The Periphery is Failing

By: Chris Martenson | Wed, Aug 28, 2013
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The next big economic dislocation might be only weeks away

For years we've preached the From the Outside In principle of markets: When trouble starts, it nearly always does so out in the weaker periphery before creeping towards the core.

We saw this in the run-up to the housing bubble collapse, as sub-prime mortgages gave way before prime loans, and in Europe, as smaller economies like Greece, Ireland, and Cyprus have fallen first and hardest (so far). We see this today in accelerating food stamp use among poorer U.S. households. In each case, the weaker economic parties give way first before being followed, over time, by the stronger ones.

Using this framework, we can often get several weeks to several months of advance notice before trouble erupts in the next ring closer to the center.

Which makes today notable, as we're receiving a number of new warning signs. The periphery is giving way.

Ever since the current economic "recovery" began, we've been warning of the high risk of a renewed financial crisis. That risk is now uncomfortably high. This is because nothing that led to the first round of troubles was actually addressed at the root level. Instead, prior troubles were simply papered over with central-bank liquidity, leaving structural weakness intact -for instance, our 'too big to fail' banks are just as big, and our sovereign debt levels are even worse than they were pre-2008.

The next crisis will be larger and more damaging than the last one, principally because nothing got fixed, political capital was spent, and trust has been eroded, leaving everyone depleted and ready to bolt for the financial exits.

With the periphery failing, we likely have only weeks - perhaps a month or two - until the next big dislocation hits.


Déjà Vu (All Over Again)

We've been here before. We've seen trouble start on the outside and progress inwards, and not all that long ago.

In 1999 and 2007, we saw the financial markets blithely trundle along higher, even as clear signs of trouble at the margins were abundant.

One of the common myths about the stock market, often repeated in the press, is that it peers into the future. The market is the 'great discounting machine.'

But the stock market powered higher into the new millennium, despite being the most overvalued it had ever been in history, before diving violently in 2001. So much for peering into the future.

And again, the stock market went to new heights in 2007, even as the housing market was obviously deteriorating and about to suffer a truly historic break after an unprecedented and bubbly run to the upside. The great discounting machine ended up reacting to trouble rather than anticipating it.

Despite these two obvious failures, many still hold to the belief that the stock market is a useful indicator of future health or distress, which means this view is more a matter of faith than fact.

My view has always been that the stock market is a 'great liquidity detecting machine' - something that fits the data very, very well - and that it's reacting to liquidity in the system more than anything truly fundamental. This has not always been the case, but ever since Greenspan opened the Federal Reserve printing presses to each and every minor financial sniffle in the mid-1990s, Fed-supplied liquidity has been the dominant driver of equity prices.

To tilt the conversation slightly, one of the enduring mysteries to me is how we have managed to experience not one, not two, but three full bubbles in the space of less than 15 years. Tech stocks, then housing, then all stocks and bonds; three bubbles, each bigger than the last.

As I have written extensively in the past, the current all-time highs in both bond AND equity prices (with bonds collectively including everything from 1-month T-bills to the worst junk paper you can buy), is nothing more and nothing less than the biggest financial asset bubble in history.

In order to believe this will all turn out well, you have to believe that this time will be different...not just a little bit different, but 180 degrees away from literally every single other financial bubble in all of history.

This is precisely what is being asked of us each day by the financial press, the Fed, the Bank of Japan, the European Central Bank (ECB), and the politicians in the Western power centers.

Our view here is that it's never different. To that we'll add:

Collectively, the above list boils down to Anything that cannot go on forever...won't. [credit: Herb Stein]

Deficits and Debts Do Matter

Deficits don't matter! Dick Cheney once famously growled, putting to words the belief system that envelops the U.S. today, especially its financial and monetary authorities. Because we've managed over the past three decades to dodge any serious consequences from racking up debts, these folks believe that will always be true. Absence of evidence becomes evidence of absence.

Sticking just to the economic "E" (leaving aside energy and the environment), our diagnosis of the current difficulties is simply that the OECD economies left reason aside and instead embarked on a sustained period of borrowing at a rate nearly twice as fast as underlying economic growth.

That is, we collectively fell for the idea that one could simply borrow more than one earned...forever. I'm always surprised by how an entire culture can collectively believe in something that no individual would ever hold to be true.

We know that we cannot individually borrow more than we earn forever. And we are equally sure that this remains true if we pool ten people together. But we accept the idea that a sovereign nation can somehow magically pull this off. This either represents a profound inability to apply logic, or a form of cultural schizophrenia, or both.


