The Coming Economic Collapse

Warner Books

Chapter One

An economic crisis is near at hand in America today, the kind of dramatic, earth-shattering crisis that periodically threatens the very survival of civilization. More specifically, it is an energy crisis brought about by the conflict between rising global demand for energy and our growing inability to increase energy production.

I first drew attention to this crisis in my 2004 book, The Oil Factor. The book was controversial, particularly because of its prediction that oil prices would reach $100 a barrel by the end of this decade. Since its publication, oil, gasoline, and natural gas prices have hit historic highs. Meanwhile, energy supply/demand fundamentals have worsened to the point that it now appears $200 a barrel by the end of the decade is entirely probable. Naturally, the negative impact this will have on our economy, not to mention your pocketbook, will be considerable.

However, what alarms us most about this crisis is the extent to which our nation's leaders and experts remain in denial concerning it. Most authorities continue to reassure the public that today's soaring energy prices are temporary, that oil reserves are virtuallylimitless, and that production will outpace demand for the remainder of our lives. This is an outright contradiction of the facts. The trends in place for the last thirty years show declining returns from oil exploration, peaking or declining oil production everywhere but in a few OPEC nations, and increasing demand for energy, especially among the world's largest developing nations.

You may find it hard to believe the experts could be so wrong. Naturally, most of us are inclined to trust in the wisdom and honesty of our leaders. We ourselves are horrified that so few are raising the alarm. Why is such a serious threat not on the front pages of every newspaper? Why are government and industry not taking steps right now to prevent the crisis?

Unfortunately, this is not the first time in recent years that a major economic threat has gone unacknowledged by our leaders. In the most significant example, until the moment when the ax fell, everyone, including corporate executives, Wall Street analysts, and the media, portrayed the situation in glowingly optimistic terms. Rather than try to prevent a crisis, most authorities actually encouraged people to act in a way that brought them greater financial loss and made the economic impact worse. We are speaking of the rise and fall of the technology bubble.

In that brush with disaster, which came much closer to destroying our economy than most people realize, we see a mirror image of what is happening today with energy. If we are to weather the energy crisis successfully, both as investors and as a society, we need to understand why similar errors in judgment are occurring, and what we must do to correct them in time.

The Madness of the Herd

It is no exaggeration to say that in the late 1990s the investment world went mad. Millions upon millions of investors ignored time-honored principles for investing in stocks, such as due diligence and fundamental analysis, and began to buy and sell purely out of emotion. Believing in the wonders of technology, they rushed to buy technology and Internet stocks like rats following a Wall Street pied piper.

The result was a financial and economic crisis that destroyed the financial security of millions of investors. However, what few people realize is how close the technology crash came to destroying our economy and even our society as a whole.

I recall one client who phoned me near the height of the bubble, in 1999. I knew him personally. We had been managing his portfolio for some time, and it had been doing quite well by typical investment standards-gaining roughly 20 percent annually.

But on this day, he announced that he wanted to handle his own investments from then on. When I asked him why, he said he wanted more technology shares in his portfolio. Clearly, he had been bitten by the high-tech mania that was spreading through the markets at the time.

Of course, there is nothing wrong with someone making his own investment decisions. However, as a professional money manager, I can tell you that it is not an easy job, especially if you are trying to make returns that are well above average. Anyone can get lucky enough to beat the market for a short time. But most of the people who do so find their luck lasts only a brief while. To beat the long-term returns of the market, without taking on excessive risk of loss, and to do so consistently, is extremely difficult.

Like many firms, we have a full-time staff that studies the markets and the economies around the world, applying detailed analytic methods, in order to stay on top of trends and spot opportunities. The result is that our model portfolios have been able to outperform the market-which means outperforming not only the average investor, but also the average professional-much of the time. However, that is the result of in-depth knowledge, long hours of hard work, and a good deal of experience. It would be nearly impossible for someone with a full-time job to duplicate single-handedly the work we do.

Now, this man had a full-time job. He owned his own business. While he was highly educated and intelligent, he did not have time to gain more than a superficial knowledge of stocks. Instead, his method of managing his portfolio was literally to run over to a television set between clients and turn on CNBC to get the latest tech tip, which he would then follow. Over the next few months, he sold every stock in his portfolio that was not technology-related, and put all his retirement savings into tech stocks. Many of his new holdings were companies he knew nothing about. He just saw them on television.

