Early Retirement Blog

The U.S. economy will soon experience a strange period of inflation deflation.

Commodity prices such as food and fuel will be rising, while asset prices such as housing and stocks will be declining.   It is a double squeeze on the economy that will create a double dip recession.

When I accurately predicted the stock market and housing market bottom this past February,   it was based on several economic factors that have since changed, factors that make a sustained economic recovery unlikely.

At that time, asset prices were oversold, the Dow Jones was at 6500, and housing had fallen to it’s historical average price of $175,000.   Most importantly, Oil had plunged from $140 a barrel to $35 a barrel, increasing both consumer discretionary spending from lower cost gasoline and food prices, and corporate profits from lower cost of resources.

President Barack Obama easily and successfully got a massive Keynsian economic stimulus package approved by Congress, China and Europe also embarked on massive stimulus programs of their own, and the Federal Reserve dropped interest rates to zero, all of which helped create an economic bottom.

Since that time, in the last six months, their has been an impressive stock market rally.   The Dow Jones has climbed 3000 points to 9500.   The bear market rally started with strong U.S. bank earnings reports, followed by stronger than expected corporate earnings reports, both of which are due to artificial factors that will not last.

Record bank profits were created by a combination of low interest rates, government bailout money, and accounting gimmeckery.

Profits were created from the spread between the near zero interest rates, banks were able to borrow from the Fed, and the high interest rates they were able to charge customers who had consumer debt.   Banks profited from using government bailout money to engage in proprietary trading, using “their” money, to trade in commodities (recall Citibank’s $100 million Oil trader).

Most importantly, an obscure organization called the Financial Accounting Standards Board (FASB), under heavy pressure from Congress cured banks when they issued rule 157 to allow banks to abandon mark-to-market pricing.    Banks that were holding toxic assets such as sub-prime mortgages, the catalyst for the credit crisis and subsequent economic collapse, could now price them at whatever amount they wished, instead of what they were worth (fair market value).

This one simple change in the way assets were accounted for instantly made banks profitable.   Goldman Sachs had record profits, banks repaid their TARP loans, and the stock market began it’s rally. Then corporations beat down-beat analyst expectations,   who in the midst of a global economic collapse, had dramatically lowered their estimates of corporate earnings.

Corporations were able to beat analyst expectations by having to pay less for resources, and from cost-cutting, laying off their employees.  Sales were down, but the lower cost of oil and other commodities, as well as a smaller payroll, allowed corporations to beat analyst expectations.   The stock market rally really took off and the S&P 500 increased in value by 50% from it’s March low.

Housing, which had been in free fall for two years, with the help of the Federal Reserve cutting interest rates to zero, finally found it’s bottom.   Americans began purchasing foreclosed homes at very low fixed interest rates.   Speculators also began purchasing foreclosed home, hoping to rent them out, and sell them later when the housing market returns in the future.   In spite of falling home prices, and increased foreclosures, home sales began to increase.

“The Recession is Over!” Declared Newsweek magazine.   GDP only fell by 1% in the second quarter declared the U.S. Government.   Federal Reserve Chairman Ben Bernanke declared that the U.S. economy was in “the cusp of a recovery.”

Economists were all in agreement, GDP would rise in the third and fourth quarters, signaling the technical end of the recession.   The recession is over, the only question that remains, is what kind of recovery would occur? Would it be a robust recovery? With increased production and employment, or a jobless recovery, with higher corporate profits and continued high unemployment?

Unfortunately, all the magazines, pundits, and economists, are ignoring what has happened in the six months since the economic bottom occurred.   In the meantime, in an effort to increase their earnings and keep their stock prices high, U.S. corporations cut off their noses to spite their faces, by laying off millions of their employees.    The same employees who buy their products.

Chinese and other foreign banks, and American speculators (hedge funds and banks), who lost faith in the U.S. economy and the U.S. dollar, began buying commodities such as oil instead of U.S. Government bonds. The Federal Reserve, in an effort to keep interest rates low, began buying U.S. Government bonds, mortgage securities, student loans, and who knows what else.

Trillions of U.S. dollars are being printed to buy trillions of dollars in U.S. debt causing the dollar to crash against foreign currencies and commodities – creating inflation.    Everything the U.S. imports, and the U.S. imports almost everything, is becoming more and more expensive.

The price of oil that the U.S. imports, despite a global economic collapse, has doubled in price from $35 to $75 per barrel in the past six months.   The rise in the price of oil not only reduces the amount of money people have to consume corporate products,   it also reduces the amount of profits the companies can earn due to the increased costs of production.

In order to beat higher analyst expectations, and increase their earnings, corporations will be forced to increase prices and layoff more employees. Higher unemployment equals less consumption equals less corporate profits. Higher prices equals inflation.

Americans will begin paying more for consumer products and will continue the trend of consuming less products. Corporate revenues will continue to shrink, and despite laying off more employees, their earnings will drop.   The stock market will crash again.

At the same time, the Federal Reserve, which has kept interest rates artificially low, by basically printing money and using it to buy U.S. Government bonds, in the face of rising prices (caused by the flight of money to commodities such as oil), and in an effort to keep the dollar from crashing, will be forced to raise interest rates.    As soon as the Federal Reserve raises interest rates – the housing market will crash again.

In effect, the U.S. is facing a period of price inflation and asset deflation, and a second recession will occur.   The third and fourth quarters of 2009 will show positive GDP.   The recession will officially be over.   During the first or second quarters of 2010 the second recession will begin.   A classic Great Depression double dip. The second recession will be deeper and longer than the first.

If you have been delaying your retirement, do yourself a favor, and take advantage of the temporary economic recovery, by retiring now.   The recent stock market rally, and housing market stabilization, is your second chance at retirement.   Neither the stock market nor the housing market will return to their 2007 highs for many many years to come.   As Kenny Rogers would say ” You need to know when to hold ‘em and know when to fold ‘em.” Take your losses and leave the table.

Visit the Early Retirement Website and learn how to retire early.

Update July 5, 2010:
One year after this article was written, it appears that my prediction, and timing of a double dip recession is coming true.   Click here to read my updated double dip recession prediction.