Eric King is one of the best financial interviewers out there, so he gets the best guests of anyone I know.
Listen to the MP3 here, recorded last Saturday, March 20.
Take-aways:
The last of the bears are capitulating, just as the last of the bulls turned bearish last winter. Everybody loves stocks after a 73% rally, and there is huge psychological pressure to be bullish.
The market only gives away free money for so long (unbroken strings of up days often come near the end, as in Spring 1930).
The last two times that the market made a double top (July/Oct 2007 and the 2000 top), the Nasdaq surged at the very peak, leaving the Dow and SPX behind. SPX has just barely made a new high, but it feels like it’s much higher than in January.
GDP expansion is very weak compared to the stock rally, bank lending and jobs are still trending negative.
This is not a recession that has ended. This is a depression that has had a big countertrend rally.
States are all bankrupt, because they always spend too much. Governments always go bankrupt in the end. (Interesting factoid: Nebraska’s constitution outlaws borrowing by the state, so they are in the best shape).
All of the dollar-denominated IOUs are going to be worthless in the end. The government’s backstop has delayed this, but the debt will still go bad. The central banks will not take on all the bad debt, so the governments are trying, but they will ultimately default themselves.
Hyperinflation is not an option with all this debt. Default (deflation) is inevitable. Government defaults are deflationary.
Cycles are part of the human social experience. Muni defaults haven’t happened since the 1930s, but that is only because that was the last time we were at this point of the debt cycle. Munis will end up as wallpaper — no way the states can pay them off.
Conquer the Crash was released in 2002, but the stock market rose for 5 more years and the credit bubble got even crazier before finally topping in 2007, but the extra debt is just making things worse now that we’re at the point of no return.
We have a return of confidence. AAII (American Association of Individual Investors) survey shows about 25% bears, same as October 2007 and May 2008 tops. This is not a good buying opportunity.
Every investing group (individuals, pensions, mutual funds, etc) has been overinvested for 12 years. Mutual funds are only holding 3.5% cash. They have never given up on stocks, even in March 2009, which was nothing like in the 1970s and early 1980s.
Very few people think we can end up like Japan, and keep breaking to new lows for 20 years. Everybody always has a “story,” a narrative as to why the market is going to keep going down (at bottoms) and up (at tops). (Story today, IMO: PPT manipulation and money printing will drive stocks up forever). The story is often exactly wrong at the top and bottom.
Interest rates do not drive stocks. Lower rates are not bullish (just look at the 1930s or 2007-2008). Rates went up from 2003 – 2007 as the market rallied. People’s logic is always incorrect at the turns. Nor do earnings drive prices: stocks fell 75-80% in real terms from 1966-1982 as earnings rose.
Oil and stocks have a correlation that comes and goes – sometimes none, sometimes very positive, sometimes very negative. No predictive power.
Markets have a natural ebb and flow that arises from herding processes in a social setting. Reasoning about causation is a waste of time.
Economists jabber on about all kinds of causation, but they never offer statistics that pass muster.
Bond funds are going to slaughter the masses. The public always buys the wrong thing at the wrong time, and a wave of defaults is coming.
The dollar is likely starting a major rally (up 9% since fall, 11% vs euro). Prechter was early on that call but it still was a good one. Might be the start of a renewed wave of deflationary pressures.
The message in the new edition of Conquer the Crash remains, “get safe.” Find a safe bank, hold T-bills or treasury-only mutual funds, cash notes, and some gold and silver. No downside to safety.
Yes there is a down side to all of those assets and they could very well decline significantly in value, especially gold and silver. In this environment they may be safer than other things but nothing is completely safe.
Thanks for this summary and the MP3 link.
Yes there is a down side to all of those assets and they could very well decline significantly in value, especially gold and silver. In this environment they may be safer than other things but nothing is completely safe.
This is a point Prechter makes often, actually. Your capital is always at risk, even in the “safest” instruments, and keeping it intact over the next 5 or 10 years will be as much about remaining nimble and moving in and out of various assets at the right times.
Graphite mentions being nimble.
A treasury only money m.m. fund that I had been using is now closed. I recently received the notice to move my funds out of it by a certain date. Due to low (zero) interest rates the fund could no longer justify its existence. Others have closed as well.
Also, two previous A+ rated banks (by thestreet.com) that I had used have seen their ratings drop to C and B respectively just within the last year or so. A small example, but nonetheless it points to the increasing difficulty in keeping your money safe in the USA.
