How You Know When
The Bubble Bursts

• Signs of bubbles everywhere – here’s how you know when they’ve burst
• After 10 years of easy money, investors may be in for a shock
• Ice-Nine comes to the desert while Saudi political targets scramble for gold

Connecticut, USA
Saturday, 18 November 2017

Dear Reader,

The following five articles represent this week’s ‘indications and warnings’ for the next market crash.

I suggest you read them…inform yourself and act accordingly (learn how here.)

Because when the bust happens, it’ll happen quickly. But by then, it’ll be too late.

Let’s get to it…

I. YOU KNOW THE BUBBLE IS BURSTING WHEN THE LAST BEAR THROWS IN THE TOWEL.

To paraphrase one of the great gems of Wall Street wisdom, ‘Nothing infuriates a man more than the sight of other people making money.’

That’s a pretty good description of what happens during the late stage of a stock market bubble.

The bubble participants are making money (at least on a mark-to-market basis) every day, while the more patient, prudent investor is stuck on the sidelines allocated to cash or low-risk investments, watching everyone else have fun.

This is especially true today when the bubble is not confined to the stock market, but includes exotic sideshows like cryptocurrencies and Chinese real estate.

It gets even worse when investors are taunted by headlines like the one in this article, ‘Investors Can Either Buy Bubbles or Be Left Far Behind.’

This article is a case study in the ‘Bubblicious Portfolio.’ Infuriating indeed.

Actually it should not be. On a risk-adjusted basis, the prudent investor is not missing much.

When markets go up 10%, 20% or more in short periods, market participants think of their gains as money in the bank.

Yet, that’s not true unless you sell and cash out of the market. Few do this because they’re afraid to ‘miss out’ on continued gains.

The problem comes when the bubble bursts and losses of 30%, 40% or more pile up quickly. Investors tell themselves they’ll be smart enough to get out in time, but that’s not true either.

Typically investors don’t believe the tape, they the ‘buy the dips’, (which keep dipping lower), then they refuse to sell until they ‘get back to even’, which can take ten years. These are predictable behaviours of real investors caught up in real bubbles.

It’s better just to diversity, build up a cash reserve, have some gold for catastrophe insurance, and then wait out the bubble crowd.

When the crash comes, which it always does, you’ll be well positioned to shop for high-quality bargains amid the rubble.

Then you’ll participate in the next long upswing without today’s risks of a sudden meltdown.

II.  SIGNS OF A STOCK BUBBLE ARE EVERYWHERE. HERE’S ANOTHER ONE.

The article above described the stock market (and other markets) as a bubble.

Where’s the proof for this?

Actually, it’s everywhere…

The Shiller CAPE ratio is at levels only seen at the 1929 crash that started the Great Depression, and the 2000 dot.com bubble.

Likewise, the market capitalisation-to-GDP ratio is above the level of the 2008 panic and comparable to the 1929 crash.

The list goes on, including consecutive days or weeks of market advances, historically low volatility, near-record P/E ratios and unprecedented complacency on the part of investors.

This article adds another warning sign to the list. It points out that certain high-yield (or ‘junk bond’) indices have fallen below their 200-day moving average.

This can be indicative of a stock market correction. Junk bonds are riskier than equities. When they get in trouble, it’s a sign that the corporate issuers are having trouble meeting their obligations.

That in turn is indicative of reduced revenues or profits, tight financial conditions, and lower earnings.

Panics in October 1987 and December 1994 were preceded by distress in bonds about six months earlier.

While there is no deterministic relationship, bonds are a good leading indicator of stocks because they are higher in the capital table and feel distress sooner. 

The October 1987 one-day 22% decline in stocks, and the December 1994 Tequila Crisis in Mexican debt were ugly for investors.

The bond market gave a six-month early warning both times. It may be doing so again.

III. AFTER TEN YEARS OF EASY MONEY, INVESTORS MAY BE IN FOR A SHOCK

It’s true that the Fed has been raising interest rates since 2015, and had engaged in tapering for two years before that.

Yet, these actions hardly constitute tight money.

The tightness or ease of monetary policy needs to be judged relative to financial and economic conditions.

You can have ‘easy money’ at a 10% interest rate if inflation is running at 15% (something like the conditions of the late 1970s). In that world, the real interest rate is negative 5.0%, (10% - 15% = -5%).

