Editor's note: the author of this piece argues for, and explains why a widespread credit collapse is a near inevitability.
The Elliott Wave Theorist, May 2007 Issue
by Robert Prechter
Reprinted with permission
I am not just bearish. It goes much further than that. The pyramid of debt, the extremity of optimism and the b‑wave label of the advance since 2002 all portend an all‑out collapse of investment prices in wave c. The decline in social mood during that wave will engender a crushing deflation in the galaxy‑sized bubble of outstanding credit and ultimately a disastrous depression. Few of us will be able to side‑step the effects of the depression, but we can all avoid the effects of falling financial prices and the deflation of the debt bubble by following the recommendations in Conquer the Crash.
Investors Are Buying More with IOUs Than Money
When I wrote Conquer the Crash, outstanding dollar‑denominated debt was $30 trillion. Just five years later it is $43 trillion, and most of the increase has gone into housing, financial investments and buying goods from abroad. This is a meticulously constructed Biltmore House of cards, and one wonders whether it can stand the addition of a single deuce. Its size and grandeur are no argument against the ultimate outcome; they are an argument for it.
Figure 1 depicts just one isolated aspect of the debt bubble as it relates directly to financial prices. In 1999, the public was heavily invested in mutual funds, and mutual funds had 96 percent of their clients' money invested in stocks. At the time I thought that percentage of investment was a limit. I was wrong. Today, much of the public has switched to so‑called hedge funds (a misnomer). Bridgewater estimates that the average hedge fund in January had 250 percent of its deposits invested. This month the WSJ reports funds with ratios as high as 13 times. How can hedge funds invest way more money than they have? They borrow the rest from banks and investment firms, using their investment holdings as collateral. So they are heavily leveraged. And this is only part of the picture. Much of the money invested in hedge funds in the first place is borrowed. Some investors take out mortgages to get money to put into hedge funds. Some investment firms borrowheavily from banks and brokers to invest in hedge funds. As for lenders, the WSJ reports today, "...the nation's four largest securities firms financed $3.3 trillion of assets with $129.4 billion of shareholders' equity, a leverage ratio of 25.5 to 1." So the financial markets today have been rising in unison because of leverage upon leverage, an inverted pyramid of IOUs, all supported by a comparatively small amount of actual cash. This swelling snowball of borrowing is how the nominal Dow has managed to get to a new high even though it is in a raging bear market in real terms: The expansion in credit inflates the dollar denominator of value, and the credit itself goes to buying more stocks, bonds and commodities. The buying raises prices, and higher prices provide more collateral for more borrowing. And all the while real stock values, as measured by gold, have quietly fallen by more than half. Seemingly it is a perpetual motion machine; but one day the trend will go into reverse, and the value of total credit will begin shrinking as dollar prices collapse.
The investment markets are only part of the debt picture. Most individuals have borrowed to buy real estate, cars and TVs. Most people don't own such possessions; they owe them. Credit card debt is at a historic high. The Atlanta Braves just announced a new program through which you can finance the purchase of season tickets. Can you imagine telling a fan in 1947 that someday people would take out loans to buy tickets to a baseball game? Instead of buying things for cash these days, many consumers elect to pay not only the total value for each item they buy but also a pile of additional money for interest. And they choose this option because they can't afford to pay cash for what they want or need. Self‑indulgent and distress borrowing for consumption cannot go on indefinitely. But while it does, the "money supply" ‑- actually the credit supply -- inflates. But it is all a temporary phenomenon, because debt binges always exhaust themselves.
