Kondratieff Wave

January 19th, 2011
The Great Recession has been officially over for a long time now. Stock market is up, Wall Street is celebrating record bonuses this year. Banks will soon hand out dividends for the first time since the recession. Bernanke says recovery will be slow and some others call it the jobless recovery. Unemployment rate is at around 9.4% and remains stubbornly high compared to earlier recovery periods that followed recessions. How come? What is special with this recovery that we do not quite see it for the main street? Or will the unemployment problem drag us down for a double dip recession?

Are We Heading for a Double Dip Recession?

Let’s face it: If the economy were doing great, Federal Reserve would not feel the need for Quantitative Easing 2 (QE2). Bernanke made it clear he wanted lower mortgage rates, lower borrowing costs to fuel the recovery that seems to be a mirage we keep chasing. The day Bernanke announced he would print money marked the day of the US dollar bottom and the buck started to rally taking mortgage rates up with it crushing the bond prices. How did that happen? We thought Bernanke said he wanted lower rates!? We will discuss this illusion of FED control when we discuss the stock market below.

Housing market seems to be turning down again. Unemployment is not any better, even though the rate of job losses has slowed down. Stock market is a bright spot, but could it be irrational exuberance? How about commodities? Is expensive oil good for our economy? Food prices are going up. And GDP is up but debt is up even more. It looks like a mixed picture. Let us discuss the details.

Credit Deflation

Even though Bernanke is printing record amounts of money, we are not seeing inflation. Base money supply is more than tripled since 2008. But where is the inflation? The answer may be a surprise to you. Our money is not what Bernanke prints. But it is what we borrow! We have reached the end of decades old era of credit inflation. FED made credit easy, America borrowed for decades. An entire nation cannot borrow non-stop, inflate the money supply and then hope that all will be fine when the pay back time arrives. Our economy is addicted to ever expanding credit. Banks create money when we borrow. This is why US dollar lost it’s value for decades. We have inflated the money supply with debt. But the real problem is that the banks demand that this money be paid back with interest. Thus entire money supply is X and we need to pay back X+I. So, without further borrowing, there are not enough dollars to pay outstanding debt. This is what causes deflation. This is why people foreclose. This is why people go bankrupt. To understand deflation better, read this free deflation report:

In a credit based economy, even if the FED prints money, total money supply which is money+credit, can contract. If creditors suspect Bernanke will print, then they will refuse to lend money at low rates and this is going to be deflationary for credit dependent sectors.

Here is a chart of base money supply. This is what FED printed in history:

Here is total credit market debt, the money we borrowed and promised to pay back with interest:

Here the point being made is that the printed money is less than 3 trillion while the total interest bearing debt is more than 50 trillion. Debt cannot be paid back without further borrowing and borrowing has stopped. Deflation in total bank credit is visible in this chart for the first time in many decades:

As seen in these charts, the amount borrowed is the money supply. And we promised to pay back with interest. If borrowing does not increase exponentially, there won’t be enough money in existence to earn to pay debt. Deflation is the real threat we are facing.

GDP is up, the media has been celebrating it with great fanfare. But the debt lurking beneath the surface is reaching excessive levels even for the United States government. The music is about to stop when the U.S loses her pristine credit grade. That will increase borrowing costs for us all and the free ride will end up in a disaster when we hit the wall.

Here is the chart for United States GDP:

Debt has two sides: Public Debt, Private Debt. 2008 crash was the result of excessive private debt. We have converted some of that debt to public debt, but in both cases, we are still in danger territory.

Here is the total public debt which is increasing faster than the GDP:

More and more portion of our taxes are spent paying interest on national debt. With this rate of debt increase, we will soon need to raise taxes to pay interest on our debt.

PIIGS are in Trouble - European Debt Problem

United States is not alone. Europe is in similar debt trouble as well. PIIGS require bailouts one after the other. Greece, Portugal, Ireland had the spotlights on them. Spain and Italy seems to be next. However, when they get their bailout, all that happens is that the can is kicked further down the road where the snowball will get bigger and face us again.

