Buckle Up : This Post is an Epic.
Now I give you Plunger:
It is important to view markets within their historical context. This allows us to understand that markets move forward as a process rather than just as a series of random events. The public never gets this and it’s why they get blindsided at market tops and never get in at market bottoms. So today we are going to view the cycles of the economy from the perspective of the broad swath of history and create a market model for the cycle. We then will “fit” our current market position into that model. This allows us to identify where we are in the greater scheme of things, which ultimately gives us a huge advantage.
Cycles repeat- It’s never different this time. King Solomon knew this and it’s why he said:
“The thing that hath been, it is that shall be: and that which is done is that which shall be done: and there is no new thing under the sun”
In ancient biblical times an economy’s cycle ended with the year of Jubilee. Every 50 years debt was forgiven and assets were returned to their owner. This was the equivalent of today’s deleveraging cycle. Since the beginning of modern finance in the late 1600s markets have de-levered themselves through a process called the post bubble contraction.
Modern finance began in London in the late 1600s with the trading of public companies on the London stock exchange. A private banking system flourished and the Bank of England was created in 1694 acting as the central bank in control of administered interest rates. This all contributed to a great economic expansion which peaked with soaring commodity prices in the year 1711. With commodities priced at highly elevated levels they crashed and the speculation shifted into financial assets rather than tangible assets. This boom in financial asset speculation progressed until peaking in the first great financial mania called the South Sea Bubble. This bubble popped in June 1720, underwent a failing rally throughout the summer then suffered an 88% crash into the fall. The time separating the commodity crash from the financial asset crash was 9 years.
The Modern Financial Model
The modern banking credit cycle has repeated itself 6 times over the past 350 years. It begins with low levels of debt and conservative financial practices. Over time as debt levels increase speculation also rises. Through the length of the full cycle several short up and down cycles occur where debt progressively accumulates. Eventually market action in commodities becomes impetuous which leads to soaring prices and an eventual bursting of the commodity bubble. A deep bear market in commodities then follows. The public then choses to shift its speculative energies into financial assets for a period of 9 years which eventually leads to extreme overvaluation in financial assets and peak debt levels. The bubble then bursts and a period of deleveraging occurs lasting typically 20 years.
This first episode of the modern credit cycle began in London and laid forth the model for the next 300 years. This credit cycle model is what Niklolai Kondratiev discovered when Stalin tasked him justify why communism was better than capitalism. Stalin didn’t like the answer so he sent him off to die in the Russian gulag. The process is one of debt accumulation which eventually builds into a great speculative boom, resulting in a huge debt overhang and eventual collapse. The collapse comes as a result of malinvestment and the unsustainability of the debt itself. Since the end of the original cycle in 1720 we have seen six of these cycles which last from 50-70 years. The cycle finally completes itself when the excess unproductive debt which is built up during the boom period gets purged from the system in a process called de-leveraging. This process is called the post-bubble contraction.
The next long term cycle of growth cannot take hold until this de-leveraging of debt occurs because high debt levels impede growth. Taking on debt pulls future demand into the present, but when the future finally arrives demand is spent, although the debt service still remains which suppresses growth. So for 6 cycles we have seen this model play out. Economic growth increases as debt levels rise and easy money eventually leads to a great boom in commodity production and rising prices. A commodity mania develops which ends in a crash. Speculation then rapidly shifts into financial assets leading to a financial bubble which peaks 9 years later. The central bank creates the money, but it’s the public who decide what to speculate in.
A cartoon depicting the reckless speculation which occurred at the top of the South Sea Bubble.
#2 Cycle 1772. After the South Sea bubble crash a long depression followed. Once debts were finally purged a slow recovery gradually began to take hold. By the end of the 7-years war in 1763 speculation in commodities reached a peak. Financial innovation allowed a great leveraging of commodity trade positions causing high prices. The commodity bubble blew out and caused a great crash. Once the crash was over speculation shifted into the stock market. Over the next 9 years the bull market which ensued was one for the ages as it was fueled by unbacked paper and government sponsorship of protected industry. In 1769 the Ayr Bank in Scotland finally adopted the inflationist schemes first proposed by John Law 70 years earlier in 1705. John Law originally marketed his inflationist scheme to the French in an attempt to bail out the French monarchy which of course led to blowing up their economy under the Mississippi Company bubble. The Ayr bank resurrected these policies and over the next 3 years the bank liquefied the markets with a tremendous amount of unbacked paper which provided the fuel for the coming great speculation. This financial “innovation” used a system of drawing and redrawing fictitious bills of exchange…in an effort to expand credit ( today’s QE). This credit creation fueled speculation, but of course the structure was built on sand. When the end came the East India Tea company was hit particularly hard and in an attempt to bail out the company the government set-up a system to sell 18 million pounds of its tea sitting in warehouses to the 13 colonies. The new legislation slapped on a tax and created a monopoly, mandating the colonies buy directly from the British at higher prices. This manifested itself into outrage resulting in the Boston Tea Party and the eventual birth of a new nation. The huge buildup and collapse of credit was ironically the driving force which led to the creation of a new nation out of the 13 colonies.
