Saturday, December 6, 2008

On the Cusp of a Deflationary Depression

A year ago, you would have to be a 'sociopath' to even consider the possibility of a Great Depression-like downturn in the economy. Now, you must merely be a 'negative person.'

Staying consistent with my imperviousness to other's opinions, and more with my interest in being correct and it's associated wealth benefits, I must be perfectly honest with you, Dear Reader: We are on the cusp of an economic calamity that rivals only the Great Depression in modern history, or the near simultaneous bursting of the South Sea (Britain) and Mississippi Scheme (France) bubbles of the 1720's.

To such a statement, there are, doubtless, many popular objections. Unfortunately, most of those objections are baseless. They rest on nothing more than the author's underlying wish that it weren't true. That it was all a dream, soon to be forgotten. And who can blame them? Don't we all wish that it weren't true? Even I wish it weren't, and I am personally benefiting from the carnage (relatively and nominally). But if I expand things a bit, to see family and friends losing their wealth and livelihoods, society crumbling around me, and heightened geopolitical issues - I still lose.

So please keep in mind that I bring you this most dire news not out of personal interest. But rather as a messenger of truth in a world of misinformation, obfuscation and outright propaganda.

Also keep in mind that this will not be "the end of the world," or "armageddon." We will not go back to living in caves and hunting and gathering for survival. The world will still go 'round and 'round. The same places will be beautiful. Children will still laugh. There will still be gatherings of friends and family for weddings, birthdays, anniversaries, etc. Making love will still feel good, food will still taste good, fresh air will still smell good. If anything, we will learn to appreciate these things more, as our obsessive materialism is what is really under attack.

There are many objections to my views. Most of them involve manipulating statistics to give a result their perpetrator is looking for. Let me disassemble them one by one, rather than addressing them all at once.

Stocks Are Cheap!

The first mantra sung by many analysts is that "stocks are cheap" on a historical basis. One example of this came from a UBS analyst this week reported by Bloomberg.:

Global stocks will withstand a “full-blown” recession and surge in 2009 as cheap valuations and efforts by governments to restore confidence in the financial system lure investors back to equities, UBS AG said.

The Standard & Poor’s 500 Index, which tumbled 42 percent to 848.81 this year, may rally 53 percent to 1,300 by the end of 2009, David Bianco wrote in a note dated yesterday. The New York-based strategist, who a year ago predicted a 2008 advance of 16 percent for the S&P 500, is now forecasting a gain that would exceed the index’s best annual performance on record.

The U.K.’s FTSE 100 Index may increase 41 percent from yesterday’s close to 5,800 in 2009, while the FTSEurofirst 300 Index may climb 25 percent from current levels, Zurich-based UBS said in separate notes.

“The consensus outlook for 2009 is a full year of gloom,” Bianco, 33, wrote in his 2009 market outlook. “We believe 2009 will bring signs of a dawn in confidence with the first faint light appearing earlier than most investors expect.”

UBS, Switzerland’s largest bank, is more bullish on stocks than some of its Wall Street rivals. Citigroup Inc.’s chief U.S. equity strategist Tobias Levkovich last month cut his 2009 forecast for the S&P 500 to 1,000 from 1,300. New York-based Morgan Stanley said this week that European stocks are likely to be little changed in 2009.

My first objection to this article is that it is self-contradictory. On the one hand Bianco claims "The consensus outlook for 2009 is a full year of gloom." Yet in the very next paragraph, two of the biggest financial institutions in the world give their expectations for higher or little-changed stock prices in 2009. The consensus view is absolutely NOT for a full year of gloom. The consensus is for a second half recovery - as evidenced by forecasts by central banks, governments, and financial institutions around the world. Right off the bat, this 33 year old hot shot (am I allowed to say that yet?) is talking out of his arse. The only gloomy consensus can be found on the internet from realistic bloggers such as myself - hardly big players.

