Can This Be The End Of The Mega Bull Which Started In 1980?

Includes: DIA, IWM, QQQ, SPY
by: Global Opportunities Analyst


The crash in the commodities market can be an ominous sign of a global deflation.

We have been in an almost constant economic growth since 1980 mostly thanks to growing debt.

This time may be the reckoning of all the excesses that have been accumulated in decades.

What I am about to describe is nothing short of a terrifying nightmare. If it comes true, and we are at the end of the mega bull market which started in 1980, there will be almost nowhere to run. Gold may go up for a while, especially at the beginning of the rout, but when other assets get badly hammered, gold holders will also have to sell something which will have become simply too expensive compared to other assets (and there could also be some deleveraging there). However, strongest treasuries will be the best place to hide, at least as long as our current capitalist/financial system stays the same. Governments will need to take on a huge amount of debt from businesses, to keep at least the relatively healthy ones afloat. That will undermine many government debts too. Many governments would probably abandon the whole modern central banking model and start printing money to cover both their operational, and interest, expenses. Those governments would therefore be exporting more deflation to the only countries standing put, not printing money at will. A terrifying scenario indeed! Just take a look at the size of this mega bull market before reading my arguments regarding the real probability of its final demise. As it can be seen in the S&P 500 chart below (from, there have been two failed attempts in the 2000s to kill the bull, but thanks to central bank policies and government interventions, from all around the world, more debt has been accumulated, which has succeeded in prolonging the current paper-wealth creation. However the biggest paper wealth in the world is not in the stock markets, but rather in property, which has gone up along stocks. And property prices are also a lot more important in the underpinnings of our current economic system.

Commodities prices may be at, or near, their bottom right now, but is that a good thing, or rather the major sign for an ominous financial and economic outlook? This is actually the $100 trillion question of 2016-2017. If the answer is that cheap commodities boost consumption and are excellent for the economy, then we shall keep, or maybe even improve, our worldwide paper wealth of today in the coming two years. But what if the answer is the latter? What if cheap commodities is the first telltale sign of an impending deflation in which earnings shrink, production is cut, and ultimately large numbers of employees laid off?

Deflation in itself isn't necessarily a bad thing. Most people are struggling to understand what is all the fuss about falling prices, which is supposed to be a good thing. Deflation simply means falling prices (opposite to inflation), so in case income does not fall, falling prices are fantastic. The problem appears when there is a huge amount of borrowing and deflation is a symptom of misallocation of capital, provided by aggregate debt. The bigger the misallocation the bigger the expected deflation. What can happen then - as growth does not match expectations when the debt was accumulated - is that debtors (for example a company) are obliged to rebalance their books by taking several understandable and simple steps: 1) they offer their products and services cheaper so that they can improve their cash position, 2) they try to reach better deals with their creditors, delaying repayment, reducing interest rates, or perhaps getting a completely new longer-term loan to replace the older one, 3) if these two first steps did not do the trick, they start selling assets to improve their books, 4) they don't hire any more and start laying off employees, 5) in case none of the above worked and the financial situation worsened the company can go bankrupt soon. All these 5 steps are deflationary, and not in a positive way. And in case the debt problem is a widespread one across the economy, the resulting situation would be called deflation. The bigger the excess capacity the deeper the deflation! These things, as memories of the Great Depression are still vivid in books and images, tend to spiral out of control as debtors get into a stampede of deleveraging, taking the above steps one by one. The debtor who takes measures first gets the better deal and those left behind get crushed. This rational competition is the reason for the stampede.

Many nowadays associate deflation with the Japanese economy, but the reality is that deflation is a much older and widespread phenomenon. The chart below can give somewhat of a historical perspective for inflation or deflation in the US. As it can be seen (from, up until quite recently (from a historical point of view), inflationary and deflationary periods pretty much evened themselves out, though it is impossible to have precise data. After years of rising prices, they seem to fall for a while, and in the long run they hover around no change. This happened because the US dollar was pegged to (or backed by) gold, and as the quantity of gold does not tend to change much, prices stayed relatively stable over the long run. This gold peg, in turn, did not allow governments to print money as they wished - hence causing real, persistent, inflation. And of course, as it can also be seen in the chart, things did indeed change after 1971 when Nixon administration abandoned the gold standard, and afterwards there was a very prolonged period of high inflation without the usual deflation, which would have followed when there was the gold standard.

