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October 03, 2007

Drowning in Debt: How do we protect ourselves?
by Mike Shedlock

In response to Is the Fed Deflating? I received several reader question similar to this one from Mike:

Thank you for your analysis. Could you please tell me, and others, what we should do to protect ourselves per your warning below?

"Those who ignore the warnings are likely to drown."

Sincerely,
Mike

Thanks for the question Mike. It's a good question and not often discussed enough. Let's add two more words to the very end of the above warning then see if we can answer your question: "Those who ignore the warnings are likely to drown in debt."

The best way to avoid drowning in debt is to not get into debt in the first place. Those who are in debt should attempt to get out of it as quick as they can. The way to do this is simple: Live within your means or better yet live below your means.

Those who carry credit card balances from month to month are not living within their means. Far too many people treated their house as an ATM, taking out cash to pay off credit cards, only to run up credit card or auto loan debt time after time. The housing ATM is now shutoff but consumers keep buying more than they can afford. The result is that credit card debt is soaring once again.

The number one rule in all of this is:

Don't Buy Stuff You Cannot Afford

Click here to see one of the funniest Saturday Night Live skits ever.

In this tenuous jobs market (see Moonbats Active Again in Massive Jobs Disaster), one needs to be prepared for the loss of a job. It can happen at anytime in any industry. The housing spillover has just started. It is highly likely the financial sector will continue to get hit. A downturn in commercial real estate and retail appears to be starting.

The Wall Street Journal reported Durable goods orders declined 4.9%. Target and Lowe's both warned. See Target Warns and Blames Florida - Lowes Blames Dry Weather.

Just as the housing problem spread from subprime to Alt-A to prime, job losses are highly likely to spread from housing, to commercial real estate, to retail. To protect oneself from a loss of income, it is imperative to have actual cash savings in a money market, short term treasuries, or short term CDs. Those barely able to make home payments now and who have no cash savings, will be in serious jeopardy if they lose a job. Don't be one of them.

Have a Years' Worth of Living Expenses in Cash

Before thinking about vacations, new cars, or even investing, I would recommend for people to have 12 months of living expenses in cash, short term CDs, or short term treasuries. Those who say "cash is trash" have never lost a job for an extended period of time.

I have and I know what it's like.

Consider a decision to have "emergency cash on hand" as sound financial planning and as an additional means test on purchases as well. Can you really afford an expensive vacation, a boat, or a new car if such purchases would deplete your savings leaving nothing for emergencies like the loss of a job?

Buy Food On Sale

Food prices seem to be soaring. Get an electrically efficient freezer and buy what's on sale. Food can easily last three to six months or longer, if properly wrapped in plastic and/or freezer paper. My parents did this. Mom would buy what was on sale, dad would wrap it in freezer wrap and label and date the package. It seems to be a lost art.

Even as non-sale prices seem to be rising, sale prices on meat (the largest part of our food budget by far), have hardly budged for six years. I routinely get center cut pork chops for $2.49 or so but the regular price is now often $4.49 or higher. Whole chickens, vacuum sealed so they don't even have to be wrapped can be purchased on sale for .49 lb. or so. I wonder how they can raise them for that price.

Last week I bought round steak for $1.49 lb. Round steak was a loss leader at .99 lb when I worked in a grocery store in 1971. That's hardly any inflation in over 30 years! Many stores will grind meat for free. Why pay $3.98 lb for ground round when you can pick up a round steak for $1.49 and have the butcher grind it for free? It's the same thing with ground chuck. Besides, you also know exactly what you are getting that way as opposed to buying a package of ground beef wondering "what the heck is in this and how fresh is it?"

Prime rib on sale is $4.99 lb not on sale is $10 lb. A 20 oz bottle of White Rain shampoo is .99. If you buy the advertised name brand shampoo it will cost over 5 times a much and it won't clean your hair any better.

If you can't afford to eat out, then don't. Even if you can afford to eat out there is nothing wrong with cutting back on the frequency and saving for a rainy day.