Next, Bianco claims "cheap valuations" for his reason to see a 53% rise in stock prices. I suppose those cheap valuations were the same reason he forecast a 16% rise for this year, but that's besides the point. Where is he getting that information? What multiple is he looking at to determine that stocks are "cheap?" Where else, other than his own forward earnings estimates.

Analysts like Bianco are still expecting earnings increases for the fourth quarter of 2008 and for all of 2009 to draw these conclusions. Yes, you read that right. Analysts are still forecasting higher profits for the current quarter Oct-Dec compared to last year, and are doing likewise for every quarter of 2009. Don't believe me? See for yourself. These are the same people that forecasted 25% higher profits for every single quarter of this year and proclaimed the whole way down that "stocks are cheap" based on those massively flawed assumptions.

So they are making up the "E" portion of the P/E valuation to reflect their own wishes and dividing it by today's price. This gives them a valuation somewhere around 11. They then use that in comparison to a ridiculously short historical time sample (5 or 20 years) of which is itself historically high (around 19) to determine - are you ready? - stocks must rise 50% to get back to "normal."

It is simply unbelievable that these "analysts" are allowed to apply their circular logic and still be afforded the airwaves to spread the message. Ancient societies had a name for these types. They called them "alchemists." And if they weren't first imprisoned for their blasphemy, they usually ended up poisoning themselves by trying to turn lead or mercury into gold. We give them six figure salaries and monthly TV spots.

The Statistics Show That This is Nothing Like the Depression

Earlier this week, Chairman Bernanke gave another speech Let's take a look:

Federal Reserve chairman Ben Bernanke said Monday the current economic situation bears "no comparison" to the much deeper crisis of the 1930s Great Depression.

"Well, you hear a lot of loose talk, but let me just ... say, as a scholar of the Great Depression -- and I've written books about the Depression and been very interested in this since I was in graduate school, there's no comparison," Bernanke said in a question period after an address in Austin, Texas.

Bernanke cited "an order-of-magnitude difference" in the current situation compared to the 1930s.
"During the 1930s, there was a worldwide depression that lasted for about 12 years and was only ended by a world war," he said.

"During that time, the unemployment rate went to 25 percent, at least, based on the data that we have. The real GDP (gross domestic product) fell by one-third. About a third of all of the banks failed. The stock market fell 90 percent."

Bernanke said the situation at that time represented "very difficult circumstances," because "we didn't have the social safety net that we have today. So let's put that out of our minds; there's no -- there's comparison in terms of severity."

To start on this, we must qualify Bernanke's own qualification. Bernanke is a student of the Keynesian version of the Great Depression. Other, far more legitimate economists, have differing views as to what caused the Great Depression. Bernanke holds that it was caused by a lack of quick response by the Fed in pumping the money supply, the gold standard and an "ill-advised" defense of the US Dollar's gold reserves by raising interest rates in 1931. He outlined his view succinctly in a 2002 speech to Milton Friedman and Anna Schwarz that can be found here. He finished his speech with this line:
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

I, and many other notable economists disagree with Bernanke's (or Friedman's) assessment of the GD. Indeed, it was caused by the Federal Reserve, but not for the reasons they state. Rather their very existence and manipulation of interest rates through the 20's caused the bubble. Socionomists would argue that it was simply time for a contraction because social mood had begun to reject the previous decade's excessiveness. Generational patterns would suggest that anyone old enough to remember the pain of the 1850's depression was dead and gone - allowing for the crazy levels of speculation. In my opinion, those arguments make far more sense than Bernanke's "We didn't do enough and being restricted in our abilities by gold is the cause" mantra. But I digress.

