The Final Market Bubble

For the last two decades, we lived in a speculative economy where one bubble appeared after another in rapid succession. We had the hot money bubble in Asia that ended in 1997, then the dot-com bubble in the late 90's, followed by the housing bubble, and then finally the commodities bubble in energy and metals. As each one ended, the financial system was not allowed to wring out its excess because central banks and governments around the world churned their printing presses, and pumped incalculable amounts of money into the economy in order to rescue it from the short-term aftermath of each bubble. The result was that when each bubble burst, a new one began almost immediately, fueled by the flood of excess liquidity. It is not over just yet - I believe we have one final bubble to work out.

The final bubble is the US dollar itself, whose current strength is fueled by a flight to safety of investors away from all risky asset classes. The flock of investors buying US Government debt has allowed a gargantuan amount to be issued without the repercussion of sky-high interest rates, which enabled the Federal Reserve to massively expand its balance sheet, and Congress to take on an astronomical amount of debt without a significant increase in borrowing cost. It was made possible by the reserve currency status of the greenback, and its perceived safety relative to all other asset classes.

This too, will end. In our epic game of musical chairs, we are now fighting for the last chair. This is how I think it will play out. For the time being, the bubble will continue in the short term. We will continue to see strength in the US dollar insofar as it is still perceived as the safest asset class. At the same time, even though the Fed is pumping liquidity into the system, the economy is still in the process of LOSING liquidity due to credit contraction. The funds that are pumped into the financial system are getting sucked into a black hole, because the credit market is frozen and the funds going in are not coming back out as loans. As long as banks refuse to lend, we are going to see destruction of liquidity, which is deflationary in nature. And the best asset class to hold during a deflation cycle is cash - which means as long as the financial system is in trouble, the bubble in the US dollar and its equivalent (e.g. treasury bills) will likely to continue.

Ironically, the eventual recovery of our economy will set the stage for its ultimate collapse. Firstly, the up-tick in the general economy will eventually cause institutions to start lending again, which will reverse the conditions from credit contraction to credit expansion, and turn deflation into inflation. Secondly, investors will have less need for safety, thus selling off safe-haven asset classes such as US treasuries and gold, putting pressure on the debt that US Government owes. Both of these are pillars that are currently supporting the US dollar, and as they disappear, we will suddenly realize that the US owes tens of trillions and it has no way of repaying. The US government will not default on its debt, but it will try to print its way out of trouble, which will likely burst the USD bubble, drive the dollar towards zero, and trigger hyperinflation.

Nobody is sure exactly what will happen when the US dollar collapses, except that it will be bad. There will probably be chaos in international trade, as a large portion of goods are priced in USD. There will be chaos in the derivative markets, as majority of the derivative models are driven by the US treasury yield with the assumption that it is "risk-free". The currency reserve of most of the world's central banks will become virtually worthless. The world's largest importer, the United States, will suddenly lose its purchasing power. There will be riots on the street similar to those that happened after the collapse of Iceland, except it will be worse by orders of magnitude.

Where will be good places to park our funds in this scenario? To be honest, there aren't very many. A lot of countries are in a similar predicament as the US. The UK banking system and fiscal situation is just as bad, if not worse, so the British pound will collapse along with USD. There are already secession talks from some of the fringe EU countries, who are soon to be facing the stark choice of either bankruptcy or abandon the Euro because the countries have no control over their own money supply, so the Euro may not survive this crisis. The Japanese have a public debt that is a larger percentage of their GDP than the United States, and it is to be serviced by a population that is aging quicker than the United States.

This leaves a few places in the world. The Canadian banking system is currently the most stable in the world, and its fiscal and trade balances are in relatively good shape, so I am bullish on the Canadian dollar. Same goes with some of the major emerging markets: Brazil, China, and India (not Russia, whose government seems set on reversing all the progress they have made in economic liberation since the collapse of USSR). Their currencies will do well versus the rest of the world, although their equity markets will not due to the export-focused nature of their economies, and their biggest trading partners will be the countries whose purchasing power disappeared. It is my view that Hong Kong will unpeg its currency from the United States when it becomes clear that the USD is on the path of disintegration, and China will also float its currency when the rest of the world goes to hell.

Gold, traditionally a good inflation hedge, will retain its value as the major fiat currencies collapse. However, I believe there will be a chance for us to go into gold at an entry point cheaper than now, during the early stage of the economic recovery, and before inflation truly appears. When that happens, I recommend moving a sizable portion of our net worth into gold, but not so much that we would miss out on a benign recovery if the Armageddon thesis turns out to be false.

