Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 8-Jul-07
As global economy continues to deteriorate, most people are oblivious

Web Log - July, 2007

As global economy continues to deteriorate, most people are oblivious

There is increasing evidence that major financial organizations are purposely covering up the dangers to the global economy posed by the subprime mortgage collapse and China's stock market bubble.

The most startling example goes back to the Bear Stearns debacle of last month. As I described it at the time it happened, Bear was forced ("extorted") into pouring good money after bad bailing out a hedge fund that it did not have to bail out. It did so to "prevent a broad market meltdown," having to do with forced resale of the hedge funds' CDO assets. Such a forced resale would create a market for CDOs, forcing EVERY bank and EVERY financial institution to re-evaluate their holdings, based on mark-to-market rules.

At the time I wrote this, this possibility was just beginning to be understood. However, numerous articles are now exposing this as a massive cover-up. I quoted several when I wrote, a couple of weeks ago, that the market for credit derivatives may be collapsing.

We now have a situation that's unique in modern times.

Imagine that you were one of the negotiators working for Bear Stearns or JP Morgan or Merrill Lynch during those 18-hour days last month when the negotiations to bail out the hedge fund was being debated. They must have realized that, without a bailout, the forced mark-to-market repricing would cause a domino effect of bankruptcies.

Thus, they may have realized that they were holding in their hands the power to force multiple bankruptcies and, at least potentially, create a historic stock market crash.

Avoiding blame

Now, of course, there are many tin-foil hat paranoics who claim that there are always people with this power. People like John D. Rockefeller and Henry Kissinger were thought to control to control the world's economy through control of oil, and that same paranoia extends today to Halliburton.

But it's an important holding of Generational Dynamics that such major events are caused by the attitudes and behaviors of large masses, entire generations of people, not the actions of a small group of individuals.

But a more precise statement is that it's generational flow that creates the necessary conditions so that even a small spark can trigger a conflagration -- a major crisis war or a generational panic. And in certain situations, it's possible for an individual to be in a position to provide that spark.

This is not a situation that was possible ten years ago, two years ago, or even one year ago. One year ago, if I had been asked, I would have said that it's impossible for anyone to provide a spark that would have the predictable effect of causing a stock market panic and crash.

And that seems to be the situation today. The situation with the mark-to-market rules is so irrestible that I can't see how a disastrous domino effect would have been avoided. So we can't be certain, of course, but it appears that the Bear Stearns negotiators had that power in their hands. At the very least, they must have perceived themselves as having that power.

Thus, I said that this situation is unique in modern times, but it's not unique in historical times. It was also true in the lead-up to the 1929 stock market crash.

Here's how it's described in the book The Great Crash - 1929, by John Kenneth Galbraith:

"Purely in retrospect it is easy to see how 1929 was destined to be a year to remember. ... [It] was simply that a roaring boom was in progress in the stock market and, like all booms, it had to end. On the first of January of 1929, as a simple matter of probability, it was most likely that the boom would end before the year was out, with a diminishing chance that it would end in any given year thereafter.

[[This is similar to an argument that I make frequently on this web site -- that a war or a panic is overdue, that it could happen next week, next month, next year, or thereafter. The point is that the probability of it happening later is increasingly small. - JX]]

When prices stopped rising -- when the supply of people who were buying for an increase was exhausted -- then ownership on margin would become meaningless and everyone would want to sell. The market wouldn't level out; it would fall precipitately.

All this being so, the position of the people who had at least nominal responsibility for what was going on was a complex one. One of the oldest puzzles of politics is who is to regulate the regulators. But an equally baffling problem, which has never received the attention it deserves, is who is to make wise those who are required to have wisdom.

Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of personal disaster which awaited them when the boom came to an end. But there were also some who saw, however dimly, that a wild speculation was in progress and that something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

A bubble can easily be punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy. Among those who sensed what was happening in early 1929, there was some hope but no confidence that the boom could be made to subside. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Someone would certainly be blamed for the ultimate collapse when it came. There was no question whatever as to who would be blamed should the boom be deliberately deflated. (for nearly a decade the Federal Reserve authorities had been denying their responsibility for the deflation of 1920-21.) The eventual disaster also had the inestimable advantage of allowing a few more days, weeks, months of life. One may doubt if at any time in early 1929 the problem was ever framed in terms of quite such stark alternatives. But however disguised or evaded, these were the choices which haunted every serious conference on what to do about the market." (pp. 24-25)

So this is what's happening right now. There are people who are very well aware that a crash is coming, but they're afraid of being blamed for triggering the crash.

