Nobody should be puzzled as to whether a market is a bull or a bear market after it fairly starts. The trend is evident to a man who has an open mind and reasonably clear sight, for it is never wise for a speculator to fit his facts to his theories. Such a man will, or ought to, know whether it is a bull or a bear market, and if he knows that he knows whether to buy or to sell. It is therefore at the very inception of the movement that a man needs to know whether to buy or to sell. – Jesse Livermore
I did a couple of interviews for RT today, and during the second one, I had a chance to get into an issue that I don’t feel can be addressed enough. The issue that I raised relates to the ineffectiveness of central bank easing during a balance sheet depression, which we are currently in.
A balance sheet depression or recession is different from normal economic downturns, in that it is marked by particularly high levels of debt. The private sector debt burden is so onerous in such cases, that even at zero percent interest rates, banks are so concerned with paying down their debts and minimizing their liabilities that they stop lending, using all fresh money to pad their balance sheets. Basically, an economy facing a balance sheet depression has a giant black hole in the center of its financial system that sucks what appears, during the capitulation stage of the downturn, to be endless amounts of money and credit into the heart of the singularity.
This is why near zero interest rates, quantitative easing (flat out monetization of debt or money printing) and the creation of special loan facilities have done nothing to bring the economy back to healthy growth. The only thing that these policies have managed to do is prevent any significant write downs and bankruptcies of insolvent banks – the same banks, incidentally, that house the black holes that are destroying any prospects for future growth.
The chart above shows the growth in total credit market debt as a function of GDP since 1922. By early 2009, during the midsts of the financial crisis, total credit market debt in the US was 50% more (at 380% of GDP) than it was at its peak during the Great Depression. This means that although we may not have seen a contraction in GDP analogous to what we saw during the great depression, the potential for that contraction is there given the size of the overall debt burden in the economy. The only question is, how much of this debt needs to be liquidated, because it is the extent of the malinvestment racked up during decades of easy credit that will ultimately determine how bad this depression gets. Likewise, the Fed’s role as sugar daddy for the banking system will determine how many decades we must endure of what the US is now calling “the new normal” of high unemployment and low economic opportunity, as bad debt is slowly written off through central bank money printing.
So, to bring this conversation back to today, I think understanding where we are in this credit cycle is important because it can help explain why we are on the verge of another bank crisis that could accelerate our move into a new recession (if we are not already in one, technically speaking of course). Although the spark this time around seems more and more like it is going to be the banking system in Europe, led by French banks, the root of the problem is the same: massive amounts of debt piled up over many years can no longer be paid back. This debt allowed for a gross misallocation of capital by funding projects above and beyond the scope of profitability, and sustained a global economy full of structural imbalances that have now reached a breaking point imposed by the laws of financial gravity.
It has been my view for some time that the US economy would head back into a deflationary period marked by a renewed destruction of money and credit, and this is why the end of QE2 has not led to a collapsing US bond market as some, including PIMCO, had feared. Instead, 10-year government bond yields have now dropped to well below 2%, a further indication that investors have more faith that an over-indebted US government will protect the value of their money better than an over-leveraged private sector.
During a period of private sector deleveraging, one should expect bull market assets to sell off, and this presents investors with great buying opportunities. Gold represents just such an asset, and although it had one of its larger sell-offs in recent memory today, I still expect the price of gold to decline further during this new round of deleveraging, as investors liquidate assets ahead of further write downs and collateral calls. I have been early on my gold call, having first made it in March of 2011 (though I own gold, not having bought any additional gold during that period means that I missed a 400 point move to the upside), but I still believe that the correction I am waiting for in this market is yet to arrive. As much as I love precious metals and hate paper currency, I understand that transactions are still settled in cash, and you can’t close a contract with bars of gold.
So, I guess what I am saying is, expect more “market turbulence” ahead and keep your eyes open for buying opportunities in bull-market assets as liquidations continue. Anyone who positioned himself/herself in cash prior to this summer can still sit pretty and wait for better deals.