There will likely be a short-lived, but voracious, stock market rally when signs of economic recovery first appear, and we should use that opportunity to off-load certain names in our stock portfolio. Companies that sell to the United States or the other failing countries will not do well, which means BRIC and Canadian exporters, and companies that serve the US, UK, European domestic markets. The banking system will implode so financials is also a sector to avoid. To the extent that we must keep some equities in our portfolio, we should focus on the ones that may outperform, relatively speaking. Domestic-focused emerging market companies should do OK (like emerging market real estates and utilities), as well as US exporters (like General Electric (GE)), and companies in industries supported by major tailwind (health care, mining, alternative energy, and technology).

Instead of trying to get the timing exactly right, let there be humility as the aforementioned strategy is implemented, in that it should be implemented in a piece-meal fashion. I would sell a little bit of the positions that don't fit the overall strategy at each major rally of equities, and I would add a little bit to gold at each correction of the metal.

Getting back to gold, the instrument a lot of retail investors will be using for their gold investment will be the SPDR Gold ETF (GLD), because that is the simplest way one can invest in gold through regular brokerage accounts. However, I recommend that we purchase some physical gold coins or bars as well when the prices go down a bit. Ultimately, the rationale for buying gold is the same as that of the people who are stocking up on guns, ammo, and water: "just-in-case". In the "just-in-case" scenario, which is the complete annihilation of the existing financial system, the fund company that offered the Gold ETF may not survive, and the banks where we opened our brokerage accounts may cease to exist. To fully hedge against this possibility, we will all need a little bit of physical gold, stored in several different undisclosed locations that are known to be safe.

Disclosure: Long GE, no position in GLD.

Comments

[Ben El-Baz:]

Ok. A lot of people are long-term gloomy on the US dollar.

I agree that the currency foundation we're standing on is super super scary.

But I'm of the optimistic mind frame that world leaders are intelligent, and at some point in the future there will be some type of Bretton Woods-like meeting where the major currency problems (problems with the US dollar, naturally) are addressed and resolved.

Countries will make concessions to other countries (government debt write-offs?), paper currency maybe becomes backed partially by gold, the US survives, economic markets continue to function.

It's not in anyone's best interests to let the dollar crash. You explained clearly how the dollar connects things. Everyone will realize this and figure out someway to manage revaluing the dollar safely.

Like some kind of worldwide managed bankrupcy of the US dollar, but different. Because it'll be proactive, before the dollar has a chance to tank. And government leaders will be smart enough to put a positive spin on things to dampen panic.

Will be a hell of a political battle at that meeting though.

Feb 09 08:44 AM

[JudeJin:]

chan, you are trying to be smarter than mortals. you want to time your gold trade? how can you be so sure that you can buy gold cheaper than now sometime in the future?

you need to re-examine some hard facts and numbers before you opine your modest ideas about gold, which all of central banks hold as strategic assets.

from what i can tell so far, you only touched the surface what gold really is.

Feb 09 09:08 AM

[JudeJin:]

let me also remind you that your gold picture is not complete without mentioning the gold mines.

Feb 09 09:09 AM

[atlasman:]

There are so many things wrong with this I am not sure where to begin. Here are a couple points:

1. There are a few bright politicians that are trying to do the right thing but are easily drowned out by the politicians that are serving their own self interest or are pursuing an ideology that can only be described as illogical (think Nancy Pelosi here)

2. The US administration and its lackeys in Congress are pursuing a policy that any sane person would agree will further weaken the dollar. If you think that they will change course immediately as a part of some global initiative you are delusional.

I am afraid US leaders are banking on the "Hope" strategy. It is after all what the President campaigned on. It is always possible it will succeed in the short run, but like any casino the house will win and in the case the Gov is not the house.


On Feb 09 08:44 AM User 353563 wrote:

> Ok. A lot of people are long-term gloomy on the US dollar.
>
> I agree that the currency foundation we're standing on is super super
> scary.
>
> But I'm of the optimistic mind frame that world leaders are intelligent,
> and at some point in the future there will be some type of Bretton
> Woods-like meeting where the major currency problems (problems with
> the US dollar, naturally) are addressed and resolved.
>
> Countries will make concessions to other countries (government debt
> write-offs?), paper currency maybe becomes backed partially by gold,
> the US survives, economic markets continue to function.
>
> It's not in anyone's best interests to let the dollar crash. You
> explained clearly how the dollar connects things. Everyone will
> realize this and figure out someway to manage revaluing the dollar
> safely.
>
> Like some kind of worldwide managed bankrupcy of the US dollar, but
> different. Because it'll be proactive, before the dollar has a chance
> to tank. And government leaders will be smart enough to put a positive
> spin on things to dampen panic.
>
> Will be a hell of a political battle at that meeting though.

