About the Author
Harry S. Dent, Jr. is the president of the H.S. Dent Foundation, whose mission is "Helping People Understand Change." He is the founder of HS Dent, which publishes the HS Dent Forecast and oversees the HS Dent Financial Advisors Network. He is the author of the New York Times bestseller, The Great Depression Ahead, as well as of The Great Boom Ahead, in which he stood virtually alone in accurately forecasting the unanticipated "boom" of the 1990s. A Harvard MBA, Fortune 100 consultant, new venture investor, and noted speaker, Mr. Dent is a highly respected figure in his field.
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Rodney Johnson is the president of HS Dent, an independent economic research and investment management firm. He oversees the daily operations of the companies and is a regular contributor to the HS Forecast and the HS Dent Perspective. A graduate of Georgetown University and Southern Methodist University, Mr. Johnson is a frequent guest on radio and television programs to discuss economic changes in the United States and around the world.
The Great Crash Ahead INTRODUCTION
The Economy on “Crack”: The End of Keynesian Economics
Imagine that someone very close to you, someone who is part of your everyday life and upon whom you depend, is a drug addict. The person goes “cold turkey” one day and inevitably begins to suffer symptoms of withdrawal and detox. Along comes the drug dealer and he begins throwing not just more drugs, but harder, more addictive drugs at this person. Do you chase away the drug dealer and nurse your friend through detox, knowing that this is a difficult period but a necessary part of the process? Or do you welcome the drug dealer and actually cheer as more drugs are taken? This might sound a bit outrageous, but it is exactly what we are experiencing in our economy! The patient/friend is the economy in which we all live; the drugs are debt, interest rates, and printed money; and the drug dealers are central bankers and the federal government. In a strange, perverse world, our markets are cheering as the patient is given more of what caused the illness in the first place!
In The Great Depression Ahead (Free Press, 2008), we forecast a strong rebound in the American economy in response to government intervention quickly followed by a vicious downturn. In October 2010, we shifted our view that the markets would weaken largely as a result of declining economic trends; instead, the markets have been perverted by the massive buildup of government debt, previously unfathomable amounts of stimulus, and ultra-low interest rates. Out of desperation in the face of a total financial meltdown, in late 2008 the US Federal Reserve (the Fed), the central banking system of the United States, dropped short-term interest rates to zero. The Fed also created a first program of “qualitative easing” (QE1), which allowed banks to pledge potentially bad mortgage loans as security so that these lenders were able to borrow hard cash and thereby bolster reserves. The economy continued to fail. As this first stimulus program began to falter in 2010 (as we forecast in The Great Depression Ahead), the Fed brought out a second quantitative easing (QE2), again basically the printing of money out of thin air. The two major devices that the Fed has to stimulate the economy (beyond fiscal stimulus from the Treasury) are: (1) lowering the Fed funds rate, and (2) printing to buy Treasuries or other bonds in the open market, which injects more money into the system.
In normal times, the Fed relies on lowering short-term rates to stimulate borrowing. Think of this as like giving the economy a cup of coffee or even a minor stimulating drug, such as speed. It revs up the system short term but probably won’t do any long-term damage. However, in this latest downturn, the Fed thought it necessary to do even more. Only in exceptional instances will the Fed print a significant number of new dollars to buy, and for good reason. This powerful tool is very dangerous—akin to giving the economy a much more addictive drug, such as crack. The Fed has printed more than $2 trillion in new dollars, and QE3 looks likely in 2012 now that Treasury bond rates are so low with the flight of bondholders out of Europe and into the US.
As part of the qualitative easing in late 2008, the Fed accepted mortgage bonds of questionable quality as collateral from banks in exchange for cash, which the banks used to replenish their reserves. But those pledges had to be paid back in short order. Realizing that banks with large loans from the Fed were in just as bad a shape as banks with mortgage bonds, the Fed changed its approach in spring 2009. Instead of holding the questionable mortgage bonds as collateral, the Fed began a program of simply buying these assets from the banks outright. Overall, the Fed bought from banks $1.4 trillion in mortgage securities, mostly Fannie Mae and Freddie Mac bonds, and bought as much as $0.5 trillion in Treasury bonds. This outright purchasing from banks gave the banks much-needed capital as their loan losses mounted. But that wasn’t enough! After this program ended in April 2010 and the markets began to sputter, the Fed reemerged with its second program, in which it bought an additional $600 billion in Treasury bonds in the open market from November 2010 through June 2011. These purchases increased the total assets and cumulative stimulus from the Fed to about $2.8 trillion! That does not count other stimulus programs, including bailouts, government tax rebates and credits, Cash for Clunkers, housing credits, the cut in the Social Security tax for 2011, and many loan and debt guarantees, the costs of which were in the trillions on their own, although much of the bailout monies have been paid back.
