By Richard J. Maybury
Sept 1999 EWR
Oct 1999 EWR
"Paradigms (pair-a-dimes) are how humans understand their world. In our minds we build these intricate models of how the world works, and we evaluate incoming information using these models."
Investors Must Understand Economic Models
The following two articles correctly predicted the big stock market crash at the end of the '90s, and the subsequent mild recession, plus the Federal Reserve's reaction to these events.
The Fed's reactions then set us up for the disaster of the late '00s.
The articles hit the target by paying attention to the Fed's and financial industry's conversion back to the Keynesian economic model.
Models, or paradigms (pair-a-dimes), are the system humans use to think. When you know a person's or organization's paradigm, your ability to predict their behavior is increased greatly.
Investors who are not informed about economic paradigms are flying blind, while those who do understand have a vast advantage in the quest for profits.
Economic ParadigmsKeynesian: One who believes in John Maynard Keynes' theory that recessions and depressions should be stopped by the government injecting money into the economy. Keynesians have little objection to extensive government controls. They believe in adjusting or "fine tuning" the economy.
From the Sept 1999 EWR
The Crash and Your Investments Part 1
In his Wellington Letter, Bert Dohmen cites a Salomon Smith Barney study of 3,000 companies over 12 months ending March 1999. Stocks with price-earning ratios between zero and 30 fell 15% while those with no earnings rose 11%. Dohmen points out that this leads to the investment rule: do not buy into companies that earn money. That’s how insane this bubble is.
I think we are now in the transition between the bubble of this decade — stocks — and that of the next — weapons and raw materials including precious metals.
Recently gold has taken another pounding; here is what I think is happening.
With the collapse of the Union of Soviet Socialist Republics, socialism was shown to be a gross failure. This leaves only three economic models still standing — the Austrian, Keynesian and monetarist.
The inflationist Keynesian view was tainted by the severe inflations of the 1970s.
In the 1980s, the monetarist view took a direct hit when velocity became erratic. This destroyed the monetarist prescription for expanding the money supply at a steady, fixed rate. (For more about velocity, see my short Uncle Eric book The Money Mystery.)
This leaves only the free-market, sound money Austrian view.
However, most economists and politicians refuse to embrace Austrianism because one of the most important Austrian conclusions is that their precious religion, statism, is a hoax — big government cannot produce anything but big trouble, its costs are nearly always greater than its benefits.
Equally important, governments and central banks today are moving into the hands of baby boomers. Most boomers were taught Keynesian economics, which means they do not understand the causes of recessions and depressions. They think the way to cure these declines is to inflate the money supply.
So, giving the Austrian view a wide berth, most politicians and central bankers have arrived back at Keynesianism. This is what they were taught in college and it is what they are comfortable with.
This tells us how they will likely react when the stock bubble bursts. They will inflate.
I do not think we will go straight from a stock crash to runaway inflation because the collapse of the financial bubble will be temporarily deflationary. Prices of nearly everything will fall for a short while and cash will be king. The most inflated items, primarily stocks and some real estate and perhaps a few other things, will fall drastically.
I do not think the crash will spread across the real economy. I checked the capacity utilization numbers for 35 major industries and found only three low enough to signal a lot of malinvestment1 in need of immediate shakeout. These three are electrical machinery, apparel, and oil/gas drilling, and none of the three are all that alarming.
Looking at the bigger picture, I also checked 74 broad economic indicators —industrial production, employment costs, durables consumption and the like. I found only two red flags—the stock market and savings rate.
So, I am confident a disaster is coming but see no reason for it to extend much beyond the financial sector. This assumes, of course, that the power junkies in Washington do not step in to fix it, as they "fixed" the 1929 crash, with trade restrictions and other controls that led to the 1930s Great Depression.
I think the crash and recession will be brief due to a 95% probability the printing presses will be quickly thrown into high gear. The deflation will be halted by a deluge of new money in nearly every nation.
We already see the beginning of this in Asia. When their stock markets crashed, the governments of Hong Kong, Taiwan, Malaysia, Philippines, Japan, South Korea and China stepped in to stop the slide.
This was forecasted in the 4/93 EWR and repeated in 10/98, and I see no reason to change my mind. Nearly all central banks including the Fed can be expected to intervene in their stock markets. Last August the government of Hong Kong spent $15 billion buying up stocksThis artificial support for stocks only insures that the inevitable great crash will be much worse when it finally happens. [Editor’s note: the great crash arrived in 2008.] The people creating the support probably expect to be out of office when the day of reckoning arrives.
For years I have heard rumors that US officials secretly meddle in the stock market, trying to force prices up or down according to whatever they feel is in the “national interest.” A lot of investors are shocked at this suggestion, but it does not seem outlandish to me. US officials meddle in the currency markets, bond markets and gold markets, proudly claiming they have the right and duty to push these prices in whatever direction they think necessary. Why wouldn't they feel this way about stocks?
