Aftershock

Books of the Doomsday Genre: Read This before You Read One of Them

Aftershock

While we at Index Funds Advisors, Inc. do not dismiss the bleak scenario envisioned by the authors of books such as Aftershock or The Day after the Dollar Crashes as completely implausible, there are a number of problems with books of this doomsday genre that deserve consideration:

 

  1. Economic forecasting is a fool’s errand at best. We know that the “experts” do no better than we would expect from chance alone. The reason for this is that the economy is infinitely complex and subject to myriads of unknown future events. There simply is no model that can adequately capture it, and it is unlikely we will see one anytime soon. It is important to understand that the market itself has some economic forecasts embedded in financial instruments such as interest rate futures contracts and in combinations of securities such as the yield difference between nominal and inflation-protected Treasury bonds. None of these market-based forecasts (where real money is at stake) currently indicate future high inflation. Furthermore, the currency futures and forwards markets do not predict a future large devaluation of the dollar. For most investors, it is probably not a good idea to bet against any of these markets.

  2. Even when an economic forecast is accurate (or perhaps lucky), it tells you little if anything about how you should position yourself. We have several examples of people (like Peter Schiff) who correctly called the real estate bubble yet still lost money because their predictions about which asset classes would thrive were simply wrong. Even if the predictor is right about what positions to take, getting the right timing on these positions is critical. For example, we know that those hedge fund managers who arrived too early to the long position on the credit default swap trade were unable to hold their positions in the face of mounting losses. The market stayed irrational longer than they could stay solvent. A more recent example is Bill Gross who predicted at the beginning of 2011 that the Treasury bond bubble was ready to pop. The bearish bets that he made against long-term T-bonds turned against him and he was forced to do a “mea culpa” after falling 3.7% short of his benchmark. Our point is that if Bill Gross who has access to a staff of PhD economists that could put most university faculties to shame couldn’t get the timing right, then what possible hope do you or the authors of the doomsday books have? Perhaps someday Bill Gross’s bet will work beautifully and whoever does get the timing right will be the subject of all manner of media adulation, but Bill Gross’s experience proves to our satisfaction that luck will be the more likely explanation than skill.

  3. Most of these books are thinly veiled attempts to get you to purchase additional services offered by the authors (e.g., subscription newsletters, expert consulting by the hour, etc.).

Getting down to the question of the predictions made in these books, the central theme is that the US government has taken on too much debt and has vastly increased the money supply (quantitative easing) in an effort to keep the financial markets afloat, both of which will eventually lead to an economic calamity characterized by high inflation and a collapse of the dollar. We certainly will not say that any of this is untrue, and we do agree that the actions of the Fed and our political leadership have increased the probability of this bleak scenario coming true, but it does not have to unfold the way the doomsday purveyors predict. The Fed does have the ability to soak up the extra liquidity it has created by selling the bonds it has purchased. The timing of course, is critical. Regarding the massive increase in public debt, yes this is a terribly difficult problem to solve because debt never goes away. However, we like to think of Winston Churchill characterizing America as a country that will do the right thing when all other options have been exhausted. The only way it will be solved is a combination of economic growth and entitlement reform (Medicare, Medicaid, Social Security, government pensions, etc). Even if we taxed millionaires and billionaires at 100% of their wealth, it would not raise enough revenue to solve the underlying spending problem.

It is important to bear in mind that there is no feasible way for the market to be surprised by the debt. Everybody knows about it. One question worth asking is whether the cost of capital of publicly traded companies (which is what drives the return on equities) is truly dependent on the amount of government debt outstanding. Historically, there is no clear-cut relationship; there have been times when the market has done quite well when there was a vast increase in the public debt (e.g., World War II). Likewise, there have been times when the market did poorly as the debt-to-GDP ratio was reduced (e.g., the late 1940’s).

In closing, we would caution investors against making any investment decisions based on what they read in any of these books regardless of the accuracy of the authors’ past predictions.