Planet Yelnick

We Have Begun the Endgame of Greenspan's Experiment With History

The Wolfpack Fund is likely to fail. With the $1T Wolfpack Plan, the central banks are "all in" and have no more pieces to shuffle on the board. The wolves can concoct short positions faster than Europe can create money via the magic of synthetic CDSs. When Soros called the Bank of England's bluff in 1992, he had to play with real money. Now he plays with derivatives.

Wolfpack is the endgame of a series of moves by Greenspan (and Bernanke) since 1987, to flood liquidity against any banking panic: Mexico, Asian Flu, Russia, LTCM, Y2K, dot-com, 9/11, housing, TARP, TALF and QE. 

The moves became known as the Greenspan Put, the assumption that he would bail you out of risky deals. It reached its ultimate expression in the period that I call the Greenspan Indian Summer, the bubble from 2002-2007 that staved off Kondratieff Winter for the moment. Greenspan knew he was playing with history. 

Greenspan's Indian Summer ended with the Mother of All Margin Calls, a post of mine on June 15, 2007, predicting the end of the bubble and the top in the market. Where this might lead is to a new global reserve currency, but that is still a ways off. 

Right now the Euro is at risk, not yet the Dollar. After a period to sort out the new plan, the Euro should fall and the Dollar should rise. As this next chart shows, the Euro popped over the weekend and faded back down today. The bluff may be called quickly. 

Credit Writedowns cites Marc Chandler (the global head of Brown Brother Harriman’s top ranked Currency Strategy Team) for noting that today was still a wait-and-see attitude: the panic is gone but bonds from the "peripheral euro zone" have not returned to normal. Marc believes policymakers are repeating the mistakes of the '30s.

Behind Wolfpack is the potential for European QE and Eurozone inflation. The plan is supposed to avoid QE via sterilization:  when central banks across Europe buy toxic sovereign debt (putting Euros into the bondholders' accounts), the ECB is supposed to sterilize the issuance by selling quality bonds, likely German Bunds (pulling Euros out of the market). But if the toxic debt is bought at too high a value, the buyers will take a bath that the ECB will try to cover, putting excess Euros into the system. Euro inflation will push it even lower against the Dollar. 

What is unclear is how fast this will play out. If markets are back to where they were last Friday by the end of this week, the bluff has been called and the momentary hope will fade. What this means for stocks and bonds I will cover then, but right now note two points from the very interesting STU this evening:

1. "The world does not have enough revenue to service the debt built up over the past seven decades"
2. The unfolding crisis will be "too big too bail"

In one of those moments EWI calls Beautiful Pictures, the bounce today retraced almost precisely 61.8% of the drop off the Apr26 high, typical for a wave 2. The alt count of an extended fifth with a zigzag (= sharp) bounce has played out, not the wave 3 down with a fourth wave triangle bounce. The implication is more upside before the next big drop. 

A reader (VB) notes in a comment that Neely has found the retracement after an impulse down with an extended fifth often retraces more than 61.8%, in effect bouncing more given the violence of the drop. The next levels after 61.85 (Sp1162) are 2/3, 70.7% and 78.6%, or Sp1170 - 1187. Another way to count this is to end the big drop right before the 'bots drove it down, or at Sp1090 instead of Sp1065. This gives slightly different endpoints of Sp1177 - 1192.

Will this play out quickly? The STU points to a morning observation from Bianco Research: if you think of today as driven by the Euro TARP, the US TARP days were when it was leaked and then when it was forced down the throats of the banks. The first bounce lasted one day; the second two days. The market declined for six more months. 

In the mother of all ironies, traders playing a capitulation low on Thursday may be hoist by their own fat finger: the bullish blather that "this was all a glitch!" may mean the normal capitulation by the bears did not occur. This meme is well explored here and here by Trader's Narrative, a site with penetrating debunking of popular fancies in the market, which concludes: "according to the McClellan Oscillator, the market will make a significant low later this week."

