Monday, January 18, 2010

Asleeper Has Awakened

Before the NASDAQ crash, I was asleep.

The dot-com bubble burst on March 10, 2000, when the NASDAQ peaked at 5,048.62, more than double its value of a year before. Other stock markets around the world crashed simultaneously, including commodities, but in the US, the stock market punished the worst was the tech-stock-heavy NASDAQ. Hiring freezes, layoffs, and consolidations followed in several industries, especially in the dot-com sector.

Several communication companies, burdened with debt from expansion, sold their assets for cash or filed for bankruptcy. Worldcom, the largest of the failed companies, used illegal accounting practices to overstate its profits by billions of dollars. The company's stock crashed when these irregularities were revealed. Within days, it filed the second largest corporate bankruptcy in U.S. history.

Many dot-coms ran out of start-up or investment capital and were acquired or liquidated. Several companies and their executives were accused or convicted of fraud, and the SEC fined Citigroup, Merril Lynch, and others millions of dollars for misleading investors.

The dot-com bubble crash wiped out $5 trillion in market value of technology companies from March 2000 to October 2002. Among the $5 trillion was about 40% of my retirement investments. I was lucky. Many lost much more.

The NASDAQ crash woke me up. I researched major market crashes, including the Great Depression, to find out what happens in the aftermath, to find out how I might get my money back. What I found was fascinating, and I'll get to that, but it also raised questioned about why markets crashed simultaneously to begin with. Being an ex-mechanical engineer with a systems engineering point of view, that was strong evidence of failure by design. I found that the reason the markets crash is the result of a monetary phenomena peculiar to our monetary system.

The problem is that some 98% of all our money is issued by banks in the form of credit, and due to the unique powers given to banks by law to create credit, there is no real limit on the issuance of credit and hence no real limit on the amount of money that banks can create. Also, the mathematics of principal plus interest favor the increasing of credit by banks until the limit of the ability of debtors to repay is reached, at which time the financial expansion stops, markets crash, and bankruptcies become epidemic. The financial money-generation system cycles between credit expansion and boom times and credit freeze, market crashes, business and individual bankruptcies.

The bigger the expansion of credit and the boom times, the bigger the crash, and contrary to popular belief, there have been more than one great depression. Our type of banking-monetary system started some 400 years ago in Europe. We in the U.S. inherited it, sort of. More like it was deliberately introduced in as quiet a back-door style as possible. In 400 years, there have actually been five great depressions, the 1930s Great Depression being the latest incarnation. The media always capitalize the "G" and the "D" to create the impression it was a one-off event, a fluke, something that will never happen again. Our current "Great Recession" may indeed be the sixth great depression, but our Government works hard to counter that impression by manipulating economic statistics. If a tree falls in a forest, and Government figures say it didn't, you are supposed to believe it didn't make any noise.

Getting back to the question of how to recoup my NASDAQ losses, I found that the best and safest investments in the aftermath of a major market crash are the precious metals. They cannot go bankrupt, default, or otherwise fail like paper assets such as stocks and bonds. Also, Government and central bank responses to market crashes are invariably the same, to work overtime to try to expand credit again. If successful, this leads to another boom and rapid initial inflation, increasing the price of precious metals. Commodities go up too but they can be more volatile. "Priming the pump" with credit and keeping credit expansion going are the keys to how recessions are turned around and prevented from becoming great depressions. They are also the ways the wealthy elite who own the banking system keep us all in debt and servitude.

If Government and central bank efforts to expand credit fail, a financial crisis can persist. If the failure to expand credit is spectacularly ineffective, the overall money supply can actually contract, leading to the dreaded debt-deflation spiral, as loan defaults increase faster than credit can be expanded, plus a general fear of debt and bankruptcy replaces greed-driven speculative investment. Another way of saying this is you can make credit available but you cannot make people borrow, and even if they borrow, you cannot make them spend. If all people do with discretionary income is pay down debt, the economy continues to slow down, debts get paid off, the money supply contracts, and velocity of money falls. This is how Great Recessions turn into great depressions. Great depressions are associated with large price drops in almost every asset category, with no safe investment position except being debt-free, holding cash.

Long credit expansions are typified by steady credit expansion and price inflation. The response to a recession is always typified by an attempt at even greater credit expansion, usually by lowering interest rates, monetary inflation and less price inflation. Responses to severe financial crises are typified by vigorous, greatly increased efforts to expand credit, which may or may not result in general price rises; it all depends on whether the banks can be made to lend, lenders to borrow, and borrowers to spend.

The latter problem is also sometimes called "pushing on a string". If the credit string is pushed, and enough people are willing to pull on the on the other end of it, a recession can be turned around, the economy will pick up, and inflation will resume but not be too bad. If the credit string is pushed, but no one wants to pull the other end, credit will not expand, and a recession can turn into a Great Depression. At that point, to avert the depression, extreme measures may be taken to prevent the money supply from dropping. Such measures, including "money-printing" aka "quantitive easing", can result in an unstable financial and economic condition wherein uncontrolled expansion of the money supply occurs, people lose faith in the money, the circulation rate (velocity) of money spikes very quickly, and "hyperinflation" occurs.

This does not, however, always happen. Sometimes, the money just flows into a few assets classes, causing market "bubbles" as investors chase gains. Or the money can just sit in a constipated banking system where there is reluctance to lend, debtors are reluctant to borrow, or there is borrowing but there is reluctance to spend. The latter situation is the justification for Keynesian-Rooseveltian proposals that the Government must then become the "spender of last resort". If these latter patterns emerge, it is possible for the money supply to just keep going down due to mathematical relations between debt, income, and money supply, and the result can be an unstoppable 1930s style Great Depression.