Bernanke confidently proclaims that because unemployment statistics, production statistics, or growth statistics are not as bad as they were at the worst depths of the GD, then we can't possibly be in a similar situation today. Bernanke could have added one word to this proclamation, and I would have left him alone: "Yet." But he doesn't appear to understand the severity and continuing weakness in economic indicators. Indeed, I can be reasonably sure that at some point in 1930, unemployment was nearing 10%, GDP had just started to contract, etc. That didn't mean a depression wasn't on the way. Just because our economy is bad, does not preclude that it cannot become worse. Bernanke seems to disagree, instead pointing to his own superpowers in being able to stop the oncoming train.

Let's review the current situation:

Retail Sales Suffer Worst Drop in Four Decades
Manufacturing Contracts to 26 Year Low
Philadelphia Fed Index Drops to 18 Year Low
Non-farm Payrolls Fall to 34 Year Low

I don't think anyone is arguing that the current situation is similar to the worst years of the Great Depression. But this is what Bernanke is saying is erroneous. What the "loose talk" Bernanke refers to is actually saying, is that the current situation and the dismal prospects of improvement suggest a similar event is possible.

In 2002, Bernanke promised Milton Friedman that nothing like the Great Depression would ever happen again. Six years later, Bernanke's entire life's work as a GD historian is being tested.

Anyone want to bet against him defending it do his death? Why should we listen to someone who has so much personal and ideological interest in a rosy outcome?

Coordinated Intervention Will Soon Trickle In/ Hyperinflation

Next up in defense of continued prosperity comes the argument that Trillions worth of global government initiatives, interest rate cuts and asset purchases by Central Banks will soon start to make it's way into the economy, and the next boom will closely follow. This argument is closely associated with the "imminent hyperinflation" that is set to lift asset markets as the currency is devalued.

This is nonsense.

Hyperinflation cannot and will not occur under the current set of circumstances. In order for expansion of the money supply to occur, there needs to be an effective use for that new capital. The central banks can issue all the new money or credit they wish. They can give it to banks for free, or "drop it from helicopters" on street corners. But if consumer's and bank's best idea of what to do with that capital is to either "save it for a rainy day" or to "pay back debt," then the net effect on the money supply will be, effectively, nil.

Consumers and banks are reacting differently to the same old (and many new) policies of economic stimulus. This is happening because asset prices are falling simultaneously around the world without exception. This asset price deflation is not something we've experienced since the late 30s. As a result, lenders have no good reason to lend, and consumers have no good reason to borrow. They'd rather save, pay off debt, fix their balance sheets, and wait for prices to fall further. But what is causing it?

Why would this happen? Neither consumers nor banks have acted like this for decades. They've always just spent their way further into debt or loaned out money without much care. Why would they stop now? Why has this crisis not just blown over like the oil shocks of '74 or '79, the inflation scare of the early 80's, the '87 Crash, the S&L Crisis, the Asian Currency Crisis, LTCM, the collapse, or 9/11? This is where things get a lot more complicated and we need to dig deep to find the root causes of this shift. In order to understand why people make the decisions they make, we need to study people. And that is what I think I do best. It is how I first became interested in economics. I was a people watcher. I would watch and compare how people acted and reacted in the different corners of the world that I traveled to.

There are two theories I have encountered that explain economic cycles in a very unorthodox manner. They both revolve around the study of people, and how they act in groups in a very long-term cyclical manner. It can be argued that both theories feed off each other.

Socionomic Theory: Socionomics revolves around the study of social mood, and how that social mood eventually manifests to asset markets, social preferences, political preferences, willingness to go to war or befriend other nations, etc. Common ideology says the opposite is true and that social mood is a reflection of events. The amount of evidence in favour of the former is overwhelming. The theory holds that social mood oscillates between optimism and pessimism over many decades, sometimes reaching levels of extreme. According to adherents to this theory, social mood in the western world reached an apex during the boom and proliferation of "new paradigm" thinking at the turn of the millennium.

The resultant crash, and heightened "terror" paranoia, were evidence that a first wave down in social mood had begun. We then had a "correction" in social mood, during which all manners of speculation, "make it or break it" mentality, and materialism ruled the day. And we are now in the midst of a second wave down where those old social values are under attack. The reflection of this social shift is the credit crisis. Not the other way around.