Demographic Destiny and the Long Term Market Picture

My long term view is that after the deflationary depression of the next 5-7 years (to 2014 at least), we will have a rip-roarin' bull market, driven in part by a new family of technologies, including mobile Internet, cloud computing, bio-engineering, and my favorite, nano-manufacturing (a whole new sort of materials assembly). After that innovation wave, however, we will be hitting some huge headwinds against the continuation of the type of increasing wealth we saw from 1870-1914 or 1982-2007. The prime headwind is the demographic demise of many of the current and future economic powerhouses around the world.  

The demographic destiny of the developed countries is already baked in: Japan, Europe and Russia are on a severe downswing in population. The US, Australia and NZ are going to be flattened but not down, due to immigration. China, the purported next great economic leader, will be nothing of the sort: its "one child" policy of its bleak Maoist period combined with its unattractiveness to immigrants dooms it to an aging and shrinking population, particularly after 2020. China is not the next US, but the next Japan. Africa and much of the Middle East are not culturally nor politically oriented to make the great leap forward of China and India, at least in the next 30 years. Latin America has huge potential, but other than Brasil and Chile, seems mired in socialist economies of the sort that have run Argentina through a roller coaster of promise and problems, boom and bankruptcy, for 100 years. This leaves India and possibly Pakistan & Indonesia as the only countries with *potentially* the sort of demographic & economic profile to drive global growth. 

What has not been widely recognized is the seminal importance of "20-somethings" as the driver of growth. Sure, household spending tends to increase into the 50s before slowing down, but much of that spending is on trading up to bigger houses, better cars, more vacations, and investments in children. A trade-up economy is quite different than a first-time economy. It is those 20-somethings who buy "firsts": first house, first car, first appliances, first furniture, etc.  It is those 20-somethings who drive innovation, and who support the social welfare systems for their elders. When the demographic mixture inverts from a pyramid (more youth, fewer elders) to a column (flat all the way up) or a worse to a V (few youth to support many elders), growth slows and welfare implodes. 

Japan today is the model of Europe and Russia in the 2020s. China should rise then decline in the 2030s. Immigration can keep the US, Australia and NZ afloat into the 2040s, but the coming depression may bring a suppression of immigration, as happened in the US in the last depression. 

What this means is a continued low return environment outside of an innovation blip in the 2020s. I have earlier commented on the demographic demise driving a low-yield environment, and on how the demographic demise will shatter the welfare state. When the Powers That Be recognize this inevitability, we might get a change of policies to promote bigger families and easier immigration. Until such a time, the demographic destiny will overwhelm most projections of future prosperity, which tend to be extrapolations of current policies based on past demographic models. 

In my just prior post I discussed the long wave count, and dismissed the near-term debacle of Prechter as overly pessimistic. In the longer term, however, he may be directionally correct. The demographic demise of the West points to one final wave up during the rise of China and India - the 2020 innovation wave - and then a long plateau if not outright decline, marred by wars and civil unrest amidst failing governments drowning in unfundable commitments to the social welfare of the aging. Like any future, this one is changeable with foresight and leadership, but given the long time frame of generations, it must be changed soon or will suffer a baked-in demographic disaster. Just as nine women cannot make a baby in a month, a plethora of wise leaders cannot fix a baby bust in a generation. 

Doug Short on the 1938 Comparison

I thought I would continue in the theme of historical analogues to the current market.  This seems like a good moment since we are in a slow patch: volume dropped late last week as the Labor Day weekend loomed, and is expected to continue light this week as it is a four-day week in the US.  (Typically four-day weeks have light trading and a slight upwards bias; note that typically the market is in an upwards bias 80% of the time.) Hence the technical indicators can mislead.  Friday was a mixed set of signals. Let's wait for a pick up of volume and clearer indications of whether this rally is truly over or has a ways to run.  

In US history this is the fourth Credit Bubble that seems destined to be followed by a Deflationary Depression.  The other three were 1837, 1873 and of course 1929.  We also have the 1989 Japan Bubble to consider.  The first chart is from Doug Short's great site and shows how the current market compares to 1929 and 1989 when you inflation-adjust the results.  The timing between 1929=2000 and 2009=1938 is intriguing.  It would suggest a lengthy down period but not a deeper drop than around Dow6K.  Since 1929 continued after 1938 to a lower low in 1942, this suggests the bottom would come sometime in 2013. 

