Saturday, May 27, 2017

Manias, Panics, Crashes And The Madness Of Crowds

Unfortunately, the speculative cycle is extremely abrupt, and therefore the economic cycle is very abrupt as well. This is going to be an education they never forget...

For some totally unknown reason, the Economics profession remains wilfully ignorant about the downside effects of cheap debt - not only on speculative portfolios, but on the economy itself. To be sure, they are well aware of the (fake) "wealth effect" thrown off by monetary policy:

The Wealth Effect:
"The wealth effect refers to the psychological effect of asset value increases, such as those experienced during a bull market, on spending patterns. The concept focuses on how the feelings of security, referred to as consumer confidence, bolstered by the rising value of assets, such as investment portfolios and real estate"

What about falling values? No effect?

The problem with this willful ignorance is that it leads to widely ingrained behaviours such as extrapolating the business cycle out to infinity. The problem in turn with extrapolation is that the business cycle bears no correlation whatsoever to the latest stale bread crumbs of backwards-looking economic data. And yet that doesn't stop economists from making serially-wrong predictions. After all, the trend is their friend until the very day it's not. 

In the bubble economy in which we find ourselves, the primary determinant as to the health of the credit cycle and by extension the "economy" is the speculative asset cycle, which I have modeled above.

This is well-documented by Minsky, but I wanted to add some additional relevant detail, because the bubble cycle is not just about credit accumulation it's about the interdependence between asset values and credit - after all, available leverage is a function of both income AND asset values

As we see above, speculative asset values are initially supported by income, but eventually supported by debt/leverage as the cycle progresses. Asset values and leverage spiral higher since one feeds off the other via the speculative equity effect. As in, look my house value went up and so did my equity. This can go on for quite some time, until such time as asset values rise too quickly and exceed available buying power. This is the Wile E. Coyote moment. Why? because the model does not go in reverse. Marginal asset values can fall very quickly, but unfortunately, fixed debt obligations do not. This results in forced selling, and ultimately panic. 

The $Trillion dollar question is knowing when it's the end of the cycle, because one must jump in the time machine and be a seller ahead of that point in time. And by my humble estimation, the only way to know it's the end of the cycle is when price accelerates after a "prolonged" period of slow and steady increase.

I would suggest that this is not a good time to be fucking around with speculative asset values...

Recession stocks:

Dow Transports

Recession sector rotation versus IPOs