Predictions for 2011 - $5 plus gas??

2011 is upon us and we enter year 3 of the Great Recession. I want to start by saying that I have an extremely positive view of the world situation as I believe that smart investors can make money in ANY market or economic environment if they understand what is really happening. It is our job as investors to make accurate decisions with our money as we make informed decisions about the economy.

So, with that out of the way, let's talk about 2011. In my opinion, this is the first really critical year for the US. We have been able to create trillions of dollars out of thin air (thanks FED!) by simply "borrowing" from the Fed.

As a recap to previous posts, remember that the Fed controls the supply of money (dollars) in the US and world. The government offers to sell Treasuries to the world and the FED is the backstop in case the world does not want to buy debt from the US government. In other words, the FED will step in and buy all the debt the US wants to create even if there is no demand for it from the rest of the world.

The biggest losers in this scenario are the US taxpayer and the small investor that has been told that investing in Treasuries is the safest, lowest risk approach to investing money. The taxpayers lose because we have to pay more taxes to service the additional debt and the small investor loses because he is making less than the rate of inflation on his money (in other words, he is losing real purchasing power every day).

By the way, the big winner is the privately owned, non government FED because we gave control over the creation of money and they get to charge us interest for it. It's a great deal to be able to write bad checks backed up by nothing and force the taxpayers to pay you interest on it forever!

To get a better understanding of this, you could simply write a "check" out on your dinner napkin, add a promise to repay with interest document (a promissory note) and give it to your waiter. The waiter could sign the note, deposit the "check" and be required to pay you interest. You do not have to actually have any dollars anywhere, you just need to make an entry in your file cabinet that the waiter owes you money and will pay interest.

The key to making this scheme work is that other banks and businesses must be willing to take the "money" from the check you wrote to the waiter as an acceptable form of settlement for the payment of goods and service. That is the second role of the FED; making sure that other banks, governments and businesses accept this "money" as payment for everything. All the banks simply have to "book" these non cash deposits into their accounting systems and "bang", you have money to spend, created out of thin air!

Now, on to 2011! The government has attempted to fix the current recession by spending trillions of dollars (called stimulus spending) hoping that this money will circulate into the economy, creating jobs and economic growth. The US and world economies are dependent upon people and businesses spending and borrowing dollars every day at high rates. As the number of dollars in circulation increase, the theory is that more jobs will be created, which will produce greater demand for goods and services, which means more jobs, and the cycle continues.

The problem is that this cycle is not sustainable over the long term. The government has to deal with this difficult phenomenon called inflation. Inflation is not some mechanism developed by evil people to punish the world's population with economic chaos. It is the natural result of people beginning to understand that there is way more money circulating around than there is goods and services available. As people realize this, they begin to understand that it is taking more and more of their dollars to buy things.

The real problem develops when people start to panic and decide to dump their dollars for other tangible assets in an effort to protect their wealth. Once this happens, inflation hits high gear and we start the process toward hyperinflation. Hyperinflation results in the whole currency creation game being ended and the currency dies. Nobody will accept it for payment and it therefore has no value.

So, you see that inflation and hyperinflation are the results of human behavior. People know that the value of their money is going down and they decide to trade it for something else. The more panicked people become, the worse the inflation. Now, the process and details of this situation are more complex in totality, but you get the idea and the basics behind inflation.

"That's nice", you say, "but how does that effect me in 2011?" The answer is that the biggest play in investing right now involves the expectation of inflation. Inflation has already hit in a significant way since 2008 (the official beginning of the recession). The prices of all types of goods and services have risen substantially over the past 2 years (if you don't believe me, check the cost of commodities yourself). As the amount of US dollars in circulation increases, the value of each of those dollars in lessened. This is called "debasing" the currency. As you are probably aware, the government has been debasing the dollar like crazy over the past 2 years, with stimulus package after stimulus package.

There are reasons why the government prefers to debase the currency instead of curtail spending and live within its means, but that is a different topic we will discuss in future blogs. For now, just keep in mind that the people in power know that they will be voted out of office if they decide to do the "right thing" and cut spending and try and lower the government's debt. This course of action would have severe immediate impact on the average US citizen, and we do not want to experience that! Government power brokers have other major agendas and they must maintain power to implement their agenda. So job one is staying office.

This morning (1/1/11) the Atlanta Journal (AJC) ran a story with the headline "Oil's surge in 2010 paves the way for $4 gasoline". The story spent most of the space telling the reader that higher oil prices are the result of increased demand for oil (mainly from China). I disagree with the statement and so does the author of the story (even if he does not understand and says he agrees). Oil is going higher because the dollar is losing value. Therefore it will take more dollars to buy the same amount of oil (inflation!).

