Conquer the Crash by Robert Prechter - Excerpts

Conquer the Crash: You can SURVIVE and PROSPER in a Deflationary Depression. Robert R. Prechter, Jr. 2002. ISBN 0-470-84982-7

EXCERPTS

If you follow the advice in this book and no financial crisis occurs, you cannot get hurt. In fact, you should profit nicely form most of these suggestions. Even if my outlook proves incorrect, the worst case is that your money will earn less than it otherwise may have.

… the largest stock-market collapses appear not after lengthy periods of market deterioration indicating a slow process of long-term change but quite suddenly after long periods of rising stock prices and economic expansion. A depression begins, then, with the seemingly unpredictable reversal of a persistently, indeed often rapidly, rising stock market. The abrupt change from increasing optimism to increasing pessimism initiates the economic contraction.

A bull market that has endured since the time of the Great Depression is definitely ending, and its termination could well mark the end of an uptrend of one degree larger, which has endured since the founding of the Republic.

… stock market advances and economic cycles must get weaker before they reverse. The final rise is where that weakness must be evident. Advances come in five waves, so the fifth wave is where the relative weakness manifests. The mechanism of that difference, I believe, is the immense optimism of major fifth waves, which encourages the populace to engage in financial speculation. Third waves are built upon muscle and brains. Fifth waves are built upon cleverness and dreams. During third waves, people focus on production to get rich. During fifth waves, they focus on finance to get rich.

A prime symbol of the deterioration … is the Federal Reserve System. Its manipulation of money and credit for the past 89 years … has been so destabilizing that it has transformed America from a production powerhouse into a society obsessed with dodging inflation and manipulating money and credit. A prime symbol of the deterioration in wave V … is General Electric, the oldest name in the Dow Jones Industrial Average. Through wave III ending in 1966, GE was one of the finest engineering and manufacturing concerns in the world. Its goods lasted for decades. In wave V, accountants took over the company and transformed it from a manufacturing concern into a financial concern. Today, its manufactured goods are mediocre and its vaunted company a cardboard edifice of credit services. It is the United States in microcosm.

If no dividend is ever paid, of what value is a share of stock? Do you really want to own a share of a super-successful enterprise that handsomely pays everyone involved in it except you, an owner?

Corporate earnings cycle with the stock market but with a 2-month to 2-year lag. Earnings do not begin to rise until well after stock prices have turned up from a bottom, and they do not begin to fall until well after stock prices turn down from a top. For this reason, the two trends often oppose each other. In contrast, book values and dividend payouts tend to be much steadier, cycling only on a very long-term basis with the largest economic trends, therefore providing a steady benchmark against which to compare stock prices to obtain a reliable relative valuation measure.

As I write this chapter, the “watchdog” of earnings, Standard & Poor’s, has just bowed to pressure to change the basis of its earnings reports to “operating earnings” rather than total company earnings so that the reported P/E ratio will henceforth be about half of what it really is.

The engine of high stock market valuation is widely shared optimism. The greater the degree of the advance that is to ending, the greater the optimism at its peak. Optimism also tends to remain strong in the early stages of a bear market … Bull markets, they say, climb a “Wall of Worry.” I like to add, “and bear markets slide down a Slope of Hope.”

To summarize, though my outlook may sound impossible, I am quite comfortable saying that the DJIA will fall from quintuple digits, where it is today, to triple digits, an unprecedented amount.

A pertinent observation with respect to our current concern is that a mania is always followed by a collapse so severe that it brings values to below where they were when the mania began.

Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt).

Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan generates the financial return that makes repayment possible. The full transaction adds value to the economy.

Near the end of a major expansion, few creditors expect default, which why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

A high-debt situation becomes unsustainable when the rate of economic growth falls beneath the prevailing rate of interest on money owed and creditors refuse to underwrite the interest payments with more credit.

A deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people’s desire and ability to lend and borrow. A depression is characterized in part by a persistent, sustained, deep, general decline in production.

