Wednesday, April 8, 2009

Best Case vs. Worst Case April 2009

Bert Whitehead, M.B.A., J.D. ©2009

How will this recession play out? I like to ask people that question (although many of them think I should know). I have noticed a strong correlation between a person’s economic outlook and their political leanings. The extremists on both sides focus on certain factors in the global meltdown to support their point of view. I’d like to examine the extremes on both sides and explain why both an extreme positive or negative outlook is at best a very remote possibility.

The Best Case: The Stimulus plan works as designed world-wide and the economy bottoms out at the end of this year. The rebound is very rapid so that the stock market is back up to 13,000 by the end of 2010 and unemployment drops to 5% and we all sing “Happy Days Are Here Again!” The government devises regulations for banks and oil producers with congressional oversight to control their profits and pricing. Taxes are raised on businesses, investors, and high income earners to pay for energy, education, and health care services while lowering the deficit with the increased revenue. Increased government spending causes inflation which threatens to get out of control.

The Worst Case: The worldwide economy reels toward collapse with the US government selling bonds to provide money to support an ever-expanding list of government-provided entitlements, bailouts, and subsidies. More pressure is applied to other countries to follow our lead, resulting in rising stagflation worldwide and hyper-inflation in some countries threatens to spread globally.

Gross Domestic Production world-wide drops precipitously. Higher tax rates to target the most productive sectors of the economy result in less total government revenue as sales and incomes drop. Small businesses close, or start operating under-ground. Unemployment rises and pushes the world into a global depression. Protests and crime increase as populations become more impoverished. War looms.

The Truth: Neither of the two above scenarios are going to play out to the conclusion. This economic cycle will end and we will recover at some point. Stimulus programs may do more harm than good, but we are not going to become a socialist country. The dollar will not collapse and putting all your wealth in gold or another currency to avoid being wiped out is nonsensical..

There are simply too many economic factors at work to be able to determine the outcome. Most changes in a free market are self-correcting, e.g. as the dollar weakens, more foreigners want to buy US goods, services and real estate, which ultimately strengthen our economy and the dollar rises again. Supply and demand result in short-term price swings as markets seek balance by testing the extremes. Lower beef prices mean more people will start eating beef, and then ranchers will grow more steers. The outlook is further clouded by completely unexpected events such as a California earthquake, or a war in the Middle East that shuts down 50% of the world’s oil supply.

Most readers of this blog have already been impacted by this recession, and those who haven’t yet are likely to be in the next year. The worst reaction, however, is to bank on an extreme scenario. It is just as foolish to sell everything you own to buy gold because some writer ‘proves’ that hyperinflation is inevitable. It is folly to put all your assets into real estate because it’s so cheap now, and you believe that the big turnaround has already begun. Home prices are still dropping, and I remember the wisdom of my father: “Son, never try to catch a falling knife!”

The proponents of both extremes have personal agendas that focus their paradigms. Politicians and government economists want us to believe that the trillions we are spending is a brilliant idea. Those who predict doom-and-gloom profit handsomely as stoking fear sells their books and newsletters. Emotionally it is easy for us to assume the short-term upswing in the stock market means the recession is over, or seeing the market drop 25% in a couple of months means we are headed to Armageddon.

The final outcome of this historical financial crisis will likely to take 3-7 years to work out, and I doubt that we will bottom out before 2011 or 2012. Political agendas of both parties were a factor in creating this circumstance. Many regulations now scorned were once endorsed by both parties, e.g. encouraging mortgages to provide home ownership for all Americans. This seemed like a good idea at a time but most see that financial regulations need to be adapted to suit a society where many people are very naïve in financial matters.

People on both sides of the aisle should be concerned and active in this conversation. Our political process depends on our input. But don’t let it ruin your life. Don’t let the extremists in the political arena and their counterparts in the financial media lead you to take precipitous moves with your investments.

Functional Asset Allocation takes your personal situation as the primary driver in allocating your investments. While changes will need to be made this year, we want you to be able to survive any economic trend. Our job is to make sure you can sleep at night.

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