Will it take a war to turn things? A similar bottom in timing was seen in Japan, but they also bottomed again 20 years after, and have not yet broken out; no war for them, only the Greenspan Indian Summer, which pulled their economy up amidst the global credit bubble.  For the US, even with the war, a good argument can be made that the Dow did not break out of the Depression Doldrums until 1949, or 20 years later.  This would peg our bottom at 2020.  Or after if we fall into the Japanese interminable funk.

Much of what I read tries to assess this crisis as if it were a "normal" albeit deeper recession.  In between the four depressions, we have had a lot of recessions and panics, but there is a fundamental difference between the setup to a recession and the setup to a depression:  a recession comes from excessive inventory and is triggered by tightening, whereas a depression comes from excess credit and is caused by loosening. I like to put it this way: 

• Before a recession, people borrow to buy forward, but are careful to stay within expected future earnings - they borrow against income.  When the recession comes, they can cut back and continue to cover their debt.  They ride it out.
• Before a depression, people borrow much more aggressively, and the bubble spurs them on - they borrow against asset appreciation.  In the '20s, it was against stocks; in the '00s, it was against houses.  When the bubble bursts and the assets drop in value, they are trapped  Their income is insufficient to carry the debt, and they get washed out.  

Which one sounds like today?  

Before the modern management of the economy that came with Keynesianism, recessions were relatively short - under a year.  After the Keynesian belief in managing an economy, recessions have lengthened, but not by much  The normal economy has enormous recuperative powers, especially if left alone.  Excess inventory is cleared out and the factories run again.  During the Great Moderation (1982-2007), we only had two recessions. Before that, we had them around the same frequency as prior to Keynesianism. (Thanks go to Milton Friedman for that, or Alan Greenspan.)

In contrast, after a credit bubble, the depression seems to last around 40 months. The 1837 one ended sometime in the early '40s; the 1873 one ended within four years.  The 1929 one bottomed in 1932. The troubling question is why we fell back down in 1938, and why has Japan never left theirs?  The major distinction between 1929/1989 and prior periods is the massive intervention of the governments to solve the problem.  Could it be stimulus extends the disaster rather than ends it?  We shall soon find out.  

Our current problem started in Dec 2007, and 40 months later would peg the end around 1Q 2011. We shall see if the massive interventions get us out early, or extends the disaster to the end of the next decade.  

One thing should be clear: we are not about to start a new bull market, even if this bear market rally extends for a number of months up towards the 62% retrace (over Dow11K and SP1200). Among many other reasons, consider this other chart from Doug Short. The recent bottom in March was not even close to a level that is a lasting bear market bottom. This chart uses the Shiller methodology to compare P/E ratios to E10, the moving average earnings over the past 10 years. Bear bottoms come with a single-digit P/E10, as low as 5 in 1921 and 1932. We touched 13 last March, not that close to a bottom indication, and have since bounced back up, approaching 20, a level which normally signals trouble ahead (overvalued). In 1938 we got down around 10, and in 1942 below 10. The lasting bottom in 1949 was at 9. This suggests the market can fall another 50% before we approach a lasting bottom.  

In the meantime massive stimulus is rolling over. The grand experiment is ending. Welcome to the petri dish!

The Kondratieff Indian Summer Brings Global Winter

If you click on the category Kondratieff Long Waves you can follow a series of posts on the coming of Kondratieff Winter, the inevitable deflationary depression that follows a credit bubble.   Back in 2005 in Kondratieff Winter and the Greenspan Indian Summer I pointed out how Greenspan was playing a Grand Experiment with History.  He faced a potential K-Winter start after 2000, and he held rates too low for too long to reflate the currency.  It worked for a time, but the prosperity generated was false ($10T debt for $6T GDP growth) and the effort created an even bigger bubble. 

This K-Autumn has been unusually long: 1982 - 2007.  The first three K-Autumns (1822-1837, 1865-1873, 1922-1929) were much shorter. Greenspan at least kept the debt-laden party going for 20 extra years (1987-2007).  Perhaps we should add a K-Indian Summer to the list of seasons.  Or perhaps after the Greenspan experiment fails so abysmally, it won't be tried for another 200 years. Let's explore this in more detail, and estimate the depths of the coming Depression.  

