Sunday, September 11, 2011

Paradigm Shifting: Greece 1.0

The situation playing out in Greece continues to be fascinating to observe, not only because of the implications for the markets in the short term, but its impact on how investors, politicians, and economist's paradigm will shift when they see a simple real life case study to compare with their text books.

Greece, like many businesses, countries, and individuals around the world began to grow rapidly over the past few decades due to the excessive debt they applied to their balance sheet.

If a company currently makes $50,000 per year in sales and they decide to borrow $3 million in 2012 to expand operations then their organization will grow rapidly if that money is put to work.

If your next door neighbor makes $50,000 in income and decides to borrow $3 million in 2012 to purchase a new car, house, and travel, then his lifestyle will grow rapidly.

Money is borrowed from future savings.

Debt does not have to be bad.  In fact, when used correctly and intelligently, it is an important part of the global economy and growth. 

For example, money that I invest into my personal company to cover expenses, marketing, and payroll usually provides me a return between 30 to 50 percent.

If I could borrow money at 10 percent interest to expand operations, and get a 30 percent return on that money, should I borrow it?

Maybe.  If I could not sleep at night because I was worried about having debt, that would negatively impact my business so the answer would be no. (I would take the money)

The same goes for purchasing a real estate investment.  If you borrow a million dollars from the bank with monthly payments of $5,000 in interest and your property provides a monthly return of $8,000 after all expenses, should you purchase the property?

Maybe.  There are many factors involved such as the building's appreciation potential moving forward.

So what is the secret when it comes to debt?  The answer is cash flow. 


Intelligent investors do not fear debt, they understand that they need to build a business model or investment that can support the cost of using leverage.

This should all seem like common sense, so why am I spending so much time discussing it?

Because when these simple examples are applied to government spending, everyone believes that the rules are different.  They believe that just like Newton's laws in science, the laws of economics and finance no longer apply.

The implosion in the small country of Greece is shattering this paradigm.  It is causing investors to rethink their models the way home prices falling did in 2006.

What is most fascinating today is that looking at the fiscal state of Greece vs. the United States they are almost identical.  In many ways the United States is far worse on paper.

Yet investors, with the opportunity to watch what is taking place in Greece right before their eyes, still believe that the United States will never experience a debt crisis.

There is almost no comparison in history to the magnitude of this ignorance.  Most bubbles popped unexpectedly in the past with very few signs of warning to the untrained eye.  To compare it to our most recent housing bubble that imploded in 2006 and caught many Americans by surprise, imagine if Greece had an almost identical implosion in their housing market back in 2004 that impacted the global financial system.  A clear blueprint of what was coming.

This inability to differentiate continues to provide opportunities for investors.  Financial advisers today are telling their clients to rush to the safety of US treasury bonds.  I believe that 3 years from now an investor would have been better served in gold.

We will soon find out if the laws of economics apply to the bankrupt United States.  The average portfolio around the world today contains .75% of its composition in gold related assets.  Bonds represent over 50% of most portfolios.

What would take place if only 3% of that bond composition shifted to gold in a market that is tiny in physical size?  We would then find out if the laws of supply and demand applied to this market as well.

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