In science and engineering, when a process reaches a point of instability where a small input can cause two or more very different system behavioral outcomes, we call that a "bifurcation point". In the aftermath of a market crash, in our current economic system, it seems that a bifurcation point occurs followed by several possibilities, depending on the extent of the previous credit expansion and severity of the underlying debt problems. In order of increasing extent of the previous credit expansion and underlying debt problems, the bifurcation points seem to be:

  • (#1) Credit expansion, renewed inflation, market recovery, gold/silver rise initially in the aftermath
  • (#2) Credit expansion, renewed inflation, continued high unemployment, multiple rotating asset bubbles, carry trades, and choppy markets (stagflation), gold/silver rise initially in the aftermath
  • (#3) Extreme efforts to expand credit fail, and a second bifurcation point occurs:
  • (#3a) Sudden monetary inflation, ie, hyperinflation, currency failure, aka a "hyperinflationary depression", is a possibility, and gold/silver are king/queen.
  • (#3b) uncontrolled monetary deflation, deflation of all asset classes except cash, counter-party failures, mass defaults on contractual commitments (all paper assets), mass bankruptcies, especially banks, extremely high unemployment, real GDP contraction, also known as a "great depression", are all possibilities, and cash is king.

Most people think that if precious metals increase in price in a successful resolution of a recession (Cases #1 and #2 above), they will decrease along with most assets in an unsuccessful resolution leading to a great depression, or at least they will decrease in Case #3(b), yet history suggests that is not exactly what happens. What seems to happen is that precious metals definitely do increase in price when a recession is successfully resolved (#1 and #2) as people anticipate higher than normal inflation. Where Case #3 is a possibility, however, precious metals hold their value or increase when it appears a recession might not be resolved successfully and investors seek safety, an asset that cannot fail (cannot go bankrupt or default), and they ponder the chances of hyperinflation. If Case #3a plays out, investment in precious metals will prove to be a very smart move. If Case #3b begins to emerge, and the system progresses into a great depression, markets and assets will suffer additional crashes, and precious metals drop too, usually in sympathy with stocks and commodities, but precious metals drop less than other assets, being perceived themselves as a form of cash, making them the next best thing to cash, and when the market crashes reach bottom, the precious metals will recover quickly as investors anticipate rapid inflation.

Now matter how Case #3 plays out, investment in precious metals then is either the best investment by far (#3a) or second best to cash (#3b). From the perspective of investment in cash, that is simply holding cash, that would be the worst approach (#3a), or the best (#3b). Risk management then says, because of Case #3(a), you must invest something in precious metals when facing the possibility of a great depression, and at least part of it must be in the physical metal in personal possession.

The time when precious metals underperform most of all other assets is when a long, slow credit expansion with low interest rates occurs. Such conditions are favorable to business and trade. Many ventures enjoy real organic growth, profitability, and pay dividends under such conditions. Gold does not grow like a business, it is simply a safe store of value, so it underperforms as an asset at such times.

This economics I learned after taking my NASDAQ beat down enabled me to recover most of what I lost from 2000-2002 by investing in precious metals. It also helped me side-step the stock market crashes in 2008. Another clue to the puzzle was interest rates; they are a lever of control by the banking system over credit expansion/contraction, but to keep it simple, I kept interest rates out of the discussion so far. In the rules below, however, I mention the interest rate because they give clues as to the direction of markets and asset prices.

My lessons learned may be summarized as:
1) Stock markets, the economy, the housing market, etc, they are all about the monetary system, banks, credit, and interest rates.
2) In stable economic times, when interest rates go up, credit expansion slows, bonds drop and the stock market usually drops.
3) In stable economic times, when interest rates go down, credit expansion speeds up, bonds go up, and the stock market usually goes up.
4) Precious metals don't always respond predictably to short term moves in the interest rate. They go up when credit expands faster than real economic growth and when stocks are at risk of failing and bonds are at risk of default, in other words, they go up in times of predictable faster-than-normal inflation and great economic uncertainty.
5) When market performance seems too good to be true, it is. But, it can seem too good to be true for longer than expected. Pay attention to Lesson 1. It's hard to tell when the market is being manipulated.
6) Markets fall faster than they rise. Never take your eye off the banks, the money supply, the value of the dollar, the price of precious metals, and interest rates.
7) In the aftermath of a recessionary market crash, buy precious metals and solid but beaten down stocks.
8) In the midst of great uncertainty before what appears to be a looming great depression, be in precious metals and in cash. In the aftermath of each severe market crash, allocate more to precious metals. As market recovery rallies begin to stall out, allocate more to cash.
9) In times of peace, certainty, and a slow steady credit expansion with reasonable positive real interest rates, get out of precious metals and into stocks and other growth oriented investments.
10) None of this is true all the time. Investing, even just trying to maintain the value of your savings is always a gamble. Sometimes you win, and sometimes you lose.

Overall, saving and investing is a losing battle for most people. The game is simply rigged in favor of banks, other financial institutions, and large corporations due to the structure of our monetary and banking system. My hope in this blog is help people recover some of their disadvantage, hang on to more of their savings, and do better on choosing and timing their investments.

At the same time, I will try to choose and comment on the best articles that explain what is happening politically and economically that threatens the life, liberty, and property of ordinary people. Hopefully, understanding will lead to more sensible involvement by the public in political and economic matters.



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