An Historical Perspective on Bailouts

Ah, the Chinese Curse: May you live in interesting times.  As the credit crisis has grown, we see references back to the "forever-esteemed editor of The Economist, Walter Bagehot" (cite below) who argued that in bubbles, the central bank needed to pull back on the credit levers (rates, reserves, margin), and during the inevitable collapse go all in with assistance to keep banks solvent.  Of course, the mistake we keep making is to increase the credit leverage during the bubble, since of course the good times will continue.

The question of the moment is, do these heroic bailouts work?  I urge you to click on this link and read Bob Hoye's analysis.  Summarized below the fold, with a prediction based on history. 

Election Correction is On!

We expected an Election Correction once the Demo's won Congress - the reverse of what happened in 1994 when the Repub's took Congress.  It is now occurring, but with a marvelous twist: it is first occurring in the Dollar in a reaction to Bush, not the Democrats.  The 'good' Republicans in 1994 and the 'bad' Bush in 2006 may turn out to bookend the period of growth and bubbles in the US.  We have undergone a great monetary experiment by the Fed during this period, and have seen the Chinese emerge on the world economic stage through 'vendor financing' of the US trade deficit.   Let's take a look at this story and project out what happens next.

Currency Market

Years ago a pundit (I believe it was James Dines) described the 1980s as a rare currency market, meaning it was reacting to changes in monetary policy, not fundamentals.  At the end of an inflationary Kondratieff Summer, someone finally breaks the back of inflation, and we enter the 'false plateau' of the Kondratieff Fall. In 1980, Volcker broke its back.  In 1982, we entered the false plateau - the "decade of greed."  Once inflationary expectations were flattened, all financial assets were undervalued, since their future cash flows would have been heavily discounted against inflation.  Once their discount rate is lowered, they immediately are of higher value.  With the magnitude of Volcker's success the re-marking to market was quite a spread.  It took a while for markets to catch up to the new reality, but they did, faltering only in 1987 with a new Fed chairman and a change in US monetary policy, to cheapen the Dollar against the Yen.  Today, with markets in lockstep - a very unusual circumstance - are we in another Currency Market?

Good Deflation and the Greenspan Indian Summer

The recent stock drop worldwide is a warning shot across the bow of the Fed, to come to grips with the growing imbalances in the world economy.  The borrowing of 8% of US GDP from the rest of the world is not a sign of strength of the US economy but a transfer of wealth to the rising economies in Asia.  What we are seeing is the coming to an end for the Greenspan Indian Summer, this period of unexpected growth and prosperity that the Fed created by flooding the economy with liquidity after the stock market crash from 2000-2002.  Greenspan is fairly clear (for a central banker) that he was attempting to stave off the deflationary depression that normally follows the bursting of an asset bubble - the so-called Kondratieff Winter, which is a bit obscure in mainstream economics but was mentioned by name by Greenspan.  The latest Fed chairman is a self-acclaimed expert in deflationary depressions, and got the nickname Helicopter Ben for a speech he gave in which he said the Fed could always prevent a Kondratieff Winter by helicoptering in money and dropping it on the economy.  But did their inordinate fear of deflation, and misreading of the current situation, cause them to over do it?  Let's take a deeper look.

Bull Flu Disease

A roundup of analysts beyond Prechter show a convergence of views from different starting points, indicating a serious correction in 2006 but a delay in the Big One Down until after 2008.  This is consistent with the Yelnick view that 2006 will be a down year under the four-year cycle, but the downturn would not begin until late May/June - this is why last year's call of a top by Prechter was called a Wolf! Wolf! call - and that the real downturn will be delayed until after the 2008 Olympics because the Chinese will spend what they have to to keep it going until then, their Y2K moment. Let's take a look.

Kondratieff Winter and the Greenspan Indian Summer

When Greenspan made his recent remark that he knew how to beat the Kondratieff Winter, it brought to the forefront what had been an obscure problem in economics.  The Kondratieff Winter is the deflationary depression that follows a speculative bubble.  Every major bubble in US history has led to Kondratieff Winter: 1837, 1873, and of course 1929.  Fortunately, they don't happen very often - about once a generation.  Unfortunately, it is our time.  Greenspan's prescription is to provide massive liquidity, which he certainly has done since the dot-com bubble popped in 2000.  Has he staved it off?

