Friday, November 16, 2007

Changing Tides V: A Return to Average

What is an "average return"?
As the Dow Jones Industrial Average (DJIA) has risen from 3,000 to 14,000 in a relatively short period of time, as house prices doubled and even tripled in a few years, and as gold has rocketed from $300 to $800, have we adjusted "average returns" up to a historically unsupportable expectation?

Just to illustrate the possibility that the recent past may be anything but "average," I prepared this chart: (see below)

Perhaps we can constructively apply the Pareto Principle here and propose that the recent past constituted only 20% of recent history but generated 80% of the investment returns. If this is the case, then not only have these outsized gains skewed long-term returns to the upside, the "average returns" of the past 12 years are not at all average but greatly above the norm (average).

For more on the Pareto Principle, please see my previous entry Hedge Funds and The Pareto Principle (February 19, 2007)

In the long view, it may be that this spike in virtually all assets--real estate, stocks, bonds and precious metals--is not "the new average" but a brief anomaly. For more on this possibility, please see my previous entry The Long Cycles of Prosperity, Decline and Upheaval (July 11, 2007)

If these two concepts are indeed at work, then we can expect a mirror-image of the huge outsized gains on the downside--that is, a period of extremely below-average returns. After markets drop back to where they would have been without a gigantic asset bubble, then perhaps they will resume historically average returns.

If we look at current history through the lens of the Kondratieff cycle (described in the essay link below), we discern the possibility that a long cycle of prosperity and decline might bottom around 2015 - 2020. For more on this line of inquiry, please see the previous entry Are We Poised on the Precipice of Another Age of Turmoil? (June 6, 2005)

What could cause such a capitulation of all asset prices and repudiation of debt? We could start by listing the structural problems which are being ineffectually papered over but which will have to be dealt with at some point:

1. Unaffordable entitlements. I have covered this ad nauseum, but Medicare and Social Security are simply not affordable--and neither are the public pensions promised to government employees.

2. Medical "care" as currently provided is exploding in cost even as its efficacy declines. This is a big part of why entitlements will have to be renounced; medical "care" (quotes communciate the fact that it is often not beneficial, but simply expensive) costs are increasing rapidly even as the positive results (better health, longer lives) become ever smaller.

3. The world's currencies are in declines which could end in a death-spiral of complete worthlessness. Judged by their purchasing power of gold, the world's currencies have already suffered catastrophic declines. (More on that next week.) If fiat money decreases in buying power, everyone paid in fiat money becomes progressively poorer.

4. Peak oil, water and food. As oil, soil and fresh water supplies are depleted, scarcity could become the norm, and costs of those essentials could rise to the point that most global consumers would have little money for anything but those essentials.

5. Debt costs crush consumers and governments alike. Should the cost of money rise, or lending dry up, then the stupendous debts taken on by consumers and governments alike in the past 15 years of "prosperity" will become too burdensome to carry. Debt will be repudiated on a massive scale.

6. Assets decline in value, eliminating borrowing power. If asset bubbles deflate, consumers will have less and less assets to borrow against, creating a deflationary feedback loop in which assets find fewer and fewer buyers even as the price declines accelerate.

7. "Asset wars" smoulder and ignite. If oil, water and food do indeed become scarce on a planetary scale then past human history suggests the probabilities for conflict rise.

For more on the cycles of human behavior which tend to make war more likely, please see The Rhythm of War (April 18, 2007)

8. Environmental degradation. Crop failures, extremes of weather, rising sea levels and drought (not to mention a virulent virus such as bird flu) could trigger social, political and military turmoil within and between nations.

I may have missed one or two, but these structural problems are certainly sufficient to cause an eventual asset/currency capitulation and debt renunciation.

Technical note: the curve-sets on the chart above are of the Nasdaq stock market for the years 1974-2007. I used this chart to suggest how asset bubbles can pop and revert to the mean. This particular asset spike was the dot-com tech-stock bubble.

Thank you, Cudick A., ($25), for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

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