The Golden Threat
The experience of the 1970s and 1980s taught central bankers that they must inflate together. If one nation inflates more than others, its currency declines faster. Investors then dump this currency and flee to others, driving the currency down even faster and throwing the country into runaway inflation (due to runaway velocity). Runaway inflations often lead to revolutions and civil wars.
The Asian depression is not over. During the fiscal year ending June 30, the Port of Sacramento, which ships US products to Asia, experienced its lowest export volume in three decades. In fact, with China’s and South Korea’s recent problems, the Asian depression threatens to spread.
My guess is that central bankers have secretly decided to stop the depression by inflating together.
The fly in their ointment is the one form of money that central bankers cannot create on a printing press — gold. The bankers know that if they all launch a heavy inflation together, investors will flee all their currencies and move to gold.
I think gold has been down recently because central bankers have decided to launch a pre-emptive strike to discredit the metal as much as possible before they gun their printing presses.
This was predicted in the 1/98 EWR and it now appears to be happening. In July, gold hit a 20 year low of $256. I still think there is a 25% chance that $180 is in the cards, and 50% for $225, but I am not much of a gambler so I have been buying.
I am one of the few. Friend Doug Casey points out that investments are the only things most people will not buy on sale. They wait for the price to skyrocket, then they buy.
If gold does drop to $180, don’t panic, just buy all you can get your hands on.
Apart from buying precious metals, I am mostly in cash (Treasury Bills) right now because I plan to pick up a lot of bargains during the coming crash.
But, I am not infallible. After the Asian depression began in 1997, Keynesians in many nations began inflating, and all of them could gun their printing presses now to stave off another crash. If they do, the result could be only a small decline in stocks, and a massive rise in prices of raw materials, consumer goods and nearly everything else, delaying the inevitable deflationary catastrophe for several more years.
In short, we should not dismiss the possibility of being sent straight from present conditions to a double-digit inflationary boom with only a mild financial panic along the way. I give this a 25% probability, so I have been picking up a few (non-Chaostan) raw materials investments, chief among them oil and gas, and precious metals. (Never own anything that is physically located in Chaostan.)
Why won’t investors simply pour the newly created money back into stocks? Because they will be afraid of them, as they were after the 1973-74 crash. That’s what set the stage for the great 1970s boom in raw materials.
Sticking my neck way out, I am guessing there is an 80% probability of a 30% stock market decline sometime before the end of the year.
Of all raw materials, silver remains my favorite; it tends to overreact wildly. If I am right about a coming inflation, silver will generate ridiculous profits as it did 20 years ago. But silver is tough to store in large quantities, it is bulky and heavy. You might consider the new Perth Mint Certificate Program (PMCP) for precious metals.
Australia is one of the most stable and secure countries in the world, and the Perth Mint is owned by the state government of Western Australia. Refining about 8% of the world’s gold mine production, the Perth Mint has been dealing in precious metals since 1899; it is the world’s oldest continually operating mint.
When you purchase your metal, the Perth Mint stores it for you and issues you a certificate. The certificate is transferable and can be cashed at any time, or you can turn it in and have your metal delivered.
The new PMCP is also useful for palladium because there are no widely traded palladium coins. ♦
From the Oct 1999 EWR
The Crash and Your Investments, Part 2
We continue seeing news reports that the Asian depression has ended and fears were groundless, the US stock market has shrugged them off.
Okay, one more time: the fundamentals. This will be a summary, for an easy-to-read complete explanation see three of my Uncle Eric books, Whatever Happened To Penny Candy?, The Money Mystery and The Clipper Ship Strategy.
When governments inject money into their economies they distort existing flows of money and cause people to create the wrong kinds of plant and equipment, often in the wrong places. This is malinvestment.
Few economists or financial experts study malinvestment, most look only at investment. In their minds, when investment occurs, this is good; whether it is the right material in the right locations is rarely questioned.
The malinvestment must eventually be shaken out, and when inflation of the money supply is halted, the shakeout begins. This is a depression.
If the depression is not allowed to go to completion — that is, if someone steps in and re-inflates — that’s a recession. A recession is an incomplete depression.
The mainstream news media keep pointing to the soaring Asian stock markets as proof that the Asian depression has ended.
I have seen little evidence that the Asian malinvestment has been shaken out.
I think the same naive foreign investors who invested in Asia in the first place and who know nothing about malinvestment have returned, pouring their money into Asia and re-inflating the Asian bubbles. The real shakeout is yet to come.
Last month I wrote about the Keynesian, monetarist and Austrian economic views. The world contains enough malinvestment, especially in stock markets, that a crash as severe as that of 1929 is called for, but I believe central bankers will inflate us out of it because they are mostly Keynesians. (please see the article on models here)
Here I should say a bit about paradigm shifts.
