FOOL ON THE HILL
Preparing for the Worst

We catch up with author of Conquer the Crash Robert Prechter and ask a few questions on everyone's mind. Prechter may have a different philosophy about investing than most Fools, but his view could teach us something, or at least get us to think a little more about how we manage our money.

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By Tom Jacobs (TMF Tom9)
September 19, 2002

Bearish talk, short selling, and Chicken Littling are usually loudest at a market bottom, just as "the sky is blue" is most prominent at the tops. So for many, Robert Prechter's Conquer the Crash might be dismissed as a contrarian indicator. That would be a mistake.

I didn't intend to turn on the scare machine with last week's review of this book, in which the author discusses his view of a coming deflationary depression. I hoped to show that there's some fascinating thinking on the dark side -- whether you agree with it or not -- that may assist you in your financial life.

I caught up with Prechter this week for an hour-long follow up. I asked some of the questions readers have about his thesis that we face a deflationary depression -- if not in this down cycle, then in the next (I simplify here. Prechter uses analysis of economic history according to theories of R.N. Elliott -- the Elliott Wave -- to forecast stock markets. His book and last week's column explain more.). Here is an edited account of our conversation, with some Fool Community thoughts at the end.

TMF: In your view of the coming deflationary depression, does war provide the antidote by historically bringing inflation? Would a war with Iraq be a way out of the threat of deflation (not that I'm recommending it!)?

Prechter: Deflation often leads to war. A downturn in social mood toward defensiveness, anger, and fear causes people to (1) withdraw credit from the marketplace, which reduces the credit supply and (2) get angry with one another, which eventually leads to a fight. So, deflation and war are both results of the same cause.

I don't think there is a reliable relationship between war and credit inflation, nor between war and a better economy through inflation. Germany went utterly broke in 1923 via hyperinflation, yet managed to start a World War 16 years later, and I don't think it did so in order to inflate the money supply! The American colonies and the Confederate states both hyperinflated their currencies in wartime, but it did not save their economies -- quite the opposite. So, the idea that a government would go to war in order to create currency inflation to save the economy is not very sound.

Governments often do inflate to finance a war, not for the good of the economy, but rather for their physical survival. If the credit markets will not accommodate borrowing, the government's only recourse is currency inflation. Then it comes down to an opinion (or evidence) of whether a government or its central bank will take that route. As I explain in the book, it would be seen today as a highly imprudent course.

TMF: What do you say to someone with a 20-year investing horizon? Can't they make it by investing periodically [as in Drip investing] throughout?

Prechter: In theory, but it's not what people do in practice. The classic psychology of a prolonged bear market is that people don't keep investing. You didn't have averaging down in the 1940s and early 1950s, and people who did could have been wealthy the rest of their lives. In a 1952 or 1953 poll, 4% of the public said it was a good time to own stocks, so 96% weren't interested.

TMF: And look at the massive bull market that followed.

Prechter: Right. Then, around 1996, after most of the rise was over, the public decided to become dollar cost averagers. If you average down in a major bear market, all of your purchases will go down in value. The best way to really make money is to stay in cash most of the time, buy near the bottom, and hold as long as you are comfortable thereafter. Then get out. This is what Joseph P. Kennedy and Bernard Baruch did.

TMF: Speaking of market timing, you note that the deflationary depression may come now or in decades.

Prechter: No, I think one has already started. But I am unsure of when the lowest low for the stock market averages will occur. That being said, all forecasting is about probabilities.

TMF: So, in your view, there's no "manifest destiny" to U.S. economic growth?

Prechter: The greatest civilizations -- Rome, Greece, France, Britain, Egypt -- are not doing as well today. To believe in unending growth is not a good approach to civilizations, much less the stock market.. I'm accused of betting against American ingenuity and hard work, but we had both of those in 1929, and stocks fell 90% from there, anyway. We had them in 1968, and the average stock fell 74%. What does hard work have to do with the trend of the stock market? The irony is that people abandoned hard work half a decade ago to make an easy retirement from stock investing. Their ingenuity went into asset manipulation instead of production.

