The study below originally appeared at Treasure Chests for the benefit of subscribers on Monday, October 2, 2006.

While I may be a bit premature about attaching a Halloween oriented motif to this piece, at the same time, it fits the situation better than any other in mind so we'll just have to go with it. And to what does it refer, a witches brew perhaps? Well, in a way yes, that's it in a nutshell all right. Of course alternatively one could just as easily characterize it as a 'big mess' in less dramatic terms. What mess is this to which we are referring? Why it's the next asset bubble, in progress as we speak. Actually, it's been there for quite some time now, but not too many see it for what it is in reality. It's the bubble to replace the housing bubble, which of course was the bubble that replaced the tech bubble, all of which being a product of an insane credit bubble, undoubtedly the primary source of our undoing in the end. Which bubble is this then, after such a grand buildup? Why it's the derivatives bubble of course. You know, the one that keeps growing like a mushroom still to this day.

According to the Bank for International Settlements (BIS), the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. No, that's not a typo, that's $344 trillion of notional value, where if one were to annualize a total, it doesn't take long to figure out the world is now trading in excess of a quadrillion worth of this paper every year. Is that a big enough bubble for you? And it goes without saying this has been a boon to the brokerages and banks that deal in these formerly exotic financial instruments, where whether you realize it or not, even if you don't participate in them directly, simply by owning a mutual fund, or a bank account for that matter, indirectly you too are captive to this trend. (See Figure 1)

Figure 1:

Can derivatives be classified as 'real' assets however? Are they not just contracts, or promises to pay if you will? And if they cannot be considered 'real' assets then, how can they be characterized as a bubble? An interesting viewpoint, one a banker attempting to baffle you with bull-pucky would raise at an opportune time while reciting a rendition of 'double speak'. But if this were true, then why are they ascribed value, traded for hard currency, and held on balance sheets? And why does the BIS itself count up all those values, notional as they may be? Answer: While it's true the notional values of derivatives will never be realized, which of course is the larger part of the scam bankers perpetuate on savers who participate in them, and much like how the insurance industry prospers, 'premiums' are paid (but rarely collected on), which as mentioned above go directly to the bottom line of the writers, who for the most part just happen to be banks and brokerages. [i.e. and if not in principal (where they only take the sweet deals themselves), as agents.] (See Figure 2)

Figure 2:

Source: Credit Bubble Bulletin

On the surface this may all appear fine and dandy to the unsuspecting, especially if you are one of the increasingly few who actually benefit from this trickery perpetuated under the guise of 'free enterprise', where to the victors go the spoils, right? And hey, myself I'm all for fair play. The only problem is the banks and brokers have become too powerful, where they routinely and not so inconspicuously put there own interests ahead of those (the ignorant public) they are suppose to be serving. Of course everybody wants to be a millionaire these days, where we have been conditioned to think this is possible, which is a very large part of the reason this 'mess' is allowed to continue growing. What's more, in spite of a long and illustrious history in the manufacture of US paper, one that includes aiding in the Super-cycle collapse of US stocks back in 1929, I am willing to go out on a bit of a limb at this juncture and speculate the confidence men from Goldman Sachs are at the top of their game right now, evidenced in what appears to be 'free reign' in managing fiscal policy at home, while spearheading foreign initiatives designed to continue expanding the paper empire abroad. (See Figure 3)

Figure 3:

Source: Credit Bubble Bulletin

With this in mind, and returning to the main topic at hand, it should be no surprise then that the use of derivatives around the world is still on the rise, and that if Mr. Paulson has his way, China will fall into the fold very quickly. One must realize that in order to be a good 'western' banker today, which he still is essentially, Hank wants to see China keep its economy humming along no matter what the cost, because he knows growth velocities at home are suffering, and that without accelerated US paper growth in the east, even the Wall Street Dawgs will begin to suffer soon. Here's a scary thought. If the paper pushers are put out of work, much like those already rendered useless in the 'real economy' through the export of manufacturing jobs to Asia, the only ones left working will be government. And then, whom would they tax?

The lack of credible alternatives is a strong incentive to allow asset bubbles to continue growing, and largely explains why officialdom condones / promotes / supports such activities, but it's getting harder and harder to find new ones. One has to wonder how it's all going to end knowing growth rates in bubbles under construction will undoubtedly prove unsustainable as well. (See Figure 4)

Figure 4:

Source: Credit Bubble Bulletin

This is why Hank is over in China attempting to keep the flow of paper heading overseas accelerating as long as possible, which is why one should not be surprised to hear about derivatives markets opening there too, where simply getting them indebted is not sufficient to support necessary growth in the larger credit bubble anymore. Nope, western bankers need them buying derivatives too, and right away in support of all the other bubbles. North American's are already enslaved up to their eyeballs in debt and derivatives rendering little to no growth prospects at home in this regard. So, what do Wall Street capitalists do? They export the manufacturing base to China boosting worker's wages so they can be enslaved in debt servitude, as well as creating markets for all the other paper Da Boyz want to send over. Genius no? The only thing is even the Chinese have growth limits, along with the fact they may be acting to slow, which poses risks to the western model. A slowdown here would not be good for the credit bubble, at large. (See Figure 5)

Figure 5:

Source: Credit Bubble Bulletin

So, the big question is what if the Chinese do not embrace the use of derivatives in good measure? Will the derivatives bubble pop soon too if this is the case? For an answer to that question, along with being a window on the larger condition of the paper world in full measure these days, and like GM was considered a 'bell weather' when the US still had a manufacturing base, one might want to keep a watchful eye on Goldman's stock, symbol GS on New York. While it appears to be pushing higher in deference to the ever-expanding derivatives / credit bubble(s), and the increased business that goes along with this trend, when the party is over for real, meaning growth in foreign markets is leveling off - Houston - we may have a problem. For now however, the top brass in China continue to see globalization as the pigs in Animal Farm would, an easy ride on the backs of others to good times. Thusly, we will have derivatives in China, and higher prices for Goldman's stock price in all likelihood, as well. (See Figure 6)

Figure 6:

In March I put out some thoughts on why the echo bubble in stocks likely had much further to go than some could contemplate at the time. Upon reviewing this piece, you will notice we centered our attention on the plight of GS shares back then knowing we would likely return one day, and here we are now expanding on these understandings. Back in March, GS was $150, and today its $170, apparently on it's way to a Fibonacci (Fib) resonance defined target of approximately $190. Just as an aside, I use this price targeting method because it's my belief movements within humans are still primarily a function of nature, no matter how much we attempt to separate ourselves from this reality.

That being said, and while this is all pure speculation, if the Fib based projection presented above is in fact correct, the implication in my mind is that both the derivatives bubble, and perhaps even the larger credit bubble itself, are approaching 'critical mass', and that 'reversals of fortune' are possibly at hand in the not too distant future. One thing is for sure, even if this were not the case, a good test will be seen once Fib resonance related resistance is achieved, so at a minimum, one might keep this in mind.

And what if this does turn out to be the real deal? You will be very happy in a few years if you take precautions now I will wager, because in a larger sense we are talking about the derivatives and credit bubbles here today, but it should not be forgotten all of our asset bubbles depend on co-existence, and that if growth rates begin to wane, the leveraged buyout bubble, the stock market echo bubble, ALL the other asset bubbles will undoubtedly feel the pinch.

Traveling a little further down the rabbit hole in expanding on the above, and narrowing our focus onto the US stock market in terms of how it fits into the grand scheme of things, as mentioned above, while growth prospects in domestic derivatives markets are likely to slow in coming days for a variety of reasons, and not ignoring the importance of credit based derivatives in the big picture, not only monitoring growth rates is important in measuring future health prospects, but also structure as well. To what structure do we refer and why is it important? In the case of equity based derivatives markets, we are referring to put / call ratios, where if you are unaware, open interest ratios happen to be the best reflection of investor sentiment in the market today based on our studies.

Further to this, and in attempting not take away from the main thrust of this piece, while at the same time covering a related aspect of the derivatives world that could hasten a popping of the larger bubble, it must be briefly mentioned that if US equity index options markets ever became disorderly (not liquid), such a condition would spread to credit and currency related contracts as well, potentially setting off a chain reaction of defaults that for all intents and purposes would shut down the global financial system. Moreover, considering the size and extent of the current derivatives bubble, if the above numbers are extrapolated into the future, very soon we will be dealing in multi-quadrillions of notional values within the totality of international markets. That's one thing about bankers; they are very predicable, where if one quadrillion is good, ten will undoubtedly be viewed as better in maintaining paper empires. The only thing is, when a bubble of this nature (size) pops, there's no coming back. Please note this whole train of thought is very consistent with conditions one would expect to see at a top of 'grand' proportions in human intercourse.

Now it's time to throw some corny (in today's world) and obvious truisms at you, which in retrospect a few years out, may be looked back on as 'hitting the nail right on the head'. Here's another. Whatever has a beginning also has an end. Sounds like Confucius, no? Relating to this, 'whenever a more natural end is avoided, no matter what you are talking about, the result is usually violent'. Awe, there's the rub. This is why we watch sentiment in US equity indices so closely, because one of these days open interest put / call ratios will drop across the board, and the floor that currently exists under prices will be gone. Why is this important? Answer: In spite of what you may think on the subject, US monetary authorities are not in a position to monetize the entire financial system, and if stocks were ever to start falling precipitously with options related support(s) removed, not only would they likely not be able to do much about it right away, it's also likely panic and dislocations will spread to other markets as well. This is because today primary dealers not only deal in stocks in a big way, but also in debt / credit markets, and currencies, with the term 'counter party risk' potentially becoming applicable in cross-markets. Puff on that one for a bit.

This is why you want to step out of the paper game with some of your assets, not the least of which is the US dollar (think of China's growing $1 trillion holdings) considering it's poised to lose reserve status one of these days. What's more, all should realize this is the biggest and most obvious contrairian play ever, where man has never been so far from his natural beginnings. One can only see this if looking through the right pair of glasses however, which was the purpose of this paper, to provide such a view, along with a warning. Much trouble of increasing complexity lies down the road for all, and only the prepared will fair well.

In the end then, it's important to realize derivatives and debt are all forms of phony money, designed to artificially pump up an ailing financial system. Moreover, once more people not only begin to realize this, but act on this knowledge, gold, silver, and any of the other real 'hard' currencies you care to mention will come into their own, even if only to support new paper regimes ultimately as reorganizations are engineered in the future. Of course this eventuality is still years off, and when you see it, the trend towards tangible assets will be a lot closer to its end than beginning, along with rather substantial bubbles in gold and silver correspondingly.

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Good investing all.