I’ve noticed similar things, Bjorn. There are now no banks at all in the Bay Area rated any higher than a B, so I’ve taken to just using a USAA checking account in which I keep the minimum amount of funds possible. And I had to move my Treasury-only MM funds from Vanguard to American Century because Vanguard closed theirs to any new investors/funds.
Mike, agree with all your analysis, but what is the time line? For the near future, until a US credit downgrade, fiscal policy of borrowing could keep the market afloat. Longer term, default through inflation seems to be the only option.
On a separate note, isn’t there counterparty risk to holding funds in any brokerage account or even Vanguard. Certainly there is counterparty risk in owning gold ETF’s. Physical gold is not much better, for you could be risking more than money when you try to exchange it. With treasuries at risk for default, where does one hide?
Mike, I have a question about why debt default is deflationary. Repayment of dollar debt creates demand for dollars. I agree that is clearly deflationary as both outstanding debt balances and outstanding dollars decrease. Default on debt, however, strikes me as equivalent to a perpetual rollover of the debt, which should tend to reduce the value of the dollar, because the future dollar demand that would have arisen to pay off the debt is no longer there. Thoughts?
Good question. Default is deflationary because it leaves creditors without money they thought they had. When the creditor is a bank, if defaults are large enough their “asset” base (comprised of IOUs) shrinks and they become insolvent, wiping out their own creditors (depositors, to the point that they are uninsured).
While this proceeds, cash is very much in demand. The debt is not rolled over — it is wiped out. Rollovers aren’t defaults, and are not deflationary, but defaults aren’t rollovers. In a rollover, creditors get paid because borrowers get new loans. In this environment people are unable to get new loans.
In the end, debt balances are much lower. This finally sets the stage for the cycle to start again with the accumulation of new debt (which is inflationary), but deflation takes years to play out. Just look at the length of a typical Kondratieff winter: perhaps 8-15 years.
Kondratieff chart: http://www.oextradingresources.com/kondratieff.gif
Interesting points. Here are some counterpoints, though. If default “leaves creditors without money they thought they had”, the flip side is that the debtors don’t have to raise money they thought they would have to, and this seems to offset that effect. And what is the difference in everyone’s balance sheet between a debtor and a creditor agreeing consensually to roll debt over forever (literally), and default, which seems to me the debtor forcing the creditor to roll the debt over forever? In rollover, the creditor is repaid, but he relends the money again immediately, so effectively, he might as well not have been repaid. Otherwise, the two seem equivalent, except for the fact that default is forced upon the creditor while rollover is consensual.
The case of the non-FDIC bank going under that you brought up I do agree is deflationary because the checks on that bank are no longer any good, and so money is extinguished.
I guess I still see deflation as requiring not just the “wipeout” of the asset side, but also the “wipeout” of its corresponding liability.
Here’s another thought experiment: suppose some central bank out there has all its assets in gold. If gold becomes completely worthless, would we expect that country’s currency to appreciate or depreciate relative to a currency that is not backed by gold? I would expect depreciation.
To me, it follows that when a central bank asset depreciates, the currency be worth less. If default renders a central bank asset worthless, then its currency should be worth less. Similarly, if default renders a bank’s assets worthless, it’s banknotes should be worth less.
Hmm, well in default a bank can no longer call a loan an asset, unlike in a rollover.
If default renders a central bank’s assets worthless, its currency should indeed be worth less. However, central bank assets are still small relative to the universe of assets and debt, which more than compensates if for instance mortgage bonds held by the Fed default.
And yes, once a default happens, the debtor is freed (at least if he can declare bankruptcy or otherwise truly have the slate wiped clean). This is why after defaults run their course the economy is free to inflate again (people again can start taking on debt — I consider the expansion of debt to be inflation in today’s credit-based system).
However, while defaults are happening en mass, money is much in demand and its value goes up. It is the process of mass default and the change in mentality that goes with it, not the final result, that drives the change in value of money.
Thanks for your insights. As a result of psychology, I can see that your view could definitely be right, if only temporarily. In the case of Greece, and the euro, though, that psychology might drive the euro lower vs. the usd since usd is the world’s safe haven.
Jui, you raise very interesting ideas. In your second thought experiment, the specific mechanism by which “gold becomes worthless” cannot be omitted from the analysis – the destruction would probably be much broader than its effect on the currency.
In your first comment, there is no flip side that favors the debtor. The default occurs because the debtor cannot pay *in the first place*; the formal realization is not a net gain to his situation (though it may cut his losses).
Jui, in a default the debtor looses the asset and any equity that he had in the asset. The lender looses all cash lent that is not recovered by the sale of the asset. At least this is true for asset backed lending. So both sides loose in the default, unless the debtor had no equity.