Paradigms (pair-a-dimes) are how humans understand their world. In our minds we build these intricate models of how the world works, and we evaluate incoming information using these models.
When information does not fit the paradigm, we tend to ignore it. Ask a person standing on the shore what he sees when a ship comes toward him from over the horizon. If he knows the earth is round, he will first see the masts, then the hull. If he thinks the earth is flat, he will not notice the masts first and will report only that the ship was very small and grew larger as it approached.
People see what they expect to see.
The socialist paradigm is dead. A few economists have been trained in monetarism, and even fewer in the Austrian paradigm; most are Keynesian.
Only the Austrian paradigm has an explanation for recessions and depressions.
Lacking this explanation, the Keynesian prescription for crashes, recessions and depressions is, we don’t know what causes them but we know inflation stops them so let’s inflate.
As explained last month, for politicians, economists and bankers to adopt the Austrian view they would have to reject their religion, statism. This is why they cling to Keynesianism. They were all raised in government-controlled schools. They were taught that government is the solution to all problems. Whenever a problem arises, we should ask a priest (lawmaker) to perform the problem-solving ritual called lawmaking.
There is little evidence that lawmaking works, but we have all been taught to have a blind faith in it.
In other words, for governments to stand aside and let the malinvestment be shaken out — for them to not inflate — the politicians, economists and central bankers would have to undergo a religious paradigm shift. They would have to give up their god and believe in liberty, free markets and a severely limited, hands-off government.
(It is my belief that socialism, Keynesianism and other forms of statism become religions that are rapidly replacing the traditional spiritual religions. Statism is taught in public schols, where spiritualism is forbidden.)
This is not going to happen. In addition to the destruction of their religion, these people would face unemployment, and they would have to go in search of honest work.
Interestingly, the inflation of the 1970s and early 1980s was stopped by a brief paradigm shift. Governments switched from Keynesianism to monetarism.
Monetarism said the way to stop the value of a currency from falling was to stop printing so much of it.
The popularity of monetarism lasted only a few years because velocity became unstable (see my Uncle Eric book The Money Mystery) and undermined the monetarist prescription for a limited, steady expansion of the money supply.
Most economists, bankers and politicians then drifted without a paradigm for about ten years until 1997 when the Asian crisis began. Forced to adopt some kind of paradigm, they went back to Keynesianism, meaning inflation and meddling in markets.
Under questioning from my friend Congressman Ron Paul, Federal Reserve Chairman Alan Greenspan once said he would like to return to the discipline of a gold standard but he is the only one left in power who feels this way. In saying this, Greenspan was admitting he believes in the Austrian model but in actual practice is forced to be a Keynesian.
Paradigms are extremely tenacious, and paradigm shifts rarely occur through converting power holders to the new paradigm. They are accomplished by teaching the young, who then take over when the old die off.
This, incidentally, is one of the main purposes of my Uncle Eric books. Written so that people as young as ten can understand them, they are widely used by homeschoolers, and increasingly in conventional schools. Part of my not-so-hidden agenda in writing them is to help kill statism before it hopelessly corrupts all other religions.
Regarding your investments, the biggest question is, when will the bubble burst?
We cannot know, but Chart A sheds some light.
When investors feel confident about the future, they tend to invest in smaller, riskier companies. When they are apprehensive, they get out of the smaller stocks and move to the big “household names” like those in the Dow 30 or the S&P 500.
If fears continue growing, they then bail out of all stocks and move to insured CDs and high quality bonds. This final stampede for safety is the stock crash.
Chart A shows that while big stocks have continued upward, small stocks are lower now than 18 months ago. This “flight to quality” is causing a gap between the small stocks and large stocks, and the width of the gap is a measure of the amount of fear investors are feeling.
We cannot foresee the breaking point, but as the gap widens, odds of a crash grow.
When the Asian crisis began in 1997, I said you should stay in the stock market only if you are comfortable with a lot of risk. As the Russell line on Chart A shows, this has turned out to be good advice, and I am sticking with it. ♦
Returning to our introduction to these two articles: when you know a person’s or organization’s paradigm, your ability to predict their behavior is increased greatly.
Investors who are not informed about economic paradigms are flying blind, while those who do understand have a vast advantage in the quest for profits. (For a detailed treatment of the Keynesian and Austrian economic paradigms, see the 8/09, 9/09, 10/09, 11/09, and 2/10 EWRs.)
Early Warning Report is one of the few financial publications that keep you informed about changes in economic paradigms, and how these changes affect your investments. Subscribe today, and know what others don’t.
1 Malinvestment: investment of the wrong type, or in the wrong location. Often caused by Federal Reserve injections of newly created money. Businesses see the hot spots created by the injections, and move into these spots to tap into the flows of easy money. When the Fed stops the injections, a crash and recession follows as the malinvestment withers.
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