Are We in the Final Phases of a Credit Expansion? Protect Your Portfolio Now

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We keep warning investors. But nothing bad happens.

Atop our worldwide headquarters, the Crash Alert flag… with its handsome skull and cross-bones design… keeps flapping in the wind. But no one pays the least attention. We might as well be a schoolteacher.

Why continue with this (now hoarse) voice of concern… when everything is clearly going so well? Isn’t it time to admit that we are wrong? Isn’t it time to look out the window… see the sun shining… and stop fretting about a downpour?

Well, of course, we wish to confess to a little weakness. We don’t know what is going on – except for the obvious thing. Obviously, the credit cycle is still in an expansion phase. We thought it came to an end in 2000… and then again last year. So far, we’ve been wrong – just when we think the party is over, someone rushes in with another armful of bottles. And, wheeee!

After the tech stocks began to crash and burn in January 2000, the whole globe held its breath. And then, in September of 2001, it shuddered. By then, the U.S. economy was already in recession – induced by the stock market correction and its knock-on effects.

Then, of course, George W. Bush and Alan Greenspan were taking no chances. They backed up the liquor truck and unloaded the biggest delivery of cash and credit ever delivered. The U.S. federal budget went from a phony surplus to a real deficit – a total swing of about $700 billion. And the Fed’s key lending rate went from 8% down to 1%; we’d never seen anything like it.

We doubted that even this would be enough to stop the credit contraction. Wages were not rising. So, consumers could only spend more money by borrowing it. Since they already owed a record amount, we doubted that they would be fool enough to go deeper into debt.

But they were. A boom in the property market suckered them into it. It gave them not only the will… but the way. Thanks to the innovations of the mortgage credit industry, they could ‘take out’ equity faster and easier than they could order a pizza. Party on!

By 2006, though, the revelers were getting a little tired. Lenders had lent too much money to too many people who couldn’t pay it back. And now the bad credits were beginning to make the headlines. All of a sudden, subprime mortgage lenders were missing their earnings targets. Then, a few of the big subprime mortgage companies actually went broke. And now, people with bad credit and no money are finding it hard to buy a house. Imagine that! Which means, the pressure from the bottom, pushing people into bigger and better houses… and higher and higher house prices… has eased off. Housing prices are no longer going up. They’re going down.

With no more equity to ‘take out,’ where will consumers get more money to spend? How will the economy continue to expand?

We don’t know. But it looks to us like the real economy is now not growing at all – but shrinking (that is to say, the sum of actual, productive labor is falling). The average worker is not really getting richer – but poorer.

Still, there’s no talk of recession – yet. Indeed, from the looks of the markets, things have never been jollier. The Dow is near an all-time record. There are so many mergers and acquisitions that the business journals can barely keep up with them. And other markets – notably China – are flying off the charts.

We see hyper financial activity… with desperate speculation all over the place. In fact, it looks to us like the final phase of a credit expansion… the final, loopy phase when investors lose their heads… and wallets… completely.

Could we be wrong? Yes, we could. But remember – the importance of any event is equal to the likelihood TIMES the consequences. There may not be a crash… but the effects of a crash could be so devastating… readers are urged to take precautions. Think about the risk factors in your portfolio and see what you can do to minimize that risk.

Bill Bonner
The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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Comments

  1. A sharp contraction of the credit bubble would cause a steep fall in the money supply by definition. Under those circumstances, shouldn’t deflation be the major concern rather than inflation? It would certainly seem like this potential, which has been clear for a year now since housing started to fall is a major factor keeping gold from going to new highs despite the growth of the credit bubble.

    If the credit contraction hits, I would think gold would get pummelled. Sadly, gold (and silver) seems to be just another asset class being bid up by the frothy liquidity at the moment. The positive correlation to stocks on a daily and even hourly chart makes me very uncomfortable.

    If I buy gold at current prices, isn’t that a bet that the central bank reaction to a bursting bubble will be to hyperinflate? Given the respective examples of deflation in Britain and the US during the Great Depression vs hyperinflation in Germany’s Weimar Republic, I would hope that they would choose deflation as the clear lesser of two evils.

    Deron Kawamoto
    May 15, 2007
    Reply
  2. Not only did the staff at the Daily Reckoning get it wrong, but so did the likes of of J. Puplova, D. Noland, R. Prechter AND Milton Friedman. As the debt bubble grew & grew and the global economy shifted into anti-gravity mode, even old Mr. Milton was at a loss. The amount of credit being created should have resulted in massive inflation, yet it did not. In fact, it can be argued most of the ground level inflation (not housing) which occured since 2002 has been the result of centralized price control (corporate monopolization) rather than the traditional shifting of costs.

    Why? Henry Liu & Doug Noland make a good case for the decoupling of the financial from the real economy, but then that begs the question, how did the decoupling occur?

    It occurred because the central banks of the world conspired with one another to create phantom collateral upon which to continue the credit bubble, evidenced by those bogus Fed Reserve Notes which turned up in Manila a few years ago. This phantom debt formed the basis for all the liquidity injected into the global economy since about 2002. The past few boom years are based on this nonexistance capital.

    This would be the meta-version of what K.A. Fitts talks about – Reagan-style voodoo economic corruption. Simply put – balancing the books is only for the little people. The Fed & the BOJ are above it.

    So central banks attempted to bootstrap the global economy out of the scary deflationary scenario Prechter kept warning about (and still is, and is still getting it wrong). This was debt free money from the core – but unlike traditional counterfiet money which will result in inflation (the Nazi’s attempted to destroy the British economy during WW2 via phony pound notes), the central banks only used the phantom liquidity as a basis from which to lend. Just like the infamous trader at Barings Bank, I figure they fully intended to take it off the table once the global growth became self sustaining.

    But it never left the system and never will. I’m guessing the big hedge fund traders caught the old men at the Fed & the BOJ red handed and are now blackmailing them, meaning, any attempt at monetary policy is useless now that this phantom credit is trapped inside the system.

    Will this phantom liquidity result in inflation or deflation? Who knows. I figure the big traders will carry the game too far and destroy the entire financial apparatus. There won’t be any place to hide then.

    stu mann
    May 16, 2007
    Reply

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