Austerity is not going to fix it. Ireland is in debt trouble. But how did they get into trouble? It is worth remembering that Ireland’s government was a model of fiscal responsibility prior to the economic meltdown. It had run large budget surpluses for the five years prior to the onset of the crisis. Ireland’s problem was certainly not out-of-control government spending, it was a reckless banking system that fueled an enormous housing bubble.

Now Ireland is being forced to severely lower the standard of living just so the bankers who swindled the country off of a cliff could be bailed out. The people of Ireland are now servants to the IMF and the bankers who were bailed out with tax payer money.

The problem is not reckless spending. The problem is the interest based economy and fractional reserve banking system. The ultimate solution is debt free monetary system, but we have to end the FED before we can get there. Debt based monetary system and debt free monetary system and the related history are discussed in the excellent book Web of Debt by Ellen Brown.

Public debt across the developed world is exploding while emerging markets are having a better time. Here is a world wide chart of public debt:

Double Dip in Stock Market?

If we look at the stock market alone, we would think that the economy is doing great. Stocks are making new highs since the recession lows. Commodities are soaring. Food and energy prices seem unstoppable even though some of this may be related to supply problems rather than demand. It is hard to imagine businesses, factories to do well, to increase profits and to hire more when their cost is going up! Remember: Record high oil prices, record low US dollar price did not prevent the 2008 crash. US dollar now is higher than the good old days when it was goldilocks economy, despite the printing press of the FED.

While the stocks are flying high, ironically, the Baltic Index that measures rates for dry shipping is steadily going down for the last few months. One could argue that shipping rates are down due to capacity increase. But we can also claim the projected demand for that capacity increase failed to materialize. Here is Baltic Dry Index:

According to the socionomic theory, stock market is a barometer of the social mood. When the crowd psychology changes, it is first reflected in stocks and the rest of the economy later. This is because it is easy to buy/sell stocks first and then make economic decisions such as hire/fire employees or start a business, expand capacity, or reduce it. In other words, people’s mood changes first, and it becomes apparent in economic indicators later. This explains why stock market goes up first and recession ends later. Similarly, stocks can decline first and a new recession can be declared well into the stock decline. Similarly, good news appear in market tops, and bad news appear in market bottoms. This is why investors need to sell on good news and buy when blood runs on the street. So where are we now? Let us connect the dots.

Bernanke made it clear that he wants higher stock prices to create a wealth effect. In our stock market driven economy, as the stocks move higher, investors’ confidence will spread into the other parts of the economy and may hopefully create more jobs.

The truth is that the FED does not control the markets. It only appears to do so when the markets move in the same direction. FED slashed rates, bailed out banks and companies during the 2008 crash but that did not prevent the markets from sliding further. Yes, the FED wants higher stock prices and yes they may manipulate stocks to provide market support, but the FED’s plunge protection team does not always succeed. The market is too big even for the FED.

Polls of money managers, as reported by Barron’s, USA today, Bloomberg indicates extreme bullish sentiment. Everybody thinks 2011 will be an up year for the stock market and that is a troubling sign from a contrarian trading perspective.
 
Optimism is at extreme levels in stocks. Everybody is going in hoping that they will sell to the greater fool. But the technical indicators about the market are ringing the bells. We have extreme bullish sentiment by various measures:

• Mutual Funds Cash Holdings
• Annual Dividend Yield and P/E Ratio
• Daily Sentiment Index
• American Association of Individual Investors (AAII) Poll
• Bull-Bear Spread
• Put/Call Ratios and
• VIX
• Intraday Trading Index (TRIN)
• Momentum Indicators: TICK, Closing Premium, Upward Gaps, Open TRIN, Volume

If you like to follow these kinds of contrarian technical indicators then you may find this interesting: Short Term Update at Elliottwave International for frequent analysis of the markets, or the monthly Financial Forecast and Elliott Wave Theorist for the big picture.