Their fear mainly stems from the fact that they're well known public figures. They may have to keep their expectations to themselves, for fear of causing a panic.

Amazingly, this is also true of financial bloggers. There are many financial blogs online these days, and many bloggers that talk about these major imbalances in the global economy. But no one seems to want to spell out what's coming in terms of a new 1930s Great Depression. They certainly must know better, since they're constantly posting dramatically awful financial information, but they never state any conclusions.

In one case, I posted a comment asking the blogger specifically for what he sees coming. His answer? Something like the Panic of 1893. I don't know if this is a joke or what, but the Panic of 1893 was equivalent to a fairly typical post-WW II recession.

These financial bloggers are also Very Important People. Some are high level financial managers, some are college professors. They're such important people that they're probably afraid that if they draw the correct conclusions then they too might be blamed for triggering a crash.

I, on the other hand, have an enormous advantage over all of these people, because I'm a total nobody. There are roughly several thousand regular readers of this web site, and probably less than half of them even believe all they read. So there's no chance at all that I'd be responsible for triggering anything.

For any official who is an actual somebody, and is in a position to take some action, there comes the dilemma of what to do, what action to take to end the craziness: "The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action," as Galbraith points out.

So this must have been a consideration for the Bear Stearns negotiators. They must have realized, as the officials did in 1929, that taking the "right" course would lead to an immediate disaster, and taking the "wrong" course, which they did, would lead to a later disaster. And besides, they could use the extra time themselves to protect their own assets, at the expense of others.

Let's now look at the major, most visible imbalances in today's global economy.

#1: Subprime mortgage based derivatives (CDOs)

There are many major imbalances in today's global economy. America's increasing balance of payments deficit is very visible, but it's not the kind of imbalance that's likely to trigger a major panic. But we'll identify three imbalances that are so near a critical stage, that a panic in the near future cannot be avoided.

The first is the the collapsing market for credit derivatives. Of the three imbalances that we're describing, the other two are large and growing bubbles that must eventually burst at some time in the future. There is no compulsion that those bubbles must burst immediately.

But the CDO imbalance appears to be a like a growing crack in a huge, monster dam. You can see the crack growing, but the dam is too big to hope to repair the crack. And you can see distant storm clouds meaning that there'll be even more floods of water pushing against the same, enlarging the crack. You know with certainty that the crack will keep growing and the dam will burst before too much longer.

Another way of saying this is as follows: The real estate bubble is already leaking. Increasingly many mortgages are defaulting, and increasingly many banks are foreclosing. That's the growing crack in the dam, and the storm clouds are the vast numbers of subprime "no documentation" adjustable rate mortgage (ARM) loans written in the last two years. It's known that many of these ARMs will "reset" to much higher interest rates this year, forcing more defaults and disclosures, so the widening crack in the dam cannot be stopped.

The Implode-o-Meter web site lists 96 lenders, as of today, that have "imploded" this year, thanks to the continuing collapse of the subprime mortgage market.

Just to take one example, Brookstreet Securities Corp. of Irvine, Calif., a lender that has hundreds of offices nationwide, closed its offices last month because it was unable to meet margin calls for its leverage assets. Brookstreet was a security dealer dealer with over 3,600 clients, who had invested a total of $571 million in the company's hedge funds. The hedge funds had invested in mortgage-based credit derivatives, purchased at full price on margin. Last month, Brookstreet was forced to re-evaluation their holdings based on mark-to-market rules. The credit derivatives are now worth far less than their original value, and thousands of clients, ordinary people, will lose their life savings.

That's just one example of one company. There are more examples every week or two.

And that's not all. The CDOs (credit derivatives) based on these defaulting mortgage loans are falling in value. There are nominally hundreds of billions of dollars of these CDOs being held by hedge funds today, and those hedge funds are being held by savings banks, pension funds, college endowments, mutual funds, insurance companies, etc., meaning that millions of ordinary Americans are going to be hurt.

Real estate bubbles and collapses seem to be a part of every generational financial panic and crisis, and that was certainly true of the Great Depression of the 1930s.

