Published 6/22/05


The internet is alive with pessimists who warn that the stock market will plummet from the current seriously overvalued levels, and that an unprecedented housing bubble will soon explode into a wave of panic selling. The Optimist, in contrast, hopes to offer some positive perspective in a soothing overview of the prospects for both major markets. As an essential disclosure, the Optimist must confess that he has no credentials for discussing either market, although he has in the past made a few modest profits in both. As one might guess from reading the commentaries by the Optimist, he focuses his investments within the precious metals arena, so he is little affected by changing price levels in either stocks or housing. Perceptive readers will recognize the previous statements as affirming that the Optimist doesn't know what he is talking about, and he doesn't have much interest in it anyway. The Optimist hopes to build on that solid foundation to provide some thought provoking viewpoints.


Stocks Are Overvalued, and Housing Is in a Bubble. . .


After reading what seems like millions of articles on our favorite internet sites, the Optimist is persuaded that their unanimous views are correct that the stock market price to earnings ratio should be much lower and that massive speculation by overly indebted purchasers have driven house prices much too high. Readers of this commentary have also read all of the same articles, and will be happy to learn that the Optimist won't repeat all the painful details that they have seen so often before. It goes without saying, of course, that selected individual stocks or houses will do better than the averages, but finding those gems may become comparable to the search for a needle in a haystack. The Optimist is as convinced as all the readers of this commentary that the stock averages and the median homes will be major disappointments to the bullish investors who expect them to gush profits like an oil well.


. . . But Stock Prices might not drop


Almost all of the articles I read are intently looking for a repeat of the October 1987 stock market crash, or the equivalent price destruction in a collapse of the housing market. The Optimist cautions that the future may hold a different path for stock and housing prices. The good news from the Optimist is that stock market prices could continue to rise for many years to come. If the stock indices do continue to rise, then the bears will find short sales to be an increasingly painful hobby. The primary reason that the Optimist considers it possible for stocks to continue to defy economic gravity and rise relentlessly is that a mysterious buyer with very deep pockets consistently steps in to purchase large quantities of stocks whenever the markets appear to be in danger of sliding down a slippery slope. The Optimist has no factual basis for identifying that mystery buyer, but he can pass along gossip he has read in other articles on the web. Those articles express a certainty that the mysterious buyer is a Plunge Protection Team (PPT) which is operated by the Treasury Department with actions that are coordinated by the Fed. For the benefit of the handful of people left in the financial universe who have not yet heard of the PPT, a simple internet search for Plunge Protection Team provides 710,000+ relevant articles to browse through for background.


Let's assume that 710,001+ articles (now including this one) can't be all wrong, and that there really is a PPT with deep pockets and with an intent on purchasing stock indexes when they show weakness. The effects on short sellers would be devastating. Bulls would begin to feel invincible and they would rush to buy any short term decline. If a decline did seem to be getting out of control, the PPT could simply step forward to absorb all the selling pressure, so that the revitalized bulls could then push the stock averages higher. The inevitable result of such action by a PPT with very deep pockets would be to insure that short sellers would become demoralized and would add more buying pressure to the market as the bears exited their short positions at a loss. The inevitable losses by the bears would further act to lift the markets higher. Foreign investors would see the bullish trend and conclude that the steadily rising stock market is an excellent place to invest a few surplus dollars they may accumulate.


The Optimist understands that many readers will think he has only proved how little he knows about the markets because a PPT operation of that magnitude would require really deep pockets, and because the buying pressure created by the PPT would reverse when they had to sell. Once again, the Optimist is happy to ease readers' concerns by assuring them that the combination of the Treasury Department and the Fed have very, very deep pockets. If millions aren't enough, then the Fed can add a few zeros to their spreadsheet and produce billions with a few mouse clicks. If billions still don't get the job done, then adding a few more zeros will let them click trillions. If the Fed wants to buy more than short sellers want to sell, then my bet is that the Fed will prevail and prices will go higher. Before the skeptics persist by sending flaming emails to tell me that is stupid because prices will just slump again when the PPT is forced to sell, consider this question. Are you sure that the PPT ever has to sell? Since the PPT is as secretive as the NSA (which is an acronym for No Such Agency), they don't exactly issue annual reports on their activities or invite an audit of their trading accounts. Maybe they take delivery of the stock certificates from their purchases and pay a few thousand technicians to shred the paper. Sounds like a great way to add jobs to the employment report, and that process would alleviate the need to eventually sell stock they were intent only on purchasing.


If a PPT exists and purchases whatever is necessary to prevent stock market declines, then the only good news for shorts is that persistent inflation will help them lose less value over time by reducing the purchasing power of the dollars they must lose in a stock market that is not permitted to decline.


