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[Editor's note: with
Thursday's big market decline, it called to mind the May issue of Robert Prechter's Elliott Wave Theorist, part of which is
excerpted below. Prechter was months early in
discussing many of the issues that the market is just waking up to.]
Excerpted
from:
The Elliott
Wave Theorist, May 2007 Issue
Robert Prechter
April 30, 2007
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 borrow heavily 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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Interim Report from July 17, here - free.
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Theorist by clicking here.
By :
Michael Nystrom
Bull not Bull
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