October 19, 2009

I find it surprising that I’m now getting inquiries from readers, asking if “we’ve reached bottom” in the current economic recession, and asking if the time has come to start buying stocks or residential real estate. It seems that the talking heads of mainstream media are using some sort of voodoo. How can anyone think that we’ve hit bottom, and an economic recovery is in progress? To dispel the myths from the CNBC Cheering Section, please consider the following. (And note that I’ve provided references for each assertion, just so you know that I’m not talking out of my camouflage hat.):

  1. A broken global credit market that has not fully recovered. See: After Lehman, U.S. firms adjust to new face of credit
  2. Lack of transparency in Mortgage-Backed Securities and other re-packaged debt instruments. See: Geithner Blames Lack of Transparency for OTC Derivatives Hit on Market.
  3. The increasing Federal debt, which is growing at an unprecedented rate. See: The National Debt Clock.
  4. Mountains of consumer and corporate debt. See: Observations on the US Debt.
  5. The Federal budget deficit. See: Federal Deficit Hits All-Time High of $1.42 Trillion.
  6. Ever-expanding bailouts. (I call this The MOAB.) See: As More Companies Seek Aid, ‘Where Do You Stop?’
  7. Monetization of the National Debt. See: Fed Could Expand MBS Purchases. (Can you spell Oroborus?):
  8. The destruction of the American consumer economy. (It had been artificially credit-driven). See: A Year After The Crisis, The Consumer Economy Is Dead.
  9. Chronic unemployment, possibly much higher than officially reported. See: Alternate Data at ShadowStats.
  10. More than $500 Billion USD in hedge funds that have borrowed short and lent long. See: Assets invested in hedge funds increase by $100bn
  11. A double wave of residential mortgage rate resets. See: this chart of scheduled mortgage interest rate resets.
  12. Continued down-ratcheting of house prices. See: Housing Prices Will Continue to Fall, Especially in California
  13. The under-reported “shadow inventory” of foreclosed houses. See: The “Shadow” Foreclosure Inventory
  14. The very likely collapse of commercial real estate (”the other shoe to drop”.) See: Is a commercial real estate bust inevitable?
  15. A huge crisis lurking in over-the-counter derivatives. See my analysis published in 2006 and the dozens of articles on the Derivative Dribble Blog.
  16. Under-funded pensions. See: Almost half of top unions have under funded pension plans.
  17. A coming wave of municipal bond and municipal bond hedge fund failures. See: The Failure of Leveraged Municipal Bond Hedge Funds.
  18. Increasing numbers of bank failures. See: FDIC: Bank Failures to Cost Around $100 Billion.
  19. Insurance company collapses–some, like AIG, were foolish enough to insure more than a trillion dollars in derivative contracts. See: AIG: Is the Risk Systemic?
  20. Worsening state, county, and city budget crises. See: State prepares for shutdown as budget deadline looms, and this article from a liberal site: Predicting Worse Ahead from America’s Economic Crisis.
  21. Loss of faith in the US Dollar, on the FOREX. See: Dollar’s reserve currency status in focus as G-7 finance ministers meet.
  22. The coming mass currency inflation, follwing some asset deflation. See: Which is more likely in 2010: Deflation or inflation?

Back in the Fall of 2008, I started hearing from consulting clients with notes of fear in their voices. They realized that something is horribly wrong with the economy, but they could not properly isolate and articulate the problem. In my estimation, the “something wrong” that they sensed is nothing short of a monumental shift in the economic climate.

America will continue in recession. Most economic recessions are simply a product of the business cycle. These recessions are relatively mild and they often last just 12 to 24 months. The economic engine just readjusts and everything soon gets back to normal. But the recession that began in 2008 is something radically different, and it won’t be short-lived. The current slow down was triggered by a collapse in the global credit market. For decades, the global credit market grew and grew, in an enormous debt spiral. Our neighbors to the south saw trouble coming decades ago, because their economies were at the time more debt-dependent than our own. As far back as the mid-1980s, their newspapers featured political cartoons that portrayed an enormous, insatiable monster that was invariably captioned “La Dueda“–”The Debt”. Our cousins in Latin America saw it coming first, but the dark side of the debt nemesis will soon be clear to everyone.

The Federal governments’s debt, just by itself is cause for concern. As an old gunsmithing friend mine, the late Chuck Brumley, was fond of saying: “If your outgo exceeds your income your upkeep will be your downfall.” Several decades of profligate spending by the US Congress are finally starting to take their toll. Just because their friend Helicopter Ben has a high-speed printing press does mean that they can continue to spend money like drunken sailors in definitely. (On second thought, I should apologize for impugning the reputation of drunken sailors. They are actually much more conservative with their funds than congressmen.)

