On February 28th, in Panic Selling Will Lead to a Sharp Bounce, we stated,

investors should be positioning themselves for a countertrend rally…We do not expect that this is the ultimate low, merely a level that will support a multi-month bounce. This reflationary bounce will be much stronger (and possibly last longer) than any other rally we have seen since October 2007. Its purpose is to put to rest the widespread fear currently in the market…This temporary bottom will support a sharp bounce into the fall.

Last month in Panic Selling Will Lead To a Sharp Bounce, we stated:

"Bearish sentiment is everywhere. Investors have finally realized what we have been discussing for the last two years. And now that we are near a temporary bottom, some investors are taking action. Unfortunately, investors are reacting to the past. They should have been in cash during the downtrend...Instead, investors should be positioning themselves for a counter trend rally: by either not selling their stocks or if they are in cash, by considering market exposure (depending on your risk tolerance)."

In June of 1966 (similar to the warm sunny days of summer in 1929 and 2007), Brian Wilson produced the Beach Boys’ single “Good Vibrations.” Capturing the positive feelings of the day, it quickly became a number one hit. But something had changed in 1967 when the Beach Boys moved on to their next album: Smile. They just couldn’t do it. With discord among the band members (Mike Love reportedly called Smile ‘acid alliteration’), Smile was simply shelved. Unable to deal with the pressure, Brian Wilson experienced an emotional meltdown. The next single released by the Beach Boys was titled “Heroes and Villains.”

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As Treasury Bill yields fell during the early 1930s, Treasury bonds moved in the opposite direction. As you can see from Table 48 (also from A History of Interest Rates), bonds rose in yield (fell in price) during the banking crises of 1930-32.

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As we stated last October (the month of the stock market’s peak); “the stock market is a sideshow, it can adjust to the economic reality very quickly as it did in 1929 (especially with credit losses already in place).”

Only misconceptions about the Great Depression cause a dismissal of the similarities. Commodities are correcting sharply as forecast. The U.S. Dollar has gained double-digits against other currencies while the Yen is “soaring to 13 year highs.”

In part one of this series, we addressed a few speculative investments that might rise over the next few years. We would like to stress that most assets will fall in a deflationary environment. We have therefore focused on preserving portfolios with U.S. Treasury Bills held at more secure financial institutions. 

As we mentioned two months ago, a speculative commodity bust would fit with the onset of a deflationary collapse. During the month of July, commodities began this correction with the largest monthly decline in 28 years. They are still falling.

Similarly, Lombard Street Research’s measure of M3 fell in July the most on record (since 1959). The chart of the percentage change in money growth is below.

As we referenced last April, it is very important in a deleveraging environment to hold your U.S. Treasury Bills at a secure financial institution.

Calling brokers and reps up and asking them if your funds are safe at their institution is like asking the fox if the chickens he is guarding are safe. What do you expect them to say?

As we forecast last month in our Investment Analysis Report, the regional banks have quickly brought about the next round of financial troubles. We expect a large decline in the broader stock market to be the next major issue. The Royal Bank of Scotland (RBS), Morgan Stanley (MS), Barclays (BCS), and even the Bank of International Settlements (the central bank’s central bank) have issued financial storm warnings. We referenced the Bank of International Settlements [BIS] last July in warning of the credit crunch last year. According to the Telegraph, they are now specifically warning of deflation. The BIS states:

Historians would recall the long recession beginning in 1873, the global downturn that began in the late 1920s, and the Japanese and Asian crises of the early and late 1990s respectively. In each episode, a long period of strong credit growth coincided with an increasingly euphoric upturn in both the real economy and financial markets, followed by an unexpected crisis and extended downturn…The eventual global slowdown could prove to be much greater and longer lasting than would be required to keep inflation under control. This could potentially even lead to deflation, which would evidently be less welcome.

We hope you have a chance to read our rebuttal to CNNMoney.com’s recent Great Depression article. While we have described the 1930 peak before (all the way back in October of 2006), we feel our analysis has been vindicated. We may take some flak for getting too far out ahead of the parade back in 2006; but our readers know we discuss long term trends. (Check our chart below on personal savings!) The reasoning in October was correct;

Higher rates will prevent many from refinancing out of their adjustable rate mortgages. Reports from Fannie Mae state that over $1 trillion dollars in mortgages will reset at higher rates in 2007. Many U.S. homeowners, whose savings rate is negative, will not be able to withstand this financial pressure. As they default, the third wave and credit crunch will begin.