For more information on socionomics, visit:

Generational Theory: Generational Theory also holds that this type of panic was completely foregone. As all of the old hands of the Great Depression moved out of the front offices of financial firms and government, younger generations moved in and began making the same mistakes the older generation had promised they would "never again" make. There are 4 different generational archetypes that typically behave similarly based on the conditions they were raised in: either a "crisis era," a "high era," an "awakening era," or an "unravelling era." Each era and each generation typically last between 15-25 years, and every person will inevitably live through every type of social change in their lifetime. Each era has a lasting effect on their respective generations.

According to the theory, people's actions (in groups) are incredibly predictable when looked at through this lens. The theory checks out with over 500 years of backtesting and only one aberration during the US Civil War. It has been successfully applied to many other civilizations as well, suggesting further that human action is more pre-determined that we may think. And it has been found that ancient civilizations used this same method to anticipate social changes.

For more information on Generational Theory, visit:
Generational Dynamics
The Fourth Turning

Combined, these two theories provide enough evidence to convince me that no amount of "government stimulus" or "pumping of the money supply" will be enough to overcome our enormous social revulsion of indebtedness and consumerism.

"You can bring a horse to water, but you can't make him drink."

Currently, central banks around the world are trying to force society to drink. That is a keystone to their Keynesian economic doctrine. That when the economy becomes so overburdened with debt, giving it a little bit more will fix everything. And indeed, that works for quite a long period of time. If social mood is at a point in it's cycle when it is willing to, and if there is a willingness among the current generation to go further into debt, they will. And then there is situations like today's where they won't.

To put everything another way, our older and more numerous generations need to sell their assets to younger, less numerous generations. This natural selling pressure is driving prices down to where younger generations are willing and able to pay for them. But there is a sudden affliction among this younger generation toward unsustainable homeownership, of symbols of wealth, and of anything that epitomized what they saw as a crazed scheme to get rich quick.

So prices will continue to fall, the psychology of deflation will entrench itself further, and an economic depression will be the result. Until enough of the excessiveness has been bled out of the system for it to regenerate itself.

How Should Policy Makers React?

The single best piece of news on the economy I could find was this headline: "Parliament in Canada Prorogued" I don't say this because I was a supporter of the Conservative Party - far from it. But I am of the opinion that the less government tries to stop the unstoppable, the better for the long-term health of the economy. In fact, my initial response to the news was, "Can we make it permanent?"

This may seem mean-spirited toward those that will inevitably be losing their jobs over the next few years, but those job losses are foregone. They will either come now or later. And if government funding is the only thing lending them legitimacy in between, society is no better off in the long-term. Think of it this way: If you were marooned on an island and only had a small amount of food with you, would you eat that food right away, or wait until you were nearly starving to start pecking away at it?

We only have so much "capital" that can be used, just like the stranded person in the wilderness only has so much food. A smart outdoorsman would immediately start looking for alternate food sources, make a strategy to survive through rainy season, and maybe even start building a raft. A panicky tourist would eat all his food and start swimming toward land. Who's got the best chance for survival?

We need to preserve our available capital for when times get really tough, we need to re-tool our manufacturing industry to make things we need (resource efficiency, medical advancements) and encourage investment from outsiders by maintaining a strong currency and sound banking system. If we use all of our capital now at the whim of political gamesmanship, we might not make it through rainy season to spring, when our chances of being rescued are far greater.

The best thing our government could do is cut as much of it's discretionary spending as possible and lower taxes. Any bailouts, stimulus packages, or spending initiatives will put us in a weaker position to emerge from this crisis strongly.

Again, I'd like to urge readers not to fear this coming depression. It doesn't mean the world is ending. It is just one point on a cycle. It can either be viewed as the end of the last cycle or the beginning of the next. Perspective is everything.

Comments appreciated.

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