THE BEAR'S LAIR Crash this year or next?
By Martin Hutchinson
At some point, this gigantic ziggurat of global malinvestment must collapse. The stock markets of the world spiral up to infinity with only an occasional hiccup and the US housing market is well into bubble mode again, pumped up by cheap money. Only gold and silver languish, hard assets that have gone out of fashion because of the lack of inflation.
At some time this bubble must burst, bringing devastation to global financial markets. The crucial question to investors seeking to maximize gains and protect their few remaining assets is: will
the burst come this year, or is it more likely to be delayed into 2014 or even 2015.
Make no mistake, there will be a crash. Interest rates have been negative in real terms for five years. That has made it attractive to leverage and has caused asset prices to spiral towards infinity. It has also disguised the extent of stock market overvaluation by inflating reported earnings, as the cost of balance sheet debt diminishes below zero in real terms.
To use the Austrian economic term, the malinvestment of 2003-07, caused by the previous bout of ultra-low interest rates, has not really been washed out. In housing, all kinds of schemes have been used to prevent the expected foreclosures, while innumerable funds have bought up the inventory of foreclosed housing, intending to use it to satisfy a rental demand that has not been proved to be there (much of the overstock being in outer suburbs, while rental demand is strongest in inner suburbs and gentrifying inner cities).
More important, the wave of leveraged buyouts carried out in 2006-07, which were expected to present a huge economic obstacle in 2011-12 as five-year debt required refinancing, have simply been rolled over. There is thus a huge amount of "water" in valuations, both from good assets whose prices have been chased too far and, more important, from bad assets that have minimal value in a free market but have been propped up by funny money.
Trees don't grow to the sky, straight lines do not continue to infinity and bubbles do not inflate indefinitely. At some point, this gigantic ziggurat of global malinvestment must collapse. The question is: when and how?
Since the beginning of this year I have held the view that we were due for a major market breakdown in 2014, probably in the second half of 2014. Monetary policy seemed likely to remain ultra-easy until the end of this year, the "Abenomics" experiment in Japan would take at least 12-18 months to work through, we were a long way from the top of the business cycle, and while stock markets were already close to all-time highs it seemed to me they had a lot further to go.
Then there was gold; I found it difficult to believe that the cycle could end without a major spike in gold prices, and the experience of 1978-80 suggested pretty strongly such a spike should take at least 12-18 months.
There are now a number of signs that the bubble may burst sooner than this. For a start, many economic commentators from the right of the political spectrum, who in 2012 were duly forthright about replacing Ben Bernanke at the earliest possible opportunity, have now reversed themselves and embraced Bernankeism, claiming that quantitative easing is the only thing keeping the economy going.
Most of these commentators had been dire in their warnings in November and December about the dangers of the "fiscal cliff" that would have closed 80% of the current budget deficit; that suggests they are closet Keynesians who have not properly shaken off their leftist training in college economics courses. Now that there is nothing politically to be gained (they think) from denouncing Bernanke, they have stopped doing so, since their Keynesianism leads them to believe the economy is about to collapse under the weight of the modest January tax increases and the even more modest March sequester.
In reality the "fiscal cliff" would have represented a return to sound economic policy. Had it been put into effect in toto, the budget deficit would have been reduced to US$200 billion or so, taking it out of the picture and eliminating the possibility of a near-term US default. Naturally, there would have been a mild recession in the first half of 2013 because of all the tax increases, but that recession would have stopped the continual inflation of asset prices, while Bernanke would have found his current $1 trillion per annum quantitative easing very difficult to pursue, since he would have been financing five times the US budget deficit.
To us non-Keynesians, the partial fiscal cliff of payroll tax increases and tax bracket increases at the upper end combined with modest but genuine spending cuts have been beneficial. By making Bernanke's monetary policy more extreme, they have also caused the bubble to inflate faster and may also have brought forward the collapse that must follow it.
There are still a lot of factors leading one to believe the burst will come next year, not this. Home prices are rocketing upwards at 12% a year, with much faster rises in places like San Francisco, but they're not far enough off the floor yet for speculative fever to cause real problems. Broad money supply is rising at only around 7%, which suggests that even with Bernanke printing like mad, the system remains under control.
The Japanese market is still less than half its 1990 level; it's probably not going to get back that far, but it seems unlikely that any Japanese bubble will burst with the Nikkei below 20,000, the level it attained in 1999-2000. Gold is positively depressed; can we really end this bubble without a gold blowout? The global economy is still far below capacity, with unemployment in the US and Europe still at deep recessionary levels when declining workforce participation is taken into account. Finally, where's inflation?
Still, there are now some factors suggesting an earlier crisis. Bond interest rates have ticked up quite a long way from their bottom. Most likely, they will tick down again, but a further rise could accelerate the denouement. The crash, when it comes, will find massive losses in the financial system, as in 2008, but this time mostly from interest rate risk rather than credit risk. Then there's the junk bond market, which is as extended as it was in 2006-07 - can it go on getting more extended for another year? Finally, while broad money supply is behaving itself, narrow money supply certainly isn't; the monetary base has risen at a 50% annual rate this year and shows no sign of slackening off.
There are certainly possible triggers for a 2013 crisis, the most obvious of which are France and Italy. Whereas the markets have to a certain extent priced in Italian risk, one should never underestimate the potential for the Italians to do something utterly foolish and make that risk immeasurably worse. As for France, that risk is not priced in at all, the 10-year OAT French treasury bond yields only 2.06%, less than the US bond of the same maturity.
Finally, the US tech sector looks ever more overextended, with $1 billion takeovers taking place at 50 times revenues, not profits, as in Yahoo's takeover of Tumblr. As with the narrow money supply and the bond markets, it seems impossible that this bubble can continue to inflate for another full year from now.
One's conclusion must be inconclusive - there are arguments in both directions. But that's a change from a few months ago, when a crash in 2013 seemed very unlikely indeed. If the crash comes this year, it will most likely be caused by the bond market, will not be accompanied by inflation or a massive gold run-up, and will allow the Obama/Bernanke team to inject a further dose of monetary and fiscal "stimulus" - thereby leading to another round of funny-money non-recovery and malinvestment.
If on the other hand the crash is delayed until the second half of next year, and is accompanied by inflation and/or a massive gold bubble, then it will be far more severe, but its causes will be completely obvious, and monetary and fiscal stimulus will not be available to rescue it, because of inflation and credit worries respectively. In that case, the subsequent recession will be prolonged and severe, but at the end of it we will have restored sound monetary and economic conditions, and will resume economic growth on a balanced basis, with interest rates well above the inflation rate and savings financing investment.
Overall, I think a crash in late 2014 is most likely, and most beneficial. But a 2013 crash cannot entirely be ruled out.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com. Copyright 2005-13 David W Tice & Associates.)