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Thursday, 8 July 2010

Stocks and Bonds Are Now Hazardous to Your Wealth

Within the next 20 years, the most profound changes in economic history will sweep the globe. The economic chaos and turbulence that we are now experiencing are merely the opening salvos in what will prove to be a long, disruptive period of adjustment.

At least that's my theory, and careful investors owe it to themselves to hear me out. If I'm right, long-term investing in stocks and bonds will deliver lackluster returns at best and be destroyers of wealth at worst.

To explain why, I need to tell you about how "Three Es" -- the economy, energy and the environment -- are interconnected and why we need to consider all three at once.

The first "E" refers to the economy. Even if we were to limit our analysis to this realm only, I could make a compelling case that stocks and bonds face the most daunting structural headwinds seen in generations. As I argued in The Great Asset Bubble, as baby boomers transition from being net savers to net spenders, this will have a dramatic downward effect on the value of the stocks, bonds and real estate that they will need to sell.

Further, we might note that the developed world has doubled its debt load over the past 10 years and seems unlikely to be able to do so again. Even more dramatically, there has been an explosive expansion in unmatched pension and entitlement liabilities. Without these increases in debt and unfunded liabilities, global growth over the past decade would have been a great deal less than it was.

Can debt continue its parabolic growth? If it doesn't, it's safe to say that the behavior of the economy that most investors accept as "the way things work" will change, and probably quite dramatically. By extension, much of what we've learned about investing in stocks and bonds during this period will mislead rather than guide.

The Second "E" -- Energy

When we bring in the second "E," energy, the story quickly compounds in urgency. Our economy is dependent on growth. Not just any kind of growth, but some percentage growth every year. Not much, just three or four percent -- but such growth is an absolute requirement for stocks to grow and for bonds to get paid back, at least in aggregate.

Petroleum -- oil -- is the undisputed king of fuels that drive economic expansion. It has no substitutes and no replacements. And it is depleting. There is growing alignment between various government and private institutions in predicting the date when an irreversible peak of oil production will occur. This does not mean "running out," mind you, just that slightly less and less will be available each year -- though at increasing extraction costs, despite our best efforts.

Some say the peak has already happened (not me), some say it will happen by 2015 (I'm with them), and a shrinking few say it will be around 2020. We have no substitutes ready to take its place. Alternative fuels are decades away from being able to operate at a scale sufficient to make up for the gap left by depleting oil.

To a long-term investor, none of these are acceptable outcomes because they all indicate that the mechanism of economic growth and wealth creation will profoundly change within zero to 10 years.

It's easy to model, predict or even intuit that a peak in oil will coincide with a peak in economic output. After Peak Oil, when there is incrementally less oil to divvy up across the global landscape, economic growth will stagnate and then decline.

The Third "E" -- The Environment

What else comes with Peak Oil? A peak in everything that depends on oil, which brings us to the minerals and other resources that we secure from the environment. Again, this is not a story of "running out" -- this is a story where things get just a little bit harder and a little bit more expensive. As a result, fewer and fewer resources will come up out of the ground and course through our economic body.

We can already see the possibility of reserve depletion of five key mineral ores over the next 15 years:

Does all economic activity cease with the depletion of a few key elements? No, of course not. But neither does our economy continue to operate in precisely the same way that it did when demand alone dictated supply.

And that's my key message here. There is a wealth of data suggesting that a period of profound change is either already upon us or coming soon enough to capture the attention of any serious long-term investor. We can no longer constrain our thinking to just one "E," the economy.

Conclusion

If my thesis and data are correct, corporate earnings will falter in the coming years. The vital ingredients needed for economic growth will be in short supply, and stocks will fail to grow. Similarly, bonds require repayment of both the principal and the interest components, which means that, in aggregate, bond values are explicitly dependent on growth. Yet Peak Oil looms in the near distance.

With this in mind, our financial models go straight out the window. We'll need new thoughts, tools and expertise to guide us towards wealth creation and maintenance. Stocks and bonds in general simply will not behave as they have in the past as we enter a new world of constant economic shrinkage. Current discount models feed on earnings growth and compounding interest that will no longer be obtainable.

In a world without continuous economic growth, we'll need a lot more than a formulaic approach allocating assets into broad market categories. Investing will have to transition away from following time-tested formulas that no longer apply. It will require a good understanding of the changing circumstances and their effects. We'll need an exceptional amount of due diligence in order to pick out the individual winners from the losers.

As I see it, trends in energy and the environment have gained too much momentum to mitigate, and global economic stagnation is the new normal. Though more effort will be required than in the past, those who can understand this and adapt have a good chance of preserving and even growing their wealth. Unfortunately, most will miss the turn. Don't be among them.

Chris Martenson, PhD, runs a financially-oriented website and subscription newsletter service, located at http://www.chrismartenson.com, that analyzes macro trends in the economy, energy and the environment. He has recently provided his views at the U.N., the U.K. parliament, Minnesota state legislature and at Yahoo!'s Sunnyvale headquarters. A far more detailed version of his views are contained within the popular and free on-line video series, the Crash Course.

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