Deadly Dow 36,000 & The Secret History Of A 70% Market Loss
By Daniel R. Amerman, CFA
Below is the 2nd half of this article, and it begins where the 1st half which is carried on other websites left off. If you would prefer to read (or link) the article in single page form, the private one page version for subscribers can be found here:
Current Asset Deflation Risks
To illustrate the extent of the danger for today's investors when the destruction of the value of money (price inflation) hides the destruction of the value of assets (asset deflation), let's begin by assuming that the markets experience a 70% real loss, which is the same as what actually happened between the late 60s and early 80s. Using a round 12,000 for the value of the DJIA, that would translate to an index value - before inflation - of 3,600.
However, we must keep in mind that much is different now when compared to this previous bout of asset deflation. For example, Europe was not then on the verge of possible financial system failure, thereby endangering US export markets, jobs and corporate profits in a globalized world.
Moreover, Asia had not yet become the world's global manufacturer, so there were still plenty of US manufacturing jobs to be filled when the economy did turn around.
Perhaps most importantly, there was an oncoming surge of free-spending young adults - the Baby Boomers - who as consumers and workers would turn the US economy around in the early 80s. This has now been reversed, with the Boomers becoming a retirement juggernaut who will be simultaneously selling massive amounts of investments into the markets, even as consumption drops with a graying population.
Given how much has changed between then and now, a mere repeat of that historical 70% decline might be considered a conservative assumption.
Deficits, Debt, "Printing" Money & Higher Inflation
As with asset deflation, when it comes to monetary inflation, there are powerful and unfortunate differences between the 1970s and now.
The Federal government has had its credit rating downgraded because it is borrowing an amount equal to almost 10% of the total economy each year, with no end in sight, to fund ever-growing government promises. As documented in my article, "Six Layers Of Deficit Impossibilities" (linked here), the current national debt amounts to $152,000 per able-to-pay US household, and the total amount owed increases to $640,000 per household when we include unfunded US government promises to future retirees.
The global financial system is being kept from collapse only by the direct creation of trillions of dollars and euros which are being passed to financial institutions and other favored corporate insiders on non-market terms.
Impossible promises to retirees and government bond buyers from effectively bankrupt governments are all too likely to be repaid with inflation. If we assume not the historical 65% destruction of the value of money - but a 90% destruction (which is consistent with the Federal Reserve's creating dollars by the trillions out of thin air), then a dollar becomes worth ten cents.
As shown below, if a dollar is worth ten cents, then the Dow must rise (in nominal terms) to 36,000, in order for it to be worth 3,600 in real terms.
The blue in the graph represents reality, with the purchasing power of our investments dropping 70% from our starting point on the left, to our ending point on the right. However, when we include the "Illusion Of Inflation" in the column on the right, and we combine 70% asset deflation with 90% dollar destruction - then we get Dow 36,000.
Paying Whopping Taxes While Our Net Worth Is Destroyed
The illustrated "fiery" rise from Dow 12,000 to Dow 36,000 is spectacular indeed, and is likely to draw the full attention of a keenly interested party - a near bankrupt government that is starved for tax revenues.
It is government fiscal and monetary policy that creates inflation; however, inflation losses are not recognized under the tax code. So we owe taxes in full on the 24,000 point rise in the Dow - even though we actually lost 70% of the value of our investments in that rise.
Eventually, excessive borrowing and high inflation will restrict the government's ability to use deficit financing, and either the spending must plummet as generations-worth of promises to retirees are broken, or taxes must be substantially increased - or both. Unfortunately, "wealthy" investors who have been enjoying apparently "stratospheric" profits on their retirement investment accounts are likely to be all too tempting of a target, resulting in rising tax rates even while retirement tax shelters are restricted or eliminated.
The above chart assumes a 50% tax rate, which while above recent rates, is still nowhere near the highest levels seen in modern history. Keep in mind that the government may be near bankrupt, with tens of millions of enraged voters not getting the promised level of Social Security benefits they thought they had been paying for with decades of payroll taxes.
Paying 12,000 in taxes on a 24,000 point "profit" leaves us with the after-tax equivalent of a 24,000 Dow. When we adjust for a dollar being worth ten cents, we are left with Dow 2,400 - which is only 20% of what we started with.
As the chart shows, the illusionary "profits" caused by inflation allow the government to use inflation taxes to take a third of the value of the assets we had left after the 70% bout of asset deflation, leaving us with an 80% loss on our savings.
Alternative Assets
A very attractive alternative for many investors is to try to bail out of paper money and paper assets altogether, and to seek to preserve wealth through tangible assets such as precious metals and real estate. Tangible assets can indeed form the cornerstone of successful investment strategies in difficult markets, but unfortunately (and ironically), most popular inflation hedges don't take inflation taxes into account.
My article, "Hidden Gold Taxes" (linked here), explores how a combination of high inflation and rising tax rates can devastate what looks like a perfectly executed gold investment strategy, turning what on the surface appears to be spectacular profits into a major loss on an after-inflation and after-tax basis, with the government effectively ending up with much of the gold investor's starting net worth.
Precious metals are a great way to survive and even profit during financial turmoil - but inflation taxes have to be fully taken into account in the strategy.