Housing Prices Could also be Protected


The Optimist has not yet heard any rumors about house prices being protected from declines, so he is happy to have this opportunity to start one. Consider that refinancing mortgages to provide cash back for spending is a major pillar on which the consumers' ability to spend rests. A serious problem with consumers' cash flow in this housing bubble could be disastrous for the economy. Even a simple decline in house prices could begin an avalanche of foreclosures because many house buyers are drastically over extended. A significant downturn in the prices of real estate would have a very damaging effect on the economy. The fed is likely to exercise it's powers to protect the economy, even if that requires putting a floor under real estate prices.


All of the readers who agree completely with the Optimist are certain that house prices have inflated a massive bubble. The Optimist is not aware of any historical precedent for a housing bubble of this magnitude, so he cannot show you the awful results after a similar bubble encountered a sharp pinpoint. The Optimist can, however, share with you the learning experience of a lifetime he was fortunate enough to have survived in Houston. More than 20 years ago, the Houston economy was as hot as a car parked in the broiling summer sun at noon in Houston. An abundance of jobs were begging to be filled, and thousands of people were moving each week from parts north to Houston. Housing prices were marked higher almost daily, and the Houston real estate market may have been one of the fastest growing in the nation. The price of crude oil was hovering at $30 per barrel near record highs, and many people in the northern states (which were in recession and had high unemployment) could afford neither electricity nor heating oil. Many prosperous Houstonians heeded the calls to share their abundant wealth with less fortunate northerners, though a few scrooges were known to grumble "Let them freeze in the dark!" Interest rates that were higher than inflation provided us with an abundance of cash flow from the profits on our silver and gold investments which we closed out in 1980. Rapidly rising real estate prices ensured our future wealth. The first half of the 1980s was the best of times in Houston.


In 1986, crude oil fired a bullet through the Houston real estate bubble. In a few short months, the price of crude oil plummeted from $30 to $10. That may sound like good news (cheaper energy and gasoline), but the reality for Houston was just the opposite. A very high percentage of the Houston economy was predicated on thousands of companies which specialized in oil production, or oil transportation, or oil services, or oil something else. By mid 1986, most of those companies sang their final verse of "Turn out the lights, the party's over," and they shut their doors forever. All of those jobs, and all of the service sector jobs which supported them, had little alternative but to move out of Houston. Motivated sellers of real estate found that there were no willing buyers. People who had put 20% down on the purchase of their dream home in 1985 were suddenly deep in the red only a few months later as house prices in Houston plunged 50%. The word "foreclosure" didn't adequately describe the traumatic financial carnage as people all across the city simply walked away from entire neighborhoods of recently constructed homes. The economic pain in Houston was excruciating, even as the rest of the nation was enjoying a speedy recovery from the earlier recession.


It is unimaginable that the Fed would permit a comparable economic devastation throughout the entire nation if they have the means to avoid it. Some pessimistic people may think that the Fed is powerless to prevent the housing bubble from collapsing, and thereby thrusting the nation into a deep depression. The Optimist offers a more positive possibility. Consider that many communities have housing bubbles because buyers who have lots of credit card debts and no surplus cash flow are buying overpriced houses with nothing down and 40 year interest only ARM mortgages, with the interest rates likely to rise. That does sound like a bit of a concern. Can the Fed come to their rescue? "Of course not!" shout the pessimists. "Inflation is rising so the Fed can only raise interest rates, and that will drive more nails into the nation's economic coffin, with the house buyers locked inside!" Well, the Optimist suspects that the Fed may not be quite so powerless in the face of potential economic Armageddon. The Fed does, after all, preside over an economic buffet which can dish out all the fiat dollars anyone wants to eat. Within just the last few years, the Fed has lowered short term rates below what any economist I know could have predicted. Why can't they do it again? The pessimists might respond that lowering short term rates will only allow increased inflation, which drives up long term rates, and mortgage rates only respond to long term rates!


The Optimist is quite content to agree that inflation must rise, and that long term rates must eventually rise with inflation. When rising long term rates begin to threaten the housing bubble, however, the Optimist offers the positive view that the Fed, working through its friendly subsidiary banks, will find new ways to prevent the housing market from imploding. As an unlikely example which is intended only to illustrate the range of possibilities, banks could offer short term interest only bridge loans, which could be renewed indefinitely for existing homeowners who cannot pay the rising costs of their ARM mortgages. Those short term loans would be for an amount sufficient to pay off the more costly ARM mortgage loan, and might even offer additional cash back to the homeowner. That sounds far fetched at first glance because the interest rate on long term mortgages has always been less expensive than the rate on short term loans. Readers should keep an open mind, however, and view this unusual possibility as yet another example of This Time It Really Is Different. The Fed could persuade banks to offer "No Risk" short term bridge loans with real estate as collateral and at an interest rate which is only a little more than the interest rate banks pay for CD deposits. Even though rising inflation will push long term rates higher, the Fed controls short term rates and can keep them low enough to ensure survival of the economy. If it was possible to sell short the housing market, the Optimist would cautiously advise against doing so.


