Tuesday, 4 September 2012

October Crash?

Although, September tends to be one of the worst performing months for Stock Markets, nearly all Stock Market crashes have occurred in October. The 1929 Wall Street Crash happened in October, and the following year, the Stock Market fell by about another 20% in October. The 1987 Stock Market Crash also happened in October. The Tech Wreck of 2000 happened in March, but after having recovered during the Summer of that Year, both the NASDAQ and Dow Jones fell again sharply in October. More recently the Financial Meltdown of 2008 kicked off in October. In the last year and a half, Stock Markets have bubbled up once more, rising by more than 30%. The Bond Markets in the US, UK, Germany and Japan are at such high levels that Yields are at levels not seen in centuries let alone decades. Other asset prices such as Gold, and other precious metals like Silver, as wells as for things like diamonds are also at record high levels. In the US, other asset prices such as for property have tumbled by around 60-70%, a similar fall was seen in Ireland, but in the UK, and Spain house prices are at extremely bubbly levels, whilst new bubbles in house prices are forming in Germany and other Northern European countries, where bubbles have been unheard of in the past. Like all bubbles, this inflation of asset prices is based on nothing substantial, which is why they always burst. Are we on the verge of another huge crash like those listed above?
This luxury 6 bedroom house in Florida was for sale for
£70,000. Before the bubble burst it was priced at $400,000.
The answer, of course is, nobody knows. These bubbles will undoubtedly burst, just as they did on those previous occasions, and just as the property bubble has burst in the US and Ireland. But, exactly when they will burst is unknown almost by definition. If it was known when a bubble was going to burst, everyone would have sold out of the asset before it did! As Keynes said, “Markets can remain irrational, for much longer than most investors can remain solvent.” But, there is another aspect of this statement by Keynes that most people don't focus on. That is, he says “most investors” not all investors. The reality, as in most things, is that the really big Capitalists often can base their decisions on what they think the market should be doing, all things being equal, rather than on what is actually continues to do. In the 1990's, for example, Warren Buffett, notably refused to invest in the fashionable technology sector. It required a lot of nerve – and money. Many Mutual Funds, specialising in investment in technology were experiencing returns around 70% per year!!! Buffett's Berkshire Hathaway was experiencing decent returns on its investments, but nothing comparable to that. Buffett, argued that he would not invest in something he did not understand, and in something that was not producing profits, and where he did not understand where any profits were to come from.

Many in the investment community argued that he just didn't get it, and that everything had changed. But, Buffet was proved right. Many of the technology companies were not making profits, and had no chance of ever making profits. It was story that had been seen in every bubble in history before it, like the Tulipomania or the Railway Mania, which also popped towards the end of the year in 1845, when the Bank of England raised interest rates, or with South Sea Bubble of 1720. All of them sucked in the savings of ordinary middle class people, who were ruined when the bubble popped. But, usually, the Big Capitalists – referred to in investment circles as the smart money – had already pulled out their money if they had been invested to begin with, or else were able to use the Crash to pick up real bargains after the dust had settled.

The railway mania did leave a legacy of actual railway lines and rolling stock in Britain, which at its much reduced valuation, provided a profitable investment for the Capitalists who were able to come in, and pick it up at knock down prices. The Technology Bubble, did leave in its wake some valuable technology companies, like Apple, Microsoft and so on, as well as providing example of business models that work, and those that do not. The small investors paid for the building up of this Capital, the big Capitalists were the ones who ultimately benefited from it, whilst the small investors got fleeced.

The Railway Mania, and the 1987 Crash, and the 2000 Crash all had something else in common. Interest Rates. The Railway Mania bubble popped, when the Bank of England raised interest rates. That was enough, to persuade money that had been invested in railway shares to take its Gains, and move to Government Bonds. All bubbles have an element of the Emperor's New Clothes to them. That is, they become self-sustaining, because no one wants to be the one who says that there is no basis to them. In 2000, when the FT and others were running stories saying that it was a bubble, no one wanted to listen, and important investment analysts, such as people at Goldman Sachs continued to argue that there was a new paradigm, that meant that stocks could continue to rise to even greater stratospheric heights. Similarly, there were people prior to the 2008 Crash who were predicting it would all end in tears. I had made several speeches as a County Councillor in the preceding years to that effect, and I remember a rather heated discussion with one Councillor who was an Estate Agent, one lunchtime to that effect. I predicted in fairly stark, but accurate terms the actual meltdown just a few weeks before it broke out – Severe Financial Warning. I was not alone, but again no one wanted to hear. Its fairly natural if you think that everything will keep going up that you will follow the crowd, just like when everyone stands up and tries to get off the plane or bus at the same time, rather than sitting and waiting for it to clear.