I am certain you can guess the result. In a period of about nine to twelve months, this man lost roughly 70 percent of his retirement savings.

It is nearly impossible for an investor to recover from a loss like this. A 70 percent loss on, for instance, a $100,000 portfolio leaves its owner with only $30,000. Even if the owner manages to double his money before retirement, that still leaves him with $40,000 less than he had at the peak.

And this man's case was far from unusual. I knew many bright, well-educated people during that period who were convinced that "this time it is different"-that the tech bubble was not a false mania, like the South Sea Bubble or the late 1920s. It was the real thing. A new paradigm had taken hold. A new world was dawning in which a company's present earnings, assets, and debt levels did not matter. As long as a company had innovative technology, or could sell products from a Web site, its stock was sure to make investors rich. Hordes of people believed they could not go wrong buying tech stocks, and feared nothing except missing the opportunity. Many risked more money than they had by buying stocks on margin or with other forms of borrowed cash.

What the majority of investors had forgotten, or perhaps never stopped to think about, was that the victims of past speculative manias had been just as certain of becoming rich.

But that is the nature of speculative manias: people en masse forsake reason and objective thinking and succumb to a primordial instinct to run with the herd. Hundreds of years ago, when a herd of buffalo was stampeded toward a cliff by Native American hunters, no buffalo poked his head above the crowd to look where they were going. Each creature simply accepted his neighbors' belief that there was an urgent need to run. From then on, they were driven by pure adrenaline, each buffalo's panic and excitement reinforcing his neighbors'. So it was with investors in the tech bubble. Greed, and a fear of being left behind, triggered the same instinctive state of excitement and panic that kept everyone's eyes glued to the financial media, their fingers hovering over the trigger buttons of their stock trading programs.

When the bubble burst, the result was financial suffering and loss on a scale bigger than anything since the Great Depression. The NASDAQ fell from 5,000 points to just over 1,000. Many of the technology and Internet companies to which average people had hitched their future went bankrupt, or were forced to downsize. We were left with a massively overbuilt tech industry and a much poorer consumer. Trillions of dollars of wealth were lost that could have financed the retirement plans, the college funds, and the other hopes and dreams of millions of investors.

Even worse, the popping of the technology bubble put the U.S. economy in an extremely perilous situation. The very fabric of our civilization came close to disintegrating.

What saved us from disaster was the rapid response from our leaders. The Federal Reserve stabilized our economy by quickly lowering interest rates to nearly zero, and in real terms to less than zero. The federal government cut taxes aggressively. Manufacturers offered zero percent financing on cars-actually less than zero, when you subtract inflation. Consumers were virtually spoon-fed money.

Low interest rates also provided a free lunch for those who refinanced their mortgages. In effect, the surge in home refinancing and the perception that home values would rise faster than mortgage rates gave the consumer a double boost. More money became available to spend, and the value of homes increased.

Without that quick response, the results could have been catastrophic. Consumers would have had far less money to spend. With the resulting decline in consumer spending, it would be hard to exaggerate how severe the recession might have become.

Remarkably, in the wake of September 11, 2001, Americans still kept their faith in the future. Yet that faith could have been shaken to the core if the number of jobs started to dry up, if home values began to fall, and if consumers suddenly found themselves without the means to pay off their huge debt loads.

Clearly, there would have been a drastic change in the consumer psyche. Fear would have replaced faith. Income levels could have fallen so far that future tax cuts would have had little positive effect (there would have been much less income on which to cut taxes). The same would have been true for cuts in interest rates. If the Fed had waited until after home prices had started falling to lower interest rates, the huge financial windfall that came from home refinancing would never have occurred.

Economic weakness would have led to increased consumer fears, which in turn would have led to greater weakness. The banks, which hold the debt of our highly leveraged society, could have been severely stressed. New lending would have been curtailed, and no doubt all but the strongest banks would have been tottering. It would have been a vicious circle of consumer fears, less spending, weakening banks, falling home and asset prices, ever greater consumer fears, further declines in spending, threats to even the strongest banks, and crashing home and stock values. Once this vicious circle took hold it would have been extremely difficult, if not impossible, to save the economy.

