Financial Sense Online Storm Watch Update for July 26, 2002

Bill O’Reilly always says, "keep it short and pithy" in reference to e-mails. I have been told at times that my Storm Updates are "a lengthy read.” The reason for their length is that they reflect the damage and the complexity of the nation's economic and market infrastructure as well as the unwinding of the world’s present monetary system. These issues can’t be discussed in simple prose or in short pithy essays. Monetary policy and its impact on the financial markets, the economy and the credit systems are complex subjects. I don’t need to tell you about the thickness of economic books. Needless to say, economic and financial issues are complex subjects that take time to explain, especially now since systemic risk exists everywhere. The world’s monetary system based on the dollar is in the process of unraveling. The expansion of monetary policy in the 1990’s and its concomitant explosion of credit fed into the financial system creating multiple bubbles in the economy and the financial system.

The Fed’s easy money policies created a massive credit bubble that inflated everything it touched. Stock prices went to the extreme with valuations for the market completely abandoned to any sensibilities. The dollar rose in value even though the country's trade imbalance was setting records as American’s consumed more than they produced. Debt levels at all levels of society rose astronomically. Government debt grew from over $2 trillion to over $6 trillion in the last 10 years. The consumer quit saving and went on a spending and borrowing spree which continues to this very day. This is reflected in the rise of all categories of consumer debt whether it is credit card debt, installment debt or mortgage debt. They are all at record levels and still rising. Corporations went on a record debt binge in order to buy back stock or to buy other companies. Margin debt rose in the financial markets and the use of leverage through the use of derivatives grew exponentially.

It didn’t matter where you looked in the economy or the financial markets, debt became pervasive and permeated all levels of the economy and the financial system. It was if our country went on a debt and spending binge without any limits. The cost of money dropped to levels not seen since Dwight Eisenhower was President. With credit easily available at rates not seen in decades, consumers, corporations, investors, institutions and governments borrowed all that they could get. Credit fed itself throughout the financial system through margin debt and the expansion of derivatives. Credit went into consumption, which drove up demand for goods and services. What couldn’t be produced domestically was imported. It was those imports that kept the cost of goods from rising or reflecting demand that was higher than supply. Without those imports, the reported rate of inflation would have been much higher.

Now we are dealing with the after-effects. All of that debt will have to be cleansed from the financial system either voluntary or involuntary through bankruptcy. What you are now seeing is the unraveling of this credit. It began to unfold first in the stock market, which was the main recipient of much of the credit expansion of the 1990’s. Inflation has two forms: money can go into things or it can go into paper. Beginning in 1995, the boom in the financial markets was reflected in the roaring stock market of the last half of the decade similar to what happened in the U.S. during the 1920’s. When it stopped flowing into the financial markets after 2000, that money flowed into the real estate market which has yet to deflate. A rise in interest rates, which will come next, will end the housing bubble and the consumer consumption binge it has spawned. I believe the rise in interest rates will be triggered by a collapsing dollar, which is another bubble that is currently in the process of deflating.

The graphs that now follow show pictorially the unraveling of this bubble. These pictures express what words cannot say. They show the unfolding trend of what may be the “grand daddy” of all bear markets in history. The experts and the politicians don’t see it. Most investors don’t see it. And the media is either too blind or too afraid to talk about it. The U.S. economy and financial markets are considered too big to fail. To many, the U.S. economy is like a giant luxury liner -- too big and too safe to sink. They said the same thing about the Titanic. It was unsinkable, but sink it did. Because it is so hard to imagine, most investors are complacent. It is as if the Titanic just hit an iceberg and the Captain and the crew have yet to tell the passengers. This morning The Wall Street Journal featured a story called “ Why Main Street Isn’t Panicking.” In the words of one investor, “Stock losses are just on paper.”; while another investor said she quit opening her monthly 401(k) statements since she has lost half of her retirement funds. This pretty much sums up the attitude of most investors. They still have jobs and the price of housing is still going up, so they still have no worries.

What Main Street and Wall Street still don’t see is that depressions or recessions, and the bear markets that follow them, are caused by changes in the demand and supply of credit. These bear markets can be short or long depending on the boom that preceded them. In the last century, we had two bear markets where stocks languished for a long period of time. Those periods were between 1929 to 42 and 1966 to 1982. The duration of these bear markets were characterized by major economic and monetary problems that took well over a decade to resolve. We are now into our 28th month of this bear market and it shows no sign of letting up. The point to understand is that bear markets can be short or long. They can be as short as two months or as long as five years. The length and severity of these bear markets, once again, are determined by the excesses created during the boom. The fact that this bear market is already in its 28th month should be a warning that something more serious is now unfolding here. It took our nation 25 years to recover from the 1929 bear market and 16 years to recover from the stock market peak of 1966.

