The 'Invisible Crash' Is Now In Sight

You can see the fear in Treasury Secretary Henry Paulson’s eyes and in those of Federal Reserve Chairman Ben Bernanke. But they dare not say how critical the situation is — lest it shake confidence and make matters worse.” ~ Bruce Bartlett

In the 1970s, investment writer Jim Dines invented the term “invisible crash.” He meant that even though in nominal terms stock prices may not have crashed, in real terms (after inflation), they have. Look at it this way: If your brokerage account is down 30% for the year, but the loss of purchasing power, as measured by the rise in the Consumer Price Index, is 20%, you’ve really lost 50%.

Dines, one of the original gold bugs, was suspicious of the government statistic CPI and criticized it for grossly underestimating the rising cost of living (I tend to agree). Instead, he used the price of gold to determine the real value of the dollar. In the 1970s, gold rose from $35 an ounce to over $700. Based on the value of gold, Dines concluded that stocks suffered an “invisible crash” in the 1970s. He wrote a book of the same title, published by Random House in 1975.

Today we are experiencing another invisible crash. Stocks are down 30% over a 12-month period. In real terms, after taking into account the CPI, stocks are down at least 40%. And with gold up almost 20% in the past year, stocks have now lost half their value in real terms.

Moreover, artificial intervention by the Fed and Congress has propped up the stock market and kept it from literally crashing. One wonders how long they can keep this going without the entire system unraveling. It’s always worked in the past. Since World War II, the government has intervened time and time again, injecting liquidity and running deficits, and it’s worked. But this time it might be different, and you need to be prepared.

The fundamental problem is that our global financial system is built on a fragile house of cards. I made a big point of this in my book, “Investing in One Lesson.” The essential lesson is that “Wall Street exaggerates everything.” A 1% decline in real GDP can cause stocks to fall 30%. Why? Because at any time millions of investors can sell their stocks with the push of a button. In today’s world, you don’t even need to make a phone call to your broker. You can go online and hit “sell all” on your brokerage account.

Moreover, it only takes a marginal number of traders to cause stock prices to fall sharply. No more than 5% of all investors caused the Dow to fall 20% in a single day (October 19, 1987).

Our monetary system is also inherently unstable. The banks operate under a fractional reserve banking system, meaning that the vast majority of funds in your bank account are loaned out. These are typically long-term loans that can’t be recalled easily. Banks are required to maintain only a 10% reserve on checking accounts, which means that if everyone tried to withdraw their money, banks could only pay 10 cents on the dollar. If they all demand their funds at once, you would have a classic run on the bank.

Banks, insurance companies, and financial institutions are all interconnected in today’s global economy. A foreign bank will own obligations from a U.S. bank. If one runs into trouble, it can hurt the other. Thus, a collapse in the U.S. mortgage securities market can cause a crisis in Europe or Asia.

Our system is based on confidence. If people lose faith in their government and their bank, they may start rushing for the exits, selling their stocks, and converting checking accounts into cash. They may also buy gold and silver coins, the ultimate hedge against crisis and bad government. (Note: The U.S. Mint has run out of American eagle gold and silver coins.)

The result could be a crash, deflation, and yes, even a Great Depression. The government will do everything in its power to keep it from happening, but there are no guarantees. Investors would be wise to play it conservatively: have a well-diversified portfolio in quality stocks, hold a strong position in cash and precious metals, and avoid any unnecessary expenses until the crisis blows over.