The writer of the story actually acknowledges this with this small comment buried deep in the text:

"The price of energy and other commodities shifted into high gear in late August when Federal Reserve Chairman Ben Bernanke signaled that the central bank was prepared to stimulate the economy by buying government bonds. The $600 billion program didn't start until November, but speculators had already starting bidding up the value of asset classes like oil.

A further oil price spurt came in late November as it became clear that Congress was likely to extend for two more years tax cuts set to expire at the end of the year."

If oil prices are rising due to demand, why does stimulus spending make "speculators" bid prices for oil up? Could it be the excuse that a stimulated economy will increase demand? Possibly, but the cost of oil will only increase if demand does in fact go up. That is a pretty risky position for a "speculator" to take (it is interesting that the word "speculator" is used for commodity traders!). I can assure you they know what they are doing and they understand that their risk is really small. They know that more dollars in circulation HAVE to result in less value for each dollar. They do not have to worry about demand to increase oil prices. They have the promise of the government to do it for them by creating more dollars!

So, I can easily see $4 plus gas prices in 2011. I hope it really is that low this time next year! As the government continues to perform stimulus spending operations, the price of gas will only go higher.

Note also in the AJC quote above that the author says "asset classes like oil". What is meant by that is that commodities (tangible items that people need or items that have natural intrinsic value) are rising and will continue to rise with each additional dollar created by government spending. Traders know this and they are preparing for the great inflation coming to the US.

What are "other asset classes like oil"? The biggies are gold, silver, other precious metals, food, energy and real estate. Each of these assets has some degree of rarity or basic human need that translates into value that is always going to exist. Due to this, people will gladly give everything they have to get these things when times are tough. Everybody needs food, shelter and warmth. We do not NEED video games, luxury cars and fur coats!

Gold and silver play the major role as there must be a medium of exchange for people to trade for major assets such as food, energy and shelter. People know that paper currency (basically IOU's from the government) can become worthless over night, so they will seek assets of true and real value in exchange for their currency. Gold and silver are the truest forms of money and they have been used during the entire history of the world as the default standard of exchange for goods and services. People will revert back to using gold and silver when hyperinflation hits.

Just remember the economic version of the "Golden Rule" we have all heard before: "he who has the gold makes the rules". The commodity traders mentioned in the AJC article above know this and they are investing in future gold in the forms of energy, food and real estate.

So, my predictions are as follows (heed them at your own risk!):
1. Government spending will increase dramatically as the federal government starts bailing out state governments with "stimulus money"
2. The US dollar will start to be dumped by foreign governments as they realize the value of their dollar denominated debt is shrinking
3. The FED will become the primary "buyer" of US debt at greater and greater rates as the world market for US debt continues to shrink
4. The debt owed by the US government will continue to rise dramatically due to the stimulus spending AND the health care legislation
5. Debts owed to the baby boomers will come due, resulting in even more spending to pay social security and medical benefits. This group is starting to retire now.
6. The working population will not be able to provide the tax revenues needed to fund all of this debt requiring the federal and state governments to increase borrowing
7. The economic wealth of the baby boomers will start to disappear from the economy resulting in a further contraction in business and needs for services
8. The baby boomers will start cashing in their 401k's and IRA's causing a further stock market crash
9. Inflation will start to skyrocket leading to hyperinflation in the US
10. Assets such as gold, silver, energy, food and real estate will escalate in cost (the amount of dollars needed to buy them)
11. Interest rates will rise dramatically causing even further strain on the economy

If this sounds like depressing news, you have missed the point. This situation (as in all situations) is offering the smart, informed investor a great opportunity to generate enormous wealth. If we can figure out where things are headed, we have a head start on the rest of the world.

My advice (and I what I am doing myself) is to start buying assets such as gold, silver, energy and real estate. I focus much of my efforts on real estate as it allows me leverage and cash flow, as well as a hedge against inflation. Buy as much investment real estate today as you can with your excess cash. If you can place long term, fixed rate debt on that real estate at today’s low rates, you will do even better. The cash flow will keep up with inflation and you will have a commodity that people MUST have to survive.

During this New Year, keep an eye out on government spending. See if my predictions come true and start taking steps to protect yourself today. Have a great and prosperous New Year!

Jeff

(Jeff Swaney's disclaimer: I am not an economist or financial planner. I am a regular guy that has spent much time and money trying to see where we as a country are headed. I am giving you my opinion only. You should do your own research before taking any action.)