Possible Economic Scenarios with the Current Market Drop

The stock market has been thrown for a loop with government feet on the economy’s throat all around the world. Businesses are being forced to close their doors and workers are being forced to stay home to try to slow the spread of the corona virus. While they may be closed and are seeing a huge drop in revenue, businesses still have expenses they must meet such as rents and power bills, so they may end up needing to close down permanently if the shutdown continues too long. They are also laying off lots of workers since they do not have anything for them to do and do not have income coming in to pay their salaries.

Hopefully adaptations like restaurants expanding delivery and take-out will reduce the impact, but it remains to be seen how well that model will work. Note, if you still have a job and your income has not been effected, one of the best things you can do is to continue to buy from businesses like you were doing before the shutdowns as much as possible since that will allow them to stay open and for them to keep workers on staff. This will help preserve your job since the money needed to pay for most people who are still working but perhaps able to work from home will be affected if other businesses are closed for long enough. For example, government workers rely on tax dollars and advertising company revenues rely on businesses like hotels and restaurants buying ads.

While the economic effects due to the virus itself have been relatively modest, with only very small portions of populations actually having the virus and getting serious complications, governmental actions to prevent greater spread and loss of life have had a serious effect on stock markets the world over. The virus is also extremely contagious, so the possibility of widespread infection and the serious economic effects that would accompany such an occurrence remains a threat.

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Obviously, the main concern right now is preventing loss of life and the serious human toll that the pandemic could cause. Eventually, however, the pandemic will end and individuals are rightly wondering what the long-term effects of the government economic shutdown will have on their portfolios, or at least what remains of them. In this article, we’ll look at possible scenarios and talk about things individuals should be doing to protect themselves financially as well as possible. We’ll focus on the US economy, but a similar analysis could be done for markets around the world.

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Possibility 1: Deflation

The worst possible scenario for investors would be for the economic shutdown to cause a long period of deflation, possibly leading to another Great Depression as was seen in the US almost a century ago. In deflationary times there just is no demand for things because people don’t have the resources to buy things. Everyone is out-of-work, so while they may need things, they don’t have the means to pay for them. Because no one is buying anything, there is no need for workers, meaning that there are no jobs to be had and people sit home idle. Industries that are not critical for life are hardest hit since people cut those out first.

In deflation, there is little or no demand for goods and services, meaning that prices fall as businesses discount and do whatever they can to unload merchandise. A brief period of deflation was seen in the US during the 2008-2009 housing meltdown when housing prices fell from their highs to reasonable values and banks ended up with houses that they demolished or sold at fire sale prices since there were few people buying. This also lead to less demand for other services, like hotels, airline tickets, home upgrades, etc… since people were using home equity loans from the inflated prices of their homes to pay for this spending before the meltdown. Once home prices stopped rising and the loans came due and could not be refinanced, the spending stopped and the whole false economy that was created (false because the money to pay for it did not really exist – it was all borrowed money) vanished overnight.

Luckily, most bouts of deflation are fairly brief. Once prices fall to the point where things start to be great deals, people usually step in and start buying. That buying begets more buying, and things start to pick up again. As buying picks up, shops and other businesses start to hire more people, which means people are able to buy things and demand increases. As more people are working, more is being produced and the economy increases, bringing stock prices higher. Eventually people start to be able to buy luxuries again and the whole economy comes back

Stock prices during deflationary times tend to drop. Stock prices are ultimately tied to the size of the dividend that a company can pay to shareholders, which is tied to the earnings of the company, which is tied to the amount of business they are doing. If they aren’t selling anything because there is little demand, share prices will drop. There is also an increased risk that companies will go out of business entirely, further reducing share prices since investors won’t buy until the potential return they can get is worth the increased risk they are taking. During the Great Depression the Dow Jones Industrial Average dropped 90% from its high over a period of about three years and it would have taken about 15 years for someone who put money in at the peak to get back their full investment. Note that someone who was investing in regular installments, instead of dropping in money in a lump sum, would have gotten their money back much faster and had a nice return over that 15 year period.

How to invest for deflation:

Times of deflation favor those who have cash assets (bank accounts, CDs, etc…) because dollars become worth more each day as the price of goods decreases. Having cash also allows you to buy shares at the decreased prices as the market drops. Having cash isn’t absolutely safe, however, since the FDIC protection depends on the economy continuing to exist, so if the economy just totally disappears and banks close, cash assets will disappear with it. The only fallback plan there is having the ability to do something to trade to others to get what you need.

