All booms eventually go bust.
We all remember the stock market crash of 2000, and most of us remember the real estate crash after the implementation of the 1986 Tax Reform Act.
Unfortunately, despite our understanding of booms and inevitable busts, it's always near the top of a boom that "dumb money" buys in. Currently, this has set the scene for a potential market bust of which few people are aware.
Supermarket Inspiration
About a year ago, I wrote a Yahoo! Finance column warning readers that the real estate boom was over. How did I forecast the end of the boom? I got my hot tip from the cashier at my local supermarket, along with other economic factors.
While she was tallying the cost of my apples, broccoli, and steaks, she handed me her new real estate agent's card and invited me to call her for my next real estate investment. Moments later, I was home writing that column. As I have always said, "When dumb money chases smart money, the party's over." Needless to say, many real estate agents and investors wrote me nasty notes.
Most economists are forecasting a strong economy, but economists worry me more than newly minted real estate agents. Most seem to be happy that inflation is in check; when I hear that inflation is in check, I begin to think about deflation, and as most of us know, deflation is much, much, worse than inflation.
The Truth
In the simplest terms, inflation occurs when there' too much money in the system. On the flip side, deflation occurs when there are too few dollars in circulation. When that happens, prices start to fall. For example, in inflationary times, prices of houses go up. In deflationary times, prices of houses come down. If prices of houses begin to drop too fast right now, it could be 1986 all over again.
I wrote a column in 2005 about how I love debt and my credit cards. The trouble is that most people do. In the past you could qualify for a loan to buy a house simply if you're alive and breathing.
The strong economy we've been experiencing for years has thus been built on dumb money -- in addition to smart money -- borrowing more and more. Even the
Warning
For the next two years, I'm cautioning people to watch their ratios between good debt and bad debt, and keep liquid reserves such as cash, gold, or silver and become a leveraged real estate investor through short term strategies.
Good debt is debt that makes you rich. An example of good debt is the debt on the apartment houses I own. That debt is good only as long as there are tenants to pay my mortgages. If tenants stop paying their rent, my good debt turns into bad debt.
Most people don't have good debt -- all they have is bad debt. Bad debt is debt that makes you poorer. Forms of bad debt are car payments, credit card balances, or other consumer loans.
On our home, my wife, Sharyn, and I keep a 25 percent debt-to-equity ratio. In other words, our debt is 25 percent of the home's value. Unfortunately, many people have an 80 percent or higher debt-to-equity ratio. That means the debt on their home is 80 percent and their equity is only 20 percent.
To protect ourselves, we have cash reserves to cover the expenses of our investments. Unfortunately, the dumb-money crowd has no reserve funds for their properties and or investments.
Where Deflation Does Its Damage
In a deflationary market, the value of your home can drop. If the value drops, the bank may call in your loan. Even if you've never missed a payment, and even if you're ahead on the payment schedule, the bank can call in your loan if they feel the value of the property is lower than the loan amount.
For example, say you buy a house for $100,000 and put 20 percent down and borrow $80,000. If the market deflates and the value of your home drops to $70,000 (because everyone else is selling their homes to get out of debt), the lender may ask you to pay the $80,000 you owe immediately.
If such deflation happens, cash will become king. There will be half-price sales on BMWs, expensive restaurants will close, and people will be out of work. And anybody who caters to people with dumb money will be in trouble. As I said before, deflation is much worse than inflation.
Smart Money, Bad Times
The good news is that during deflationary times, smart money reenters the market, so crashes are great for smart people with smart money. Instead of listening to the optimistic economists, then, you should eliminate bad debt and improve your debt-to-equity ratios on good debt.
Most important, study; if you want to be smart, you need to learn. I'll discuss what you should study in the second part of this column. For now, be aware that if deflation comes and there's a recession, it won't have much effect on the poor. Instead, it'll punish middle-class people who think they're rich because their houses and stocks have gone up in value.
Finally, don’t forget the impact of our weakening dollar; some forecast that a gallon of milk will be at $5.00 by summer due to the weak buying power of our dollar.
The moral of the story is that those who prepare and know how to invest will make it through the tsunamis ahead and make a whole lot of money, which can be used in part to educate others.
Have a happy, healthy and prosperous New Year.
James Gage