Technical conditions indicate a stock market top, rather than a stock market bottom. When everybody is so sure that stocks will go up, or will go down, generally the opposite happens. This is because if only 3% of traders are bearish and 97% are bullish, it means that we ran out of people who will change his mind and buy. Similarly, it means we have alot of people who can potentially change his mind and start selling!

Bernanke wants the stocks to go up to create a wealth effect. This is no more than a scheme to keep the population content. Nominal stock prices held up since 2000, but the disaster in stocks is visible in this DOW chart priced in Gold. Stocks are a zero sum game. As long as the money supply does not expand, stock market does not create wealth. It only shuffles it. Investors who time the market well end up making money at others’ expense. Buy and hold is long dead. Trading stocks, market timing is the new game. During 1980s and 1990s, we had a huge boom in credit. We literally created money by borrowing and this new money inflated the stocks. But money supply is not inflating anymore. If we were to use our entire money supply to invest in stocks, it would send the stocks higher. But then when we sell, we would get back exactly the same money, only distributed differently among the market participants. So, how is this observation relevant now? Today the problem is money supply, that is the broad measure of money supply: M3 is deflating.

If you find yourself wondering why whatever investment you touch ends up losing you money, you will not be alone. During deflation, cash will be the only place to hide. Do not try too hard.

Here is some laugh with Willie E. Coyote where whatever he does, he ends up losing:

Technical indicators suggest, on the long term, major market bottoms have certain characteristic and this stock market big picture study shows 2009 stock market bottom was not one of them. If we are indeed at a top, then the coming double dip recession is going to be one of the major recessions we ever had, or perhaps the next Great Depression.

Housing Market Double Dip

What about housing? Housing sector is supposed to be the engine of job creation and growth. After the first time home buyer credit expired, housing market resumed it’s down trend. We do not see a recovery in housing yet, however prices are not going down that fast either. We keep hearing that a wave of foreclosures will bring down the home prices. Recently CNBC claimed double dip in housing is a sure bet. But experts have been saying that for sometime now. When is it going to happen? Let’s take a look at the quotes:

“[Standard & Poor's] predicts the nation is about to see a deluge of new foreclosures that will drive real estate values back down.”
– The National Policy Institute (February 19, 2010)

“I believe we are about to see a tsunami of foreclosures.”
– Saxo Bank Chief Economist David Karsbol on CNBC (August 25, 2009)

“The housing market is about to get hit by a new wave of foreclosures.”
– National Public Radio (April 15, 2009)

The coming deluge/ tsunami/ wave of foreclosures has been long predicted, yet stubbornly hasn’t show up. Indeed, 1 million foreclosures in 2010 and a record 1.2 million forecast for 2011 is nothing to scoff at, but it has not pushed the prices down yet. First time home buyer credit provided some support for home prices but since it has ended prices started to come down. If we head for a Great Depression type crash, maybe a long one in Japanese style, then property value can continue to decline for decades, little by little every year!

Banks are not in a hurry to foreclose and sell their inventory. Some people simply do not pay their mortgage and they live rent free allowing them to spend on other consumer items and pay down credit card debt. If the bank were to foreclose and sell the property, then it would have to take the loss. Where as if the banks does not foreclose the property it can still claim it is worth the original mortgage amount and as long as liquidity crisis does not hit, the bank remains solvent. With a blank check from Bernanke, they can keep selling their foreclosures at a slow rate. This keeps the home prices inflated. On the long run, how this helps to the American people is not clear. After all, it is better to have affordable homes rather than expensive homes. Why would you want to work more to pay for your home? If home prices go up across the board, when you sell, you can only buy another one. It is not true wealth. Higher home prices only help the bankers who lend money that does not exist and they demand interest for it. This is the ponzi scheme banks are running and the government wants housing bubble to continue. However, if we ran out of borrowers there is not much Uncle Sam can do. Credit inflation does not work beyond certain point. Jaguar Inflation analogy is a good one to explain the credit problem.