Governments have often outlawed free-market determinations of what constitutes money and imposed their own versions upon society by law, but earlier schemes usually involved coinage. Under central banking, a government forces its citizens to accept its debt as the only form of legal tender. The Federal Reserve System assumed this monopoly role in the United States in 1913.

In 1933, President Roosevelt and Congress outlawed U.S. gold ownership and nullified and prohibited all domestic contracts denoted in gold, making Federal Reserve notes the legal tender of the land. In 1971, President Nixon halted gold payments from the U.S. Treasury to foreigners in exchange for dollars. Today, the Treasury will not give anyone anything tangible in exchange for a dollar. Even though Federal Reserve notes are defined as “obligations of the United States,” they are no obligations to do anything. Although a dollar is labeled as a “note,” which means a debt contract, it is not a note for anything.

The International Monetary Fund, the World Bank and similar institutions, funded mostly by the U.S. taxpayer, have extended immense credit around the globe. Their policies have supported nearly continuous worldwide inflation, particularly over the past thirty years. As a result, the global financial system is gorged with non-self-liquidating credit.

If the duration of recent past cycles is to repeat, then the falling portion of the current economic cycle would last another two years, and the depression would reach bottom in 2004.

The primary basis for today’s belief in perpetual prosperity and inflation with perhaps an occasional recession is what I call the “potent directors” fallacy. It is nearly impossible to find a treatise on macroeconomics today that does not assert or assume that the Federal Reserve Board has learned to control both our money and our economy. Many believe that it also possesses immense power to manipulate the stock market.

For many people, the single biggest financial shock and surprise over the next decade will be the revelation that the Fed has never really known what on earth it was doing. The spectacle of U.S. officials in recent weeks lecturing Japan on how to contain deflation will be revealed as the grossest hubris.

If people and corporations are unwilling to borrow or unable to finance debt, and if banks and investors are disinclined to lend, central banks cannot force them to do so. During deflation, they cannot even induce them to do so with a zero interest rate.

One example of action impelled by defensive psychology is governments’ recurring drive toward protectionism during deflationary periods. Protection is correctly recognized among economists of all stripes as destructive, yet there is always a call for it when people’s mental state changes to a defensive psychology.

The ultimate effect of deflation is to reduce the supply of money and credit. Your goal is to make sure that it doesn’t reduce the supply of your money and credit.

The ultimate effect of depression is financial ruin. Your goal is to make sure that it doesn’t ruin you.

The main goal of investing in a crash environment is safety. When deflation looms, almost every investment category is associated with immense risks. Most investors have no idea of these risks and will think you are a fool for taking precautions.

An added problem with owning government bonds is the political risk. Governments have a long record of stiffing their creditors in a crisis, and no government is immune from adopting that solution to its financial problems. A new regime especially may have little regard for previously squandered credit.

In the initial stages of a depression, sellers remain under an illusion about what their property is really worth. They keep a high list price on their house, reflecting what it was worth last year. I know people who are doing that now. This stubbornness leads to a drop in sales volume. At some point, a few owners cave in and sell at much lower prices. Then others are forced to drop their prices, too. What is the potential buyer’s psychology at that point? “Well, gee, property prices have been coming down. Why should I rush? I’ll wait till they come down further.” The further they come down, the more the buyer wants to wait. It’s a downward spiral.

Taking out a home equity loan is nothing but turning ownership of your home over to your bank in exchange for whatever other items you would like to own. It’s a reckless course, and it stems from the extreme confidence that accompanies a major top in social mood.

Owning an array of investments is financial suicide during deflation. They all go down, and the logistics of getting out of them can be a nightmare. There can be weird exceptions to this rule, such as gold in the early 1930s when the government fixed the price, or perhaps some commodity that is crucial in a war, but otherwise, all assets go down in price during deflation except one: cash.