Ever since the abandonment of the gold standard there has been a new normal in which "price stability" (as central bankers put it) has been "achieved" (again, according to central bankers) under rigorous effort and serious supervision of the major central banks around the world. Central bankers declare to have brought prices under control because prices did indeed creep out of control in the 1970s, immediately after the US abandoned the gold standard. However, central bankers, by aiming for this apparent price stability - which meant moderate inflation, but never deflation - gave businesses and consumers courage to go and take on more debt, and they did. And this continuously-added debt created continuously growing demand, which in turn allowed businesses to grow, pay their employees more, and then they could go on and get even bigger loans. Take a look at the chart below (from! Although total debt has been coming down in recent years in the US, as it can be seen, government debt has been rising, as the government has been taking on more debt from some businesses and households who started deleveraging after the financial crisis. But still, total debt is at unprecedented levels - above 300% of GDP.

During the gold standard it was much riskier to take on a lot of debt, as the great depression (and many times before that) had proved. Too large a debt burden could cause very serious troubles. However since 1980 central bankers seem to have mastered the art of almost-continuous economic growth, by creating price stability (as they call it, meaning benign instability, above zero) which in turn allowed businesses and consumers to take on more debt so that the economy could grow. When businesses were unable to take on more debt, consumers came to the rescue, and when consumers got exhausted, governments came to the rescue, and when governments got exhausted, central bankers came to the rescue. One question is still out there - who comes to the rescue when businesses, consumers, governments, and central bankers have all been exhausted and taking on even more of the thing scares the hell out of the other participants? Well, that's one bit that has been left unanswered! And that's in fact the $100 trillion question! It has been over 35 years from the starting point of applying this strategy. There isn't really any evidence somebody devised such a plan, to achieve growth by ever greater indebtedness. It's probably more of an accident of history. Fed and government interventions after each downturn in the economy and their intolerance toward reducing economic excesses caused the current situation. Over these 35 years output growth has been achieved with greater indebtedness rather than technology, which is the foundation of sustainable growth. Although we have had tremendous amount of technological advances since the 80s, humanity's current consumption levels are still far above what technology alone would have provided. And having debt in itself, within an economy, is by no means something negative. Debt can be used to buy a house in installments rather than in a down payment. The worrying issue comes when this debt accumulation becomes endemic and is used by corporations, consumers, and governments, to create growth, whether it is growth in EPS (Earnings Per Share in companies), or output growth in the whole economy. Maintaining aggregate debt at a certain level, without constantly pushing it upwards, could have probably done good by providing affordable and reasonable mortgages to households and some level of improved liquidity to companies. However, nowadays, taking on debt to expand production, buy back shares, or to buy all kinds of consumer goods, is seen as normal. This has been going on for more than three decades reaching critical levels, as the 2008 recession proved. But it didn't stop there. Corporate debt in the US and other countries, especially in Emerging Markets, has risen tremendously since the crash in 2008. This has created excess capacity and artificially high EPS and dividends. Look at the two charts below - first about the US (Goldman Sachs research) and the second about Emerging Markets (Barclays research):