It takes time for malinvestments in the economy, excess credit, and stock market valuations to correct themselves. Add to this the propensity for government to interfere with the process and postpone the cleansing process and the time is lengthened. A good example is the U.S. economy during the 1930’s and Japan's economy during the 1990’s. During these times, both countries experienced a credit boom and a stock market and real estate bubbles that collapsed when credit contracted in the financial system and the economy. This is still taking place in Japan and is just beginning in the US.

Just how this bubble will unwind and how it will play out in the U.S. has yet to be determined. They say history always repeats itself, but it never repeats exactly. There are always extenuating circumstances that make each repeat cycle similar-yet-different than the previous cycle. We are now at war. So, instead of building factories, we are now building bombs. This war will be different because we have already been told it may last a very long time. There are no large armies on the battlefield that can be forced to surrender. So there will be no peace treaty. Terrorists don’t collectively gather at a peace table and voluntarily surrender. They have to be killed and it is unlikely the U.S. or any other western government is willing to do what is necessary to end this war. In other words, when at war, act like the Romans.

So war is likely to be with us for a very long time. During war, the power of the government grows; while the general and private economy shrinks. During war, government will grow even larger, deficits will get bigger and taxes will be raised to pay for simultaneous government expenditures for guns and butter. The money spent on butter will go up to pay for those who have lost their jobs in the private economy. The money for guns will go up because weapons are destroyed and ammunition and bombs are consumed. During war, armies kill and break things, so property is destroyed. During war the private economy shrinks while the government expands. This means economic growth will decline in the general economy, which will be reflected even further in the stock market. War also adds another element of uncertainty to the financial markets. Uncertainty makes the markets unstable.

To explain what is before us would take a lot of words. I believe it can be said more simply with pictures.

Bear Market in Stocks

What you see on the left is a bear market in stocks that is in its 28th month. In my opinion, this bear market has much further to go and has now entered its second and most destructive phase. As the graphs of the three major indexes show, the primary trend of the markets is down.

Bull Market in Commodities

The second set of graphs below show a new bull market in commodities or “things” which has just begun. The bull market in gold and silver are in a corrective process during the first leg up. The rise in the CRB Index reflects that this bull market in commodities is expanding to a broad class of commodities from grains, soft goods and industrial metals, to energy.

This new Bull Run is climbing a wall of disbelief that will be with us until the second bull phase of this market begins. It is similar to the financial markets. During the first phase of the bear market, the public is still complacent as reported in Friday’s Wall Street Journal. They don’t believe that the primary trend has changed. It is the same for commodities. Nobody believes this bull market is for real other than those who understand fundamentals or know how to read charts.

When the price of metals soar, and when the next leg of the bear market unfolds with a crash, perceptions will change. Attitudes will change from complacency to fear, which will be reflected in plunging stock prices on one hand and rising metals on the other.

This graph above of the derivative growth of our major banks -- really three J.P.MorganChase (JPM), Citibank (C), and Banc of America (BAC) -- is what will create the next major financial crisis. When it unfolds, it is going to be big. Each of these top three banks look and act more like a hedge fund then they do a traditional bank. It doesn’t matter if it is off-balance sheet financing to corporations, high-risk loans to emerging markets, underwriting risk through derivatives, or trading for their own accounts. These banks are taking big risks and these risks are starting to unravel.

The next set of graphs show the stock of Northrop Grumman (NOC) and General Dynamics (GD). They reflect the current war that is shortly to expand. The U.S. is building up a sizeable force in the Middle East. Those troops are there for one reason and isn’t for patrol.

Start paying attention to the headlines. What are they saying? What are they not saying?

In summary, the primary trends are changing from debt to financial asset deflation, from peace to war, and from paper to things. That is the message of these charts. You, the reader, must draw your own conclusions. You can agree or disagree. What is important is that you don't remain complacent. This is a time for understanding and conviction. You must understand the times for they will guide your investment decisions.

I will conclude today's Storm Watch Update with something I wrote in Tuesday's Market WrapUp:

"This is not the time to hesitate or the time to be without firm convictions or beliefs. If you don’t have them, get into cash and be content with what you have left. For those of you that believe what the rise in gold and fall in the financial markets are telling you, it is time to take advantage of those who are subsidizing the price of gold and silver. It is the time of mice and men. It is a time when those who have convictions must stand by their beliefs because those who have none will eventually follow." ~ JP


	Storm Watch Update KEEP IT SIMPLE by Jim Puplava www.financialsense.com July 26, 2002