The mainstream business press is beginning to focus on this issue.  The Wall Street Journal ran a front page report at on the conundrum that Greenspan faces: by providing such liquidity, he may have staved off the Kondratieff Winter (for the moment), but he has created distortions elsewhere, in the real estate bubble, increasing trade deficit and massive US borrowing from overseas.  The New York Times Sunday Magazine ran two pieces the same week, perhaps unintentionally connected, one on Gold Bugs patiently waiting for a return to a gold standard following a Dollar collapse due to excessive debt, which is the cause of the Kondratieff Winter; and the other one about semi-luminaries in Silicon Valley still striving to make a killing, having not made enough during the bubble ("$10 million is but chump change") - they still believe another bubble awaits their good fortune. Since then we have had so many real estate bubble stories that one could say that there is a real-estate-bubble STORY bubble.

This is a high contrast issue for investors.  In a Kondratieff Winter, cash is king, and one needs to conserve it to survive the period.  In a Kondratieff Spring, a rising tide lifts all boats, and an investor should be "all in."

Muddying the issue is that every crash has a bounce, a wave 2 or wave B, before continuing to drop.  Investors who were confident at the prior top are even more convinced during the bounce that they caught the bottom. Normally the bounce comes quickly, and ends quickly; but this drama has unfolded in an unnerving slow-motion for the past five years.  This makes it even harder to discern the onset - or the end - of the Kondratieff Winter. Which is it?  Investors remain bullish, and the Cassandra's are dismissed. (As a living example, check all the comments to the recent Wolf! Wolf! posts; the uber-Cassandra, Prechter, has called the top prematurely so many times his opinion is now a contrarian indicator.)  Yet we must remain cautious about whether 2003 marked the bottom.  The normal markers of a bear bottom were not present - low P/E ratios, lack of interest in equities, and a burst of new investment based on fundamentals.  Instead, we have the disturbing trend of massive US borrowing to keep the economy afloat, a truly unprecedented occurrence.

Clearly Greenspan's efforts, combined with Bush's fiscal profligation and the expense of the war in Iraq, have all contributed to smooth over the brief recession after 2000 and pave the way for a slow-motion unwinding of the excesses of the bubble.  We have experienced few of the types of problems that we went through in the three prior K-Winters.  Even the mildest of them, from 1873-1896, was a worse deflation, and in the final three years, 1893-96, a much steeper recession (they called it a Great Depression at the time).  Are we past it?  Did Greenspan stave it off?  Or is it awaiting us in the next ten years?

In the middle of the Greenspan Indian Summer, it is time to consider this issue. 

Greenspan and Beating the Kondratieff Winter

Greenspan made a remark years ago that he knew how to beat the Kondratieff Winter - the period of deflation that follows a stock crash and debt overhang - by providing massive liquidity (ie. printing money). The Mogambo Guru (pseudonym for an occasional writer for Barron's and other financial publications) opines, in his own immutable style, on the bigger mess that Greenspan may have made by following this latter-day Keynesian advice. The full piece is in today's Daily Reckoning. Here are some excerpts, with emphasis added:

"America has become more of a debt 'junkie' than ever before with total debt of $40 trillion, or $136,479 per man, woman and child. ... And then when you divide this $40 trillion cumulative debt by the 70 million people whose jobs are not government jobs or are paid with government money, then those poor 70 million private-sector workers have to work to pay off $571,428 apiece! Hahahaha! Whose idiotic idea IS this? Hahahaha!

K-Wave V: The Rise of Machines

Thinking about the K Wave question: will the coming always-on world being brought to us by widespread broadband and wireless connectivity be the new factor of production that takes us out of the K-Wave Winter and starts the cycle anew? 

A broader new factor is digitization, of which the always-on world is a subset.  It may finally take us out of the 'paperless' office into a new paradigm where documents are not created with the intention to print but created for a pure digital existence.  More generally it will spawn a vast collection of web services, which are machine to machine communications.   

We have only so much attention time to give to always on communication, but our machines can talk to each other orders of magnitude more.   They will allow the scaling of an information economy beyond the bounds of the prior analog world.