History is replete with financial irony and unexpected knock-on effects. Consider how this loose credit caused a great speculation which then collapsed resulting in a credit contraction leading the British government to impose a tea tax to help save a private company which stirred an uprising and ultimately birthed a new nation.
In our modern era we see these types of unexpected knock-on effects also. Consider how the Saudi’s opened the oil valve and flooded the world with oil in 1985 to regain market share which wrecked the Soviet economy, ultimately destroying an evil empire…ah, the irony of it all. In both cases however, the end result was all good!
Boston Tea Party December 1773- A burst bubble in London creates a new nation.
#3 Cycle 1825. London remained the financial center of the world where the prime economic activity was centered. Here again, we see war causing a great speculation in commodities fueled by wartime finance. Following the Napoleonic wars commodities continued to boom for another year until 1816 when they peaked and crashed. Soon thereafter, speculation channeled itself into the financing of the canal boom and steam ship line debt expansion. With the opening up of the new sovereign states of South America an export boom was also stimulated. Stocks were financed and sold to develop these ventures and speculation returned to these financial assets. With the easing of credit from the Bank of England market activity eventually became reckless as easy money once again fueled a great speculative bubble. From its lofty levels the bubble burst and the stock market crashed in 1825… again, 9 years after the commodity peak. The crash was triggered by the Bank of England selling a very large block of Exchequer bills, to “contract the circulation”. (This sounds eerily similar to the FED’s current threat to unwind its balance sheet as a possible defense against Trump trying to make changes in the FED’s charter and governorship). The crisis spread throughout Europe and all of Latin America where debt issuance was wiped out. A serious depression followed in 1826.
Note how commodity peaks correspond to wars.
#4 Cycle 1873. After the US war for Southern Independence (erroneously named Civil War) much financial power became centered in NY and the US became a modern economy. The wartime economy produced a mania peak in global commoditiy prices by 1864. In 1862 once the Union decided how it was going to pay for their side of the fighting, with fiat based green back dollars and bonds sold into the open market, commodity prices began their accent. With monetary aggregates now liquifying the economy and government purchases of armaments, clothing, food, rations, paying railroads for transport, iron mills, and textile manufacturers this all led to a great speculative orgy in commodities. The speculative mania reached the likes of which had never quite been seen before. Almost every man who had money at all employed a part of his capital in the purchase of stocks or of gold, copper, petroleum, or of domestic produce in the hope of scoring a gain. When the end of war was in sight the bubble burst and speculation then shifted into financial assets. The next 9 years was the era of the great rail boom.
Government policies fueled malinvestment as railroad profit became based on wild real estate speculation founded on government land grants. This was particularly pronounced with the building of the uneconomic Northern Line which would be in direct competition with the the Central Line. By 1873 the bubble became mature and rail debt became oversubscribed. As credit strains developed it was believed that the US Treasury could solve all problems by inflating without limit since the central bank was not restrained by a gold standard. The reality proved otherwise resulting in the great crash of September 1873 and the bankruptcy of the house of Jay Cooke, the prestigious railway financier. The Grant administration was clueless to act and made no attempts to cure the depression. In this episode Washington essentially let the whole process burn to the ground which led to a deep cleaning of excesses. This process took 20 years and was known as “The Great Depression” finally ending in 1895. The nation’s financial state and debt levels were now reset providing the base for a great expansion over the next 35 years.
This quote from Galbraith explaining the speculation captures the climate of the times:
“Nothing in the nineteenth century is more remarkable, than the way men forgot the last railroad debacle and proceeded to lose money in the next. But perhaps it made sense at the time. The largess extended to rail companies by the governments of the US, both state and federal was stupendous, in anyone’s language. US citizens desirous of a piece of their country’s real estate upon which to call home had to pay around $1.25 per acre to do so. The rails received in total about 100 million acres of it for free. At $20 per acre, which a good deal of the land rose to fairly quickly once the lines were laid, it grew into a half million-dollar grant per mile of track built. For Jay Cooke’s Northern Pacific, that represented $1.1 billion to collect, merely by out-laying some $100 million to build the line, which Cooke could get bond holders to pay for anyway. That’s enough to render anyone’s memory forgetful.”