These breathtaking moves may seem like a massive effort to “solve” our economic woes, but they are not; they are window dressing. As our work clearly has shown, the natural order is for booms to be followed by busts. What happens when the economy fails again as demographic trends continue to slow, especially after late 2012, when the top 10% who control 44% of income and peak 5 years later than the average baby boomer in late 2007 drop off in spending as well?
It would be one thing if this injection of money went largely into lending and spending that bolstered the economy, eventually driving up tax revenues to help make up for the debt, but that has not happened. Bank reserves have risen by over $1.5 trillion, while business lending has barely moved off of its crisis lows. Consumer loans clearly have declined as well. Banks (and other investors) who sell their bonds to the Fed simply turn around and invest in riskier assets, like high-yield bonds, stocks, and commodities. Such investments lead only to greater speculation and greater bubbles in all investments outside of real estate! When does it ever end?
Lowering short-term rates merely makes borrowing and lending more attractive without expanding money supply directly. Lower rates also encourage banks to borrow short term and invest in longer-term Treasuries, which keeps rates lower than they would normally be. QE literally prints money out of nothing and currently is being used to buy Treasury bonds and mortgage securities. This activity puts money directly into the system; as a result, longer-term rates are pushed even further down by adding more demand (the Fed’s buying of bonds) in an attempt to bolster borrowing and asset prices. And the Fed has used QE more than once: a second round, QE2 in late 2010, and a third is likely in 2012. Using QE is like using the drug crack, whereas lowering short-term rates is more like using the drug speed.
The first side effect of these drugs is the sudden drop in the value of the dollar, which results in higher import, food, and gas costs for everyday consumers. The second is a return of bubblelike market activity in everything from stocks to junk bonds to commodities. Such bubbles will burst eventually, critically injuring aging investors and retirement funds. The third is lower returns on fixed income, which directly impacts retirement portfolios and affects the ability of the largest segment of aging consumers to spend, forcing them to chase riskier investments. The rise in Treasury bond rates toward 3.5%+ that we have been forecasting has not occurred yet. QE2 was successful in forcing down interest rates on Treasury bonds, and then came the flight in capital from Southern Europe into US Treasury bonds that forced them even lower, to well below 2.0% on 10-year Treasuries despite 3% GDP growth and 3%+ inflation. Such bond yields should be 4%+ in 2012 without QE. A QE3 in 2012 in reaction to likely slowing in growth after QE2 wears off is likely to spark rising rates down the road, first from inflation fears and later from deficit concerns and credit quality as deficits persist and economic growth is disappointing considering this massive amount of stimulus.
The Fed stimulus will continue to fail, Treasury bond rates will ultimately rise as in Europe, and the overarching trends of slowing demographics and debt deleveraging will set back in. The great economic crisis of 2008 will likely return in the summer of 2013 or by mid- to late 2013, at the latest, and will be even worse.
If the Chinese and other foreign governments stop buying our bonds, either the Fed must buy many more of these bonds (out of desperation), or bond yields will rise sharply. Thus far, US bond purchasing by the Fed has greatly outweighed the reduction in buying by the Chinese. But if the Fed keeps buying, you can bet that the global bond markets eventually will see this as a sign of weakness and will force rates up anyway as they perceive rising risks. Again, the biggest risks are in the bubbles in stocks, commodities, and bonds that have been building since March 2009. Such bubbles set up investors and retirement plans for another crash and brutal loss in net worth between 2013 and 2015.
Although QE2 depressed the dollar at first, the dollar, like Treasury bond rates, has been rising off and on since early 2011 into mid-2012, which goes against what most investors expected. This shows that such investors don’t understand the new environment, which will be deflationary. In contrast, we forecast that the dollar and Treasury bonds would appreciate in early 2011, and likely will again from mid-2013 forward.
The Keynesian Drug: Invented in the 1930s, Adopted in the 1970s
Our government and most governments around the world have been on the Keynesian plan ever since the early 1970s, when the last long-term boom came to an end. John Maynard Keynes first came up with his theory of the government stimulating to offset private economic slowdowns in the 1930s. Every time the economy slows, the Fed lowers short-term rates and implements fiscal stimulus that it hopes will rekindle consumer and business spending. We have been living off economic “speed” for a long time, since the 1970s, about the same time that baby boomers discovered recreational drugs as well. While drugs failed to resolve the social issues of the 1970s, the parallel economic approach has always seemed to work, because it coincided with the growth of the massive baby boom generation’s demand for spending and credit, especially on housing as baby boomers grew into adulthood and matured.