Feb 09 09:10 AM

[MarkitWacha:]

I'm long on rural ranches. This crisis may be a trigger for people to revert to a more agrarian society. I think that we'll see a balance of US manufactured goods, too. For instance, how long can it be possible for a retail establishment (WMT) to sell something like a clothing iron for $5? It costs more in energy and materials to manufacture than that, not to mention ship a few thousand miles from China. It's going through a markup, so someone somewhere is selling it for $2.50. That must come back into balance.

This depression will be tough to get through, but it will bring a needed balance, assuming that the crazy US Congress doesn't overreact and implement socialism/communist policies.

I'm looking forward to a world where there is more manufacturing and less collectivism.

About gold, I think that it will take a hit when people stop purchasing luxury items like jewelry, and then it will rise when gold bugs buy it (or both). If you want to store value in a commodity, loan as much as you can in a fixed rate loan and buy land in a depressed area. The coming inflation will pay your loan for you. Land can always produce something. This is already happening in Mexico (EWW), with the peso's recent collapse to 14 and change per dollar. Or, purchase some GSG.

I agree with the riot scenario. Order will eventually be restored, though. Life will go on.

Feb 09 09:20 AM

[Machiavelli999:]

"2. The US administration and its lackeys in Congress are pursuing a policy that any sane person would agree will further weaken the dollar."

It must really bug you that the dollar is up since October. Up a lot actually. It must also bug you why we are experiencing deflation. Like the author of this article and Peter Schiff you think its just a temporary phenomenon, but what you'll find is that the dollar continues to gain in strength. But this will not mean good news for the economy. It will mean we are entering a deflationary trap and we'll be in a 10 year depression.

Feb 09 09:55 AM

[dagnabbit:]

If you really believe in the coming collapse, you should be recommending that everyone be long in GUNS. :-)

Feb 09 10:24 AM

[Truefire:]

For those of you that think that the rest of the world will offer the US some kind of debt restructuring, that is some wishful thinking.

No matter how you slice it, we are in a bad way. We either have an unsustainable debt carry situation with runaway taxes to pay down the debt or a seriously devalued currency with our collective savings vaporized. Either way we're screwed.

Feb 09 10:35 AM

[Bad Dog:]

To those who think that the US is drowning in debt, I have to say that WW2 left the US with debts exceeding 120% of GDP. We had just paid millions of people to stop what they were doing and start building machines that would mostly be destroyed or scrapped at some point. We built ships, loaded them with goods, and sent them out into the Atlantic or Pacific to be sunk by an enemy submarine. Then we made things worse by paying for much of the reconstruction of western Europe, and on top of that built the interstate highway system. Surely, after all this "wasteful spending" the US was in an even bigger whole than it was in 1932? I rest my case.

Feb 09 11:40 AM

[earthtravel:]

I think you forgot to mention the 2012 mayan calendar and the roswell alien factor, oh and isn't Elvis still alive?

Feb 09 01:42 PM

[@TexasER:]

The is an outstanding article. I'm not sure what the real chance of the hyperinflation scenario is. But for the benefit of all you doomsayers…it’s not 95%. And to you gold-bug-bigots out there, it’s greater than 5%.

So what I really need is a canary in the coal mine. So far the best thing I have come up with is retail gold coin premiums. I’m not saying this is all that great, just the best thing I have come up with. (Read: please post better ideas)

This a very thin market (much thinner than the already thin gold wholesale market). And the only value non-numismatic gold coins have is Armageddon insurance. Premiums “normally” have been in the 3-6% range over spot. They jumped up to around 12% in Q4 2008 but have started coming back down.

Before you say…”yea, but only crackpots buy physical gold,” remember that a hyperinflation event would be precipitated by crackpots getting a whole lot of new company.

Feb 09 04:04 PM

[ThinkRight:]

No bubble is 'final' :-(

Feb 09 04:36 PM

[nova:]

It is a well interesting article by Gene Chan.