After reading CNNMoney.com Editor Paul La Monica’s piece on the comparisons to the Great Depression, we felt compelled to respond. Unfortunately for Mr. La Monica, the article regurgitates common beliefs about the Depression which conflict with historical fact and basic economics. We hope to set things straight. We begin with Mr. La Monica’s words:

The unemployment rate skyrocketed during the Depression, peaking at nearly 25% in 1933. The current unemployment rate is just 5%. And that's only up from 4.5% a year ago. Contrast that with the far more explosive spike at the beginning of the Great Depression - from about 3% in 1929 to nearly 8.7% in 1930, according to the U.S. Bureau of the Census.

Last month we stated: “we should expect rocket-launched (oh they’ve saved us) bear market rallies.” Since that time, the DJIA has had two separate blastoffs. That’s all it took for investors to forget about the massive deflation that is happening in U.S. neighborhoods. We view the rise of the last two months as a breather before more serious selling takes hold. Goldman Sachs (GS) agrees and is warning ‘delusional’ investors of a sell-off of “a further 15pc over the ‘near term.’”

Warren Buffett has also recently stated “the recession will be more severe than most expect.” Meanwhile, the Fed is wondering why all of its extraordinary measures have not increased liquidity. We advise investors not to get swept up in the bullish hype of the recent upturn and follow the old Wall Street adage: “Sell in May and go away.”

The panic we suggested would occur in our report last month has enveloped the credit markets.

When the house of (credit) cards begins to fall in on itself, the trend turns from inflation to deflation. That’s when creditors turn their focus from lending to collecting and debtors turn their focus from borrowing to repaying. But by this time there are too many IOUs, and debtors cannot service them, much less repay them. Falling asset values and economic contraction thwart efforts to honor the loans. Debtors begin to default. When that happens, the game is up.
– Bob Prechter, Elliot Wave Theorist

As Charles Kindleberger asks in the investment classic Manias, Panics and Crashes:

The essence of financial distress is loss of confidence. What comes next - slow recovery of belief in the future as various aspects of the economy are corrected, or collapse of prices, panic, runs on banks, a rush to get out of illiquid assets and into money?

Financial speculator and billionaire, George Soros states in his FT.com commentary: “the current crisis is the culmination of a super-boom that has lasted for more than 60 years.” In June’s Higher Rates Reflect Default Risk we described the end of the last credit boom:

In 1928, the U.S. Treasury Bond similarly broke out of the channel and rose to a higher yield. This coincided with the end of ‘easy’ money which forced the deleveraging of the economy and concluded with the financial crisis of 1929-1932.

What we think of as 'money' has been tremendously expanded by the use of debt. Now that fear has entered the credit market, money has become scarce putting pressure on leveraged asset prices. Margin calls are becoming more numerous throughout the system. Central banks, through various schemes, will attempt to reflate the credit bubble. But they will fail because they cannot create confidence.

Another Bank Run

Fed Injections

“In late 1836, the Bank of England, concerned with inflation, raised interest rates.

As rates rose in England, credit tightened, and U.S. asset prices began to fall.

We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.

We clearly disagree. Credit Suisse’s ARM Reset Schedule, included in our last report, shows that over $1 Trillion dollars worth of adjustable rate mortgages will reset over the next 5 years. Bloomberg is just now reporting on the extent of the subprime meltdown. Even more telling is what credit derivative market charts are showing.

“Of course, nothing about the horses’ chances actually shifts; it’s the same horse, on the same track, in the same field, but in the mind of the betters, its prospects improve significantly once that ticket is purchased. Once a stand has been taken, the need for consistency pressured these people to bring what they felt and believed in line with what they had already done.”

Markets are cyclical. Unfortunately, investors that stay fully invested, diversified, and ‘consistent’ until the end of this bear market will lose most of their funds. In our last article we concluded that a greater than 50% correction in the Chinese indexes over the next 2-3 years was highly probable. On Tuesday, the Shanghai Composite Index plunged 8.8%, the most in 10 years. The downside percentage decline for the Dow Jones Industrial Average will be similar and will be detailed further in our next article.