0 votes

Beyond Bearish

Editor's note: the author of this piece argues for, and explains why a widespread credit collapse is a near inevitability.

Excerpted from:
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.

* * *

Read the Elliott Wave Theorist's Interim Report from July 17, here - free.

Subscribe to the Elliott Wave Theorist by clicking here.



Trending on the Web

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.

Houses due to crash into wall street on 9/11

I almost missed this because the moon phases shift a bit between the solstice and equinox.

Chris Carolan has a dow-theory award winning paper at his site:

http://www.calendarresearch.com/autumnpanics.html

Briefly, autumn crashes tend to occur 55 hours before the new moon, either in the 7th or 8th lunar month (new moons after the equinox).

That would be about September 10th for his 6-27 or 6-28 date labeling.

The new moon was right on the equinox (Technically I haven't checked if it was just before, but the jewish calendar is numbering things as if March's new moon started the first month).

It gets better. Crashes tend to occur 55 days after the peak - this happened in 1989, and 1987 - and the july 26 1996 bottom (which was an intraday crash) was 55 days after the top. July 20 + 55 days is about September 9th.

There are a few other timing things which might come into play, but rarely do things set up this well - my only concern is that it would be a bit early, but the new moons are early this year.

Massive Liquidation

Many: you either posted this late, or people don't understand (care?) the trillions of $'s lost in the last two days~ugly, ugly, ugly, and the massive liquidation underway. For the past two years I have been almost frantic because for the first time in my life I find no safe haven~other than NO debt, a combo of da Bear's recommendations, the ability to pay the property tax, food, shelter, etc. until the dust settles. It's not going to be pretty. This is NOT like the S&L crisis, where the Fed could round-up and "contain" their banking domain. If this wasn't so drastic, why would Paulsen be on the tube endlessly telling us it's okay (and he's making his 4th trip to China begging them again to bail us out!). Why would we send people to China begging them to buy our mortgage debt because our treasury auctions are sucking so bad and they aren't buying? Many people are going to get forced really quick into a finance/econ lesson. Shame on them for not knowing how to reconcile a checkbook/financial stmt. or read a balance sheet. Shame on them for finding it boring and taking no interest in the things that SHAPE our world. What a rude awakening this is going to be. I'm not saying it's happening next Monday, as I do believe we'll see some super pump first, but the greatest credit bubble ever IS losing air. My dear grams (92 when she died a few months back) commented everytime we got together and talked "stocks": "there's too much of everything" ~ "don't people know or remember what it's like when the banks won't lend money to ANYBODY when there's a credit crunch?" She knew what is coming~been there, done that. My parents were Dr. Paul's age; I've lost ALL of my older generation family in the past five years. Ron Paul fills that void I feel~the yearning for people who possess my elders' decency, work ethic, independent nature, and common sense economics. He's also brought US all together to share here at this site, our Meetups, and elsewhere~I am so grateful for these bonds, my new friends. Because when you-know-what hits the fan, the line will be drawn.

It's a good read. i

It's a good read. i subscribe so i know what his line of thinking is. his last interim report from july 17 is also good. it is free at elliottwave.com.

the best things to do in deflation is get in US treasuries (you can buy treasury-only money market funds) and actual dollar bills. and some gold and silver coins for protection.

also, here is a great comparison of today's market to that of 1987.
link: http://www.financialsense.com/fsu/editorials/silberman/2007/...

from that chart it looks like the dow in 1987 peaked in either august or september and then crashed famously in october.

the 1929 pattern was also very similar.

but our market (in elliott wave terms) is ending a period of financial speculation that cannot be maintained because the real physical economy based on manufacturing and real things is declining.

it really is a huge ponzi scheme. that is probably why Ron Paul dislikes the Fed so much...

da bear

da bear