But it was also true of the previous generational global financial crisis, the the Panic of 1857. I've previously described how the real estate bubble was formed by quoting from a 1950 book by Allan Nevins, The Emergence of Lincoln: Prologue to Civil War 1859-1861, Volume II. Now let's take a look at Nevins' description of how the bubble unraveled:

"[When] the panic was over, the inevitable aftermath of depression had to be faced. It closed down over the country like a chill mist, filling the next two years with slowly diminishing misery and discontent. A painful readjustment in values had to take place. The price of land, for example, sank to a level bearing a far closer relation to tillage returns. Not merely speculators, but farmers who had mortgaged themselves to buy excessive tracts, paid a sad penalty. As late as 1860, Greeley wrote from Prairie du Chien: "The West is poor. The collapse of the railroad bubble ... has spread desolation over the land." Consumers' goods were a drug on the market. Europeans, estimating that they had lost hundreds of millions of dollars in worthless securities bought during the previous five years, were in a morose mood, and it gave them little comfort to think that Americans had lost more.

[President] Buchanan wrote an inadequate analysis of the panic into his message of 1857, dwelling upon the stale theme of vicious systems of paper currency and bank credits. He said nothing about extravagant railroad construction, reckless speculation in land and commodities, or swollen imports. The London Economist characterized it as "a cloud of dust to cover a disgraceful retreat -- a great scapegoat for the rash and impudent speculations -- and in some cases, we regret to say, for the impudent frauds practised upon the too-gullible and too-avaricious people of the Old World." No action was expected of the general government in dealing with the depresion, and except for certain palliative measures by the Treasury, nothing in particular was done. (pp. 193-94)"

As I said, the situation with subprime mortgages and CDOs no longer seems to require a panic. Holders of assets with credit derivatives are increasingly being forced to mark their assets to market, and the repricing is now in the works and cannot be legally stopped. No panic is required. This is a structural imbalance that is now inevitable in the near future.

#2: Shanghai Stock Market Bubble

The second imbalance nearing a critical stage is the Shanghai Stock Market, which has been in bubble territory for almost a year.

Recall that a sharp fall in the Shanghai stock market triggered a momentary panic on Wall Street in February.

The Shanghai stock market is extremely volatile, and is showing the signs of volatility that precede a panic and crash. Here are the values of the composite index for the last three weeks:

    Date      Index       Change
    -----     -------     -------
    6/18      4253.34     + 2.92%
    6/19      4269.52     + 0.38%
    6/20      4181.32     - 2.07%
    6/21      4230.82     + 1.18%
    6/22      4091.44     - 3.29%
    6/25      3941.08     - 3.68%
    6/26      3973.37     + 0.82%
    6/27      4078.59     + 2.65%
    6/28      3914.20     - 4.03%
    6/29      3820.70     - 2.39%
    7/02      3836.29     + 0.41%
    7/03      3899.72     + 1.65%
    7/04      3816.16     - 2.14%
    7/05      3615.87     - 5.25%
    7/06      3580.50     + 4.58%

An online correspondent has informed me that the Shanghai stock market is exhibiting "a possible crash pattern as follows:"

"From the high, there was a drop of about 20%, then a rally back up to test the high (but not exceed it). From the retest, there was another drop and the end of that drop shows one daily close below the close of the previous drop. From there, the market has rallied for one day. This is the exact pattern that was made in 1929 before our market crashed. The Hang Seng (Hong Kong Index) made a similar pattern before it crashed in 1997. If the SSE follows these patterns it will crash next week, and the crash will be H-U-G-E."

Now, I personally am not into this kind of short-term forecasting, nor would I be anywhere near so certain that there'll be a crash next week, although my online correspondent may wish to brag about it if it happens.

But there's no doubt that this bubble must crash soon -- next week, next month, next year, as I always say.

And when it does crash, there's no doubt that it will have major percussions within all of China.

Will this affect the United States? Remember that the economies of China and America are very closely tied together these days, as you read the following account from Nevins' book of what happened in the Panic of 1857:

"British and American interest were so closely connected that a blow to one struck the other with almost equal weight. More than a fifth of the British exports in 1856 had gone to the United States, while more than a third of the foreign government securities ordinarily listed on the British exchanges were American. When business with America was half-paralyzed, American stocks and bonds dropped to abysmal levels, and New York paper becamse unsaleable, then British merchants, bankers were hard hit; In October and November a dismal success of failures was chronicled by the British press. Scottish banks were smitten as by a plague. One London brokerage house failed for five million pounds. In France the Crédit Mobilier bubble was priced. French failures in the autumn of 1857 were even more numerous and calamitous than British. Norway, Sweden, and all the Baltic ports suffered heavily. Hamburg, one of the principal trading links between North Europe and America, was brought to her knees. A far east as Poland and Austria, the battering impact of the panic was felt.

