Cycles Of Crisis & The Containment Of Crisis

(Brief Excerpts & Chapter Links)

Stocks, bonds and homes account for the great majority of the net worth of most people - and all of these asset values are up by 30% to 50% over the last 20 or so years, when compared to long term averages (even after accounting for inflation).

As explored in this analysis, there is a shared reason for these much higher valuations. There is also a reasonable chance that they could eventually go much higher still, and perhaps persist for many years to come - though the path to that possible future would be a surprise to most people.

On the other hand, if we at any point merely return to the average valuations of most of our lifetimes - then what could be the loss of most or all of their home equity and much of the value of their retirement accounts could have long-lasting consequences for many millions of households.

The graph above shows asset prices from 1975 to 2018, as a percent of the long term averages for each class before the year 2001. Whether we are looking at stocks, bonds, homes or gold - the trend lines are all up sharply since 2001, even in inflation-adjusted terms.

This perception is confirmed when we knock out the "zig-zags" by averaging the prices from 2001 to 2018 for each asset category, and then compare the results to the averages from 2000 and before, as shown in the graph below.

Each dollar of earnings for stocks in the S&P 500 is being valued by the markets as being worth almost 50% more, compared to the prior long term average.

Single family homes are worth about 32% more, even after adjusting for inflation and changes in home sizes. Equivalent ten year Treasury bonds are being valued as being worth an average of about 34% more.

And while gold is quite different from the other categories - it shares the dramatic increase in value since 2000, with the inflation-adjusted price per ounce being up by almost 50% compared to prior long term averages.

While the specifics vary widely on a year by year basis for each asset class, the dramatic average price increases for stocks, bonds, housing and gold are no coincidence. Instead, there is a common causality in play, and all can be traced to the same source - the unprecedented and heavy-handed policies that the Federal Reserve adopted in response to the asset bubble collapses of 2001 and 2008.

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Next Recession: Turning Zero Percent Interest Rates Into A 21% Yield

If there is a new cycle of recession in the next few years, then it is highly likely that the Federal Reserve will take extreme measures in response, with the primary response being to swiftly knock short term interest rates back down to zero percent.

For many investors - the combination of recession, heavy-handed Fed interventions, and the return of zero percent interest rate policies (ZIRP) is likely to produce devastating results for their portfolios, and possibly their standard of living in retirement.

At the same time - some quite attractive profit opportunities will also exist, once we learn how to see them.

This analysis explores one reasonably simple, practical and easy to implement alternative for playing the new Federal Reserve cycles. It shows how to turn zero percent interest rates into a 21% annual return. It has nothing directly to do with precious metals - other than being a complementary strategy that can be used as part of a diversified response to a potential recession. Unlike most investment categories - the harder the recession strikes, the better and faster this investment is likely to perform.

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Five Graphs Showing How Fed Cycles Created 6X The Real Estate Profits

As explored in this analysis, the fundamentals governing investment valuations have changed in the last 20 years. Using real estate as an example, we have seen increases in price that dwarf historical averages - even in inflation-adjusted terms. Yet, the losses can be much greater as well, as can be seen in the graph below.

The five graphs use the tools of financial analysis to explore in detail an aspect of investment valuation that is counter-intuitive for most people but yet is likely to be essential for investors in the modern era: how what might seem to be bad news can in a logical and rational process create new levels of investor profits that may substantially exceed historical averages. These new relationships have changed not only real estate investment, but have also changed investment performance for stocks, bonds and precious metals.

When we understand why the recent past has been so different from long term averages, then we can also understand why some of the largest profits and losses in history may still be ahead of us - but what will govern those profits and losses are factors that few homeowners and investors are taking into account today.

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The Wealth Function, Fed Cycles & Permanent Losses

In a previous analysis we explored the relationship between a new generation of heavy-handed Federal Reserve interventions - and the highest asset prices in history. There is a problem, however, with asset prices that are based on extraordinary interventions - what happens to the asset prices if the interventions cease and we return to average?

The new Fed cycles can produce some of the highest asset prices and profits in financial history - but they also carry the potential for some of the greatest losses.

As explored herein, the simple stress test of assuming a return to the normal investment valuations of most our lifetimes could inflict investment losses that are not only crippling - but are effectively "permanent" as well. There would be no reason to expect a cyclical recovery of those losses, even when the economy itself fully recovered.

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The Lucrative Profitability Of A Move To Negative Interest Rates

If we face an amplified crisis in the future - then the U.S. government and Federal Reserve have no intention of just letting the market forces play out. Instead, the intention is to contain a potential deeper round of crisis with the most extreme interventions yet.

In this analysis, we will explore a potential amplification of the Fed cycles, and how a possible future of negative interest rates in combination with quantitative easing could become one of the largest redistributions of wealth in U.S. history, with hundreds of billions of dollars in profits going disproportionately to insiders - at the expense of the general public. As illustrated with a step by step example, when we follow the money - $279 billion out of every $1 trillion in newly created money could end up going straight into the hands of organizations and individuals who make up a relatively small percentage of the nation.

If there is another recession, then the Federal Reserve intends to engage in what could become the largest round of monetary creation in U.S. history. Those dollars will be quite real, and the reason for their creation is to spend them. A big chunk of that spending will become profits going straight into the pockets of investors. This won't actually be a closed game - anyone can try for a share of those new Federal Reserve dollars, but first they have to understand that the game exists, and then they need to learn how it is played.

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Using A Matrix Framework To Identify Cyclical Risks & Opportunities

The United States has been moving through cycles of crisis and the containment of crisis, with an unprecedented degree of heavy-handed interventions by the Federal Reserve feeding the cycles and deeply distorting investment results.

These cycles are likely not over, but are ongoing and may even be amplifying. If the cycles do continue, and particularly if the amplification continues, then some of the biggest losses which we have seen to date are likely still ahead of us, and possibly within the next few years. These losses could be devastating for many millions of investors following traditional strategies.

However, when we take not a "gloom & doom" perspective, but a cyclical perspective, then we can understand the many logical reasons for why a new cycle of some of the highest asset prices and largest profits of our lifetimes for 1) stocks; 2) bonds; 3) real estate; and 4) precious metals could also still be awaiting us in the coming years.

In combination, the cycles and the extraordinary degree of Fed interventions create more volatile markets, with higher highs and lower lows than have existed in the past - and they do so in a rational sequence, much of which can be understood in advance by investors.

Using a matrix, with the cycles as the columns and the investment categories as the rows, we will introduce a new framework for seeing and understanding the many investment implications of the cycles in an environment where the economy and markets are still dominated by heavy-handed Fed interventions. This framework can be systematically applied to identify the logical sequences of nontraditional risks and heightened opportunities for each of the individual major investment categories at each of the different stages in the cycles, as well as in each of the transition points between the cycles.

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