It is fascinating how the whole world has learnt from the US how to have almost-continuous growth. China, not being a democratic country, has even gone one step further. They have achieved the only real continuous (not almost-continuous) growth out there. And this in turn, while nobody noticed, created another party to take on debt, and that party was 'your neighbor' - or in fact, in a macro sense, other countries. Since the 2008 crash it has actually been China, and to a smaller extent other Emerging Markets (the neighbor in this analogy) which, by taking on a huge amount of debt, spurred this anemic growth that the world has been witness to. And China seems to be exhausted now. Other major Emerging Markets also seem to have been exhausted. When US businesses, consumers and the government took on just about enough debt not to spook each other, there was the unexpected (at least to an observing economist) savior, the neighbor! More and more countries joined the club and took on more debt, and consumption didn't stop growing. Or maybe it did, when it peaked last year! This may be the bubble that can dwarf the one which burst in 2008. And it can indeed be the crash to bring down Warren Buffett! It is outside the scope of this article, and it would be a very long explanation, but the fact is that Warren Buffett's (Berkshire Hathaway's) huge (paper) wealth has been built on leverage, whether directly or indirectly through subsidiaries. It's not only Warren Buffett. Of course any equity investor in the US (or around the world), big or small, is sitting on paper wealth mostly reliant on direct or indirect leverage.

Take a look at another chart below (businessinsider - it's from 2010 - I couldn't find a better one out there, but it's still relevant today, as things haven't changed much), showing total US debt from almost 100 years ago until our times. Back then there was no China or Emerging Markets (as meaningful participants in world trade and finance), and coincidentally, the crash of 1929 came earlier (compared to now), when total debt was much smaller. Following years were marked by devastating deflation.

Of course nobody wants to see another great depression (forget about the great recession). As the current world debt situation stands, businesses, consumers, governments, and pretty much all the 'neighbors', are loaded. Central bankers can take further measures to encourage more indebtedness, but who is going to take on more debt now? Will more central bankers (especially the US) take interest rates below zero? And if they do, would that help in an environment in which nobody is willing, or able, to take on more debt? The game can go on forever as long as there are enough participants to take on more debt, but the problem is that participants are 1) finite, and 2) wary of each other. This is a zero sum game in which the smarter participant gets rid of the stick (the debt in this case) early. And nobody wants to be the last one holding the stick. How will governments convince consumers, or businesses, to take on more debt when they have already seen what happened in 2008? Eventually the government would need to take on some of the bad debt, but it cannot take on all the outstanding debt out there as that would completely deplete its credibility in the eyes of the other participants, domestic and international. Governments would become wary of each other, and the ones taking on most of the debt would fail, because their solvent citizens would move their hard assets to shelter under safer governments (or currencies). This wariness among market participants is the reason encouraging further indebtedness from now on seems to be a very tricky endeavor. Pretty much all the developed countries in the world, plus China, are either near, or above, 300% total debt to GDP. Can we just go higher, to let's say 500%, and keep on having economic growth and the prosperity we have come to enjoy since 1980? It is a possibility of course, but because fewer and fewer businesses and consumers are willing to participate, it is unlikely to happen. The Japanese started first to offload their excess debt to their government because their deflation started much earlier. Europeans reached their tipping point after the 2008 crash and have actively been offloading their excess debt to their governments too. Now, at or toward the end of the current economic cycle, it is going to be US and China, where governments will have to take on more debt from their businesses and consumers. This doesn't mean Europe and Japan are off the hook! After persistent deflationary pressures of recent years Japan and Europe were helped by US and China, and some other smaller, healthier, markets to export some of their deflation by devaluing their currencies (Yen and Euro). Recently China has started, grudgingly, to export some of its own deflation to the rest of the world. Imported deflation from Europe, Japan and China has left the US with no inflation of its own, and on the brink of deflation. Who will everybody now export deflation to? There is too much talk about China nowadays, but the fact of the matter is that China is not the real cause, but rather one piece of a much bigger issue which was started in the US more than 30 years ago. Countries can continue devaluing their currencies, trying to pass on some of their deflation to others, and they will do so for a while, but the remaining ones will just have to contend with everybody else's exported deflation. Europe and Japan will continue, in the coming period of time, their policies that have caused devaluation in their currencies, and China will most probably join in. And this will just alarm, and anger, the US. China does not seem to be able to hold things together and it may not be up to its leaders to choose further devaluation or stricter capital controls (both of which will export deflation). Chinese citizens are going to do it instead. And Chinese leaders will just have to take measures to contain the consequences. This process started last year in China but it hasn't reached truly critical levels yet. China still has more than $3 trillion of currency reserves - though not all of it easily and freely accessible. Chinese capital flight was at an annualized rate of $1 trillion in the second half of 2015. This has good chances of accelerating - further pushing the Yuan lower and exporting more deflation to the rest of the world - as world economy slows in 2016 and there will be less demand for Chinese exports.

