"tiny bubbles"

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    Rodney C. Cook, Ph.D.

    It appears that the markets have behaved largely as anticipated, following the lines of probability. The primary downward trend is supported by a nascent reversal of the secondary trend. That is, the stock market has retraced a bit. Lower lows are most likely in the offing. Gold shares have broken out of their wedges to the upside, indicating that there is decent upside in the coming months. Fortuitously, those shares recommended a few short weeks ago have achieved double digit gains. For those who took positions at this time, it should be a bit easier to hang on for what I expect to be a very wild ride.


    The turbulence ahead will be best weathered by those who can define money. Unfortunately, even Sir Greenspan admits that he no longer knows what money is. This is distressing. The ability and authority to create money no longer resides with central banks. It was atomized and distributed throughout the system, most egregiously in the mid 90's. This has lead to the greatest inflation in history; a frothy mass of speculative excess and overcapacity that has infiltrated all aspects of global society. So, the supply of money in all of its various forms exploded: Inflation. The cure: Deflation.


    The great bubble in share prices was but a symptom of inflation. The collapse but a symptom of deflation. A simple understanding of the process should enable us to invest as bubbles become apparent, and divest as they implode. Easy, right? Well, maybe.

    In the case of shares, it seems so obvious in hind-sight. Monetary aggregates were growing at historic rates dramatically inflating the money available for investment. It flowed to shares creating the perception of incredible wealth. However, in aggregate, this money was effectively destroyed the day it entered the market. As the global portfolio of share prices soared, the value of the portfolio did not. Quite simply, at some unknowable tipping point, the offering for sale of these shares exposed the underlying value: There were too many to go around and share prices plummeted. The money was gone. Deflation in action.

    This process continues and will continue for several years. A froth of bubbles forming and popping, as money and stuff attempt to re-align.

    Money and Stuff

    Gaining advantage seems straight-forward. Simply look at the relative supply of money to stuff in a given market. When money growth exceeds stuff, buy stuff. When stuff exceeds money, sell stuff. Easy enough.

    The problem arises, as you may have guessed, is that there are lots of different kinds of stuff and lots of different kinds of money. The stuff and money are all convoluted in a morass of overlapping economic activity that cannot be grasped in its entirety by mere mortals. Or the Fed. Thus the bewildering array of opinions on the subject, and the various tortured permutations of the -flation suffix. All of the various forms of x-flation can exist simultaneously. Most disagreements can best be understood by the differences in the definitions of money and stuff. And the best investment strategies can best be understood not just by isolating and understanding the dynamics of a particular market, but by identifying where the vast majority of investors have it wrong. Where money and stuff are not understood in context.

    Federal Reserve Notes

    Few will argue that the Federal Reserve Note (FRN) is money. The few that will argue have some important insights. It is not a US dollar anymore. It is a government sanctioned private note. It is not backed by stuff of any kind. It's supply is controlled by the Fed with off-setting debit and credit entries with their member banks. So, knowing the opinions of the Federal Reserve Board and their member banks is a pre-requisite for investing in or with FRNs.

    There is no limit to the number of FRNs that can be created. The liquidity created by the Fed in the 90's created a speculative bubble in stocks. The market could count on the Fed to inject the necessary liquidity into the system to maintain share prices. Investors grew to rely upon this "Greenspan put" to eliminate risk. Clearly both the Fed and the investment community had it wrong. The price appreciation in this market reversed, despite the continued injection of FRNs.

    A very few made profits on the way up, AND profits on the way down. It was no accident; however, it is important to note that those who understood the process typically shorted shares too early, often by as much as two years. They failed to accurately estimate the magnitude of this bubble. Thus they missed the tipping point at which to change strategies. Secondary downward trends were fairly regularly misinterpreted as reversals in the primary trend, because the fundamental imbalance between stuff (shares) and money (FRNs) were redefining historic extremes.

    While there is still money to be made shorting shares, it might be more interesting to explore possibilities for the next bubble.