So this passage paints a picture of the government policy which incentivized a vast heated financial speculation across all asset classes and demographic groups fated for a huge ultimate smashup which occurred in the fall of 1873.
#5 Cycle 1929. WWI was known for its great commodities bull market and it continued to boom for two more years after the war, peaking in 1920. The economy then entered into a short term depression. Under the Harding administration little was done to relieve the situation resulting in commodities crashing, and debt quickly becoming purged from the economy. This allowed a quick economic recovery to take hold followed by a robust expansion.
Throughout the 1920’s the FED, as always focused on the past, was concerned with persistently weak global commodity prices. As a result, they over liquified monetary aggregates which fed themselves into financial assets instead. This resulted in the speculative boom known as the roaring twenties. Just prior to the wild blow off stage in the NY market, in 1929, the President of the NY FED, Benjamin Strong stated that he was going to administer a “little coup de whiskey” to the markets in an attempt to assist the British pound. So in 1927 he began selling the USD and buying hefty amounts of treasuries thus extending credit to the masses. (QE 1920’s-version) With the publics interest now engrossed in financial assets the market went into overdrive and the mania blew out in October of 1929. Again note the pattern, 9 years after the commodity peak. The 1929 crash and the period leading up to WWII became know as our grandparents “Great Depression”
#6 Cycle 2008. Our current cycle up began after WWII in 1946. It is erroneously taught and believed that WWII took us out of depression. Sorry that’s just wrong, solving the unemployment problem by putting working males into fox holes does not end a depression. Wartime rationing actually reduced living standards, hardly something that occurs in an economic recovery. But what the war did was to clean up the balance sheets of the average American. With nothing to buy people accumulated savings and paid off their debts. After the war all the pent-up demand could be released using cash-not credit, which led to the prolonged expansion of the 1950’s and a roaring bull market until 1966. The secular bull market of 1982-2000 ended in a narrow mania in the Dot-Com sector. As crazy as it seemed, it was not a classic end-of-cycle bubble as It was not preceded by a commodity bubble and it was not followed by a full blown financial calamity like the 1930’s. In addition, one of the identifying features of a classic end-of-cycle bubble is for the economy to turn down simultaneously with the financial markets. The top of the 2000 Dot-Com bubble led the the economy’s downturn by a full year. This is not in line with the full credit cycle model.
After the mild 2001-2002 recession, commodities did however, reach a mania peak in 2008. Attempting to rescue the Dot-Com crash, Alan Greenspan lowered rates to 50 bps, but only succeeded in stoking a bubble in real estate and commodities. Remember the FED creates the money, but it’s the public who decides where to speculate and where the money ultimately flows towards. In the past a major war was the catalyst for the commodity bubble, however this time it was the Chinese infrastructure build out.
Above we see how commodity prices developed into a mania from 2002-2008 then crashed, this time not caused by war but China infrastructure build out.
It appears we may have just completed a dead cat bounce over the past year.
So here we sit at a precipitous point, 9 years past the commodity blow out. We take a look around and what do we see? We see the Everything Bubble or as Doug Noland calls it the Sovereign Finance Bubble where everything gets inflated to great valuations. Leading the pact are the FAANG stocks which are in a full blown mania blow off. Additionally, all the US indexes are up against new highs and European stocks are at levels of upward momentum not seen since before the last crisis in 2007.
XLK- Inclusive of the FAANG stocks.
Since the beginning of modern finance ALL cycles followed the same sequence to the top. A great commodity speculation peaked 9 years before the final mania in financial assets peaked. Furthermore, the stock markets in London and Europe peaked in May-June, followed with a short correction then underwent a failing rally lasting the summer then crashed into the fall, and finally cleared by November. The US markets, however put in their peaks in September-October and crashed into the fall. In all cases the distinguishing feature of bubble endings is the economy tops with the stock market, whereas in normal bear markets the market peaks about 12 months before the economy peaks.
London and European Markets
Knowing that London and Europe historically peak in May-June, let’s take a look at these markets today. The below charts focus on both daily and weekly RSI as an indication of the level of exuberance. Once the RSI reaches these levels that we see today it limits the move and indicates a likely top. The RSI readings on both markets are at their highest since before the 2007 peak. Weekly RSI at these lofty levels typically signal a peak in the market.
London Weekly and Daily- Note the extreme RSI readings
Below we see the same picture for Europe- RSI Extremes
Below- Party on Dudes?
