The Austrian Prophecy

“It is much better to have your gold in the hand than in the heart.” – Thomas Fuller

The last thing I want to do is scare you – but it’s time to wake up and smell the souffle!

I’m talking about our puffed-up economy. With one good poke, the whole thing could tumble down and you, my friend, would be left picking up the crumbs. I’m telling you this now, because there’s still time to make changes to your portfolio. But you have to act quickly.

You’re probably thinking to yourself, “What’s the big rush? I don’t see anything out of whack.”

But that’s the problem. Everyone’s having way too much fun.

Just last Tuesday, for example, my wife dragged me out to dinner because it was her birthday. (Talk about chutzpah!) She chose a trendy restaurant where the food is very good but overpriced.

We had a great time. But it amazed me that we had to wait for a table… in the middle of the week… in Baltimore, a city not known for its affluence. The place was filled to the brim with people of all ages, just out for a Tuesday night nosh on some $30 veal chops.

Is the whole freakin’ nation on ecstasy? The economy grew just 0.7 percent last quarter, for crying out loud. Does that sound to you like we’re on a roll? There’s a major disconnect, here, between a tired economy and a population that continues to spend. So, it needs to be asked…

Are we in a bubble? If we are, how big is it? Will our homes be worth a third less a year from now? Are our stock markets about to crash?

Maybe I’m out of line raising these questions. Maybe it doesn’t matter. Whatever it is we’re in, we should enjoy it while it lasts, right?

Really? Even if the whole thing falls to pieces with little advance warning?

It’s not as if it hasn’t happened before.

Nobody saw the Great Depression coming. The Japanese were living it up until the economy fell off its perch in 1991. The Asian countries were flying high in the 1990s, but hit a wall beginning July 1997 – exactly 10 years ago. And our own tech-stock bubble popped big-time in 2000.

What did all these crashes have in common? They all had fat and sassy assets fed by a period of non-inflationary growth.

Wait a minute. Isn’t growth without inflation a good thing? Isn’t that what the government, employers and employees, and Democrats and Republicans want? Isn’t that what the Fed is trying to do RIGHT NOW: keep inflation low while nurturing growth?

Yes, it is a good thing. But the economy runs in cycles for a reason. At some point, a growing and forgiving economy allows some sloppiness and silly investing to creep in. The sloppiness leads to economic inefficiency, and the frivolous investing leads to lower and uneven returns.

But when inflation isn’t a problem, governments don’t raise interest rates to stop these bubbles from growing bigger and bigger… until they burst with devastating results for the economy and people’s investments.

Assets all over the world have been increasing in value since the middle of 2003, and it’s created some wacky incongruities:

  • Should a Moscow apartment overlooking the Moscva River really sell for more than an apartment in Manhattan overlooking Central Park?
  • Should the stock market in India (the Sensex) really be valued higher than the U.S. Dow?
  • Should a hamburger in London really cost 50 percent more than one in Delray Beach, FL?

Is it just a coincidence that the asset class that went up the most in the U.S. in the past five years – homes – is suffering from a surge of defaults from its most vulnerable group of investors: homeowners with weak credit?

The subprime mortgage crisis is just the first sign (and certainly not the last) of what happens when money gets overleveraged. Hot on its heels is the Alt-A home mortgage market (a category between prime and subprime), where defaults are also rising.

Amazingly, there’s a group of economists who have predicted the straits we’re now in. They call themselves the Austrian School – named for its Austrian-born proponents, Ludwig von Mises, Joseph Schumpeter, and Friedrich Hayek. And one of its many adherents – William White – heads the economic and monetary department of the Switzerland-based Bank of International Settlements (BIS).

In its recently released annual report, the BIS said, “There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral, and, in turn, more risk-taking… [which]… can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”

But besides the subprime and (looming) Alt-A crises, things have been eerily calm this year. Last year, just 0.8 percent of high-yield bonds defaulted – the lowest in modern times. And this year has seen only three defaults so far.

This, my friend, is the proverbial calm before the storm.

How calm? Psychologically, we occupy the same space right now as the rich and confident Japanese did in the 1980s. That’s when they were coming over here and buying some of our most cherished and expensive properties – like Rockefeller Center – as if they were tin trophies stocked at the Dollar Store.

They were convinced that they had unlocked the secret to unleashing incredible wealth from their tightly woven corporate economy… much like today’s hedge funds and private-equity groups are convinced that they have discovered the secret of creating enormous wealth.

As “the Austrians” put it, the Japanese economy then shifted into reverse. Some 20 trillion dollars disappeared from investors’ portfolios, and for the next 15 years the Japanese economy slumbered.

Can the same thing happen to us? I’m afraid so.

The Austrian School thinks that easy credit and investor exuberance is a dangerous combination. Its solution is to raise rates, but its advice is falling on deaf ears. The Fed would raise rates only to pour cold water on inflation. It thinks that slowing economic growth by itself will eventually deflate assets.

But the economy is expected to pick up the pace in the second half of the year. If it hasn’t yet slowed the overpricing of assets, there’s no reason to expect it will tomorrow.

As I mentioned earlier, the Fed has been attempting to encourage growth and discourage inflation – a balancing act that some observers think can be done, while others aren’t so sure. But if you want to know what the economy has in store for us, ignore that bogus act and pay attention to the only high-wire performance that matters: balancing cheap credit and asset growth.

How much longer can tens of billions of leveraged dollars be allowed to pour into our bloated assets – driving up prices, which are then turned into extravagant profits for hedge and private-equity funds at the expense of…

Yes, you guessed it, at the expense of you and me and the mutual funds we invest in.

When these reversals happen, markets unravel at astonishing speeds. Everything we own could be worth much less before we’ve had time to react. It happened to the unsuspecting Japanese investors. It’ll be no different for us.

We’re not at the tipping point yet. So right now, while there’s still time, the best thing to do is increase your gold holdings. Whatever you hold now, double it. If you don’t have any, convert 20 percent of your portfolio to gold. It’s come down in price recently, and is currently a good buy. But that’s not why we’re buying it. We’re buying it for insurance. Gold offers the best financial protection during times of crisis and crashes.

I know this is a big step to take. But I’m not exactly telling you to head for the hills. The very worst that can happen is that the Austrians are wrong and you’re stuck with a precious metal that is rising in price.

But I believe the Austrians have our number. While others are talking about the other bubble – the “it-can’t-happen-here” bubble that shields us from an increasingly toxic easy-credit environment – they are talking about the only bubble that matters.

Take heed. It can and probably will happen here unless the free-buying ways of big money change. But, unfortunately, those free-wheeling spenders are getting bigger and more powerful by the day. And we’re all going to have to pay a price for their “masters-of-the-universe” exuberance.

[Ed. Note: Andrew Gordon, ETR’s Investment Director, has authored several books on energy markets, global countertrade practices, and the hot growth sectors of China and Russia. A former professor of marketing and finance, he is the editor of INCOME, a monthly financial advisory service that uncovers income-generating stocks that promise safety (first and foremost), along with much-higher-than-average profit potential.]