We can agree and disagree with some of his thesis regarding to the specific future economic & political developments. At the same time, the article and its predictions are based on facts and quite substantive:
- Endless and unrestrictive printing of fiat-currencies will inevitably lead to a hyperinflation
- A collapse of the US$ will not be an end of the world. Remember that the world somehow managed to exist and prosper for millenniums without US$ as a reserve-currency.
- Gold was able to survive everything including rise & fall of endless empires and civilizations.
- The Western world and its civilization are about to undergo a major historical challenge not seen for a many centuries
- Will US$ collapse to zero "over night"? I doubt. But US$ significant fall is inevitable.
- We are blessed to live at a juncture of the world major changes. Any empire falls at some moment, and the USA is not an exception. Unfortunately, the USA leaders and its people have lost “a compass”.
- The fall of the Roman Empire was felt for many centuries.

Feb 09 07:51 PM

[tonyb:]

we were then a powerful manufacturing creditor nation. today we are the largest debtor nation, with an economy based on a house of cards of debt, 72% consumer driven, with little savings, and the average american houshold with 10K of credit card debt, 1 of 5 mortgages under water, an insolvent banking system, states and municipalities in bankruptcy, and an insolvent fed gov. there are 8,000 baby boomers retiring DAILY, and this growth is exponential. fed revenues are plummetting, so this must also be added to the massive amounts of pork stimulus, and bailout monies spent thus far, and its only the beginning. you also did not have back then the massive unfunded liabilities coming due more so day after day as retirees obtain social security and medicare benefits. there are less than 3 workers supporting these retirees, and as this depression unfolds there will be less. what is happening today is all unsustainable. you cannot raise taxes enough to sustain all of this.

On Feb 09 11:40 AM Bad Dog wrote:

> To those who think that the US is drowning in debt, I have to say
> that WW2 left the US with debts exceeding 120% of GDP. We had just
> paid millions of people to stop what they were doing and start building
> machines that would mostly be destroyed or scrapped at some point.
> We built ships, loaded them with goods, and sent them out into the
> Atlantic or Pacific to be sunk by an enemy submarine. Then we made
> things worse by paying for much of the reconstruction of western
> Europe, and on top of that built the interstate highway system. Surely,
> after all this "wasteful spending" the US was in an even bigger whole
> than it was in 1932? I rest my case.

Feb 09 10:34 PM

[Gilbert A...:]

Tonyb as strong point,

And I do agree that a collapse overnight to zero for Us dollar is exagerate.

Even Iceland didn't go down to zero overnight. Doomsayers arguing for Zimbawe or Weimar republic are not serious. US is not a replica of those coountries.

But Us dollar will go down. It's like a choregraphy organized by central banks, they are going down all along. They all practice the same monetary policies.

That's why I am confident with gold to remain high and reach new summit.

I don't see the Canadian dollar to be the best haven to get away from a UsD collapse, since Canada send 80 % of its products in USA, it is hard to do good business when your main client is in big trouble.

Feb 09 10:56 PM

[auto44:]

The united states was natrual resources rich at that point,now we are required to buy most of those things from others. The only thing of real value in the end is resouces and the cleaverness to use them for the good of society and make a profit at the same time. With out profit there is no incentive to take the necessary risks.


On Feb 09 11:40 AM Bad Dog wrote:

> To those who think that the US is drowning in debt, I have to say
> that WW2 left the US with debts exceeding 120% of GDP. We had just
> paid millions of people to stop what they were doing and start building
> machines that would mostly be destroyed or scrapped at some point.
> We built ships, loaded them with goods, and sent them out into the
> Atlantic or Pacific to be sunk by an enemy submarine. Then we made
> things worse by paying for much of the reconstruction of western
> Europe, and on top of that built the interstate highway system. Surely,
> after all this "wasteful spending" the US was in an even bigger whole
> than it was in 1932? I rest my case.

Feb 10 12:41 PM

[derryl:]

Hyperinflation can be stunted by a value added tax (VAT) on everything. A 100% VAT would instantly double the price of everything so 1/2 of any money that is spent (rampant spending contributes to or causes price inflation, as our recent bubbles experience shows) would flow to Treasury, and Treasury could remove that money from the economy by using it to buy back its bonds from the Fed. Or Treasury could just lock it in a vault.

There is no limit how high the VAT could be set. If it was 500% then a $1000 item would cost $6000 and pretty soon even a hyperinflationary spending mood would be cooled down because the government would suck so much money out of the economy every time anybody spent some money.

In hyperinflation the velocity of money reaches warp speed as everyone tries to trade their cash for something they think will hold its value. So we bid up the prices of everything to get rid of all our money before it is worth less.