A little good advice is that when you find yourself in a hole, stop digging. At the same time the Fed is deploying creative financing as a lifeline for existing homeowners, the Fed could also begin to reduce the scope of the problem in the future by encouraging banks to gently increase down payment requirements for the purchase of a new home to maybe a few hundred dollars per million dollars of house price. That type of old fashioned restraint would help to slow the rampant new construction which is adding too much supply to the bubble, and would help to channel America's dwindling supply of greater fools into existing houses where they will help to keep the bubble inflated.


Deflation Will Not Be Permitted


Even though the Optimist previously slew the Worry About Deflation dragon, that multi headed Hydra continues to pop up in web sites everywhere. Those sites argue variations of (A) there is already much too much debt (astoundingly true); (B) the economy is weak from loss of solid manufacturing jobs (sadly true); (C) low cost foreign labor will prevent the US economy from adding the dependable jobs that are needed for sustained growth (frustratingly true); (D) a perpetually weak economy cannot afford to pay the escalating debt service costs (frighteningly true); (E) the trade, current account, and budget deficits all add crushing new debt at an ever faster rate (unbelievably true); (F) the combined weight of all these negatives makes a depression unavoidable (inevitably true); and (G) therefore there will be deflation (probably false).


Those who correctly foresee the coming depression persist in remembering the Great Depression of the 1930s. That was a dreadful time in America, and deflation acted to make the pain far worse than it otherwise might have been. It was not possible then to have a depression without deflation because legal tender was gold and silver. Even after FDR confiscated gold from Americans, the dollar was still convertible to gold overseas. The linkage of the dollar to precious metals prevented the fledging Fed from flooding the US economy with liquidity. As the economy cascaded into deeper levels of depression, there was insufficient money to meet the needs of people, so money became scarce, and therefore more valuable, so that the dollar could buy more stuff in the 1930s than it could in the 1920s. The Optimist's definition of deflation is the dollar increasing in value so that it has higher purchasing power. Because money in the 1930s was gold and silver, deflation was an unpreventable economic reaction to the financial excesses of the 1920s.


Compare and contrast the 1930s with now. The comparison is easy. America of today is deep in debt which is growing at an exponential rate, and jobs are fleeing our nation at a frightening pace. Cooking that recipe can result only in a depressionary stew, and the Fed's ability to control the process is limited to slowing the rate at which the broth is simmered. The contrast is equally easy. Legal tender is no longer gold or silver. Precious metals no longer constrain the Fed from creating liquidity. Since the Fed is capable of adding essentially unlimited amounts of fiat money to the economy, they now have the ability to insure that a debt snowball doesn't roll and grow enough to transform into an avalanche. Even though a depression is just as inevitable over the coming years as it was 75 years ago, deflation is now optional. Instead of being an economic necessity as in the 1930s, deflation is now determined by a political process. Politicians and the Fed can choose whether to continue climbing the ever steepening inflationary mountain, or falling off the path into a deep deflationary ravine. The Optimist can offer no guarantees, of course, but he is grateful that he has the opportunity to bet that politicians will always opt for the relatively easy and less painful path of inflation rather than the sure political and economic death of falling into a deflationary depression.


Those who expect deflation to give their dollars greater buying power, are likely to be disappointed as the value of those dollars shrinks over time. The advocates of deflation make the mistake of looking at today's economic problems through a filter which shows only the results when the laws of 1930s economics are relevant. Instead of the 1930s as a model, we need to look closely at how the economy performed 30 years ago. The stagflation and rising misery index of the 1970s will show the direction in which our present economy will move into the future.


The immense amount of USA wealth that is owned by foreign nations does represent a wildcard that even the Fed may not be in a position to control. The Optimist is hopeful, however, that foreign nations will continue to handle their international financial dealings in a moderate and responsible manner.


