The Burmese have a saying that men fear the tiger that bit them last, not the tiger that will bite them next. Investors who feared the last tiger of inflation have been bitten by a very different predator.
Deflation, not inflation, has struck virtually all long-term investment assets in the last two years. Gold is down from $850 an ounce to the $345 range. A one carat D-Flawless diamond, the benchmark used by investors, is down from $50,000 to $20,000.
Similar but less dramatic declines have taken their toll of more conventional investments. Stocks are down, particularly those in the oil industry. Bonds are down in response to the Federal Reserve's tight money policy and to fears of another burst of inflation once the current recession ends. Home Prices are down after allowing for seller financing at concessionary rates. The decline in home prices is especially painful because homes were the best single investment for most people during the last decade.
Collectibles are down, too. Investors who hoped to make a quick profit in art and old English shotguns now find that their only returns are aesthetic pleasure and grouse on the table. When the hot money that poured into collectibles as inflation hedges poured out again, it created a void that sucked prices downward. Worse yet, the market for many collectibles, never very active in the best of times, is evaporating as the current recession deepens. Like many homeowners, collectors who try to sell their collectibles for cash often find there is no buyer.
The common price decline in long-term assets has two common causes: the collapse of overpriced inflation hedges along with the collapse of inflation and the rise of long-term interest rates.
In a financial version of Newtonian physics, what goes up so far often comes down so hard. Gold went up from $35 per ounce to $850 in less than a decade. Homes, diamonds and collectibles all enjoyed spectacular gains as investors rushed from a rotting dollar into the nearest inflation hedge. When inflation declined from double digits into single ones investors rushed out of those same inflation hedges, leaving their prices vulnerable to decline. The inflation hedges that have fallen most during the last two years of declining inflation generally are the ones that earlier rose most while inflation was soaring.
Inflation hedges declined not only because they became overpriced in a speculative boom, but also because rising interest rates reduce the value of all long-term assets. That fundamental fact of finance was instantly clear to bondholders, but only now is becoming fully apparent to investors in other assets as well.
When interest rates go up, bond prices go down. Every investor who has used a table of bond yields knows that part of investment theory. Every investor who bought the U.S. Treasury 10 percents of 2010 at $100 in 1980 learned how that theory works in practice when the price of those bonds later plunged to $69 as their yield rose to 14.5 percent.
Not all long-term assets react to rising interest rates as fast as bonds. Stocks wavered while bonds fell, then reluctantly followed them down. Conventional wisdom among investors today is that high interest rates offer such stiff competition that stocks are unlikely to go up unless interest rates decline first. If corporate profitability continues to crumble as it has so far this year, however, even a renaissance of lower interest rates may not be enough to restore life to the stock market.
Real estate prices lagged even more than stocks. Intelligent sellers realized that rising mortgage rates mean declining home values, so they quickly offered small price discounts to sell their homes and then put the proceeds in money market funds. Less well-advised sellers maintained their high asking prices, still dreaming of the prices they might have obtained during the speculative boom and fervently hoping for a quick decline in mortgage rates.
In the great national waiting contest between homeowners and mortgage rates, the clear winner is mortgage rates. Sellers who waited too long now find they must offer larger discounts and seller financing at concessionary rates. Sitting on an unsold home also means losing the opportunity to reinvest the proceeds at today's high interest rates.
Since many inflation hedges were leveraged with debt, a rise in the price of that debt radically altered an investor's potential for profit. Borrowing at 8 percent to buy a home going up at 15 percent was very profitable, but borrowing at 16 percent to buy a home going down in value is not. When gold hit $800 per ounce the prime rate was 20 percent, which meant that gold had to go up by $160 per year for a leveraged investor merely to break even. Investors who borrowed to buy gold have discovered that financial leverage multiplies unexpected losses just as efficiently as it multiplies expected gains, assuming an investor is fortunate enough to enjoy gains.
When trouble comes, it generally comes in battalions rather than alone. Deflating asset prices have been accompanied by inflating consumer prices, creating the worst of all possible worlds for investors who live off their assets--their living costs are going up while their investment values are going down. The continued rise of consumer prices, even at today's reduced rates, means that the already large nominal decline in asset prices is even larger in real terms.
The paradox of declining asset prices and rising consumer prices is explained by the very different markets in which those prices are set. Most consumer prices (farm products are a notable exception) and the labor costs that go into them are administered rather than set by market forces. Large corporations, powerful unions, and even the local doctor or lawyer tend to set their prices with only moderate regard to competition. Administered prices tend to be reasonably stable with an upward trend, but with particular resistance to decline unless enormous economic pressure is applied.
Asset prices are set by market forces rather than by the administrative action of corporations and unions. Stocks, bonds, real estate and other assets have their prices set by the competitive action of many buyers and sellers. These market prices tend to be far more volatile than administered prices both in good times and in hard ones. The recent decline of asset prices is a painful example of volatility on the downside.
Even in the darkest cloud there is a silver lining for someone. The silver lining belongs to investors in short-term assets such as Treasury bills and money market funds. Interest rates on these short-term assets have been high enough to provide generous real returns for the last two years, a dramatic contrast to the last generation when investors in short-term assets were systematically swindled by rising inflation, high marginal tax rates and artificially low interest rates set by federal regulatory authorities.
Just as desirable as the high real returns available on short-term assets is the opportunity to buy long-term assets at prices much lower than two years ago. Stocks and bonds are much cheaper now than in 1980. Real home prices are down sharply in the some period. The investor in short-term assets has the opportunity to profit from the distress of investors in long-term assets by purchasing their assets at distress prices. The highest returns accrue to the asset in strong demand with a limited supply, and today that asset is cash. As in past periods of tight money and deepening recession, cash is king.