But if Treasury takes a large slice of that money out of every transaction then after purchase #1 for $1000 (with a 100% VAT) the seller only has $500 to get rid of, and after purchase #2 for $500 the seller only has $250, etc. Pretty soon there is no longer 'too much money' in the system. It's a fast way to suck money out of a system where too much money is chasing too few goods.

There ARE solutions to these monetary problems. We don't have to just sit back and allow arithmetic problems involving money to cause the world to end. The solutions would be politically difficult (a 500% VAT!!! Raise the guillotines!). Maybe Paul Volcker will be the guy who kills hyperinflation.

Feb 10 11:03 PM

[Blair:]

On Feb 10 11:03 PM derryl wrote:

> Hyperinflation can be stunted by a value added tax (seekingalpha.com/symbo...)
> on everything. A 100% VAT would instantly double the price of everything
> so 1/2 of any money that is spent (rampant spending contributes to
> or causes price inflation, as our recent bubbles experience shows)
> would flow to Treasury, and Treasury could remove that money from
> the economy by using it to buy back its bonds from the Fed. Or Treasury
> could just lock it in a vault.
>
> There is no limit how high the VAT could be set. If it was 500%
> then a $1000 item would cost $6000 and pretty soon even a hyperinflationary
> spending mood would be cooled down because the government would suck
> so much money out of the economy every time anybody spent some money.
>
>
> In hyperinflation the velocity of money reaches warp speed as everyone
> tries to trade their cash for something they think will hold its
> value. So we bid up the prices of everything to get rid of all our
> money before it is worth less.
>
> But if Treasury takes a large slice of that money out of every transaction
> then after purchase #1 for $1000 (with a 100% VAT) the seller only
> has $500 to get rid of, and after purchase #2 for $500 the seller
> only has $250, etc. Pretty soon there is no longer 'too much money'
> in the system. It's a fast way to suck money out of a system where
> too much money is chasing too few goods.
>
> There ARE solutions to these monetary problems. We don't have to
> just sit back and allow arithmetic problems involving money to cause
> the world to end. The solutions would be politically difficult (a
> 500% VAT!!! Raise the guillotines!). Maybe Paul Volcker will be
> the guy who kills hyperinflation.

There is only one problem with this concept: There are such things as black markets. With such a large spread introduced by the VAT, there will be enough 'fat' to enable profitable VAT avoidance transactions. Mankind has always been inventive to avoid taxes and there is no reason to think this situation will be an exception.

Feb 11 03:30 AM

[Ballad:]

Good piece. Desperation rules. Those in the know are starting to make some genuinely fearful and occasionally extreme comments, which is as good an indicator as any of how badly things are unravelling.

Just the other day Barack Obama warned that the US was facing a potential catastrophe. In the UK, one on the government's economic advisers said the downturn would surplus the Great Depression. Banks around the world are dropping like flies, or would be if governments weren't stuffing them full of taxpayers' funds.

I like gold. It got a track record. As a currency it's survived a tad longer than the US dollar. Several thousand years versus a spotty couple of hundred. It used to be that 35 US dollars got you an ounce of gold. What could you get today? Something less than 4%, I think. And if you've got any Louisiana dollars, just how much gold do they buy now? Gold has outlasted civilizations and kept its value.

I think being long on milk cows is, truly, a sensible idea, But in the spirit of the times, leverage up with a derrivative. I'm thinking evaporated milk. Less methane. If you're a Marxists, though, you might prefer to control the means of production.

The really smart person will diversify. I suggest adding cans of Campbell's soup to your portfolio. That way you're buying a tangible resource: you've got the tin. You can enjoy the soup with a glass of milk. And the labels should soon be worth more than American dollars.

Feb 11 11:57 AM

[Pookiedog:]

I agree with most of the things Mr. Chan has written and the things that everyone else has added to this discussion. I definitely agree with returning to agrarian lifestyle and owning a few protection assets (e.g. gold & guns), but I think everyone has forgot about silver coins ...I think in the long run silver will be a better tool in asset protection than AU. History has shown us that gold can be confiscated by the gov't during economic turmoil (1933). I believe that this will happen again, once the dollar has collapses and citizens will be force to relinquish their gold assets for the "amero" the North American Union currency. Now, I know this sounds like a conspiracy theory, but I think it is a strong possibility in the next 2 to 3 years. Well, we just have to wait and see...

Also, what about the Kuwati dinar its currently trading over $3 bucks against the dollar and it could only go higher if the dollar collapses, right?

Feb 18 02:56 PM