Fortunately, our leaders did the right thing. The unprecedented amount of liquidity rescued our economy, and society as a whole. The collapse of many tech companies led to less capacity. Stocks began to rally. Eventually, the all-too-real threat of a vicious circle became something of a virtuous circle.

All in all, we were very lucky to survive the tech bubble. We were lucky to handle the aftermath in a short space of time. We were lucky we had the ability to flood the economy with liquidity so quickly. The crisis we face today in oil cannot be solved as easily. We may not be so fortunate this time.

The Inescapable Truth About Technology

As individual investors, there is little we can do to prevent mass hysteria from occurring, let alone the imbalances in society that can provoke a major economic crisis such as the tech bubble or the growing oil squeeze. We can, however, learn to avoid such ill-founded hysteria ourselves. Moreover, as the energy crisis unfolds, we must acquire the ability to protect ourselves financially, and grow wealthier, despite the resulting turmoil.

The most important question raised by the technology crash is why so many intelligent people-professionals and nonprofessionals alike-did not see the bubble for what it was. What fooled them into pursuing such a mad course of action that inflicted so much damage to their own future?

Because, of course, it was a kind of madness. It was a madness based on the false belief that technological progress would continue to rise exponentially, solve all of the world's problems, and make every investor a multimillionaire within a few short years.

In reality, technology could do none of those things. In my 1999 book, Defying the Market, I pointed out that, contrary to popular belief, the rate of technological progress has begun to decline. For example, in the early part of the twentieth century, science made major breakthroughs at a rate of five or more per decade. However, since the 1960s, the rate of breakthroughs has decreased. There were only three in the 1970s (quantum cosmology, chaos theory and fractals, and antiviral drugs), one in the 1980s (DNA replication), and none since.

Improvements in computer technology have also slowed, with the latest generation of computer chips only slightly faster than their predecessors, and the most popular software packages little changed from five years ago. There have been no big medical discoveries since antiviral drugs in 1978. And in recent years, high tech has not helped us increase the world's supply of food or freshwater, or solved our pressing need for new energy sources.

The slowdown in technology follows the general pattern of human progress. Every time civilization undertakes a new profitable endeavor, the biggest gains are made in the beginning. There is no mystery to this. We naturally pursue the biggest and easiest gains first, just as, when we pick apples from a tree, we start with the best apples that are easiest to reach. Eventually, when these run out, we turn to the smaller, harder-to-reach fruit. Consequently, every endeavor-from agriculture to technology to oil production-eventually must suffer diminishing returns.

One reason for the slower pace in electronics and computer development is that we are reaching certain physical limits, such as bus speeds, and the wavelength of light used to etch silicon chips. As a result, it is increasingly difficult and expensive to make even minor gains.

It was obvious in the late 1990s that the technology industry was maturing and that the best technology stocks were not the ones developing new technology. They were companies like Dell that were making money through sound management and excellent marketing strategies to achieve a dominant position.

Yet for some reason, people's expectations for technology seemed to balloon just as the industry began to peak. Only in 2000 did investors realize the high-tech industry was not living up to their exaggerated expectations. The massive demand, sales, and profits that had been projected failed to materialize.

Of course, I was not the only person who predicted the technology bubble would end in disappointment. Others expressed similar concerns. Warren Buffett, arguably the world's most successful investor, stayed away from high-tech companies altogether.

And of course, the truth about the technology industry was available to anyone who took the time to study the matter deeply. But those of us who contradicted the herd were decried by the so-called experts at the time as over the hill, our voices drowned out by the enthusiastic ravings of the other side.

The Ubiquitous Lies

Clearly, much of what the experts said about technology stocks was inaccurate. However, while it might be tempting to create a conspiracy theory to account for what happened, the falsehoods were so widespread that it is impossible to blame a deliberate effort by any one group.

On the one hand, journalism and the media have a traditional obligation to provide accurate and unbiased reporting. For that reason, most people are inclined to trust what they see on television and in the newspapers.

(Continues...)

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Excerpted from The Coming Economic Collapse by Stephen Leeb Glen Strathy Copyright © 2006 by Stephen Leeb. Excerpted by permission.
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