The Shanghai Top is in.
The below chart of the Shanghai index should make it apparent that a top in this index is well behind us.
The Post Bubble Contraction. (PBC)
We have seen the model for the modern financial credit cycle has repeated 6 times over the past 350 years. It starts with a low debt, de-levered economic structure which allows growth to finally take hold. Through a period of around 50 years the expansion accumulates debt which eventually impedes growth. The debt level is a form of overhang to the economy and before growth can resume it needs to be cleared. This clearing process typically takes its form as a deep depression. This de-levering period is referred to as the Post Bubble Contraction and typically lasts about 20 years. Debt is cleared through a range of processes, from repayment and restructuring to outright default. This resets the balance sheet of a nation and allows growth to take hold in the next cycle. The financial crisis of 2008 began this process, however the central banks of the world aborted it and their efforts have led to the credit bubble getting even bigger. Some private debts have shrunk, but others have risen such as auto and college debt. Sovereign debts of all nations however, have grown with the possible exception of Iceland.
Stock Market Performance in the PBC- Rallies Weak and Narrow.
Cyclical economic recoveries in a PBC are characterized as sub-trend and anemic. The recovery since 2009 fits this description aptly. Stockmarket rallies also lack robustness. The cyclical bull market since 2009 exhibits these characteristics with low decreasing volume over the past 8 years. In the chart below we see volume continue to contract throughout the rise. The only time an increase in volume occurred was during a price decline in late 2015. This is consistent with PBC dynamics: muted sub-trend growth throughout the first recovery phase.
Breath is narrowing
In addition to declining volume, breath is becoming increasingly narrow as the advance continues. Presently 60% of all S&P 500 issues are below their 50 DMA and the market is being driven principally by the FAANG stocks. This narrow sector is reflected in the XLK ETF. Check out the RSI readings being driven to the wall as a result of fresh money gushing into this sector.
Metals in the PBC
In a PBC base metals and energy decline relative to gold. Gold’s real price goes up as the real price of most commodities goes down. This eventually enhances operating margins and results in a bull market in precious metals mining stocks. Gold performs better in a deflation because it maintains its purchasing power better relative to other assets. So gold mining actually does well in a deflation and a bull market eventually gets underway. Over time, as more gold is produced it re-liquifies the monetary system and a general economic recovery ensues.
Currencies in the post bubble contraction (PBC)
The currency equation is probably the least understood aspect of the PBC. So much analysis is stuck in the old gold bug narrative of “evil FED prints money-the USD must fall”. We will take an expanded look at currency dynamics as ones analysis needs to go beyond the simple statements we hear such as “The USD is going down”, as if that was actually analysis.
Above the USD- From a simple perspective. It still looks fine, moving averages still in ascent, price still consolidating.
During the cycle expansion financings are conducted in the senior reserve currency. Fulfilling this role, the USD has been the vehicle for the bulk of the lending post WWII. As debt is created it acts as a synthetic short against the currency as extinguishing the loan requires dollars to be purchased to cover the debt. A construction project in Brazil borrows the loan in Dollars not Real. Paying the debt off requires a purchase of dollars which strengthens the currency. The post bubble contraction’s de-leveraging reduces credit in the system and causes loans to be paid off or extinguished. This process completes the transaction and covers the short thus strengthening the senior currency. In addition, since oil is invoiced in dollars a declining oil price lowers the supply of dollars causing a further shortage, thus providing a price boost for the currency. These dynamics are not unique to this cycle they occurred before with the British pound, however sound analysis indicates that the main strength afforded to the USD is actually a result of the broken and impaired Eurodollar system.
Above- A hard back test, but nothing broken.
There is no way I can condense the full argument of the Eurodollar analysis in this short section so I recommend listening to Jeff Snyder’s recent podcast explaining in detail why this is so.
After downloading his charts and listening (maybe two times) one can see that the Eurodollar system is broken resulting in a massive shortage of dollars throughout the world. The world runs on dollars so this shortage of dollars is countering the reflationary policies of central banks causing them to fail. This shortage is causing the USD to rise during the PBC since we have a USD based system and demand drives up price.
A few salient points may help one understand what’s going on. The Eurodollar system is the result of the failed Bretton Woods monetary regime after WWII. Since the US Government refused to honor its promise of converting accumulated dollars into gold a secondary market developed throughout the world since the 1960’s for those dollars. An independent market for these dollars allowed dollar holders to trade them since they had accumulated surpluses as the USD was not allowed to clear in a complete circle of trade.