As far as I can tell, virtually everyone else sees things differently. Countless bulls on stocks, gold and commodities insist that the process is simple: the Fed is inflating the "money supply" by way of its "printing press," and there is no end in sight. The Fed is indeed the underlying motor of inflation because it monetizes government debt, but the banking system, thanks to the elasticity of fiat money, manufactures by far the bulk of the credit‑‑‑credit, not cash. If you don't believe credit can implode and investment prices fall, then why did the housing market just have its biggest monthly price plunge in two decades, and why is the trend toward lower prices now the longest on record? If you don't think credit and cash are different, then why are the owners of "collateralized" mortgage "securities" beginning to panic over the realization that their "investments" are melting in the sun. Lewis Ranieri, one of the founders of the securitized mortgage market recently warned that there are now so many interests involved in each mortgage that massive cooperation among lawyers, accountants and tax authorities will be required just to make simple decisions about restructuring a loan or disposing of a house, i.e. the collateral, underlying a mortgage in default. In the old days, the local bank would suss things out and come to a quick decision. But now the structures are too complex for easy resolution, and creditors are hamstrung with structural and legal impediments to accessing their collateral. The modern structures for investment are so intricate and dispersed that a mere recession will trigger a systemic disaster. When insurance companies and pension plan administrators realize that they can't easily and cheaply access the underlying assets, what will their packaged mortgages be worth then? And what will happen to the empty houses as they try to sort things out? This type of morass relates to debt. Cash is easy; either you have it or you don't.
The gold and silver markets know the difference between money inflation and credit inflation. Gold has made no net progress in the past year and in fact for the past 27+ years. Silver is languishing, still trading 75 percent below its high in dollar terms, making it by far the worst investment of the past quarter century. Flat‑out currency inflation would have a powerful tendency to show up immediately in gold and silver prices. Credit is another matter. Gold prices reflect the fact that an increase in debt is not the same as an increase in cash. New cash is here to stay; debt expansion can morph into contraction. Thriving creditors, moreover, do not want metals; they want interest. And credit is voracious, eating up debtors' capital at a rate of 5 percent a year. When the debtors become strapped, they sell other assets, including gold, to get cash to pay their creditors. Eventually, creditors with falling income due to default will join the ranks of those with less money to buy things. But most investors don't see it our way; in April, for the second time in wave b, the DSI reached 90 percent bulls among traders in both gold and S&P! When else in history has it happened? Try never. Although the past few years show that there can be periods of exception, markets usually do not reward a lopsided bulk of investors with the same outlook.
But there is a much more important event for believers in perpetual inflation to explain: the trend of yields from bonds and utility stocks. In the 1970s, prices of bonds and utility stocks were falling, and yields on bonds and utility stocks were rising, because of the onslaught of inflation. But in the past 25 years bond and utility stock prices have gone up, and yields on bonds and utility stocks (see Figures 2 [not shown] and 3) have gone down. Once again, this situation is contrary to claims that we are experiencing a replay of the inflationary 19‑teens or 1970s. Those investing on an inflation theme cannot explain these graphs. But there is a precedent for this time. It is 1928‑1929, when bond and utility yields bottomed and prices topped (see Figure 4) in an environment of expanding credit and a stock market boom. The Dow Jones Utility Average was the last of the Dow averages to peak in 1929, and today it is deeply into wave (5) and therefore near the end of its entire bull market. All these juxtaposed market behaviors make sense only in our context of a terminating credit bubble. This one is just a whole lot bigger than any other in history.
Some economic historians blame rising interest rates into 1929 for the crash that ensued. Those who do must acknowledge that the Fed's interest rate today is at almost exactly the same level it was then, having risen steadily‑and in fact way more in percentage terms‑since 2003. So even on this score the setup is the same as it was 1929. Remember also that in 1926 the Florida land boom collapsed. In the current cycle, house prices nationwide topped out in 2005, two years ago. So maybe it's 1928 now instead of 1929. But that's a small quibble compared to the erroneous idea that we are enjoying a perpetually inflationary goldilocks economy with perpetually rising investment prices.
As to whether the Fed can induce more borrowing by lowering rates in the next recession, we will have to see, but evidence from the sub‑prime and Alt‑A mortgage markets as well as ratios like the one in Figure 1 suggest more strongly than ever that consumers' and investors' capacity for holding debt is maxing out. I see no way out of the current extreme in credit issuance aside from the classic way: a debt implosion.
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