How Bad Can It Get?

It’s time to get our heads out from under the covers and face our worst fears. The financial crisis is world-wide, and the U.S. is actually better off than most countries. Iceland is bankrupt, and others (including Russia) are teetering. What happens when a crisis turns into a complete collapse?

Keep in mind that the worst possible outcomes are short-term. We’ll take a look at those and then look at the reality of the long-term.

Short-term Possibilities:

Scenario #1: Complete Financial Collapse. Likelihood = 1% - 2%. This could rival the Great Depression scenes we see in old movies with bread lines, tent towns of homeless, etc. You’re not able to use your credit cards, or write checks. In the worst case, where faith in US dollar evaporates, bartering or using gold becomes the basis of commerce.

This extreme outcome could be produced in our current economy if one or two extremely destructive exogenous events occur in the next year or so. These traumatic events could be anything from a huge California earthquake, Al Qaeda usurping power in Saudi Arabia and strangling the world’s oil supply, or severe weather changes brought on by global warming, etc.

We have suggested that clients who are genuinely concerned about this worst-case scenario keep 1-2% of their portfolio in gold bullion.

Scenario #2: World-wide Deflation. Likelihood = 5-20%. Countries try to protect their economies using tariffs, which sets off retaliation in other countries so global commerce dries up. Shortages become a way of life. Widespread deprivation kindles violence, terrorism escalates, and a large scale war may loom.

Even in this case, the dollar would likely be the world’s safe haven. Decreasing prices enable those who have cash or U.S. Treasury bonds to survive and prosper.

Scenario #3: Recession Reaction. Likelihood – 15-35%. Panic sets off contraction in consumer spending which cascades through the economy. Classic recession response, including lay-offs, unemployment of 10-15% in US, higher in other countries. The Euro may be destabilized by conflicts in monetary policies of member nations. Cutbacks in inventories closes factories; bankruptcies increase. Portfolio Panic Reaction leads many people to take foolish risks.

We work closely with clients to manage their endogenous risks, rebalance portfolios accordingly, make sure that adequate liquidity is maintained.

Scenario #4: Volatility Eruption. Likelihood = 25-40%. We are likely experiencing this phase now. Market prices in securities, commodities, housing, etc. take huge swings in waves of panic trading. Investors retreat to the sidelines, so trading volumes vacillate. This is how the market finds price balance, by testing the extremes. This could be a relatively short phase followed by onset of recession which could be severe, or gradually recover as markets begin to bounce back.

This is most difficult time for investors. In today’s economies this scenario usually stirs government intervention in the markets. This brings the danger that the money supply is increased faster than productivity gains which can trigger spiraling inflation. Having a long-term fixed rate mortgage is the best protection against inflation. Survival in this phase requires clients to turn off the TV.

Scenario #5: Bounce Back. Likelihood = 15-35%. If governments are successful in shoring up confidence in their economies, and adequate liquidity is available in capital markets, stable commerce will again emerge. Housing prices will drop to the point where entrepreneurs can buy up excess inventory and rent out homes with a positive cash flow. New business formations provide most new employment opportunities.

The stock market is likely to start rebounding a year or so before this phase kicks in. Clients guided by Functional Asset Allocation, which we preach, will prosper in this stage since they will not have sold off their stock holdings. Those who have continued dollar-cost-averaging, (e.g. through their 401-k’s, etc.) will enjoy rapid accumulation in their portfolios.

Long-term Outlook. Likelihood – 98-99%. As this downturn is relatively severe, it may take another 2-3 years to substantially recover. Then we will enjoy approximately 5.5 years (on average) of prosperity, which we will soon take for granted. On the next downturn, we will be again surprised. We will go through though another down-cycle as we have for the past century. Again we will think that ‘it is different this time.’ A year or so into that downturn we will again anguish about “How Bad Can It Get?” Then I will send out this blog again, as I did seven years ago in Nov. 2001…

Sleep well tonight! Bert

© Bert Whitehead, M.B.A., J.D. 2008