“From now on depressions will be scientifically created.” (Congressman Charles A.Lindbergh, after the passage of the Federal Reserve act 1913.)
Before I get into the details of this article, I strongly suggest you read a related article: You can do that by clicking HERE.
People have always believed, mistakenly, that the best time to invest their money (whether their investment is stocks, bonds, real estate, etc.), is when the economy is booming. That is because during this time, you’re likely to see the price of everything rising. And this is true. As I type this, the DJIA (Dow Jones Industrial Average) and the S&P 500 stock indexes are making new highs. The public, for some reason, gets the impression that this rise will continue forever and to confirm their belief, they’ll speculate in some sort of an investment while the market is high and end up losing everything a short time later. How does this happen? Let me explain….
Before I can explain the phenomena described in the previous paragraph, I have to explain the boom and bust cycle by which America runs. The boom cycle is when we’re experiencing prosperous times…unemployment is low, there’s plenty of money in the economy and so on. This is achieved during times when the Federal Reserve (The Fed) lowers interest rates in order to stimulate the economy, which usually occurs after a downturn. The bust period occurs when the economy overheats and the Fed steps in and raises interest rates to slow down the economy due to a fear of inflation, which results in a downturn or a recession. Now let’s explain what happens when interest rates increase and decreases.
When The Fed lowers interests rates, what they’re doing is increasing the money supply. The banks and the government are the ones who end up w/ this money. The banks then loan this money to businesses (and also to homeowners) which allows the businesses to make investments, which leads to job creation. To pull off this cash infusion, the Fed buys securities from the government and the banks. When the Fed makes these purchases, they pay for it with an electronic credit that counts as reserves in banks. Due to there being more dollars in the economy, by law of supply and demand, the value of the money that is already in circulation will deteriorate. By the way, when there’s lots of money in the economy, unemployment is low which threatens wage inflation and products also become scarce compared to the money in cirulation — that’s when inflation becomes a threat. Now let’s talk about the raising of interest rates. When the Fed raises interest rates, it’s the same process except in reverse. Instead of buying securities from the government and banks, they sell those securities back to them (repos/repurchase agreements), which takes money out of the economy…thereby, decreasing (contracting) the money supply. Again, by law of supply and demand, a contraction in money supply will increase the value of money. During the time of high interest rates, it takes less money to purchase items because the money has increased in value and also there’s a surplus of goods available due to the high level of production that occurred during the boom period.
However, one may easily interpret the preceding paragraph as an indication that high interest rates is a good thing for the common man because prices fall and surely if prices fall, that’s good for everyone. For the common man, that can be a blessing or a curse. By the time this article is complete, you will know why it could be a blessing, but for now, let me explain why high interest rates (less money in the economy) is a curse for common people. When money is taken out of the economy, there’s less money to facilitate trade. Capital for business becomes scarce which usually leads to massive job loss. Money also becomes scarce for everyday working people. For this reason, items become cheaper to purchase — due to the fact that during the expansion phase of the business cycle, lots of items were produced but a contraction of money has made money less plentiful. On the flip side, to bring an economy out of recession, the Fed will lower interest rates and money again becomes plentiful. When money is plentiful, businesses expand, more people are able to find jobs and there’s more trade being conducted.
To illustrate this point with a real world example, take a look at the chart below (click to view at full size). Take a look at the blue line. If you’d notice that around 2006 going into 2007, interest rates were raised to slightly over 5%. And if you all remember, this is precisely when the Housing Crisis began, around mid-2007. After going through a year or so of a deep recession, The Fed began to lower interest rates. In mid 2008, as you will see, we’ve been at an interest rate of nearly zero. Again, if you’ve been paying attention, you would see that the economy began to pick up around this time.
Now that we’ve gotten that out of way, let me explain as I previously stated, why investing during market highs is a bad idea. Typically, market highs occur at a time when the economy is nearly at it’s overheating point. As previously mentioned, this is when the Fed is ready to step in and raise interest rates in order to cool down the economy. Those who understand this mechanism usually begin getting out of their investments around this time, leaving those who just got in the game, holding the bag….essentially, losing their money. The reason that the smart money investors made money in the first place is because they took advantage of the inflated prices created by the Fed. Again, let me explain….
When we’re in the bust phase of the business cycle, interest rates are higher and money is of higher value. As I stated earlier, this allows a person to purchase items cheaper. This is when the smart money, who are sitting on cash as a result of selling their investments near the high, starts buying up things like stocks, real estate, and other investments because their money will go a lot further. Then when the Fed lowers interest rates to stimulate the economy, the price of these investments increase along with the price of everything else, allowing the investors to realize a profit on their investment if they sell at the right time.
Conclusion: With everything that has been stated, you now understand why more fortunes are created during the times of economic downturns. I can point to plenty of stories of people who went from being your everyday working to becoming overnight millionaires after the subprime crisis of 2008 reversed. That is why the best thing to do during the anticipation of a recession, if you’re a working person, is to continue to work and save money aggressively so that when the economy reaches a lowpoint, you will have cash on hand to purchase assets for pennies on the dollar.