Dow-Jones: I Told You So 14 Months Ago

In February 2009 (when the Dow-Jones was hurtling towards 6500) I made a startling prediction:   "The Obama stimulus package, worth some 800 billion USD, the 1.9 trillion USD in TARP funds and the endless Fed injections and auctions are bound to revive the moribund American economy by the third and fourth quarter of 2009. The Dow-Jones is likely to touch 10900, consumption will recover, as will housing starts and, in some markets, housing prices. But this 'recovery' will prove to be a false dawn. It will last 2 quarters at most and will be followed by a recession so deep and dangerous that it would truly qualify as a Depression. The current recession is merely a prelude to the depression of 2010-5."   (Quoted from my article titled "The Next 18 Months: Recession, False Recovery, Depression", dated February 22, 2009).   In December that year (2009), in an article titled "Dow Jones: On the Way to 4800", I modified my prediction and called the end of the rally at DJIA 11200. On the week of April 28, 2010, the DJIA reached 11200 and reversed sharply.   From the February 2009 and December 2009 articles:   "The Dow-Jones may yet see-saw between 7800 and 11200, but as the dimensions of the crisis emerge more clearly, it will head to its next technical target: 4800.   Here are the reasons:

(i) The stimulus should have been more sizable, taking into account the dimensions of the crisis.

The fate of modern economies is determined by four types of demand: the demand for consumer goods; the demand for investment goods; the demand for money; and the demand for assets, which represent the expected utility of money (deferred money).

Periods of economic boom are characterized by a heightened demand for goods, both consumer and investment; a rising demand for assets; and low demand for actual money (low savings, low capitalization, high leverage).

Investment booms foster excesses (for instance: excess capacity) that, invariably lead to investment busts. But, economy-wide recessions are not triggered exclusively and merely by investment busts. They are the outcomes of a shift in sentiment: a rising demand for money at the expense of the demand for goods and assets.

In other words, a recession is brought about when people start to rid themselves of assets (and, in the process, deleverage); when they consume and lend less and save more; and when they invest less and hire fewer workers. A newfound predilection for cash and cash-equivalents is a surefire sign of impending and imminent economic collapse.

This etiology indicates the cure: reflation. Printing money and increasing the money supply are bound to have inflationary effects. Inflation ought to reduce the public's appetite for a depreciating currency and push individuals, firms, and banks to invest in goods and assets and reboot the economy. Government funds can also be used directly to consume and invest, although the impact of such interventions is far from certain.

(ii) The US government should have nationalized the big banks, let other financial institutions that are not too big to fail do so, and force mergers and acquisitions on the rest. Half-hearted measures intended to provide balance-sheet relief are unlikely to restore trust in financial intermediaries. In the absence of such trust, banks will not resume their traditional roles of capital allocation and interbank lending. As it is, we are likely to see a run on some of the banks, including at least one or two majors (probably Citigroup and Wells Fargo).

(iii) Europe's real economy as well as its financial sector are a mess. France, in sliding officially into a recession, has joined Spain, Ireland, and, now, the United Kingdom and Germany. The "recovery" there is feeble as false as the one in the USA. Battered by a strong euro, expensive energy, and mighty competition from China, the US, and India, European exports have stagnated. As opposed to the USA (where exports constitute 18% of GDP), Europe is dependent on foreign carbon fuels and foreign markets for its goods and services. Exports constitute more than 40% of Eurozone GDP.
Moreover, Europe's commercial banks are in horrible shape - far worse than America's. This year alone, European banks must pay 1.41 trillion US dollars in principal and interest, mainly to bondholders. They don't have the money and they cannot borrow it from other banks because interbank lending has all but dried up. Many of them are already technically insolvent. They are also over-exposed to emerging markets in Eastern Europe, Latin America, Africa, and Asia as well as to profligate eurozone members such as Greece and Spain, Italy and Portugal, and, outside the eurozone, to the crumbling economy of the United Kingdom. Austrian, Greek, Swedish, and German banks are exposed to default risks throughout Central and Eastern Europe. Consumers and businesses in Serbia, Ukraine, Hungary, and other teetering economies owe Austrian financial institutions $290 billion - almost the entire GDP of this country!

As local currencies depreciate in the near future (when the US and China sink into Depression), debts, denominated in foreign exchange, will grow more expensive to service. As the real economy contracts, in the first phase of what appears to be a prolonged recession, bad loans mushroom and reserves are exhausted. This requires cash-strapped governments to recapitalize major banks. Faced with current account and budget deficits, some of these sovereigns are scrambling for outside infusions from the likes of the IMF.

Europe's recession will be profound and protracted. Asia is likely to follow suit: Singapore, Japan, South Korea, and Taiwan are already technically in recession and China's growth rate is a fiction, fueled by massive and indiscriminate lending by state-owned banks. A contraction of GDP in both India and China is no longer inconceivable. It seems that yet again, the USA will be faced with the daunting task of dragging the rest of the world back to growth and profitability.

(iv) To finance enormous bailout packages for the financial sector (and the auto and mining industries) as well as fiscal stimulus plans, governments will have to issue trillions of US dollars in new bonds. Consequently, the prices of bonds are bound to come under pressure from the supply side.

But the demand side is likely to drive the next global financial crisis: the crash of the bond markets.

As the Fed took US dollar interest rates below 1% (and with similar moves by the ECB, the Bank of England, and other central banks), buyers are likely to lose interest in government bonds and move to other high-quality, safe haven assets. Moreover, as countries that hold trillions in government bonds (mainly US treasuries) begin to feel the pinch of the global crisis, they will be forced to liquidate their bondholding in order to finance their needs.

In other words, bond prices are poised to crash precipitously. In the last 50 years, bond prices have collapsed by more than 35% at least on three occasions. This time around, though, such a turn of events will be nothing short of cataclysmic: more than ever, governments are relying on functional primary and secondary bond markets for their financing needs. There is no other way to raise the massive amounts of capital needed to salvage the global economy."