled with soaring gold and silver prices.
Precious metals rose in the 1970s not because of the poor economy but because of inflation. The 1970s were a rare case of stagflation, something that doesn’t fit in with today. Currently, the economy is humming along, but inflation will be a big issue. Thus, when inflation starts to creep up it will be a once in a lifetime opportunity for medium term investors who are willing to hold onto their gold and silver positions for at least a year.
The Fight for Resources
There’s a prime fundamental reason (besides inflation) that supports the rise in commodity prices (especially gold and silver). It’s simple. We have fewer and fewer resources to feed a larger and larger population. When Thomas Malthus first predicted that the world would end (this was back in 1798), he forgot to factor in technology. Technological improvements can increase the efficiency at which we extract our resources. HOWEVER, even technology has a limit. The efficiency is ultimately limited to the amount of resources we have. Currently, the world is reaching a turning point. If all the emerging market nations start to consume at the rate Americans do, the world’s resources would be gone sooner rather than later. When the demand for raw materials goes up and the supply goes down, prices will soar.
Historical Charts
You’ve all heard it – historically, the U.S. stock market has yielded (on average) 7.5% returns. That’s actually a really clever lie concocted by brokers and financial groups to get you to purchase equities.
The “average of 7.5%” is from the post-War period. If you look at a different time frame, such as if you were to include the Great Depression, the “average rate of return” is a lot less. That’s what the financial industry does – repackaging facts to make them look better than when they first came in.
The post-war period is actually an anomaly, a period of unprecedented economic growth that is unlikely to be repeated again in the near future. This growth was caused by major technological revolutions, from household appliances to computers to the internet and high speed communications. Today? Come on guys – the market is going to grow at 7.5% with a bunch of undergrads making $0.99 iPhone apps.
My point is, if the stock market is going to pick up its pace in the long run, it needs to be supported by major technological leaps. Unfortunately, since the dawn of the internet our society’s brightest have been attracted towards the fast money of internet riches, drawn away from solid industries that actually contribute to mankind’s life (think of space mining, green energy – the capital intensive industries). Thus, without any major technological revolutions happening right now how can we expect economic and market growth to pick up? We can’t. There’s no driver for the growth engine.
The Summary
To sum it all up, I’m going to divide things into two time frames. The medium time frame is the 1-5 year outlook, whereas the long term outlook is 5-20 years.
For the medium outlook, things are looking decidedly positive. Once inflation picks up (which is inevitable with all the money printing), stocks and commodities are going to soar, particularly gold and silver whose bull markets aren’t over.
However, the long term is less positive. Sure, the stock market will still experience long term bull markets. But I don’t think the average rate of return will be 7.5% anymore, unless we experience another major technological breakthrough. The problem is that these breakthroughs are the results of years and years of work, something that hasn’t happened thanks to all our smartest engineers being attracted to industries that do not really contribute that much to mankind. (I like Facebook as much as the next guy in line, but hey, it hasn’t had as much an impact on my life as the advent of the computer has.)
This post was featured on the Making Sense of Cents, My Wealth Desire, thank you!
How about the population and the demand?. There is a continuous price increase of other commodities due to demand. Like gold and silver as you said. Because of increase of population, the demand also for these precious metal goes up. The supply become less due to low of production yet there is a big population in need of commodities.
On a side note, the thing about gold and silver is that there is almost no real demand for these. They simply represent the rest of the commodities.
All I know is that I’m not going to use precious metals as too big of a hedge against inflation. Pretty much all currency in the world is now fiat. If economies collapse, the paper gold I have will be worthless. The physical gold will probably buy me a really expensive loaf of bread…
I’m not saying that economies will collapse – if inflation is a big issue, then precious metals should at least keep pace.
Great article that steps back and looks at the big picture.
I think that your idea of a major technological innovation heralding in a new bull market is a good one. Who knows when that will happen?
I think gold is going to 1000 before we go much higher. For the long term, I think it is a good hedge against inflation.
Like Holly, I won’t be using precious metals as a way to hedge my portfolio. I have seen too many retail investors run and cling to them thinking it’s going to be their savior and leave stocks, or anything else, in the rearview mirror. It’ll definitely be interesting to see what happens once the pullback on QE begins and takes hold.
The stock market, as measured by the S&P 500, has returned 8.92% since 1871. You can see for yourself here: http://www.moneychimp.com/features/market_cagr.htm.