Consider Wants vs. Needs vs. Affordability

Do you really need an SUV? Can you afford one? What about the cost of filling it up? Auto sales persons, real estate agents, and in fact nearly every sales person's job is to convince you that what you are looking at is affordable. If one has to stretch a car payment out to 5 years to be able to "afford" it, the car is simply not affordable in my book. But even if the car is affordable what about the increase in auto insurance? The salesperson is 100% guaranteed not to mention it.

Cars, trucks, and boats are depreciating assets. If they are depreciating faster than you are able to paying off the loan, then they are not really affordable. It's best to pay cash for such items. But if you can't do that, at least make sure you are not upside down in the loan a few years down the road.

Interest only loans and teaser rates on houses do not make houses affordable either. Many are finding that out the hard way right now. Perhaps the sales agent forgot to point out escalating association dues, hurricane insurance costs, property tax, and heating bills when considering "affordability".

Reduce Leverage

Paying down mortgage debt is a reduction in leverage. It's a good idea. In contrast, some financial advisors are recommending that people take out home equity loans and buy stocks. This advice is based on the premise that the stock market always goes up over time. The current advice is to Aim High. I disagree.

Didn't we just hear the same thing about home prices?

At 20% down homes are already highly leveraged. Increasing leverage for the purpose of investing stands a good chance of losing twice. All it takes is a continued decline in home prices and another bear market in equities. Both are likely. Risk is a two way street. It is not always rewarded. Leveraging up and throwing the rest into stocks is simply poor financial advice no matter how it turns out.

Stock prices and housing prices fell for 18 years in Japan. The same can happen here. I'm not saying they will, I am saying they can. There certainly have been many 10-20 year periods where stocks went down to sideways. It's a huge mistake to judge things from the recent bull market.

Consider Retirement Plans

The closer one is to retirement the more risk avoidance is likely to come into play. The key here is to understand your timeline as well as your risk tolerance. Someone five years from retirement does not have ten years or longer to break even if the market takes another slump. Someone in the S&P and holding from 2000 is just now back to even.

Look at LBOs now being balked at by Citigroup (C), Lehman (LEH), Merrill Lynch (MER), Goldman Sachs (GS), and Bear Stearns (BSC). As long as they could securitize the debt they were fine in pumping it. Buyout Bingo has now stopped. If Citigroup does not want the debt or the deals why should anyone else?

One of the reasons that earnings have been high is underwriters were able to pass the CDO and mortgage trash to pension plans and foreign investors, collecting enormous fees along the way. Another reason was that people continued to buy stuff they could not afford, primarily on the belief that home prices would continue rising.

Investors needs to understand how the credit binge affected earnings as well as the likelihood that the credit binge grinds to a halt. Traders have no such considerations.

No one really knows for sure if stocks are going to drop or not drop, but they certainly are nowhere near as cheap as most make them out to be. Historically stock market returns with this backdrop have been weak to poor. Is this time likely to be any different?

Bear markets have a way of exposing fraud and all sorts of other problems. One look at housing should be proof enough. The stock market is not immune either. Risk has increased and one should factor that risk assessment into investment decisions.

Challenge Traditional Thinking

The past several years have been rather amazing. Nearly every asset class around the globe rose in unison. This is not normal market behavior. What was correlated on the way up can easily be correlated on the way down. In that regard, diversification does not guarantee success nor does traditional thinking.

Traditional thinking still boils down to a recommendation of buying a mix of stocks and bonds (with bonds specifically meaning corporate bonds). Unfortunately there is no magic formula that can properly allocate stocks and bonds in a portfolio by a person's age as some attempt to do. And if the economy is headed into an economic slowdown, default risk will rise and corporate bonds (especially junk bonds) are likely to be punished.

In general, corporate bond spreads are simply too low vs. treasury yields to make them a good buy at this juncture. But that has not stopped advisors from recommending them.

There are ways to hedge stocks but those ways are seldom mentioned by advisors. And there is nothing at all wrong with seeing increased risk and pulling some chips off the table. There are also currencies, commodities, and precious metals to consider.

Advice on all these issues has to be given individually and that advice also needs to consider the goals, risk tolerances, and timelines of the investor as well. That is what we do at Sitka Pacific Capital Management.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Michael "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Visit http://www.sitkapacific.com/ to learn more about wealth management for investors seeking strong performance with low volatility.

Copyright © 2005-2008 Mike Shedlock

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