The same was true with the 1987 and 2000 crashes. In 1987, there had been a period in which Ronald Reagan had been following the Voodoo Economic policies of people like Arthur Laffer, who argued that the US budget deficit could be reduced if the Government slashed taxes. This he said would cause US capitalists to invest, work harder and so on, which would then launch a period of rapid economic growth, which would boost government revenues. It was based on no substantial economic theory, or empirical evidence. Not surprisingly, when Reagan followed this advice and slashed taxes the US Budget Deficit and Trade deficit ballooned. There was no massive increase in economic growth, in fact, during this period, as in Britain, the process of de-industrialisation continued with large amounts of manufacturing being relocated to Asia. The very rich, did not work any harder, but merely saw the opportunity to increase their earned and unearned incomes even more, whilst the wages of workers continued to stagnate or decline in real terms.

Eventually, the market got spooked, and Bond investors began to question how the US would pay for these deficits, pushing up yields on US Treasuries. Once again, that was a signal that the party was over, and money flooded out of the Stock Market. It caused a bigger percentage fall than happened with the 1929 Crash. The crash of 2000 was pretty similar. During the 1990's, Alan Greenspan, who was a follower of Ayn Rand, put forward a similar idea that if taxes were cut, and markets freed up, Capitalism would experience a new golden age. He convinced Bill Clinton of this idea. When the intended rise in productivity did not materialise Greenspan thought that something fundamental had changed in the US economy, which meant that the real figures were not showing up. Having previously been an advocate of sound money, and of Gold, Greenspan began to print money to keep interest rates low, and to prevent stock market, and housing market falls. This came to be called the “Greenspan Put”.

This continual printing of money to keep the Stock and property markets afloat continued throughout the 90's, and provided the basis for US consumers to keep spending, even as their wages were stagnant or falling in real terms. It meant that even as their manufacturing jobs were moving to China, they could take on new jobs in the many retail outlets that were being established selling those imported goods, or else working in other forms of service industries. A few of the better educated were able to get jobs working in the expanding Finance Sector, or else in the only really dynamic and globally competitive area of the economy outside agriculture, technology. The deficiencies of the US education industry led Greenspan on more than one occasion to decry the growing gap that was opening up between these different types of workers. Meaning they needed to increase their higher education so that Capital in these areas had a larger supply of educated workers at its disposal, and therefore, cheaper workers. It created a significant disproportion in the US economy – a similar history and situation existed in the UK – which mirrored a growing disproportion in the global economy – A Crisis Out Of All Disproportion.

Towards the end of the 90's the contradictions and tensions within the system were made clear by the Asian Debt Crisis, and the Rouble Crisis. But, these were really signs of the end of a period of Long Wave decline. The Asian Debt Crisis was soon resolved, and like the real investment that arose from the Railway Mania, it left behind it, masses of real productive investment in the Asian Tigers, which provided the basis for their rapid expansion. That is the difference between the Asian Debt Crisis, and the European Debt Crisis. The latter debt has largely been accumulated to finance consumption, and the inflating of asset bubbles not investment.

Symptomatic, was the printing of huge amounts of money by Greenspan and other central bankers ahead of the Millenium. Not only was this intended to ensure that Banks' ATM's had sufficient cash for the holiday period, but it was intended as a safety measure, just in case the much feared Millenium Bug, did crash computer systems, and with it, economies. In the event it was a damp squib, and Greenspan and other Central Bankers started to withdraw the money they had injected, and began to raise rates from what were then historically low levels. Once again, the higher interest rates were enough to cause the crash. Since then, interest rates have gone to even lower levels, as even more money has been printed.

But, as is usual in the scheme of things, the more you do things, the less they tend to have the same effect. Massive money printing after 2000, and particularly after September 11th. did not enable the NASDAQ to recover from its 75% fall. Today, 12 years on, its still only just over half its level in 2000. The money went into other assets, such as houses, but even there a large part of the rise occurred between 1997 and 2002, with prices once more doubling after 2002. Yet, when the sub-prime crisis hit, even more money printing could not stop US house prices tumbling by up to 75%, and even now 4 years later, they are still falling. What really rescued the US economy after 2008, as in Britain and elsewhere, was not more money printing, but the co-ordinated fiscal stimulus introduced by Governments. Its no wonder that yesterday, at the paralympics, George Osborne was booed, whilst Gordon Brown was cheered!

Each round of Quantitative Easing introduced by the Federal Reserve, as with the Bank of England, and now the ECB in the form of the LTRO, seems to have less and less effect on the real economy, because with no prospect of any fiscal stimulus, or likelihood of strong growth, neither consumers nor businesses have any interest in borrowing money even at historically low rates. The only function the money printing has performed in the last couple of years, is to bolster the Balance Sheets of the banks, prevent a housing price collapse in the UK, and provide finance to those who can afford it, to invest in tangible assets like Gold, or in speculative assets like shares. Its that, which has pushed Gold up to nearly $2000 an ounce last year, and has caused Stock Markets to rise by 30%.

