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The Pattern of Financial Meltdown (Protagoras, November 5, 2007) It is very hard to be sure, but if there is a financial catastrophe underway, as opposed to a very serious correction, it will have the usual accompaniments in the media. There's a sort of S shaped curve. At the bottom we have a BusinessWeek cover on the Death of Equities. This is probaby occasioned by some spectacular collapse, which in Austrian terms can be considered as a writeoff of malinvestment. Things then start to recover, as the bad debt has now been written off, the assets have gone at enormous discounts to people who can make some productive use of them. However, the media are rather event driven and so don't see it. Politicians are also event driven. So for the longest time we have slow improvements which are not noticed, or which the media will tell us are temporary. The curve is very shallow, but up. It is only when the curve starts to rise that some of the doubters get convinced, and when it gets to the steepest part of its rise you have people like me who about halfway up start to think this is unsustainable. However, it carries on. A huge percentage of gains are recorded in this phase of the market. When all the doubters and everyone who lost their shirts at the bottom are convinced, Business Week then publishes a cover story headlining The New Economy, Masters of the Universe, or perhaps Making a Fortune in Real Estate. Then we know we are at the top. However most of the time, the subsequent decline follows the same pattern. It has to convince the doubters, and this happens gradually. So don't blame the media or politicians too much. They are not conspiring. They are just behaving as usual. And also remember that they personally do not live in the same country as the middle class Americans who are having financial problems. That is also a big factor. In recent years, the country seems to have split into two. There are those that work, are thrown out of work, fight the wars, lose their houses. There are those who drink lattes and have no idea what the price of chuck is, and fill their shopping carts without ever looking at a price tag. Journalists and politicians are in the latter camp. I am not sure whether what we are now seeing is a 1929 type catastrophe or something more on the lines of classic bear markets. There are strong arguments for the former. If you look at stock market turnover as a percentage of GDP, Alan Newman on Crosscurrents has published charts showing it is similar to that previously unique period. The credit bubble - Doug Noland this week in his piece on the Prudent Bear gives some numbers for the amount of derivatives outstanding - is unprecedented. The relaxation of lending standards in US housing seems to have been unprecedented, and the rate of foreclosures seems to point in an ominous direction. I am convinced by Simmons' arguments on oil production. But I was convinced when I read Peak Oil by Deffyres, and that was when it was first published quite a few years ago now, and the crisis, if it is real, is only just now coming on us. The best way probably to look at it is not to try to predict but to try to recognize - to prepare a list of things that will mark a systemic crisis. Prediction is much harder than recognition. It will not just be one thing. I would guess that first among these would be the failure of AIG and the other credit insurers. A second might be the insolvency of Citi. Perhaps the final one would be collapse of GS and Morgan. Certainly the collapse of Levitt and other builders would be a straw in the wind. At some level the stock prices of WalMart and Home Depot may give advance warning. I think the issue with lots of the current arguments used in the bearish sites is their lack of quantification. Yes, we are seeing a rise in foreclosures. But from very low levels. And we could see this, and still escape with a recession. How high does it have to go to produce a crisis? Similarly, it is true that derivatives outstanding is an enormous number, in the long term the chances of disaster from it seem high. But, if it doesn't happen in the next ten years, it may be less of an issue for me personally than the rate of inflation. My own expectation is that we will indeed see a systemic financial crisis, accompanied by insolvency of many of the US and UK banks. But I recognize at the same time that this is an expectation with a huge margin of uncertainty both in terms of time and extent. There's some chance that I could be quite wrong and that in some way I cannot see, we will muddle through. A way to play this is by LEAPs. One could buy long term puts on (say) Apple and Goldman Sachs. Think of it as insurance, expect to lose it, hope to lose it. If they expire worthless, heave a sigh of relief and buy some more. And be very alert to these instruments rising sharply in value. If they do, we are on the verge of a panic. For more on a wide array of other topics, please visit the oftwominds.com weblog. 
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