The good news is that you still have time to protect your stocks from a plunge that will rival that of the Great Depression.
How so? This decade has featured record debt levels, extreme income inequality not seen since 1928 -- according to the New York Times [registration required] in 2005 the top 1% (over $348,000 in income) took home 21.8% -- their largest share of national income since 1928, and a negative savings rate of -0.7% -- last seen in 1933 -- the depths of the Great Depression.
Why does this mean that stocks will fall? Many of the top 0.01% -- those making over $25.7 million a year -- are getting that way by borrowing money. Consider Blackstone Group CEO, Steve Schwarzman, whose annual compensation is estimated at over $500 million. If banks and bondholders were not willing to lend Blackstone billions of dollars, his deals would not work. In 2006, a record $480 billion was used to finance leveraged buyouts and Moody's expects the default rate on this debt to increase to 3.07% this year. Bad buyout loans could lead to corporate bankruptcies and worker firings.
Another group in the top 0.01% are CEOs who send lower paying jobs overseas to maximize their business profits and boost their incomes. According to the Wall Street Journal [subscription required], Princeton University economist Alan Blinder estimates that 30 million to 40 million jobs could be sent overseas due to globalization. For those American workers whose jobs are offshored, it could be harder to pay their bills. But the bosses who send the jobs overseas should be just fine.
And those who are getting by despite negative savings are heavy borrowers. Those lower income people are among those taking on a record $2.4 trillion in consumer installment debt. And they are disproportionately represented among the borrowers of $1.3 trillion worth of subprime mortgages -- 47% of which got loans despite no verification of their incomes or no down payment. When low teaser rates reset, borrowers can't keep paying -- 2.2 million are expected to default.
And the problem is not limited to lending against houses. Investors are borrowing to buy stocks at levels that exceed 2000 -- right before the dot-com crash. Specifically, in 2006 stock margin debt hit a record $286 billion. If investors who borrow money to buy stocks need to pay it back due to a drop in price, the margin debt lenders will sell that stock fast -- accelerating a stock market decline.
In the 1980s and 1990s I witnessed this pattern: low interest rates encourage borrowing. Borrowing drives up asset prices. Banks loosen their lending standards to keep growing -- figuring that if a borrower defaults they can always sell the collateral at a profit. This encourages asset producers -- in this case home builders -- to increase the supply.
And when the borrowers can't pay, the supply exceeds the demand and prices tumble just as lending standards are tightened. Banks fail, borrowers default, companies fire workers, and eventually the excess supply clears and the market recovers.
With record levels of borrowing, the big unknown is when this clearing will begin to reverse economic growth and how long it will take to be completed. Money market funds would be a safe haven in the meantime.