Authored by Robert Gore via Straight Line Logic blog,
It will be a crash like we’ve never seen before.
SLL has been accused of trafficking in “doom porn.” Guilty as charged. If you don’t like doom porn, don’t read this article, it’s hard core. If you prefer feel good and heartwarming, there are plenty of Wall Street research reports and mainstream media stories about the economy available. Enjoy!
In 1971, President Nixon closed the “gold window,” which allowed foreign governments to exchange their dollars for gold. This severed the last link between any government and central bank-created debt and the real economy. Debt could be conjured at whim, and governments and central banks have done so for the last 46 years.
Not surprisingly, credit creation without restraint has papered the globe with the greatest pile of debt mankind has ever amassed, measured in nominal terms or relative to the underlying economy. A measure of how extraordinary this situation is: most people regard it as normal, if they think of it all. Debt is a first mover, a financial constant. Any exigency small or large can be met from an unlimited credit pool that will always be with us. How to rebuild Houston, Florida, and Puerto Rico? No problem, borrow.
Although fiat credit creation by governments and central banks is unconnected to the real economy, its effects are not. Their debt becomes an asset within the financial system. Through fractional reserve banking, securitization, and derivatives it become the basis for a multiplication of the original debt. That multiplication is many times the multiplier (the reciprocal of the reserve requirement) taught in introductory macroeconomics classes whereby the debt is contained within the banking system.
Nominal global debt is reckoned at between $225 and $250 trillion, or about three times global GDP. Financial, debt-supported derivatives (financial instruments whose prices are derived from the prices of other financial instruments) are estimated at anywhere from $500 trillion to $1 quadrillion notational, or six to twelve times global GDP.
Overpriced houses did not cause the last financial crisis and almost bring down the world’s financial system, securitized packages of mortgages and their associated derivatives did. The Panglossian view of derivatives is that most of them can be netted out against offsetting derivatives, thus actual exposures are far less that notational amounts. The real world view is they can only be netted out as long as all counterparties remain solvent. As we learned in 2009, that is not always a correct assumption.
Globally, unfunded old age pension and medical liabilities, not counted as debt but still promises made that often have the force of law, sum to another $400 trillion. In the US, they are about $210 trillion, or about 11 times US GDP. Demographics amplify the liability: across the developed world, declining birth rates and extensions in life expectancies mean a shrinking pool of workers supports an expanding pool of beneficiaries. In the last month, SLL has posted four excellent articles by John Mauldin for those who want all the gruesome details. (Just enter John Mauldin in SLL’s search box and they’ll pop right up.)
This doom porn, the skeptics will say, is almost as old as Deep Throat (released in 1972). Markets crash from time to time, but they always bounce back. Central banks and governments come to the rescue with fiscal stimulus (increased government debt) and unlimited fiat debt.
Why should we worry now?
There are a number of reasons.
When the world was less indebted, a fiat currency unit’s worth of debt produced more than a fiat currency unit’s worth of expanded output of goods and services. Sometime within the last year or two, the marginal economic effectiveness of all that government and central bank debt reached zero, and is negative after debt service.
With the world saturated in debt, another fiat currency unit of debt produces no increase in output. Kick in the costs of servicing and repaying that debt, and increasing debt is actually retarding economic growth. It accounts for the long-term slowing growth trend, flat incomes, and “secular stagnation” that puzzle so many economists.
It also accounts for the lack of inflation that puzzles so many central bankers, at least in the price indexes they look at. They are looking at the wrong indexes. The relevant indices are stock, high-grade bond, real estate, and cryptocurrency prices, still at or close to record highs, and corporate and securitized-debt credit spreads to treasury benchmarks at record lows (indicating massive complacency about corporate credit risk). Here inflation—the speculative kind that blows bubbles—is alive and thriving.
With the Federal Reserve now taking steps to shrink its balance sheet and other central banks making noises about doing the same, global fiat debt creation may go into reverse for the first time in many years. Brandon Smith at Alt-Market.com argues that this is part of plan leading to a crash and global, centralized monetary control.
He may or may not be on to something, however, valuation extremes and sentiment indicators point to the same conclusion concerning a crash. SLL maintains financial markets are exercises in crowd psychology, impervious to government and central bank efforts to control them, designed to separate the maximum number of speculators from a maximum amount of their money.
Robert Prechter, of Elliott Wave International, has written the chapter and the verse on markets and psychology. (SLL reviewed his groundbreaking tome, The Socionomic Theory of Finance.) Consider the following from Elliot Wave International’s October “Financial Forecast.”
Every month another sentiment indicator seems to pop to a frothy new extreme. Last month it was the percentage of cash that members of the American Association of Individual Investors harbored in their investment portfolios. At 14.5%, it was the smallest allocation to this safe alternative since January 2000, the same month that the Dow Industrials began a 38% decline that lasted through October 2002. Last month, we also showed a new bullish extreme for the five-day average of Market Vane’s Bullish Consensus survey of advisors. On September 15, the average pushed to 71%, a new ten-year extreme.
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The most recent Commitment of Traders Report shows that Large Speculators in futures on the CBOE Volatility Index (VIX) have amassed a record net- short position of 172,395 contracts.
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This record bet on subdued volatility sets the stage perfectly for the period of “high volatility” that EWFF called for in August.
...Large Speculators in the E-mini DJIA futures have pushed their net-long position to 95,976 contracts, more than four times the number of contracts they held in January 2008, shortly after the Dow started its largest percentage decline since 1929. So, investors are betting to a record degree that the stock market will continue to rise and volatility will continue to remain subdued. Paradoxically, these measures indicate that exact opposite.
...Various media accounts confirm that a rare complacency now dominates the stock market.
One doesn’t have to buy in to socionomics to realize that virtually everyone is now on the same side of the boat, a condition generally followed by the boat capsizing. Using conventional valuation measures, the only time stocks have been more highly valued is just before the tech wreck in 2000.
If one does buy into socionomics, the last few upward squiggles in the stock market will put the finishing touches on intermediate, primary, cycle, supercycle, and grand supercycle Elliot Waves dating back to 2016, 2009, 1974, 1932, and the 1780s, respectively. In other words, this is going to be a crash for the ages.
Given the unprecedented level of global debt, that appears to be the most likely scenario. Every financial asset in the world is either a debt claim or an even less secure equity claim—a claim on what’s left after debt is paid. Much of the world’s real, tangible assets are mortgaged.
When the debt bubble implodes, a global margin call will prompt forced selling, driving down all asset prices precipitously. Most of what is currently regarded as wealth will vanish. Opening up the world’s fiat debt spigots full force won’t stop this one. The notions that governments and central banks have speculators’ backs, that problems caused by excessive debt can be solved with more debt, will be revealed as monumental follies. And markets will not come back, at least in our lifetimes.
Long-time readers will point out that SLL has been issuing warnings for years. Again, guilty as charged. However, we’ll join Mr. Prechter and company in their prediction that US equity markets top out before the end of this year. (They called last year’s top in the government bond market, adding to an impressive list of correct calls.) If we’re wrong, it won’t be the first or last time. If we’re right, given the magnitude of what’s coming, being a few years early won’t matter at all.
Our concluding clichés: fear is stronger than greed and markets go down much quicker than they go up.