The Great Bubble of 2016 (…and 2017)

2017 Note: As of May 2017, nothing in this analysis has changed. If anything, the issues noted below have only increased in magnitude, and logic dictates that the three potential outcomes noted below remain exactly the same.

I’d like to turn from music for a moment to write a little something about the current financial markets.

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History shows that credit bubbles tend to pop once every 7-9 years, and it appears that the next big bubble pop may be upon us now. This one, unfortunately, involves not just the stock market, but bonds as well.

Actually, it’s arguably much bigger than that, with several simultaneous bubbles occurring at once: In student loans, in consumer car loans, in stocks, in high-end art and collectibles, in private debt, and in government debt.

The reality is that housing prices still need to come down significantly compared to rents, wages and other prices. This is almost as true now as it was in 2008. College tuition prices need to fall dramatically. So do car prices and medical costs and stock prices, as well as bond prices, relative to their yields.

All have been propped up by extensive money “printing”—along with other factors. And, although I believe none are being properly accounted for in consumer price indexes, it is clear that each of these is priced unsustainably high compared to median incomes.

The end game is that these prices will either fall dramatically, or stabilize at current levels (in response to heaps of additional money printing) as the prices of everything else rise around them.

Now that the US central bank, The Federal Reserve, has stopped “printing” money, asset prices are just beginning to fall, and quite dramatically. January 2016 saw, literally, the worst beginning to a year in stock market history.

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If you think this through logically, there are really only three potential ways for this to play out in the near term:

Scenario 1: The Great Deflation

I think that this is actually the least likely scenario. One could reasonably argue that this is what should happen, but in any case, chances are that the central banks around the world won’t let it happen.

In the absence of interference, a major debt deflation likely would have occurred way back in both 1999 or 2008 at a smaller scale, but central banks prevented this.

In our last two crashes, inflated asset prices should have dropped dramatically (which they did), many more bad businesses and bad banks should have gone out of business (which they didn’t) and a whole lot of excess credit and money should likely have disappeared from big business’ as well (which only happened a little bit.)

Instead, the Federal Reserve started dropping “money from helicopters” in the form of Quantitative Easing, a 21st century approach to flooding the markets with newly-minted dollars. This re-inflated asset prices. effectively kicking the can down the road. We have now just stumbled upon that can once again.

The new Federal Reserve Chair, Janet Yellen, has effectively gone on record saying that they will take this same can-kicking approach once again in response to any large market downturn, because, in her words she believed the Fed’s Quantitative Easing program “worked so well” the last two times we tried it.

This approach essentially means firing up the “presses” and printing as much money as is necessary to avoid a deflationary outcome in the near term.

If a Great Deflation actually did occur, we would have a very severe recession with a tremendous number of personal and business bankruptcies, and a default on a good portion of the US government debt as well.

This would likely result in the most short-term pain, but potentially the most long-term gain, if were were to make necessary reforms.

It’s also the least outcome to occur, because it is not in the Federal Reserve’s interest, nor is it in the interest of the bankers who own it, or politicians who select its Chair.

Scenario 2: The Rollercoaster Crash

Not a bubbleI believe this is the second most-likely scenario.

There is a reasonable chance that the Federal Reserve would allow asset prices, debt levels, and money supply to fall significantly before rushing in with “helicopters dropping money” once again.

This would mean a tremendous drop in asset prices, followed by an enormous increase in all prices. However, the prices that would rise the most would likely be hard assets, commodities and consumer goods (as well as foreign stock prices) as the market sought a new equilibrium.

Until now, we have been stuffing a good deal of newly-minted dollars into domestic asset prices and bailed-out banks’ balance sheets. But we have also been “exporting” much of our inflation, in the form of foreign holdings of US dollars, thanks to our status as the world’s reserve currency.

As soon as more money printing occurs, foreign holders of dollars are less likely to hold onto them, instead exchanging those rapidly-devaluing dollars for hard assets, effectively “bidding up” prices across the board. This would exacerbate increases in the cost of living for everyday Americans.

Scenario 3: The Great Stagflation

This strikes me as the most likely scenario for the near-term, though it may occur in concert with Scenario 2.

I believe that the Federal Reserve will most likely jump in with additional money printing before markets drop too excessively and a massive deflation sets in.

This would cause inflated asset prices to stabilize more or less where they are, while hard asset prices and foreign equity prices go through the roof in comparison.

