reprinted with permission
THE LONG WAVE ANALYST - MODERN KONDRATIEFF ECONOMICS
Final Part
The Plight of Paper
"Who needs gold when we have Greenspan." New York Times headline as quoted by Bell, Andrew. The Globe and Mail, July 31st, 1999.
It is precisely because of Alan Greenspan that we do need gold. Mr. Greenspan, as head of the Federal Reserve board, has orchestrated through a low interest rate policy and unprecedented monetary growth, the greatest stock market bubble in history. This bubble threatens to destroy the entire world financial system. Unfettered by the constraints of a gold standard system, Mr. Greenspan is responsible for an enormous expansion in credit, which has fueled the speculative excesses that now pervade the US capital markets. He is revered by these speculators who are financially benefiting from the rising markets.
While they praise Mr. Greenspan now, these same speculators will vilify him when the stock market bubble bursts and they are left with nothing but memories or dreams of wealth.
Most economists pay little heed to this monstrous expansion in the money supply, because it has not translated into the usual price inflation. What they fail to see is that this monetary growth has created inflation in the investment markets, particularly the stock market which is a bubble but, like all bubbles, invisible to those inside. The rise in the Dow during the present autumn of the Kondratieff Cycle is almost three times bigger than the gain made by the Dow between 1921-1929. The crash which followed that bubble reduced the value of stocks to one tenth of the value that they had been at the 1929 peak. It is probable that the crash of the current stock market, which will herald the Kondratieff winter will be every bit as large as the crash of 1929-1932.
Traditionally, the autumn period of the Long Wave is the season of rising speculation, particularly in the stock market. Why stocks? Because it is an asset class that is affordable by most people. Shares are highly liquid; that is, easily transferable. For the most part, investing in shares requires little or no knowledge; just open an account with a stockbroker or buy an equity mutual fund. Now, of course, as the stock speculative bubble reaches unprecedented dimensions, stockbrokers and equity mutual funds are de classi. Everyone is now an expert and the day of internet trading is the vogue. Who needs a stockbroker or a mutual fund manager, when all that is required is a little reading and an on-line stock trading account? After all, stocks do nothing but go up ad infinitum. Every reversal is simply a buying opportunity for a further gain.
The outcome, however, is unlikely to be any different from that which speculators experienced at the onset of the previous Kondratieff winter and the Wall Street crash that precipitated it. "Mrs. Claretook to speculating.At the peak of stock prices she might have sold out for close to a million, but she could not let go. And in the end lost everything, even her home She was in the grasp of the spirit of a mad time, when even men deemed 'wise' talked of a New Era" Pound, Arthur. Atlantic Monthly, 1932.
"Accessible now to anyone with an Internet connection and a credit card, the stock market has become a universal distraction, a sanctioned narcotic. You are either plugged into it or made constantly aware of how foolish you are not to be. In hospitals and schools, in dens and kitchens, the amateurs are mainlining stocks. They have one eye on their day job and the other on their stock portfolio, posted in red and green on their computer screens. Once a barometer of the country's work, the stock market now is another way to play." Puamgarten, Nick and Spitz, Tinker. National Post, Saturday, August 28,1999. P. B1.
According to an SIA/Investment Company Institute survey, nearly 50% of US households own stock which is massively higher than the estimated 21% in 1929. A quarter of all US assets, almost $11 trillion, is invested in the stock market. 6.3 million Americans trade online and since last year approximately $10 trillion of US shares have traded on the NASDAQ and New York Stock Exchanges. Trading has become a US fixation and celebrities like Barbara Streisand are now courted for their investment acumen. Many Americans have quit their jobs so that they can devote their undivided attention to trading the market. Many others, while maintaining their jobs, are devoting a huge amount of their working time to trading. An executive at a US real estate investment firm said, "everyone here just trades all day.It gets to the point were you feel like a loser if you're not playing the market." Ibid. P.B2.
How would you like to put your good health in the hands of this doctor who said, "I trade between patients. I've been trying to get the anesthesiologist to replace the EKG monitor with a ticker, but we don't know if that's going to fly." Ibid. P.B2. There are countless stories like these that demonstrate the extent of the bubble that goes by the name of the stock market in America. There are usually signs, not always recognisable at the time, which lead to the stock market crash presaging the winter of the Kondratieff Cycle, and the collapse of paper assets.