A large percentage of stocks go to nothing, so "the market comes back" is wrong. You could have -- in retrospect -- spread money among the 30 Dow Jones Industrial Average stocks and had many profitable decades. But the averages routinely add and delete stocks, so an investor would have to rigorously follow the averages and change holdings. Nobody does it.

TMF: So then, aren't we better off today with index funds?

Prechter: In one sense, yes, if they are low expense. But in another sense, their proliferation is a symptom of a massive public desire to speculate, which is bearish.

Losing money is the best slap in the face to wake people up. Some say, "I'll never do this again," and maybe they won't, but their kids will. A smaller percentage -- the ones who learn from the experience -- say, "I screwed up; I need to stop rushing from gold to bonds to real estate, and sit down and learn something about this very difficult field.

TMF: Ah, real estate. What about talk of a housing bubble?

Prechter: We've just seen the end of the housing bubble. Housing bubbles are rare. When they occur, they are pervasive and devastating. It pays to keep those cycles in mind when investing. Today, we see record foreclosures and delinquencies, which are results of low lending standards.

TMF: I note you lack the traditional academic credential of a Ph.D. Are you criticized for that?

Prechter: Yes. But the profession of economics has not followed the right path to determine what's likely to happen next in macroeconomics. It's better to talk to someone who understands psychology than economics. Conventional macroeconomics is an error pyramid based on the false premise that investors behave rationally and that people are as predictable as machines to changes in input. "If you lower interest rates or raise taxes, people do so-and-so." They don't always.

TMF: But what about behavioral economists like Richard Thaler?

Prechter: Behavioral economists are on the right track. They have placed the human mind in its proper level of importance in their research.

TMF: Now, I'm sure our readers are wondering, what have you done with your own money?

Prechter: I've followed my own advice [cash and safe equivalents]. I haven't sold my house. It's not the largest part of my net wealth, and I've paid the mortgage off. If you like where you live, like the property, understand that it's consumption and not investment, and you're not overcommitted -- in too much debt to keep it up -- then fine.

TMF: Aren't the wealth preservation strategies you present in your book only available to the wealthy?

Prechter: For true safety, you must go overseas. The safest repositories, banks, and insurance are all in Switzerland, and, yes, they do have minimums. The average citizen should find adequate safety in a U.S. Treasury money market fund or a highly rated bank, and have a little in bullion-style metals. Between the safest bank and a T-bill-only money market fund, I'd go with the latter.

TMF: To close, do you have a critic you respect?

Prechter: If there were, I wouldn't want to give them any ink, anyway [we both laugh]. There's a website named after famed Austrian economist Ludwig von Mises. He was the genius who wrote Human Action. When Credit Anstalt offered him a job in the late 1920s, he wanted nothing do with it, because he was convinced the world was heading for a massive credit bust -- a deflation. He wrote books saying that expansions in credit fostered by a central bank always lead to bust and depression eventually. I thought the Institute would respect his view, but they keep putting things out like "The Imaginary Evils of Deflation." You could look at that piece if you want. Ninety-five percent of economists (down from 99% a year ago) think that deflation is impossible, and 95% of the ones who think it is possible think it will be benign. That's not what history has to say about it.

Fools respond
We began talking about these ideas last week on our Fool on the Hill discussion board, where StringCheeseMark posted this Foolish response:

While I, like you and Tom Jacobs, am bullish for the long haul, I see no reason to believe that we have 'hit bottom' or that the market turnaround is imminent. Like Tom, I think listening to and learning from opposing points of view is healthy and protects you from the hubris of having it all figured out. While the Dow dropping to the 700-range in the next few years might be an overstatement, we must remain prepared to continue to lose money in the short term in the market. Not having read his books, I can predict what the advice to the investor will be: 1) Pay off debt, 2) Live below your means, 3) Diversify your holdings into non-stock investments, 4) Invest most heavily in your own personal earning power, 5) Keep six months of expenses as a 'cash buffer,' and 6) Don't buy stocks with any money that you can't see losing 75% of in the next three years and waiting a decade to show significant capital gains.

Amen! Want to talk to others about these ideas? Consider our Economy and Markets or Communion of Bears discussion boards.

Tom Jacobs can leap tall buildings in a single bound. The Motley Fool has a full disclosure policy.