As Disraeli said, the business mismangement of half Europe was suddenly exposed. "All the bubbles, blunders, and dishonesties of five years' European exuberance and experiments in credit were tested or revealed." (pp. 190-91)

This is the kind of massive financial destruction that can be expected to occur in the United States and world wide, when the inevitable crash of the Shanghai stock market occurs.

#3: New York stock markets

I've written about the New York stock markets many times. I've been pointing out for years that a stock market crash is mathematically certain, given that the market is overpriced by a factor of more than 250%, just like 1929.

Earnings growth, 2003-present. <font face=Arial size=-2>(Source: WSJ)</font>
Earnings growth, 2003-present. (Source: WSJ)

The Dow has maintained astronomically high levels of price/earnings ratios because of astronomically high levels of earnings growth since the year 2000, as the graph shows. In fact, double-digit earnings growth began in 1995, and has continued to this year.

Basically, investors were betting that double-digit earnings growth rates would continue for all time, and that justified the high levels of price/earnings ratios.

But as I explained in my 2005 article, long-term average earnings growth rates are 11%. After 13 years of growth rates averaging 18%, the law of "Mean Reversion" dictates that earnings growth must be considerably lower than 11%, in order to restore the long-term average of 11%. This might mean, for example, that earnings growth will be at 4% for 13 years; or it might mean 4-5 years of earnings reductions, then a faster return to 11% annual growth. But in the end, it will have to average 11%.

Some people pooh-pooh these claims, thinking that the law of Mean Reversion can't possible be an immutable law of nature. And yet it is, as immutable as the law of gravity. There is no possibility avoiding this earnings result.

When I wrote my 2005 article, I thought that average earnings growth would start falling shortly after that, ot they didn't. But now, in 2007, it has, and the graph shows that it's apparently falling rapidly.

This undercuts the entire rationale that investors have followed for overpricing the stock market. When this fact sinks in -- and it could happen tomorrow, next week or next year -- investors will panic and start to sell.

The Law of Mean Reversion also applies to the Price/Earnings ratio index, which has also been well above average since 1995. It too will to fall sharply from its current value of around 18 to a much lower level. It's been well-below 10 six times in the last century, most recently in 1982, and my expectation is that it will fall at least that far again. Stock prices will fall to the Dow 3000-4000 level or lower.


The three global imbalances that I've listed -- credit derivative collapse, Shanghai stock market bubble, and Wall Street bubble -- are now at the point of "high alert," for the reasons that I've given.

As I've done several times in the past, I must once again strongly recommend to all my readers that they pull out of the stock market, and also out of (and associated investments, including mutual funds, money funds, investment trusts, hedge funds, and so forth). Keep in mind that I'm not alone in this recommendation -- Morgan Stanley in Europe delivered a "Full House" sell signal on stocks just last month.

After a financial panic occurs, cash will be king. You should plan on keeping cash in your bank account. If you insist on investing in something, I recommend short-term (6 or 12 month) Treasury bonds. You can purchase these online, for no commission, at . I don't think long-term (5 or 10 or 30 year) Treasury bonds are a good idea, because there are hundreds of billions of dollars worth of them languishing in central banks around the world, especially China and Japan, and in case of an international financial crisis, these would all be dumped on the market, making them nearly worthless. Stick with short-term bonds.

This web site has been up since 2002, and has been making serious predictions since 2003. Many of these predictions have been counter-intuitive, and have been completely opposed to the "general wisdom" and the statements of pundits, journalists and politicians. And yet, every Generational Dynamics prediction has either come true or is trending true; none have turned out to be wrong.

We're now entering another time of extreme danger, and it's important that you be prepared. I'll repeat the message that I've posted many times before: No one can stop what's coming, any more than anyone can stop a tsunami. You can't stop what's coming, but you can prepare for it. Treasure the time you have left, and use the time to prepare yourself, your family, your community and your nation. (8-Jul-07) Permanent Link
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