Hot-Money Bubble Dynamics

For years now, ever since the Fed et al. embarked on the global rescue plan that involved little more than flooding the world with historically unprecedented amounts of freshly printed money (a.k.a. "liquidity"), that money has been sloshing around looking for things to do.

With interest rates on 'safe' investments at 0% (or close enough), that hot money has been looking for anything that resembles a decent yield. This 'yield chasing' went to every corner of the globe and piled into any and every market that it could.

Some of these markets were the headline U.S. and European equity and bond markets, and some of them were so-called 'emerging markets,' such as Brazil, India, Thailand, the Philippines, and Indonesia.

As this hot money flowed into these emerging markets, the respective countries -in order to prevent their currencies from rising too much -did the usual and recycled the money-flows back into U.S. Treasury paper, German Bunds, and other sovereign debt instruments.

Now, all of this is being undone.

It is a hot-money machine running in reverse, and it is creating the usual distortions, difficulties, and hardships for the afflicted countries. Currencies are plummeting, as are local equity and bond markets.

In short, to understand where our financial markets are and where they are headed, you don't need to know much about fundamentals at all. Earnings, GDP, job growth, etc. are secondary to liquidity flows. That's why the various markets are so keyed on the Fed's next statements and when and how extreme the 'tapering' might be.

That's all that really matters.

Well, that's not entirely true. For reasons that cannot be entirely explained nor controlled, sometimes bubble dynamics just end. People stop believing. And what was once a virtuous cycle suddenly morphs into vicious one.

I believe that's the moment where we are now. And, as always, it's starting from the outside in.

In Part II: Blast Shields Up! Prepare for Incoming! we look at the growing number of klaxons warning that central bank policies to prop up the global economic system are failing at an accelerating rate.

There are many fronts on which this losing battle will be fought, but our biggest concerns lie in the bond markets -ultimately and including U.S. Treasurys.

Defensive maneuvers are the name of the game now for the prudent. Make sure you're one of them.

 


Click here to access Part II of this report (free executive summary; enrollment required for full access).

 


 

Chris Martenson

Author: Chris Martenson

Chris Martenson
Peak Prosperity

Chris Martenson

Executive summary: Father of three young children; author; obsessive financial observer; trained as a scientist; experienced in business; has made profound changes in his lifestyle because of what he sees coming.

I think it's important that you understand who I am, how I have arrived at my conclusions and opinions, and why I've dedicated my life to communicating them to you.

First of all, I am not an economist. I am trained as a scientist, having completed both a PhD and a post-doctoral program at Duke University, where I specialized in neurotoxicology. I tell you this because my extensive training as a scientist informs and guides how I think. I gather data, I develop hypotheses, and I continually seek to accept or reject my hypotheses based on the evidence at hand. I let the data tell me the story.

It is also important for you to know that I entered the profession of science with the intention of teaching at the college level. I love teaching, and I especially enjoy the challenge of explaining difficult or complicated subjects to people with limited or no background in those subjects. Over the years I've gotten pretty good at it.

Once I figured out that most of the (so-called) better colleges place "effective teacher" pretty much near the bottom of their list of characteristics that factor into tenure review, I switched gears, obtained an MBA from Cornell (in Finance), and spent the next ten years working my way through positions in both corporate finance and strategic consulting. From these experiences I gather my comfort with numbers and finance.

So much for the credentials.

The most important thing for you to know is the impact that the information that I've now placed on this site had on me. Let's do this as a Before and After.

Before: I am a 40-year-old professional who has worked his way up to Vice President of a large, international Fortune 300 company and is living in a waterfront, 5 bathroom house in Mystic, CT, which is mostly paid off. My three young children are either in or about to enter public school, and my portfolio of investments is being managed by a broker at a large institution. I do not really know any of my neighbors, and many of my local connections are superficial at best.

After: I am a 45-year-old who has willingly terminated his former high-paying, high-status position because it seemed like an unnecessary diversion from the real tasks at hand. My children are now homeschooled, and the big house in Mystic was sold in July of 2003 in preference for a 1.5 bathroom rental in rural western Massachusetts. In 2002, I discovered that my broker was unable to navigate a bear market, and I've been managing our investments ever since. Since that time, my portfolio has gained 166%, which works out to a compounded yearly gain of 27.8% for five years running (whereas my broker, by keeping me in the usual assortment of stocks, would have scored me a 38% return, or 8.39%/yr). I grow a garden every year; preserve food, know how to brew beer & wine, and raise chickens. I've carefully examined each support system (food, energy, security, etc), and for each of them I've figured out either a means of being more self-sufficient or a way to do without. But, most importantly, I now know that the most important descriptor of wealth is not my dollar holdings, but the depth and richness of my community.

I hope you find what I have to offer here useful.

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