In the last few weeks, share prices have risen strongly again, and Gold has risen by 10% on the back of hopes that Bernanke is about to engage in QE III, and the ECB is to begin printing money to buy peripheral European Bonds. Even if that happens, once the initial euphoria of the drug wears off, markets are likely to crash. But, there is no guarantee the drug will even be available. Central Banks and politicians have been playing a dangerous game with markets for months, particularly in Europe. They have kept holding out the prospect of some substantial measures of monetary easing and so on, which would put a floor under the investments of all the speculators be they in share markets, bond markets or property markets. Each time, what they have provided has been less than adequate let alone spectacular. This time is likely to be no different.

The Federal Reserve has been very contradictory in the messages it has given out about whether QE III is on the way, and this close to an election it has an additional problem in not wanting to appear to be acting politically – particularly as the Republicans have said they would sack most of them, and some Republicans want to scrap the Federal Reserve altogether. The Bank of England is under pressure, because QE has increased inflation, which is once more ticking up again, and it has cratered many Pension Schemes that were already under pressure. There are a large number of Baby Boomer pensioners, whose savings are being destroyed by inflation, and which are providing them with no returns because of low interest rates, who are the most active voters. And, the ECB has once more rowed back on just how much Bond buying it might do.

Ed Yardeni coined the phrase Bond Vigilantes
Sooner or later, with economic growth faltering, and with deficits continuing to rise, markets will again question on what basis Bond prices can be so high, and yields so low. The so called Bond Vigilantes might be the ones who spark it, but it is just as likely to be someone who realises that the Emperor has no clothes, who will begin a collapse of the Bond Bubble, which will send interest rates sharply higher, Stock Markets sharply lower, and because of the effect on mortgage rates through Bond Yields, will crater the property market in the same way it has crashed in the US. The Government and the banks are trying to avoid that, because it will destroy much of the banking system, but such a crash is inevitable at some point.

A look at Gold, shows that it too is unlikely to be unaffected. On every occasion when there has been a big sell-off in other markets, Gold has fallen too, as the dash for cash leads investors to sell everything including Gold to raise money. It always rises again later, as money printing causes the smart money to look for an asset which in the longer term will hold its value – houses can't do that, because they are already in a massive bubble, and they are a consumer durable not an investment, so when people's disposable incomes are squeezed they don't buy houses, whereas speculators do buy Gold. When the prospect of further easing disappeared last year, Gold dropped around 25%. If there is a big crash, and even more money printing as part of getting out of it, which would have to be accompanied by a big co-ordinated fiscal stimulus – then Gold will rise. Otherwise, it is likely to fall.

House prices have continued to drop significantly in the UK despite the official figures. The house next door to me was put up for sale in April at £450,000, and has already been reduced to £400,000, and another house along the road has been reduced by £50,000 too. Yesterday, I went to look at a very nice house in an acre of ground with views across to Wales. Its up for sale at £325,000, but even the Estate Agent told me he'd advised the sellers to accept an offer of £285,00, which he thought was very generous, as the only other offers had come in at £250,000. He confirmed that house prices were falling sharply. Unfortunately, this is typical of every such bubble, and is exacerbated by the irresponsibility of the press, which continue to foster ideas that it can go on for ever, until the crash happens, when they are then the first to say “Why didn't anybody warn that this was going to happen?”

As I said at the beginning nobody knows whether there will be a Crash in October. I don't have a crystal ball. I do believe that we are going through a three yearly cyclical downturn, which should end by the beginning of next year, but that in itself could spark a crash. Any economic upturn, especially in Europe, will cause Bond yields to rise. Already, Banks are struggling to borrow at low rates. Santander and others have raised mortgage rates already. At the same time, the number of people in arrears with their mortgages continues to rise. If that is happening at a time when according to Nationwide, mortgage affordability is at a fifteen year low, then any rise in interest rates will have a crippling effect. With rates at such low levels even a small rise could double payments. If mortgage rates went back to their long-term average of around 7%, the property market would certainly crash substantially. Yet, such a crash could be the best thing that could happen. In the US many people simply walked away from their houses, leaving the Bank with the debt, and with a worthless house whose value could not repay the debt. For about two decades large numbers of people in the UK have not been able to afford a house, whilst that has also caused rents to rise sharply. A significant property crash of around 80%, taking prices back down to the levels of 20 years ago, would mean that people would once more be able to afford to buy a house, and some people who already own a house – as opposed to renting it from the Building Society via a mortgage – would be able to move up to a better house. The real losers would be the banks and building societies whose irresponsible lending practices blew up the bubble in the first place.

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