So European and Caribbean banks operated on this Eurodollar system while conducting business and loans. As Snyder points out for some reason after 2011 these banks have backed away from engaging in this currency system. (it is my reckoning it’s risk related as they don’t want to ultimately be caught holding the bag.) This has had the effect of massively reducing the monetary aggregates in the system. It is NOT coincidental that this bank disengagement began at the same time gold peaked in late 2011.
At each successive USD market event since 2011 a part of the Eurodollar system has come off line, the result has been a reduction of monetary aggregates in a US Dollar world. This has caused the reflation trade to run out of steam and the only inflation we have had was caused by rising oil prices over the past 18 months. That oil price rise was likely only a dead cat bounce and has now resumed its fall.
As the European and Caribbean banks reduced their Eurodollar exposure the Japanese banks picked up some of the slack and lent to the Chinese since the Chinese economy is backed by the Eurodollar system. Keep in mind the Chinese pay for their oil in USD and need dollars. Now however the Japanese banks are withdrawing their lending from the Chinese due to perceived risk which again has the effect of shrinking supply.
Above- Clean view of the process ahead of the PBC.
Bottom line on the Eurodollar is that this system which fuels the world is breaking down and supply is diminishing. Another round of QE will not address this problem as the chief effect of QE was for the credit to simply sit on banks balance sheets and only improve sentiment not the money supply. This is a structural issue and is getting worse. The recent weakness in the USD over the past few months is not due to a failing currency it more likely can be attributed to fitting into the financial buoyancy enjoyed by the major stock market averages. A break of support levels of up to 2% is consistent with past shakeout moves in the dollar and does not mean its upward move is over. By July the USD should have completed its base and resume its advance.
Conclusion- Who is Ben Bernanke?
A professorial monetary hack, a clansman of John Law of the South Sea bubble. A self-proclaimed “history expert” who evidently never read a page of history prior to the year 1930. He shamelessly titled his autobiography “The courage to act” where it would have required much more courage not to act and let the system self correct.
What we can see from the historical record is that central and private bank lending eventually gets out of hand. Easy money distorts peoples perception of reality and this leads to a great speculation, first in commodities then financial assets. The bubble bursts because the quantity and quality of debt is no longer sustainable and the entire edifice comes crashing down. This process then takes about 20 years to burn out and purge the debt accumulation. From all indications using the historical model it would appear the world is positioned to take the ride again.
Plunger’s Big Trade Update- Oil Short
After all the hype of the OPEC meeting and the immediate selling of the news after the meeting OPEC announces this:
Pathetic! As if they still have any credibility with the market.
Could this be the expected H&S buildout?
Recall the principle of significant technical patterns often form on S&R lines. Below we see a H&S is currently being backtested from below its neckline. Good low risk short entry.
All systems go on the Big Trade.
DOW Theory Update
This week the DOW went to a new high, unconfirmed by the transports. So the non-confirmation is still intact, however I would not bet against this market. I suspect the US markets still have upside before September.
If you are in the market I recommend dancing near the exit as the bank index is showing a continued divergence with the general market. This is the same divergence developed at the top in 2007.
Gold Stock Watch
The inverted USD vs Gold chart shows the USD has been almost perfectly inversely correlated with gold. This relationship remains intact:
However the below chart of gold vs the HUI shows that something has to give pretty soon. Since May 10th they have been going opposite directions. Which way will they go when they get back into alignment?
The principle gold bottoming metrics:
Waiting to get back above a rising 30 EMA.
Stock of the Week- Sage Gold
Who says going to investment conferences doesn’t give you an edge? In early May at the Metals Forum in Vancouver I heard the story and liked the chart of Sage Gold. The chart was showing it had done all the technical work of a rising consolidation and was ready to resume its advance. It was telegraphing an imminent move higher.
Sage has a tight share structure and a $13 million market cap so it could move real fast if the market gets interested. This week Sage blasted off, due to a brokerage house making a 94 cent call on the stock. But here is the thing with Sage, it is just the type of company that the market has turned its focus towards. A small project with upside discovery that works at today’s metals prices. We don’t have to bet on the come here. They are entering production in September. No big capex, no hype, just results. That’s what is working in this market, not pie in the sky.
Disaster of the week- Arizona Silver Exploration
If you have been waiting for comical selling to hit the market….well you finally got it! Down 75% in one day on poor drill results. As Spock has mentioned this is just the first round of drilling so the sell off would seem a bit extreme. My take is that whenever a stock is waiting on drill results and is sitting on a weekly RSI of 87% it’s set-up for an epic disappointment if the results don’t come through. This is what happened:
Mind the RSI.