As you know, in early August of this year the Dow dropped nearly 400 points. Within hours, I received phone calls from producers at Fox News, CNN, and Bloomberg asking for my perspective on the near-crash.
The first question they asked was, "Are you still investing?" I answered, "Yes."
In fact, I told them that on August 9 my wife, Kim, and I closed on a $17 million apartment complex in Tulsa and were quite happy with the investment.
Their next question was, "Do you think the Federal Reserve should intervene to save the economy by dropping interest rates?" My reply then as well as now: "No. This is a capitalist system, not a communist one. Anyone who expects the government to bail them out every time their greed and stupidity causes them to lose money is being foolish."
Winners and Losers
While this sounds harsh (and it is), I explained that the hedge funders, private equity players, and those with other portfolios losing money were big boys and girls. They know the game and how it's played, and shouldn't expect the government to bail them out.
I went on to explain that I did feel for the little guy whose home value was dropping as fast as his 401(k) plan, and that if the little guy loses confidence in the system, a recession may follow. The ripple effect caused by the subprime meltdown and stock market volatility doesn't inspire confidence or encourage spending.
If people stop spending, a lot of small business and families will suffer as the economy contracts. So while I talk tough about the big players, I do feel for average investors.
The Squeeze Effect
I know it's not polite to say "I told you so," but early this year I wrote two columns here predicting that what happened in August might be coming. Well, it did, and I told you so.
In one of those columns, I wrote about the upper-middle class possibly taking a beating by what stock traders call a short squeeze. I also wrote that many middle-class people could be caught in a cash squeeze -- and that's happening, too.
Today, millions of people are caught in cash squeezes that cause them to default on their home loans. A cash squeeze ripples through the economy when people, desperate to hang onto their real estate, begin selling other assets -- such as their cars -- just to raise the money to make their mortgage payments. This is what's happening now, and I expect it'll become worse through October and possibly into the holiday season of 2007, as more and more homeowners reluctantly turn over the keys to their homes.
A Cash Crash
The August stock market mini-crash I predicted was also a short squeeze for cash. Many banks, afraid that hedge funds and mortgage companies were holding subprime debt, called the loans on those businesses. And because the companies' subprime debt wasn't liquid and no one wanted it, the businesses had to begin selling liquid assets that institutions did want to buy.
In other words, just like the middle-class couple forced to sell their BMW at a discount to raise cash, these businesses were forced to sell their liquid assets. And because of the banks' margin calls, good assets dropped in price and bad or questionable assets weren't able to be sold.
Consequently, August was a great time to be an investor, because you could pick up great stocks at cheap prices (more on that below).
The Confidence Factor
Another question I've been asked a lot lately is, "Will this loss of confidence spread?" Again, my answer is, "Yes."
As I wrote in February, my concern is that we may be entering a deflationary period -- not an inflationary period, as many economists believe. And deflation is a lot harder to cure than inflation.
To cure inflation, the Fed simply raises short-term interest rates. That slows the number of dollars entering the economy. In a deflationary economy, however, you can pump money in, but if confidence is gone the economy can continue to deflate.
That is, people become savers, not consumers. If people become savers, then those in a short squeeze for cash may start selling more and more things of value, such as second homes, boats, cars, and jewelry, just to raise cash. And if people stop spending and start selling, the ripple effect is that millions -- even those with good credit -- begin to get hurt. Not only will housing prices continue to drop, but restaurants and small specialty shops will suffer, and people will begin losing their jobs. When people lose their jobs the situation grows worse, as more confidence leaks out of the system.
The Federal Reserve can lower interest rates again, but once that confidence is shattered, it might take awhile for the economy to rebound.
Drop and Correct
As I wrote in February, when cash and credit are plentiful, the economy expands. When cash goes into hiding, even if the Fed makes more credit available, the economy may deflate or stagnate.
It's these last two scenarios that I'm concerned about. If we deflate or stagnate, the financial problems will grow regardless of what the government does.
I stated in my August TV and radio interviews that it's best to just let the economy drop and correct. If the government keeps saving people from their own greed and foolishness, the crash will only be put off to a later date. I say let the market correct itself, even if it's painful. Let the foolish ones take their lumps and learn their lessons.
Bargains Are Plentiful
The silver lining to all this is that it's a very good time to be bargain hunting.
In the current economy, cash is king. As more institutions and individuals are forced to sell assets to raise cash, you may come across that one investment you've been waiting for.
For example, in 1987, the stock market crashed, real estate took a dive, and savings and loan institutions were wiped out. It took about five years for the economy to recover. During that period, the government formed the Resolution Trust Corporation (RTC). The RTC took some of the best real estate in the world and sold it for pennies on the dollar. Thanks to the RTC, in five short years Kim and I went from struggling financially to becoming financially free. It was a five-year short squeeze on cash that made us rich.
I sincerely hope you can profit from the next short squeeze the way we did then, rather than being among those who get squeezed.