2010 was the year of short sale. Obama promised to bring down foreclosures, so the banks were ordered to do their best to accomodate short sales. The irony was that there’s nothing short about trying to buy or sell a house via a short sale. It’s usually the longest, most drawn out means of buying a home, and it often ends in failure. Many buyers experience of jumping through hoops for many months as they wait for the bank(s) to approve their short sale offers only to be denied.

In the meantime, the owner of the property, who was intent on doing the noble thing to avoid foreclosure by selling the apartment for less than the purchase price, couldn’t hold out any longer and ended up filing for bankruptcy. Bank loses, buyer loses, seller loses.

That led to the “agony”: Banks, once the grand facilitator to achieving the American dream of home ownership are now the ultimate impediments to that dream. While mortgage rates stand at historically low levels, the increasingly strict lending standards of institutions make it harder for even the most creditworthy person to buy a home.

In the end, the seemingly confounding scenario was exactly as Conquer the Crash anticipated back in 2002:

So, the big question is — how have things fared since then? Has the “agony” of a fear-stressed housing slump finally turned into a confidence-inspired recovery?

Well, in the days following home buyer credit, a slew of upbeat housing reports emerged that prompted the mainstream pundits to declare that yes — in fact — the worst was finally over. Among them:

• US housing starts leapt to a four-month high.
• New home sales gained 6.6%.
• US existing home sales soared 10%, the strongest gain in nearly 30 years. In the words of one major news outlet: “Realtors: US Recovery Has Begun. We’re clearly seeing a solid bottom in the housing market. The overall direction should be a gradual rising trend in home sales.” (Associated Press)

Flash ahead to today, and it’s plain to see that said “recovery” in housing never existed. Like a weakened scaffold, the supposed “floor” of falling values dropped out beneath the sector once again, leading to even further losses. Here, this January 11, 2011, news item fills in the details:

Housing Double Dip Accelerates in June 2011

Readers interested in housing should be aware that prior downturns in housing did not recover for decades. If you need a home to live, it may be a good time to buy an affordable place cash down or little debt as long as your savings from rent covers your cost. The rule of thumb is that if your 10 year rental income/savings cover the entire purchase, it is a good buy. If the ratio is 15 years, it is average deal. But if it reaches 20 years and beyond, then the price is too high. And in many markets in the US P/E ratio for homes is still at 20 times and is not a good investment. Going forward, if deflation intensifies, rents may go down as well.

Buying a home for investment purposes is a big bet. Unless you have specific knowledge about new developments in a prime location, then your chances of making money is more like a gamble. You will be betting on the price, and the place. Japan has seen declining property values for decades. United States is not immune. People say Bernanke will print money. As seen in the latest episode of QE2, printing money can scare creditors who will refuse to lend money at low rates. Thus, it can be deflationary. Keep in mind, Japan has fiat currency. If deflation was easy to fix, they would have fixed it by now. In Japan demographics is not helping. But similar baby boomer problem exists in the U.S. As more and more percentage of the population is aging and retires, they borrow less and spend less. For many Americans their home is their only investment to fund their retirement. Thus, we can expect that supply of homes, especially single family homes for sale will continue to be there for a while.

Double Dip Unemployment

Unemployment is not getting any better. But if we head for a double dip, staggering job losses of 800 thousand per month may appear again. You may hear that unemployment rate is going down. But the government uses different criteria to count count these numbers. The official rate is called U3, and there is a broader measure that is U6. U6 is skirting with Great Depression levels now. Percentage of people who are actually employed is going down. That is not a good sign unless we found a new way, a well fare economy where we don’t have to work but still deserve all the fruits of creation. Only in our dreams, right? New job creation is still below break-even levels compared to population increase. Most of the decrease in claims is due to discouraged workers falling off the radar.

Current unemployment rate compared to other recessions:

Is it a Single Dip Depression?