    Government Sponsored Entities

    Not too many recognize that liquidity, or the electronic derivatives of FRNs, are a separate form of money. All are generally lumped together and called dollars, but the differences are important and subtle. A most important observation is that the GSEs have created as much liquidity as the Fed over the past few years. Thus the inflation in the housing market. This inflation, through refinancing, has spilled over into the general economy by subsidizing consumer spending. The price increases have been noted by the pundits, and many have equated this to a bubble ready to burst.

    I am not so sure.

    Global Deflation

    This is Japan's great depression. Deflation has been plaguing Japan for a decade. Decades remain. Until the bad debt or excess money, is recognized and dealt with. Eight of the largest ten banks in the world used to reign from Japan. No longer. The deflationary winds blowing from Japan have precipitated economic discontinuities through out the world, and the winds are still growing. Global credit growth, the largest form of money, has been declining for two years now. It is this deflationary wind that drives the primary downward trend in most global financial markets.

    The current slate of Japanese monetary authorities are ringing the claxon. Expect them to devalue the yen and fix prices in the future. They can no longer monetize their debt without endangering the yen. It will be up to the rest of the world to monetize this debt. Expect the G7 to cooperate.

    Fed watchers are alarmed. Much more so than usual. Perhaps less so than justified. Shortly after the tragedy in New York, Fed minutes note that if interest rate cuts don't work to reflate the economy, then they might start aggressively monetizing debt. (Interestingly bizarre, was the mention of buying gold mines, but this is another story. A much more frightening story for another spooky night around the campfire.) More recent commentary from the Fed indicates that they will be much more aggressive.

    Much, much, more aggressive. Radically so.

    Bubble in progress

    So, what is the next bubble? Interest rate cuts buoyed shares. The next bubble will be determined by the Fed. It must choose what debt to monetize. I expect them to prioritize mortgage backed instruments. The reason is simple. This will continue to drive mortgage rates lower, and housing prices higher. This will allow continued refinancing to support the consumer market. Which supports the financial markets and our trading partners.

    Such a subsidy could push mortgage rates below the 5% level, which is widely considered to be the point at which the open market for mortgage backed securites dries up. This may be the last line of defense for the Fed. It is certainly the next.

    How high could we go? A blow off is possible here. During the 30s residential real estate plunged up to 90%. Since this current inflation is much larger, one could expect real estate to rise to the point where similar declines are fathomable. At some point this Greenspan put will fail, as it did for shares, and prices will decline substantially. But do not underestimate the ability of a radicalized Fed to hold the line.

    My personal strategy has been to purchase two homes using this subsidized credit, and to pay for one with the price appreciation of the other. I will need to sell one home near the top, to avoid holding debt in excess of the price when the market reverses. For me this process is nearly complete, and I am watching diligently for a reversal in the housing market. The statistics are mixed, and it could go either way at this point.

    My personal objective on this front is one fully paid for home. The value of a home, after all, is constant in the context of my family's daily life. The only practical effect of a price decline would be lower property taxes. To the extent this strategy continues to work, great. To the extent that it doesn't, I will pay for the home by harvesting investments in the primary trend.

    Future Bubbles

    The process of monetizing debt threatens to expand to include, potentially, most anything. Even obscure forms of foreign debt. Thus, there will be future bubbles that can be anticipated and played to advantage. The key is to continually challenge the definitions of money and stuff, and look for a dynamic where the majority are in error and playing the wrong side of the trend: Keynsians are easy marks.

    The End Game

    While the game does not really ever end, per se, there is a point where the primary trend in financial assets will reverse and head back up. Unfortunately, this will not occur until all the excess money is ravaged by inflations and deflations around the globe. The Fed will attempt to inflate. If they "loose", we get a good old-fashioned deflationary depression. If they "win", we get Weimar style hyperinflation here in the US. Oh goody.

    In either event, the last bubble will be physical gold and silver.

    January 8, 2003
    Copyright c 2002. Rodney C. Cook, Ph.D. All Rights Reserved.
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