However, the Keynesian approach has three problems. First, the economy never gets to “exhale” and fully balance out the excesses in debt and expansion from each growth surge, so it gets less efficient and trim—like getting more obese. Second, lower interest rates feed bubbles in asset prices, as we saw first in tech stocks, then in housing, then in emerging markets and commodities. When these bubbles burst, the Fed stimulates again, and that only drives the next set of bubbles. When does it ever end? Our economy just gets more perverse and volatile and less functional—just like any drug addict.
Why the “Great Crash Ahead”? The Fed has now stimulated a third and even more perverse bubble, which is not driven by fundamental trends. At least during the previous bubbles, productivity was growing rapidly, fueled by new technologies and demographic growth. The current bubbles have only government stimulus as fuel because economic trends are slowing, which is why the stimulus has had such disappointing results each time. QE1 got us to 4% growth before it failed. Then QE2 took us to 3% growth in late 2011 before petering out. A QE3 in 2012 is likely to fizzle out at more like 2% growth by early to mid-2013. The current bubbles in stocks, gold, commodities, and junk bonds will burst and bring back the housing, mortgage, and banking crisis even stronger, greatly injuring investors, retirees, and pension/retirement plans again.
Chart I-1: Dow Megaphone Pattern, 1995–2015
Data Source: Yahoo Finance, 2012
Chart I-1 initially came from the March 2012 issue of our newsletter, The HS Dent Forecast, and it is probably the most critical chart for illustrating the actual impact of the desperate Fed stimulus on stocks. It shows three major bubbles that also form a larger megaphone pattern, which indicates a massive fall in the coming years, most likely between mid-2013 and early 2015. In this pattern we see three bubbles with each one peaking a little higher, and with each crash bottoming a little lower. The first bubble was around tech stocks and peaked in early 2000. A huge crash followed, especially in tech stocks, which bubbled the most. The NASDAQ was down 76%. That crash formed the B wave down. Very low short-term rates after the 1990–1991 recession and the S&L crisis helped to fuel that bubble. The second, broader and higher bubble peaked in October 2007, with an early 2006 peak in real estate and a mid-2008 peak in commodities on each side. The greatest bubble here occurred in emerging markets and oil. That bubble was fueled by short-term rates, pushed down to 1% by the Fed. The crash of 2008/early 2009 formed the next D wave down. Now we are seeing a final bubble in stocks (US, Europe, China, and emerging markets), commodities, and bonds (especially junk bonds, which have rallied 90% since late 2008—nearly as much as the 111% rally in the Dow since March 2009). The NASDAQ has rallied 147% and emerging markets have rallied 138% at their top. Gold has rallied as much as 169% since late 2008 and silver a whopping 465% when it topped near $50 in April of 2011. This final bubble is likely to peak at a Dow 14,600 or a bit higher by mid-2013. Then a larger crash, likely triggered by a blow-up in Spain and southern Europe, is likely in early to mid-2013 and the Dow is likely to bottom by late 2014 or a bit later between 5,600 and 6,000. The ultimate bottom in the Dow is likely to be more like 3,300 to 3,800 between 2020 and 2022 before the next global demographic boom begins.
With the Fed keeping short-term and long-term interest rates low, speculators, investors, and pension funds are chasing higher yields on everything from corporate and junk bonds to commodities to stocks. Never have all of these investments gone up at the same time for so long. As in the 2008 crash, when everything goes up together, they then go down together, and there is nowhere to hide and no way to diversify. The US dollar index and US Treasury bonds were the safe haven in the last crash and will very likely be again. Gold and silver will not protect you, as they did not in late 2008!
The ultimate lows between 3,300 and 3,800 by 2022 or so line up with our observations that almost all bubbles either go back to where they started or fall even a little lower. The stock bubble started in late 1994 at 3,800 on the Dow, so we have been expecting 3,800 or lower for an ultimate bottom. The housing bubble started in early 2000. Home prices would have to fall 55% from the top to get back to those levels. The more a bubble grows, the more it attracts investors, but such a bubble also will fall farther, creating another wave of havoc.
It would be one thing if the government’s plan actually worked, creating sustainable economic growth so that high debt and asset prices would not be such a burden. However, the demographic and debt deleveraging trends we face are massive and will make sustaining a recovery even more difficult than for Japan in the 1990s, where a demographically induced crash that started in the early 1990s is still in force. Today the GDP of Japan is little higher than it was in 1990, 21 years ago! The big picture is very simple: adding stimulus and debt always works at first but never works long term. It takes more and more stimulus to create less...
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