Setting the Stage for the Stock Market Crash
"A sad tale's best for winter." Shakespeare, William
Most bear markets are caused by rising interest rates. Mr. Greenspan understands this and that is why he has been somewhat reluctant to reverse the three interest rate cuts he instigated last year following the 20% correction in the stock market. But the Federal Reserve Chairman is caught between a rock and a hard place. On one hand, if he raises rates to dampen speculation in the stock market it could lead to a stock market crash and, following that, very difficult times for the US economy. Conversely, a failure to raise rates will lead to a fall in the value of the US dollar. So Mr. G. is raising rates in a series of incremental increases, a quarter of a point at a time. Undoubtedly, he desires that small and well-telegraphed interest rate hikes will effect a gentle reduction in stock market values and at the same time inflate the value if the dollar which should, or at least he hopes it should, restore foreign buying into the US Treasury and stock markets. While Mr. Greenspan has the power to manipulate short-term interest rates, long-term interest rates are set by the market and these rates have risen considerably since they bottomed last October. From a low of 4.75% at that time, they have reached as high as 6.25% recently and it is certain to go even higher. More than 7% is to much to bear for the highly inflated stock market. Although it is probable that increasing rates have already started to impact negatively on stocks.
The problem for the US is that it is now the largest debtor nation in the world and as such is dependent upon foreign creditors. If these creditors fear either that US rates will rise or that the value of the dollar will decline they will withdraw their credit and US rates will begin to rise. Worse still, if they begin to sell their substantial positions in US debt because of these same fears, US interest rates will have to rise dramatically.
The Financial Times of London recently wrote, "foreigners may finally have had their fill of Uncle Sam's IOU's." The article went on to say that even before the recent fall in the US dollar that began in July it had become apparent that the foreign appetite for US Treasury debt had been in decline and that in the first quarter of this year foreigners became net sellers to the tune of $17.3 billion.
So, what is now occurring in America is similar to the experience of 1929; that is, an increase in interest rates and a withdrawal of foreign capital. These two circumstances were instrumental in the Wall Street crash of October 1929. Will it be any different this time? We doubt it. After all, the Kondratieff winter invariably starts with a stock market crash. It is the crash of US stocks which will lead to the destruction of the US dollar and start the Kondratieff winter. The Kondratieff winter will ensure the destruction in value of all paper assets and other investments whose values compounded on a mountain of credit during the Long Wave autumn. This devastation in the value of paper assets will ensure the victory for gold. The sole purpose of the Kondratieff winter is to rid the economy of the unsustainable level of debt built into the economy throughout the three previous Kondratieff seasons. This purging of debt allows the economy to start afresh at the onset of spring. Thus winter is invariably the season of deflation and depression.
Gold enjoys two seasons in a Kondratieff year, summer and winter. Summer is the season of inflation; and inflation simply erodes the value of paper money. Gold rises in sync with this decline in the value of paper. On the other hand, paper assets including paper money are destroyed during winter and the value of gold soars, because there are no alternative choices for money. In the following table we have suggested a possible sequence and timing of events in the US capital markets, based upon our interpretation of the US position within the Kondratieff Wave.
EventTimeForeigners begin to liquidate their US debt holdings. (@$1.5 trillion)Already begun.US dollar fallsAlready begun.US interest rates riseAlready begun.Foreigners intensify their sales of US debtBeginning.Gold shares rise anticipating gold metal price increaseBeginning.US stock markets start to fall Beginning.US dollar begins a more rapid decline and US interest rates begin steeper increaseSept/Oct1999.Foreigners increase liquidation of US stock positionsSeptember 1999.US stocks crashSept/Oct 1999.Dollar crashes; US interest rates sharply higherSept/Oct 1999.Major worldwide move to gold. Gold price and gold share prices move sharply higherOct/Nov 1999.US in Kondratieff Winter-Deflationary/depression beginsJanuary 2000.Worldwide monetary crisis caused by US dollar debacle.February 2000.Gold and gold share prices move to new highsFeb/April 2000.
Kondratieff Autumn and the Debt Bubble
"Wilt thou seal up the avenues of ill? Pay every debt, as if God wrote the bill." Emerson, Ralph Waldo.
It is debt which finally destroys the economy and that debt assumes massive proportions during the Kondratieff autumn. This time the debt at least within the US economy has reached astronomic levels, which have been fueled by a Federal Reserve Board, unfettered by gold, adding copious amounts of money to the economy. The US total debt now is in excess of $20 trillion; couple that with a negative amount of consumer savings and you have a recipe for financial disaster.