In effect, the bank pays you to borrow. That’s easy money.

By most models including the famous Taylor Rule, rates in the US today should be about 2.5% instead of 1.0%, so we have easy money today and have had since 2006.

This comes on top of the ‘too low, for too long’ policy of Alan Greenspan from 2002- 2004, which led directly to the housing bubble and collapse in 2007.

The US really has not had a hard money period since the mid-1990s. That’s true of most of the developed economies also.

What’s going to happen when central banks start to normalise interest rates and balance sheets and return to a true tight money policy in preparation for the next recession?

We’re about to find out.

This article describes how central banks all over the world including the Fed, ECB, and the People’s Bank of China are in the early stages of ending their decade-long (or longer) easy money policies.

This tightening trend has little to do with inflation (there isn’t any) and more to do with deflating asset bubbles and getting ready for a new downturn.

But, in following this policy, central bankers may actually pop the bubbles and cause the downturn they are getting ready to cure.

This is one more reason, in addition to those described in the articles above, why the stock market bubble is about to implode.

IV. WITH THE PARTY CONGRESS OVER, CHINA COOLS OFF RIGHT ON SCHEDULE

We told our Strategic Intelligence readers not to expect financial fireworks in China through 2017.

The reason had to do with a Communist Party Congress that happens every five years and just concluded.

China’s President Xi Jinping wanted a second five-year term and expanded powers from the Congress, and he got it.

He also wanted to make sure that there were no adverse developments in the Chinese economy or capital markets that could disrupt his plans.

So China goosed their economy with debt-fuelled infrastructure spending and kept a lid on interest rates, currency fluctuations and capital outflows until the Congress was over.

Now that it is over, ‘Big Xi’ will begin to tackle China’s economic imbalances using his new political power.

This means more bankruptcies, less infrastructure spending and a slower economy.

This article shows how those changes are already taking effect and reveals clear signs of slowing Chinese growth. This will only get worse.

Xi may not get the soft landing he expects, and may find that by removing stimulus in the form of bank debt and low rates, he may actually pop the stock market, real estate and debt bubbles that have been keeping China going.

This happening in China at the exact time the US is going through a similar tightening process raises the prospect that the world’s two largest economies, the US and China, could hit the brakes simultaneously and bring global asset bubbles crashing down around them.

Investors are smart to increase their cash allocations until the gigantic economic experiment is over.

V. ICE-NINE COMES TO THE DESERT. SAUDI POLITICAL TARGETS SCRAMBLE FOR GOLD.

In my most recent book, The Road to Ruin, I describe a phenomenon called ‘ice-nine’.

The idea is that in the next financial panic, regulatory authorities will not be able to print money or lower rates enough to stop the panic because they failed to normalise rates or balance sheets after the last recession.

Liquidity will drain out of money market funds and the government will have to suspend redemptions to prevent a collapse.

Investors will then turn to banks for liquidity and the only response will be to close banks. Then investors will dump stocks, and the stock exchanges will close, and so on. One by one, the entire system will be ‘locked down’ to stop a liquidity crisis that’s bigger than the central banks’ ability to liquefy.

I got the idea for ice-nine from another book, Cat’s Cradle, by Kurt Vonnegut. In that book, a doomsday machine in the form of a water molecule called ice-nine is unleashed.

The molecule is frozen at room temperature and turns water into more ice-nine when it comes into contact. Eventually all of the water on earth turns to ice-nine and life on earth dies in a frozen wasteland.

That seemed like a good metaphor for how the financial system will be locked down little by little until the whole system is frozen.

Some readers objected that this could never happen.

My answer is that it happens all the time.

In 2013, the banks in Cyprus were frozen.

In 2015, the same thing happened in Greece.

In 2017, the Spanish government shut down banks in Catalonia in response to an independence movement.

Banks in Puerto Rico were shut when the power went out after Hurricane Maria. Every bank in America was closed shut in March 1933.

As the article shows, bank accounts of political targets are being frozen today in Saudi Arabia.

Whether the reason is financial panic, natural disaster, or political targeting, the result is the same.

Freezing bank accounts is the first resort of governments trying to maintain control.

When sceptics say, ‘It can’t happen here’ I point out that is what people all around the world said until it happened to them.

All the best,

Jim Rickards
for The Daily Reckoning Australia