Today the debt problem is much bigger than the days of Great Depression. Back in 1930s and 1940s private debt to GDP ratio was much lower. An eye opening chart clearly shows the extent of our problem in “Surviving Deflation” article. After Great Depression, debt to GDP ratio went up because GDP was going down. During the World War 2, United States public debt went up to 100% of GDP and eventually we grew out of that debt by expanding our productive capacity. We became the production center of the world and we helped the world to rebuild after the war. Many people today point out that today’s public debt problem is not as bad as World War 2. There are two arguments against that: 1. In the old days private debt was not as high as it is today, thus the economy had room to live with public debt. Today BOTH private debt and public debt are at record levels which is a major difference. 2. When we borrowed during World War 2, we sold bonds to the Americans and we built the greatest manufacturing capacity the world has ever seen. Today, if anybody is doing that it is China. Not United States. Merely borrowing to buy Chinese consumer items is not going to make a lasting recovery. Consumer consume, go into debt. Only producers prosper.

Gary Shilling’s article “Here Comes a Double Dip Recession” explains various reasons why double dip is a strong possibility. Gary Shilling states while inventory liquidation is helping the recovery, other major engines of growth such as employment, consumer spending, residential construction are lagging. Consumer is still deleveraging and it is likely to last a decade before we reduce debt to GDP ratio to a sustainable level. Without home equity, consumers are not able to borrow and spend. It is possible that structural employment problems are here to stay and unemployment may never get back to it’s low levels again, not in the near future. Employers are cutting costs driving productivity higher. Many employers cut back their contribution to 401K plans and some have totally eliminated them. State and local governments are broke and once the federal money dries out, mass layoffs are coming. Given that private businesses and government agencies are slashing jobs, the consumer cannot spend extravagantly. There is talk of spending cuts across the world. Austerity is the popular term. Even mortgage interest deduction is being questioned. Housing struggle continues and we are already in a double dip crash in some sense. Given the huge overhang of excess house inventories and resulting further price declines, it will be years before residential construction shows any meaningful rebound.

Our Keynesian deficit of 1.5 trillion is funding about 50 to 60 million jobs in America. You can calculate it when you consider average salaries and velocity of money. This is not sustainable. Rest of the world will not keep lending us money so that we can consume what they produce.

This is well described in Peter Schiff’s Island analogy:

A couple of Chinese, and an American got stuck in an Island out in the ocean. In order to survive, they made a plan. Chinese would hunt, pick fruit, raise crops, carry, cook and wash. American would eat. When an economist looks at this Island, he says “look if American did not exist, the Chinese would not have jobs”. This is not true. In order to improve their life style, the first thing Chinese will do is to kick the American off the Island!

The clock is ticking. When we can no longer borrow, today’s unemployment will be a pleasant dream. Great Depression is going to pale. This is how empires end. Printing money, borrowing money are not the signs of a healthy economy. They are the signs of a dying economy.

Demographics is not helping: Baby boomers are beyond their peak spending years. They are going to sell their homes. It is their main investment that was supposed to fund their retirement. They are going to sell their 401Ks. This is going to cause further contraction in credit markets. Stock prices will have headwinds ahead. Home prices will have constant pressure due to boomers trying to downsize, move to retirement homes or live with their children.

Economic conditions do not point to sustained prosperity for the United States. In fact, there are reasons for 100 years of lackluster economy and lagging stocks. Conquer the Crash laid out the reasons back in 2002 and the crash has started exactly as explained. It is a must read to understand how bad it can be. History had examples of it. We are not immune.

Right now, you can download the 8-chapter Conquer the Crash Collection, free. It includes:

• Chapter 10: Money, Credit And The Federal Reserve Banking System
• Chapter 13: Can The Fed Stop Deflation?
• Chapter 23: What To do With Your Pension Plan
• Chapter 28: How To Identify A Safe Haven
• Chapter 29: Calling In Loans & Paying Off Debt
• Chapter 30: What You Should Do If You Run A Business
• Chapter 32: Should You Rely On The Government To Protect You?
• Chapter 33: Short List of Imperative ‘Do’s’ & ‘Don’ts”

Visit Elliott Wave International to learn more about the free Conquer the Crash Collection and read the latest financial forecasts.