How Far from Normal are We?
As I have mentioned, I have been hard at work on my book and am approaching completion of the raw manuscript. The title of the book is What's Wrong with Money?: The Biggest Bubble of All - and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. Even better, you can pre-order it already, even though it's not due out until later this year or early next year.
Yesterday, I finished up the draft of the second section, which is the "where are we now" section (there are three sections in total, and I am part-way through the "investing" section). I really enjoyed writing the following section and I think the charts are fun. So I thought I would include a snippet of Chapter 9 here for you:
If a length of steel is flexed, it is impossible to know exactly when it will fail. We can, however, figure out when that critical point is approaching, and estimate the probabilities of structural failure for a given load. These are just probabilities, and of course such an estimate depends on our knowledge of the structural properties of the piece of steel.
With economies and financial markets, the science has not yet advanced enough for us to say that we know the "structural properties" of economies and markets. And yet, we can measure the stress markets are under by measuring departures from normalcy and make observations about the degree of risk.
Didier Sornette wrote a book in 2003 called Why Stock Markets Crash: Critical Events in Complex Financial Systems. It is a terrific read for anyone interested in studying these questions and exploring the developing science of critical points in financial markets. His work goes a long way towards explaining why it is so easy to identify a bubble and yet so hard to predict the timing of its demise.
So in that spirit, let us look at a few pictures that illuminate the degree of "departures from normalcy" in which economies and markets currently are. Figure 9.6 shows the nice relationship between the increase in GDP-adjusted money supply (M/Q from Figure 3.1) and the increase in the price level (P) over the nice, regular, period between 1962 and 1992. I've added to this plot a dot representing the latest ten year period, and (for fun) a dot representing the ten years ending in the heat of the stock market bubble in 1999. Do we appear to be out of normalcy?
Figure 9.6: Compounded money growth versus compounded inflation, 10-year periods
Figure 9.7 shows the relationship between stocks and spot commodity prices, as represented by the S&P 500 and the Bloomberg Commodity Index. The curve is from 1991 to 2007, excluding the period around the equity bubble (1998-2002). The two dots show the current point, and the point from December 1999. Do we appear out of normalcy?
Figure 9.7: Stocks versus spot commodity prices
Let's try one more. Figure 9.8 shows the same commodity index, but this time against the money supply. It makes sense that spot commodity over time should move more or less in relation to the aggregate amount of money in circulation. The relative prices of two items are at least somewhat related to their relative scarcities. We will trade a lot of sand for one diamond, because there's a lot of sand and very few diamonds. But if diamonds suddenly rained down from the sky for some reason, the price of diamonds relative to sand would plummet. We would see this as a decline in the dollar price of diamonds relative to the dollar price of sand, which would presumably be stable, but the dollar in such a case plays only the role of a "unit of account" to compare these two assets. The price of diamonds falls, in dollars, because there are lots more diamonds and no change in the amount of dollars. But if the positions were reversed, and there were lots more dollars, then the price of dollars should fall relative to the price of diamonds. In this case, dollars have been raining from the sky and yet their price relative to commodities has not fallen - that is, the nominal price of commodities has not risen, as we would have expected. Figure 9.8 shows that the price of money, relative to hard assets like physical commodities, may be in the greatest bubble it has ever been in. And since, unlike stocks and unlike real estate, everybody holds money, this may be the biggest bubble of them all.
Figure 9.8: Commodity prices versus money supply
All three of these figures - and I could have chosen many others - show a highly-flexed economy and highly-flexed markets. A break in this steel bar is almost assured; the only question is when.
Moreover, while we hear so much today about the "coming deflationary depression," I have to say that with the quantity of reserves in the system and the direction in which the monetary pictures are flexed, there is in my opinion as much chance of a deflationary outcome as I have of being appointed Prime Minister of Egypt.
 Sornette, Didier, Why Stock Markets Crash: Critical Events in Complex Financial Systems, Princeton University Press, 2003.
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