Why do banks fail? For nearly 200 years, the courts have sanctioned an interpretation of the term “deposits” to mean not funds that you deliver for safekeeping but a loan to your bank. Your bank balance, then, is an IOU from the bank to you, even though there is no loan contract and no required interest payment. Thus, legally speaking, you have a claim on your money deposited in a bank, but practically speaking, you have a claim only on the loans that the bank makes with your money.

Some states in the U.S., in a fit of deadly “compassion,” have made it illegal for a bank to seize the home of someone who has declared bankruptcy. In such situations, the bank and its depositors are on the hook indefinitely for a borrower’s unthrift.

The estimated representative value of all derivatives in the world today is $90 trillion, over half of which is held by U.S. banks. Many banks use derivatives to hedge against investment exposure, but that strategy works only if the speculator on the other side of the trade can pay off if he’s wrong.

If the authorities in your country decide to disallow short selling, the bad news is that this option will be closed to you. The good news is that they usually take such actions near the major bottoms, so it will probably be about the proper time to cover shorts and start composing your “buy” list anyway.

If your government decides to confiscate gold, your country’s banks will be recruited in the operation. If it happens sometime in the coming crash, the reason will probably be “fighting terrorism.”

With the retirement setup in the U.S., the government need not be as direct as Argentina’s. It need merely assert, after a stock market fall decimates many people’s savings, that stocks are too risky to hold for retirement purposes. Under the guise of protecting you, it could ban stocks and perhaps other investments in tax-exempt pension plans and restrict assets to one category: “safe” long-term U.S. Treasury bonds. Then it could raise the penalty of early withdrawal to 100 percent. Bingo. The government will have seized the entire $2 trillion held in government-sponsored, tax-deferred 401K private pension plans. I’m not saying it will happen, but it could, and wouldn’t you rather have your money safely under your own discretion?

Bear markets engender labor strikes, racial conflict, religious persecution, political unrest, trade protectionism, coups and wars. In the area of personal behavior, part of the population gets more conservative, and part gets more hedonistic, and each side describes the other as something that needs reform. One reason that conflicts gain such scope in depressions is that much of the middle class gets wiped out by the financial debacle, increasing the number of people with little or nothing to lose and anger to spare.

Usually in a major bear market, you are less likely to encounter a mob, a criminal or a terrorist than to face state-sponsored controls within your own country or military attack from without, and there may be little that a retreat or karate can do for you in those situations.

You cannot anticipate every possible law, regulation or political event that will be implemented to thwart your attempt at safety, liquidity and solvency. This is why you must plan ahead and pay attention. As you do, think about these issues so that when political forces troll for victims, you are legally outside the scope of the danger.

Far more people in the past century had their lives wrecked or terminated by domestic implosions that by war. Whether you lived in Russia in the 1920s, Germany in the 1930s, Europe in the 1940s, China in the late 1940s, Cuba in 1959 or Cambodia in the 1970s, the smart thing to do early was to get out of Dodge.

People and institutions that best weather the system-wide debt liquidation of a deflationary crash and depression are those that take on no debt and extend no risky credit. This is the ideal situation for most people most of the time, anyway.

If you are entrepreneurial, start thinking of ways to serve people in a depression so that you will prosper in it. For example, I am writing this book. Think about what people will need when times get hard.

Don’t rely on government programs for your old age. Retirement programs such as Social Security in the U.S. are wealth-transfer schemes, not funded insurance, so they rely upon the government’s tax receipts.

Government surpluses generated by something other than a permanent policy of thrift are the product of exceptionally high tax receipts during boom times and therefore signal major tops. They’re not bullish; they’re bearish and ironically portend huge deficits directly around the corner.

Don’t expect government services to remain at their current levels. The ocean of money required to run the union-bloated, administration-stultified public school systems will be unavailable in a depression. School districts will have to adopt cost-cutting measures, and most of them will result in even worse service. Encourage low-cost free-market solutions, which will benefit both children and teachers.