Besides having some cash for near-term needs, the other thing to do during deflationary times is to continue to invest regularly. This may seem pointless as you see the stock market continue to fall and the money you put in be wiped away, but it will be the best move in the end. Most of the time the recovery is fierce and producing rates of return in the 20-30% range or higher. Buying on regular intervals allows you to reduce your cost basis, meaning that you’ll be that much better off when the economy does come back. There is also evidence to show that most deflationary periods are short, provided the government doesn’t interfere in an effort to fix the economy as was done during the Great Depression. During that time, rules on companies like making it impossible for companies to lay people off and minimum wages that had to be paid made companies reluctant to hire, perhaps extending the Depression a lot longer than it needed to last. Deflationary times will eventually end, and most of the time it will only last for a period of six months to a year before the economy is recovering and roaring back to life.

In selection of what to buy, index funds are safest. You want to make sure that your investment will still be there and you’ll have money in the game when the recession or depression comes to an end. Some individual companies will be wiped out, taking away your whole investment, but at least a portion of the companies in an index fund will survive, so you’ll still have an investment for when the economy takes off again. Even though it is a good time to buy stocks and you may not have as much cash available to do so as you’d like, buying on margin is a bad idea during these times since you could still lose your whole investment should a margin call occur. Note that a primary cause of the market collapse that lead to the Great Depression was that stocks were being bought on margin, causing speculators to lose everything when margin calls occurred.

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Possibility 2: Inflation

A second possibility, which is looking more and more likely, is for inflation to pick up. Inflation is where prices increase and the buying power of dollars drops more and more each year. In times of extreme inflation, called hyperinflation, prices can double over the course of a month or even a few days. This causes those who have the money in cash or cash assets to be wiped out since, suddenly, their savings won’t buy what it used to buy.

The reason inflation is looking likely is that the government is sending out trillions of dollars in checks to individuals, trying to keep the economy moving by putting money into the hands of consumers, but the reason the economy is stagnant is that the government is not letting businesses operate normally. This means that there are fewer goods being produced but people are getting money to exchange for goods anyway. Rather than everyone making stuff and providing services to exchange, only some people are producing but the others not producing still have money to exchange. This will cause more demand for the goods that are available, which is things like food, which will drive the prices of these goods up. The good things about this is that the increases in prices will help discourage hoarding since people will just not be able to overbuy, but the bad thing is that cash savers will be hurt and stocks and bonds will initially be hit.

How to invest for inflation

Inflation will initially cause stock prices to drop. The reason is that interest rates will increase as savers demand more interest for their deposits since they are losing more to inflation. This will mean that the returns from stocks will need to be higher than they are now to make up for the risk of buying stocks instead of putting money into the bank, causing stock prices to fall. Bond prices will also drop as interest rates rise since bond investors will want a higher interest rate to make up for their risk as well. The good news about inflation is that it does not tend to cause businesses to go out of business, just for consumers to have a harder time paying for things.

After the initial drop, stock prices will tend to rise since they can just charge more to make up for the effects of inflation and the dollar price of the company will increase as dollars become worth less. Note that the rise in the stock price due to inflation is not actually income for the investor (although he will still pay taxes on that gain) since the buying power of the dollars he will receive for selling at the higher price will be equal to the dollars he used to buy the shares. Only real increases in the price of the stock, those beyond inflation, are investment gains.

In inflationary environments you’ll want to have your money invested in stocks since the price of stocks will at least keep up with inflation. Companies are really not hurt by inflation since they can just raise their prices as they need to pay more for goods and increase the salaries of their employees. It may slow sales at first, but as people get used to prices increasing and they see their wages increase, they’ll go ahead and accept the higher prices. During these times people may also start to buy things like gold jewelry to sell later to try to take advantage of inflation.

After inflation has set in and interest rates have risen, you’ll also want to put some of your money in bonds. (Nowadays, this will normally mean buying a bond fund since finding individual bonds to purchase has become nearly impossible.) This is for two reasons: 1) The interest you’ll be collecting from the bond will be higher than the rate of inflation, and 2) the bond price will be low compared to what the price will be when the bond matures, meaning that the amount you’ll be repaid when the bond matures will be substantially above the price at which you can buy it. For example, you may get a bond that matures in 10 years and will pay out $1000 at that time. Because the price of the bond dropped when interest rates went up, you may be able to get it for only $600 if the bond was issued before the inflation started. This means you’ll make $400 per bond, or about 4% per year, in addition to the money you collect in interest over that ten-year period. If you can get a 6% interest rate on the bond, this means that you’ll be making a 10% return, which is favorable when compared to the traditional returns of the stock market.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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