Many of you I am sure have followed the investment advice from the richest man in the world, Mr. Warren Buffet. There is good reason to follow the Oracle from Omaha. Take a look at historical returns from his Berkshire Hathaway:

Compounded Annual Gain: 1965-2007 21.1%

Overall Gain: 1964-2007: 400,863%

S&P 500 Compounded Annual Gain: 1965-2007: 10.3%

Overall Gain: 1964-2007: 6,840%

Anyone would be hard pressed to argue with amazing results such as the above. Yet Buffet in his annual letter to shareholders expresses concerns over continued growth given the current state of the economy. The Pollyanna expectation of many investors may not come to materialize in a market that is seeing severe corrections. Buffet in his letter points out that over a century, the Dow hasn’t been such a great performer:

“How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.”

So over a century, the Dow only returned a compounded annual return of 5.3%. Not bad by any standards but again nothing to come home to brag about. But the idea that stock markets can continue to yield such high returns especially in the current climate is somewhat unwarranted. Buffet explains to us using simple math how preposterous this is:

“Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow - recently below 13,000 - would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.”

Given the current market it is very hard to envision a Dow at 2,000,000 but aren’t we reminded of the 30,000 Dow being prognosticated during the tech boom? Does that seem like a realistic number anytime soon? We can learn a lot from what is being told in the market simply by looking at the numbers:

“I should mention that people who expect to earn 10% annually from equities during this century - envisioning that 2% of that will come from dividends and 8% from price appreciation - are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about doubledigit returns from equities, explain this math to him - not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.”

Even a modest 10 percent annual gain would bring the Dow to a 24,000,000 mark in 2100. This math test seems to fail in so many different sectors in our economy. Let us use this simple math on real estate in the state of California. Last January, the median price for a home in California hit $551,000. For over 3 years straight, prices in California where appreciating by 20+ percent each year. Let us run two different scenarios going out 10 years into the future:

20 Percent Annual Gains - California Median Home Price

Doesn’t seem very likely does it? But again, even in the midst of the bubble people rationalized that 20 percent year-over-year gains were some how rational. Let us look at 10 percent annual gains:

10 Percent Annual Gains - California Median Home Price

Again, even this scenario seems highly unlikely. We also know that the median home price in California is now $430,370 for January of 2008, a decline of 21.9%. Let us run these scenarios except with a 5 percent declines and 10 percent declines:

5 Percent Annual Declines

This of course seems more realistic. Yet the 21.9 percent decline brought us down to the January 2012 price in one year. Clearly prices cannot continue to drop at this rate forever. Let us run the 10 percent decline scenario:

10 Percent Annual Declines

With this model, we seem to reach more realistic conclusions. But you can see how tunnel vision captivated many investors and they forgot to run fundamental analysis on investments to demonstrate basic economics. For housing, prices have to have some connection to area incomes and the health of the economy. Like Buffet is saying, expecting ridiculous returns forever simply does not coincide with the math.  And losing 63,000 jobs in one month is not exactly going to send stocks skyrocketing to the moon.

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With so much talk about the credit crisis you would think that many people would realize that not all credit is good for you. So what is the reaction of our central bank leaders? They decide to extend more liquidity to banks but the only problem is the majority of the population is already maxed out. No longer can they support back breaking monthly payments. The credit card offers in the mail are now subsiding. There was a point in time where I was receiving an incredible 3 to 5 offers per day. It was simply unbelievable and unsupportable. As we have discussed in a previous article, residential real estate is predicted to decline by 20 to 30 percent and $20 trillion in wealth is stored here. You can imagine what is going to occur when prices start declining even further. We are only in the first rounds of the credit retrenchment and already our economy is on the verge of a recession.

Let us take a look at a very important chart, household debt service as a percent of disposable income:

As you can see from the above chart we have been on a steady upsurge since the 1980s. Even during the technology bubble and the current housing bubble average households didn’t feel richer because more and more of their money went to service their debt obligations. At this point we have reached a plateau of nearly 14.5 percent of disposable income used to service debt. In the early 90s we tried a bit to scale back but it is extremely hard to resist plunking down all your money on AOL stock options. Let us look at another chart that takes a look at household credit market debt outstanding:

Currently there is an amazing $13.64 trillion in debt outstanding. As we mentioned with the $20 trillion in residential wealth, a 20 percent decline will wipe out $4 trillion in wealth while the debt outstanding does not change. What we are seeing is a convergence of equity plowing into reserve wealth. When this occurs you see a negative wealth effect and a retrenchment in consumer spending. If you are wondering why the government is so eager to send us checks in the mail this is why. The US economy is based on 70 percent consumption. Any small decline in this massive part of the economy is enough to tip us into a recession. That leads us into our next chart, retail sales:

The above chart shows retail sales year over year changes. As you can see, the last time we went year over year negative was after our 2001 recession. If we aren’t technically in a recession, we’ll soon be in one and this one is looking more like the early 1980s recession. Time to cut up those high interest credit cards.

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