I think it’s important to understand the different types of economic conditions we may experience at any point in time and build your portfolio around that rather than try to predict the near-term future. Stocks are your best bet for long-term growth. Something like TIPS can help you directly hedge against unexpected inflation. US Treasury bonds are as close as you can get to a guaranteed return, which serves as a good hedge for times when stocks are down. I’m also with other commenters that precious metals aren’t part of my portfolio. I’m not really interested in something that doesn’t have an expected return.
I personally don’t touch bonds because I’m not too knowledgeable about the subject.
I’ve got a calculator on my site – like Mr. Becker, I’m getting over 8% annualized using the Shiller data back to 1871, dividends reinvested (Jan ’71 – June ’13). If I do Jan 1871 to Dec 1939 for the Great Depression I get ~7%, and that’s cherry picking the worst possible timeframe. Taking it one step further, I have another calculator that aggregates by period. Using that same dataset, I made a separate calculator with rolling periods – over 40 years, a full 72.63% of periods beat 7.5%.
And seriously… Malthus? I know it’s in vogue amongst a certain intellectual subset to claim that humans are a net harm for the planet – but in a world where cattle are considered an asset, do you really want to wave that flag? Truth is, the planet has more than 7x the population it did when Malthus predicted we’d go the way of your 4th grade fruit fly experiment. Somewhere between the ages of 14-24 most humans become a net benefit for society… and, hey, someone born today might invent a new food technology in 30 years!
Newsflash: the world didn’t end in 1798, and more people have been pulled out of poverty in the last generation than in the entirety of human existence. A human born today in 2013 is more likely to die of the symptoms of overeating – diabetes, heart disease and the like – than starvation and lack of vitamins. Add all of that to Western Countries having birth rates below replacement level, plus coming food technologies (hybrid crops, skyscraper farms, insect farming and the unknown) that may very well provide for a few billion more.
I agree with PK, Malthus’s predictions of population growth exceedting food production were generally wrong. The Green Revolution and other advances in food production technology have made it a moot point.
30 years from now technology may move in a completely different direction. Sea weed, anyone?
I’m not saying that the world is ending – I’m just saying that it’s going to be a lot more expensive to stay alive.
May I point you to Exhibit A on why QE I/II/III/Nightmare on Elm Street 15 hasn’t led to the expected inflation that doomsayers foresaw? http://dqydj.net/wheres-the-inflation/
As a technologist, I’ve been invited to my fair share of private equity/venture capital/IP transfer discussions, and, not having lived in Silicon Valley or Beacon Hill, I can say that what I saw with my small sliver of exposure gives me great confidence that we’ll continue to have innovations and breakthroughs (peak oil anyone?). Furthermore, as other countries start to develop the ability to highly educate their populaces (the smartest employees I ever had were all IIT graduates), they’ll innovate as well, providing a net benefit to society.
Even if you’re a pessimist, it’s wise to plan for lower returns in your retirement planning anyway. Better to reach FI earlier than expected than never at all.
I explained why the inflation hasn’t happened yet.
Interesting opinion. I’d like to think that we’ll keep innovating and achieve that 7.5% growth rate. I bet there were people back in the 50’s who said that there was no growth left because we had come up with everything. I think that the innovation will continue no matter how many previous items have been created.
Inflation is definitely a concern, but I’m still planning on investing in the market and do have hope for the average returns that we’ve seen over the past few decades.
Troy! This is a sobering look at our economy and very well written I might add. You make an excellent point about tech breakthroughs too. These things do take many years to research and develop.
I agree too, that many of our greatest minds and much effort is going to waste on fluff. But that is because the lowest common denominator in the US just keeps sliding down further and further with no end in sight. In other words, they are meeting the demands of our lumpenproletariat. We had better get a handle on our education system if we want to thoroughly address this.
Loved your article, Troy!
I think the degradation of our top talent is going to end one day. When the bright minds realize that the app market has been saturated, they’ll be forced to look elsewhere for profits.
Hi Troy! I just wanted to thank you for writing such a post. Perhaps CJ and I can discuss this, and I will come away with something. I fear I need to reread!
Our experience with buying and selling gold was giving each other gold bracelets for Christmas 16 years ago and then selling them back two years ago. We got a weekend trip away which was highly enjoyable. Thanks, Troy!
Guess the fight for resources is going to a serious one wherein the winner gets to make the rules. To elevate from negative economic condition, production needs to be pumped up. In the wake of shortage of resources – labor, minerals and agro, it’s nearly impossible to revive the economy.
Yea, and at the moment, America (+ Canada) has the most. Don’t forget to count in Africa. Africa’s problem is that it’s not politically stable – that’s how Chinese companies are able to go to Africa and exploit their resources.