We will eventually end up with a huge amount of debt taken over by governments across the world because they will be unable to cut their expenses for the fear of adding to an already high private sector unemployment. This is a huge dilemma, and there is no simple solution, but the fastest and most convenient one, which has so often been used by governments in the past, is to print money at will, without using the central bank as the middleman, and not adding to the borrowing. More borrowing would simply be unrealistic in a deflationary environment. If the government would still be considered solvent, adding more debt would just reduce its credibility in the eyes of the lenders, and reduced credibility would push yields higher, making it impossible for the government to service its new debt. But these are uncharted waters. The only example is Japan, where they have had deflation for decades, which has resulted in a ballooned government debt of almost 250% of GDP. However they had the advantage of being able to provide goods and services to the rest of the world - a world which could still accumulate more debt and have significant growth and benign inflation. Japanese government debt yields are historically low, so investors don't seem to be concerned about the government's ability to service its debt. Nonetheless, in a hypothetical future in which there will be deep worldwide deflation (in US dollar terms), it is unlikely that governments will enjoy the current sanguine approach by investors, and shakier governments (Spain, Italy, France, Japan etc) with highest debt ratios and less ability to service their obligations will simply become unable to accumulate more debt to cushion their weak economies. Where can all this hypothetical (but very probable) situation end? Apart from very high unemployment levels and economic misery, it can also bring an end to our current Central Banking system. Some governments would simply start printing money because they would have no ability to borrow in hard currency, while stronger governments would just limp on and hope for better times in the future. No matter what, our current inflated paper wealth would no longer be there and would no longer make any sense. Stocks and corporate bonds (apart from the ones which would disappear altogether) all over the world would have to adjust to levels that are almost inconceivable today. And I don't really know the fair level.

There are two, perhaps if we can very generously call them, bright spots, in the horizon! Chinese government is not exactly loaded, yet, compared to other major governments in the world, with a total government debt ( - numbers are quite different from various sources for total government debt, including local governments) of less than 60%. This means that the Chinese government can still take on more debt from a deleveraging corporate sector. Another somewhat of a bright spot, that may encourage investors, probably in the short run, would be some signs from the Fed that they are willing to stop raising rates, or even cut them. Nevertheless these are not measures which will bring growth, or stop an impending deflation. They can only be used to contain a serious panic. And officials, in China or in the US, will probably need to deploy all the measures, but they will only do so when things get much uglier.

The first to lose in a painful deleveraging situation are shareholders, then creditors, and the last one to stand is usually the government. But not all governments are safer than corporations! Historically, governments have failed many times - only Greece did so recently. The best thing to do would be to avoid exposure to the weakest links, and eventually seek safety in the treasuries of strong and stable governments like the US and Switzerland. Germany has relatively low public debt (compared to other developed markets), but its heavy dependence on exports, its potential for instability because of a possible mass refugee issue next year (perhaps as bad as this year), and also its connection to the Euro, make it somewhat of a risky place. In the case of a deep deflationary environment there will be no demand for quality loans (loans that can actually be repaid), so treasury yields will be much lower than they are today, hence buying US treasuries now at slightly above 2% for the 10-year maturity seems to be a bargain. And of course more and more of the indebted will need to sell assets to pay down their debt, and this will be horrible for stocks, corporate bonds, and even real estate. Let's just pray that all I have written is nothing but a product of my cynical imagination!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have sold all my shares and bought US 5-year notes.