Consumer non-mortgage debt in the US has increased 70% or $565 billion to $1.4 trillion since 1992. Over the same period household mortgage debt has grown 50% to $4.2 trillion. Overall, household debt is now close to 75% of GDP versus 47% at the beginning of the Kondratieff Autumn. Stuart Fieldstein, President of SMR Research, a credit research company, recently wrote that, "These figures aren't pretty. However, you look at it, about one third of all households are broke." (www. prudentbear.com)
The same is true for American corporations who have also been on a debt binge, which now translates to $3.7 trillion. This debt is growing exponentially on the back of stock buybacks and corporate mergers.
Perhaps most troublesome of all is the huge increase in margin debt that is up 300% since 1995 and now stands at $176.9 billion. In addition to this margin debt is the unmeasured amount of debt that households have accumulated through home equity lines of credit and second mortgages that have been invested in the stock market.
All of this debt however pales in comparison when measured against the derivative exposure accumulated within the financial markets. Derivatives are in their own way similar to margin debt because they allow a relatively small amount of money to control a significantly larger amount of value in the underlying asset. Worldwide derivative exposure is estimated to be a mind-boggling $100 trillion. In the United States the seven largest banks have $33 trillion of derivatives on the books- the majority of which are related to the credit markets. $29 trillion of these positions are over the counter, meaning that these trades are not subject to government or exchange regulation. What is more frightening is that this enormous speculative position is covered by a paltry $460 billion in equity capital and 40% ($13 trillion) is not offset, or in derivative parlance, is "naked".
Notional Derivative Exposure of Major US Banks (ContraryInvestor.com)
BANKTotal AssetsTotal
Derivatives
(Notional)% OTC
Contracts% Interest
Rate Contracts% Foreign
Exchange
Contracts% Credit
Exposure to
Risk Based
CapitalChase$296.7$10,261.593.5 %78.9 %19.7 %380.3 %JP Morgan175.88,653.679.882.913.1820.3Citibank300.93,625.395.043.153.7202.5Nationsbank317.12,700.964.094.93.080.8Bankers Trust104.62,524.193.566.230.2472.7B of A257.51,870.289.162.336.690.3First Chicago74.21,421.294.782.816.5219.5
For every derivative position taken on one side of the market there is another on the other side. This means that one side or the other has made the wrong choice and stands to lose everything. The majority of the interest rate derivative exposure of the large US banks is probably on the short side of bonds in order to protect their large exposure against rising interest rates (although this exposure cannot be anywhere near the amount that they are supposedly hedging). On the long side are, probably, the largest US brokerage firms and there is no way that they will ever to be able to meet their obligations in the face of rising US rates -- and they are rising.
The pervasive debt which stands as the edifice of the US financial emporium has made it a house of cards, which threatens the entire US financial system. The debt bubble invariably bursts at the beginning of the Kondratieff winter and this leads to deflation and an economic depression.
The bursting of the US stock market will lead to the destruction of the debt bubble and all paper assets, including the US dollar. At this stage the victory for gold will be complete.
Kondratieff Cycle as an Investment Guide
We live approximately through one complete Kondratieff Cycle. It is for this reason that most of us have little understanding about where the economy is going, because we have not lived the experience. Students of the Long Wave can turn their knowledge into experience, which affords them a huge advantage over economists and investment advisors. Even though very few of us have lived through the previous Kondratieff autumn (1921-1929), we can still extend our knowledge of that period and compare it to the present autumn and see the many similarities that exist between them. As students of Kondratieff we know that the autumn period builds into an orgy of speculation, which invariably leads to a stock market crash.
The two principal contributors to the 1929 Wall street crash were rising interest rates and foreign withdrawal of capital from the United States. These two factors are again making their presence known on Wall Street. If past history is anything to rely upon, then a crash of US stocks is imminent and the Kondratieff winter of deflation and depression will follow. This will usher in the age of gold.
Suffice it to say that it is probable that two rocket ships will soon pass each other at some point not far from the earth's atmosphere. The rocket ship Stock Market on its reentry back to earth after its trip to the moon; and we hope it lands without crashing. The rocket ship Gold is on its way to the moon!
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Ian Gordon
ian_gordon@canaccord.com
December 17, 1999
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