The Triple Redistribution Of Wealth
Fortunately, there are solutions. But to apply them, one must first recognize and understand the redistribution of wealth.
While the value of the paper dollar did fall by 65% between 1968 and 1982, and the inflation-adjusted value of the paper wealth that is the Dow did fall by 70% - the real wealth of the country as a whole did not fall by 65-70%. For real wealth is not paper assets in a bank or brokerage account, but is goods and services. Real wealth is the economy and the collective standard of living.
The economy did not fall, but rather it grew by a cumulative total of 25% in inflation-adjusted terms over those 14 years, with an annual average real growth rate of about 1.6%. The 70s and early 80s were deeply troubled, and this real annual growth rate is about half of the long-term average for the modern era in the United States - but the sum total when it comes to real wealth was still positive.
Now, we know that tens of millions of savers who were relying on their savings to at least partially pay for their standard of living did necessarily see a fall in their standard of living - because what their dollars could buy for them did fall by 65%, and after-tax interest payments were not nearly enough to keep up.
However, this dramatic drop in potential standard of living was not experienced by the nation as a whole. Rather, there was necessarily a redistribution of wealth - with tens of millions of other people benefitting (albeit accidentally in most cases) from the destruction of the paper dollar that was severely hurting tens of millions of savers.
We also know that there were indeed millions of stock investors who experienced asset deflation savaging the purchasing power of their portfolios. Because the value of paper wealth in the form of stocks fell by 70% - while overall real wealth grew for the nation - there was indeed a major redistribution of the relative rights to enjoy this real wealth of goods and services.
Inflation taxes are, of course, a major redistribution of wealth. Government economic policy creates inflation, while government tax policy pretends inflation doesn't exist. Through taxes, massive illusionary profits are taken from savers and investors, and redistributed by the government.
When inflation is high, inflation taxes act as lead weights, pulling down and even crippling the performance of most inflation hedges and general investment strategies alike - until one realizes that they are created by government blindness to inflation. On a fundamental level, this blindness necessarily opens the door to out-of-the-box counterstrategies for achieving profits that are in plain sight - even if government tax policy doesn't see them.
Turning Wealth Destroyers Into Wealth Creators
When we put the three wealth destroyers on the left column together - as has happened in the past and may be happening again in the near future - then conventional finance strategies simply can't cope, not once we look at results in after-inflation, after-tax and after-expense terms.
The end result is the impoverishment of savers and investors by the tens of millions. And because the great majority of paper assets are held by older people, it will be the Boomers and their parents who pay the highest costs, as wealth is redistributed away from them.
I have spent many years studying these issues and exploring different possible solutions. And over these years I have become convinced that the best answers can only be found by first finding the right questions to ask.
The essential questions aren't about how to achieve the best results within a conventional long-term investment approach. Because as we saw with the "perfect timing" scenario, when broad and powerful wealth destroyers are moving against all investors, and on a sustained basis - then coming out ahead becomes excruciatingly difficult, and in the real world will likely only be achieved by a tiny fraction of investors.
Instead, let me suggest that the better approach is to move to a more fundamental and holistic level, taking into account everything that determines our net worth and standard of living, and asking the three following questions:
How can I personally and realistically change my financial profile and strategy so that monetary inflation redistributes wealth to me? And the higher the rate of inflation, the higher my real wealth grows?
How can I change my strategy so that asset deflation becomes a profit opportunity rather than a wealth destroyer?
How can I take advantage of the government's blindness to inflation and reverse inflation taxes, so that instead of paying real taxes on imaginary income, I am (perfectly legally) paying imaginary taxes on real income?
These are not the usual questions.
But they are the essential questions.
Because when we successfully answer all three questions, and reverse all three wealth destroyers, then we have three wealth creators instead. These wealth creators can then build upon each other, and transform our personal finances in a time when paper wealth is being destroyed all around us.
Finding the best answers means stepping well outside the usual approaches, and this will mean that our strategies may look radically different than those around us. Which is exactly what we need, because if sustained high monetary inflation, severe asset deflation and inflation taxes do return - those who do nothing to change their "normal" financial profiles will face year after year of pervasive and sustained financial pain, with declining wealth and potentially declining standards of living. Much like they did before, only on a larger scale this time.
What you have just read is an "eye-opener" about one aspect of the often hidden redistributions of wealth that go on all around us, every day.
A personal retirement "eye-opener" linked here shows how the government's actions to reduce interest payments on the national debt can reduce retirement investment wealth accumulation by 95% over thirty years, and how the government is reducing standards of living for those already retired by almost 50%.
An "eye-opener" tutorial of a quite different kind is linked here, and it shows how governments use inflation and the tax code to take wealth from unknowing precious metals investors, so that the higher inflation goes, and the higher precious metals prices climb - the more of the investor's net worth ends up with the government.
Another "eye-opener" tutorial is linked here, and it shows how governments can use the 1-2 combination of their control over both interest rates and inflation to take wealth from unsuspecting private savers in order to pay down massive public debts.
If you find these "eye-openers" to be interesting and useful, there is an entire free book of them available here, including many that are only in the book. The advantage to the book is that the tutorials can build on each other, so that in combination we can find ways of defending ourselves, and even learn how to position ourselves to benefit from the hidden redistributions of wealth.