Investment Profits Are a Different Question


So let's recap so far. The Optimist has argued that the Fed will not permit the stock market to suffer a sharp drop, will not allow the housing bubble to collapse, and will not tolerate deflation. Does that mean stocks and houses are good investments? No! Even as the fires of inflation burn ever hotter, the economy continues to cool as it slides toward depression. The profit outlook for stocks is bleak. Without growing profits, the rise in stock prices will be sluggish at best. Similarly, as more Americans lose their jobs, the number of greater fools who bid up house prices will dwindle. Stocks and houses will also find it difficult to advance against the strong headwinds of higher long term interest rates and rising taxes. The Optimist guesses that the prices of stocks and houses will rise over the next decade, but at a rate which is much less than inflation. If that guess is correct, then a chart of the inflation adjusted prices of stocks and houses should soon peak and begin a slow descent into the future. That inflation adjusted chart is where the proponents of deflation will find what they seek. Even though the nominal prices will stay steady or climb slowly, the true values will inexorably decline due to the loss of purchasing power caused by inflation.


The prices of precious metals, in contrast, will not only advance with inflation, but will likely rise faster as the price compression of the last two decades is released. The Optimist is grateful that he can diversify his portfolio by investing in precious metals in several different ways!


Addendum to Stocks and Houses Might Not Fall Off a Cliff  6/26/05


A few readers may have misinterpreted this commentary as a quick reaction to one specific event or another within a few days preceding publication. The Optimist is flattered that readers believe he has the ability to quickly produce a quality work on demand within a very brief time. Alas, the unfortunate sordid truth is that quick work done by the Optimist has little style, and is filled with errors, omissions, and inadequately presented ideas. Resolving those loose ends can take days of editing time. For this commentary, those few days of writing time were spread out leisurely over the preceding three weeks.


The Optimist has been intently interested in inflation versus deflation debates for more than 30 years. The 1970s were an exciting learning time, but that environment offered only a limited viewpoint with respect to inflation. Throughout the decade, inflation was ever present, painfully obvious, and persistently increasing. Many of us began to believe that increasing inflation was a permanent fact of life, and we were aggressive in purchasing real assets (i.e., precious metals, commodities, collectibles, real estate, etc.) to profit from the obvious trend.


In 1980, Paul Volcker changed the rules of the investment game, and taught us new lessons. By sharply increasing interest rates to higher than inflation, he reversed the previously rising trend of inflation. Although inflation was still much higher than it is now, it then became increasingly more difficult to profit from bullish bets on precious metals. By 1986, I realized that neither the level of inflation nor the level of interest rates was the key to successful investing in precious metals. The actual controlling factor was the level of real interest rates. In a fledging newsletter which I published for only a few months in 1986, I presented a chart like Real Interest Rates Control Gold and Silver to explain why precious metals exploded higher in the previous decade, and then plummeted in the 1980s.


Real interest rates provide good guidance about the investment climate in much the same way that a calendar offers guidance about the temperature. Any day in the year can be hotter or colder than the day before, but it is more profitable to bet there will be hot days in the summer and cold days in the winter. With a bias based on real interest rates, the Optimist has "diversified" most of his investments into several precious metals "eggs," but he keeps them all in the same inflation basket where he watches them like a hawk.


Since the success or failure of his portfolio depends in large measure on the relationship between interest rates and inflation, he is intensely interested in the future course of both.  Several different people on various websites have authored many articles over the last year emphatically stating as fact that rising debt and worsening employment makes a deflationary collapse inevitable soon. Since the Optimist's basket of eggs would take a painful tumble if those forecasts are correct, he reassesses his bullish posture every time he reads about the certainty of imminent deflation. Each time so far, he concluded that deflation is not the choice that he wants to bet on until the Fed takes the painful action to push real interest rates firmly into positive territory (déjà vu 1980). That viewpoint continues to be comfortable for the Optimist. He cautions all readers, however, that they should keep an open and inquiring mind about all viewpoints, and they should do their own due diligence as if their portfolio profits depend on it!


Those who so clearly see deflation ahead may yet be proven correct. For now, however, the Optimist does not share that vision, and he is content to continue betting that precious metals will prosper until real interest rates return to positive territory. The Optimist wishes good luck to all investors, though he secretly hopes that inflation optimists will score better in this grand game than deflation pessimists!


Click this link to see reader comments and replies by the Optimist (updated 7/19/05)



* * * Notice * * *

This commentary presents only the viewpoints of the Optimist, and it is intended only for perspective and entertainment.  Please do not interpret any portion of this work as investment advice.  If any of the concepts discussed here appeal to you, then you must do the work to decide if and when and how you should invest.  The Optimist does not ask for any profits you make, and he cannot be liable for any losses incurred as a result of your investment decisions.  The Optimist wishes you the best of luck in whatever you decide to do or not to do.  Cheers!


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by Jim Otis