Because modern banking in the western world is based on interest charges that create continuously compounding debt, credit cannot continue to grow indefinitely. At some point the excesses of malinvestment become so great that the entire system collapses. This is what we are now witnessing: a banking panic that is spreading uncontrollably as wave after wave of ugly debt gets destroyed by margin calls and subsequent business failures.

Some economists are fixated on reading charted histories–and unrealistically expect that by doing so that the can reliably predict future market moves. Although they are working from a flawed premise at the micro level, the chartists do have some things right on the macro level: There are major economic “seasons” and even climate changes. The most vocal chartists like Robert Prechter hold to what is called the Elliot Wave Theory. And the big bad nasty in this school of thought is a Kondratieff Winter. This “K-Winter” is an economic depression phase that the world has not fully experienced since the 1930s. An economic winter does not end until after the foundations of industry and consumer demand are rebuilt. This can be a painful process, often culminating with war on a grand scale. (It was no coincidence that the Second World of the early 1940s was an outgrowth of the Great Depression of the 1930s.)

The US Federal Reserve and the other central banks are furiously pumping liquidity to the best of their ability, but in the long run they will not be successful. At best, dumping billions in cash on the economy will delay a depression by perhaps a year or two. But inevitably, a K-Winter depression will come. And the longer that it is delayed, then the worse the depression will be. Further inflating the debt bubble will only make matters worse.

“Big Picture” Implications

As I’ve mentioned before, hedge funds are presently most at risk in the unfolding liquidity crisis, because they use lots of leverage in lending funds that they themselves have borrowed. They borrow short and lend long, and effectively use debt compounded upon debt.

Even more alarming is the scale of global derivatives trading, particularly for credit default swaps (CDSes). Derivatives are a relatively new phenomenon, so most derivatives contract holders are only just now experiencing their first major recession. Thus, it is difficult to predict what will happen in a genuine K-Winter phase. In a perfect world, derivatives are a nicely balanced mechanism, where there are parties and counterparties, and every derivatives contract equation balances out to have a neat “zero” at its conclusion. But we don’t live in a perfect world: Companies go bankrupt. Contracts get breached. Counterparties disappear and disappoint. We have not yet experienced a full scale “blow up” of derivatives, but I predict that if and when it happens, it will be spectacular. The pinch in CDSes (a form of derivative contract) in 2008 was just a faint foreshadowing of what we’d experience in a a full-blown derivatives collapse.

The scale of derivatives trading is monumental, and the vast majority of the population is blissfully ignorant of both its scale and the implications of a derivatives crisis. There are presently about $500 trillion of derivatives contracts in play. That is many times the size of the gross product of the global economy, but the average man on the street has no idea what is going on. It won’t be until after the giant derivatives casino implodes that the Generally Dumb Public (GDP) awakens and asks, “What the heck happened?” Since the credit market began to collapse in the summer of 2008, the number of new derivatives contracts has dropped precipitously. But whether the aggregate derivative market is $400 trillion versus $500 trillion, when a crisis occurs there will undoubtedly be some very deep drama.

The next decade will likely be characterized by successive waves of inflation and deflation, and perhaps some of both simultaneously, at different levels. Countless corporations, and perhaps a few currencies or even governments will go under as this tumult plays out. (Take note of the recent vote of no confidence in Latvia.) The current low interest rates will soon be replaced by double-digit rates, much like we saw in the late 1970s. The dollar will lose value in foreign exchange, and may collapse completely. The Mother of All Bailouts (MOAB) will inevitably result in mass inflation. The bull markets in silver and gold will surge ahead, propelled by economic and currency instability. (Investors will be desperate to find a safe haven, when currencies and equities are falling apart.)

Mitigating the Risks

Be ready to “winter over” the coming K Winter depression. That will require: 1.) Prayer. 2.) Friends and /or relatives that you can count on (a “retreat group”). 3.) A deep larder, and 4.) An effective means of self defense with proper training. (For each of those four factors, see the hundreds of archived articles and letters at for details.)

Since additional large-scale layoffs seem likely, it would also be wise to have a second income from a recession-proof home-based business.

In the event of a “worst case” (grid down) economic collapse, it would be prudent to have a self-sufficient retreat in a rural area that is well-removed from major population centers. Get the majority of your funds out of anything that is dollar-denominated, and into tangibles, as soon as possible. The very best tangible that you can buy is a stout house on a piece of productive farm land. It will not only preserve your wealth, but living there may very well save your life.