Kondretioff Rules

Yelnick has received some questions regarding whether the Kondretioff Wave conditions have been satisfied, which would be another supporting condition for a new bull market, or whether a major deflationary debacle awaits.  Like all cycles,  the K Wave is more descriptive than prescriptive (Elliott Waves are more prescriptive than cycles), but provides enormous insight into our current  economic condition.

The K wave was identified in the '20s by Kondretioff,  a Russian economist who studied capitalist systems.  When asked by Stalin in the '30s if the Great Depression was the collapse of capitalism predicted by Marx, he said no; based on his work, the West would rise again.   For his insight, he was sent to the Gulag.  Unfortunately for him, he never returned.  Fortunately for us, his work filtered  out.

The K wave is a 54 year cycle (+/- a year or so) with internal phases that are sometimes characterized as seasons: spring, summer, etc.  Spring   phase: a new factor of production, good economic times, rising inflation.  Summer: hubristic 'peak' war followed by societal doubts and double digit inflation.  Fall:  the financial fix of inflation leads to a credit boom which creates a false plateau of prosperity that ends in a speculative bubble.  Winter: excess capacity worked off by massive debt repudiation, commodity deflation & economic depression.  A 'trough' war breaks psychology of doom.  New factor of production emerges, happy days are here again, cycle begins  anew.

K-wave I: 1789 - 1842.  New   factor:  canals.  20 good years. 1812, peak war. US invades Canada, gets slapped back.  White House burns. 1815-1824, inflation, turmoil, weak Prez (John Quincy Adams), end of Federalist rule.  1828, Andy Jackson elected, false plateau of prosperity. 1837, Bank of US cancelled, severe depression, deflation.  Ends with trough war, Remember the Alamo! we win Texas from Mexico.

K-wave II: 1843-1896.  New factor: RRs.  1861, peak war. 1865-1873, reconstruction, inflation, Prez   impeached.  Turmoil. 1873, RR fiasco, financial panic.  First bought of deflation as Civil War inflation ended.  False plateau of growth.  1879, return to gold standard.  Second RR bubble bursts.  Deflation continues. Ends with trough war, Remember the  Maine! we conquer Spain's remaining colonies. 

K-wave III: 1897-1949.  New factor: oil/autos.  20 good years.  US becomes world economic leader.  1914, peak war to end all peak wars.  1919-1925, inflation, turmoil, scandal (teapot dome).  Coolidge becomes Prez.  False plateau. Roaring  20s.  1929, Crash.  Depression.  Severe deflation.  Ends with trough war, Remember Pearl Harbor!, Pax Americana.

K-wave IV: 1950 - 2004 (?).  New factor: aerospace.  20 great years.  American Century. 1966, peak war: Vietnam!  Rising inflation.  Wage and price controls.  Oil crisis.  Nixon resigns.  Vietnam war is lost, American innocence gone, stagflation, Prez Carter blaming malaise not on government but on the people. 1980, Reagan elected.  Morning in America.  Volcker kills inflation.  False plateau!  Greed is good.  1990s, deflation in Japan, dot-coms in US, Greatest Asset Mania of All Time, bubble bursts, now in longest bear market since 1930s.  On schedule, trough war, Remember 9/11! we go into nation building. 

Most of the primary K-Wave predictions have been satified.  We have had the K-Wave false plateau followed by a speculative bubble. We have had deflation in commodities for a while, and some currency deflation (eg. Japan).  We have had enormous rolling debt repudiations: Mexico, Asian Flu, Long Term Capital  Management, Telecom bubble companies. We have started our trough war (War on Terror). NYFD is heroic again!

Is the cycle turning? In timing the K-Wave would nominally end now, in the period of 2003-2005.  But two caveats. First, in previous cycles we had much more severe economic disruption - the downturns in 1840s, 1880s and of course 1930s were considered depressions.  Second, the new factor that leads us out of economic hardship should be emerging.  It might be broadband/wireless - the always-connected world - but that was the subject of much of the bubble!  So while the new factor is apparent, the K-Wave Spring recovery is not yet emergent.  Both caveats suggest more trouble ahead, and more likely bottoming in 2004 or later than now.