This would result in massive declines in purchasing power for Americans, runaway increases in the cost of living, and we’d see a marked increase in consumer prices, while unemployment rises.

It would basically be what happened in the 1970s on a somewhat more dramatic scale.

However, people’s 401ks and home prices would not fall to dramatically in nominal terms—Only in real, inflation-adjusted terms. That is one factor that makes this “solution” much more politically viable.

Americans who have big mortgages or a lot of student loan debt would benefit to some degree (There are a lot of them.) They would be able to pay back their loans with essentially “cheaper” dollars.

Meanwhile, Americans with low debt who diligently save money in dollars would be hammered pretty hard. (There aren’t nearly as many of them these days, unfortunately.) This because each time a new dollar is printed, it detracts relative purchasing power from a dollar that already exists.

Because of that demographic reality—the US now has a huge proportion of borrowers compared to savers—this will likely be considered the most politically acceptable outcome. (At least for the very immediate term, which is all politicians really care about.)

And so, I believe this is the situation most likely to occur.

Actionable Tips

No matter what, in each of these three scenarios, the same underlying phenomenon occurs:

The real value of US stocks, bonds and bank holdings goes down. Meanwhile, commodities and other hard assets get bid up. And, in either case, the purchasing power of Americans goes down compared to those who live in developing economies throughout the world.

The silver lining is that this will likely lead to less inequality on a global level. But that silver lining is hard to see when it comes at the expense of your retirement savings.

So, if you want one actionable tip, here it is: If your savings are not yet diversified into some reasonable percentage of commodities and foreign stocks and, now is the time to do it. They are both currently dirt cheap in dollar terms.

In the case of massive deflation, their values are very unlikely to drop as much as the value of stocks and bonds, because they have already dropped so far, as deflationary expectations are essentially already “priced in”. In the somewhat more likely case of significant inflation however, those prices will once again go through the roof.

Even if their value didn’t increase in real terms, their relative value would increase compared to other assets, helping you to retain your purchasing power and storing value until more reasonably priced equity and bond investments are available in the future.

Whatever happens, there is no likely case in which the prices of commodities and hard assets would not rise relative to most other paper assets in the coming years.

Especially cheap right now are oil, silver, platinum, palladium, steel, copper, and many soft agricultural commodities.

Gold prices are already starting to ratchet up dramatically, and while they are not the cheapest buy, they are likely to rise first, most quickly and most dramatically do to the metal’s history as a hedge against paper currencies.

There are also great deals in foreign equity markets, when compared to the US stock market. Some of these deals may get better still as the Federal Reserve continues to “play chicken” with interest rates and suggest that it may continue its current tightening cycle.

(Incidentally, many investors still do not recognize that the current tightening cycle actually began way back in 2013 with the “tapering” of QE programs, so we’re actually quite very far into it.)

But as soon as the Fed flinches, which it most likely will, these prices will likely skyrocket. Historically, stocks tend to rise slowly and fall rapidly, while commodities tend to do the exact opposite.

If the Fed actually does continue tightening, these already-depressed values are likely to go down less compared to others, as they have already fallen very significantly on deflationary expectations.

So be forewarned. That’s what’s coming in the relatively near term. Those your likely scenarios. If anyone wants to discuss what happens in the longer term, that’s quite interesting as well.

2017 Update: Those who are blindly buying US stocks today at even higher valuations, under the rationale that potential tax breaks or deregulation may justify such prices in the future, appear, in reality, to be betting on outcome #3—likely without recognizing it.

They seem to wagering their life savings on a “silent crash”. While this might be wise if nominal returns were all that mattered, in the real world, it is inflation-adjusted purchasing power that is the true measure of your investments’ performance.

If the current, excessively-high, broad-market valuations do end up being justified by future growth in earnings, all that will mean is that inflation will have accrued to such a degree that the purchasing power of your stocks holdings will have decreased. Don’t make the mistake of confusing nominal gains for real ones. I’ll do another post on that in the future.

Justin Colletti in an educator, and engineer, and an econ nerd.

PS: Obviously, you should talk to your financial advisor before making any major changes to your portfolio.

I can’t give specific financial advice, but I can tell you what I have done and am doing. And that’s to diversify a reasonable portion of my savings into more modestly-priced non-U.S. equity markets, commodities and physical assets.

Your needs may be different, and remember that there is no one-size-fits-all advice. Investing, even wisely, always carries some risk.

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