As Of: October 2, 2001
Prepare For The Worst, Hope For The Best
As bad as things are, they could get worse.
I think there has been an amazing lack of focus on the real potential problems that our economy faces. Knowing the worst case is not an admission that there is a high probability of it happening, but it is important to frame the extreme in order to develop a contingency plan. Confidence does not come from knowing that one can weather the most probable case. Confidence comes from knowing that one can weather the worst case. Anything better than the doomsday scenario then becomes good news.
On the day in which the Federal Reserve has lowered interest rates for the ninth time in a row, the only question I hear being asked is: "What happens if the economy is over stimulated and we start seeing inflation again?" The answer is simple. When the Federal Reserve sees the economy growing and the rekindling of inflation, interest rates will be raised. I do not hear anyone talking about what happens if the Federal Reserve keeps lowering rates and the economy does not respond. This is the "You can't push on a string" scenario that was last worried about in the early 1970's. What if we keep moving toward deflation? Interest rates cannot go below zero. We are close to approaching a no-man's land in which monetary stimulus may not work.
While stock market prices are an indicator of the economy, the stock market is not the real economy, nor is it the most important consideration for the average American. Although a falling stock market has a wide ranging impact, the average American probably measures his financial well-being more on the basis of his home, his job, and his savings. Unfortunately, the average American under the age of 65 has no experience with deflation or depression and the consequences that surround a failing economy. Even with the NASDAQ 100 down more than 70%, although the typical person is admitting that perhaps their retirement plans have been dealt a setback, the rest of their life is still fine. They may be spending a little less at the mall, but they do not perceive any reason to change the basic financial structure of their lives. A husband and wife living in a $350,000.00 house, with a few months savings in the bank, and good jobs, aren't too worried about the stock market. After all, typical Americans probably measure their worth based on the equity in their house and their earning power. But this same couple might have a $150,000.00 mortgage, a car loan, and some credit card debt. It probably takes both incomes to service the debt and meet daily living expenses. What happens when one or both spouses lose their job? Do they really have $200,000.00 equity in their house? If they can't pay their debts and the house goes into foreclosure in the middle of a depressed economy, the only bidder at a foreclosure sale may be the mortgage holder. Suddenly the net worth of the couple is zero!
Does this sound far fetched? The Massachusetts Land Court says mortgage foreclosures are running 2% ahead of last year, and are rising to the highest level since 1997. But more importantly, they are expected to soar by the end of the year. As reported in the Boston Globe, an auctioneer that specializes in the sale of homes foreclosed by municipalities and lenders "expects a 50 percent increase in auction sales of single and multifamily homes by year's end." Everyone thinks "This won't happen to me", but it is important to ask the question "WHAT IF?"
I raise this issue because being a successful investor involves more than just focusing on which stock to pick. It is important to keep the larger picture in view. We might have a short economic contraction followed by a nice stock market rally. However, there is some possibility (regardless of how remote) that we may have a long, deep, extremely painful slump that could involve deflation, and could even be labeled a depression. Prepare for the worst, and hope for the best.