Great Depression 2.0: 90% More Downside

As the de-leveraging slowly works its way down from the top to the bottom, I would like to pose the prediction of 90% further downside in the financial markets.  I am not 100% sure in this prediction, but I have been putting the data together in the last two days and there are a few clear statistics that stand out to support this theory.

First, let me say that this 90% move will probably not be happening in the next week or month.  This could take years or even decades.  The insinuation, however, is that the momentum and technicals are in place to take us there.

To begin with, we need to understand what is wrong with the financial markets and the economy.  At the heart of the problem is credit and debt.  Too much credit has been extended and too much debt has been racked up on the back of that credit.  Many people like to believe that this credit bubble began somewhere in the early 2000′s, when the housing market began its most recent rally, or when structured derivatives (Mortgage Backed Securities) allowed that rally and other structured credit products (CDO’s, CDS, etc.) were created to create other credit rallies.  However, I think a more accurate and common argument these days is that the actual credit bubble began back in the early 1980′s, primarily between 1981 and 1984.  (Interestingly enough, 1983 was the year that several larger companies started to accept each others credit cards.  This chart shows the growth in Credit Card debt taking off in the early 1980′s.)  A look at the charts shows us that this is when America (individuals and companies) really began to take on more debt.

As you can see by these two images (the same poor quality image, posted twice to help clarify) that have been used as a frame of reference for Marc Faber’s recent talks and by Seeking Alpha, the US Credit Market Debt as a percentage of GDP began growing beginning in the early 1980′s.  The ratio has grown to rougly 331%, meaning our nations economy has more than 3 times the amount of debt than the economy makes each year.  A ratio of more like 130%-160% (1.3x to 1.6x levered) has been a much more stable level of debt for the economy for over the prior 70 years of the last century (the Great Depression saw a similar spike in this ratio). 

While the economy at 3 times levered might seem large or small to some, let us compare that with the largest banks, such as Citigroup, which is currently 15x levered (the most levered bank in the US), according to CLSA’s Greed and Fear.  On a side note, the European banks are between 20-60x levered, a very scary thought indicating a global, not just American, depression.  Either way, it is clear why the credit market and overextended debt pain is beginning with the banks before it percolates through to the rest of the economy.

Lastly, we should have a look at the government debt.  While the US Government is not in nearly as much trouble as its businesses within, the Government is also near highs in the debt-to-GDP ratio.  The US National Debt, currently roughly $10.5 trillion has recently breached the 70% of the US GDP ($14.56 trillion) level.  While the leverage ratio of the US Government is not nearly as scary as the Credit Market, it does show a very large rise from the mid-30% level at the beginning of the 1980′s.

Now that we have identified the timing a size of the credit market bubble, let us move on to the equity market, which is more commonly how people track our economy.  Up until recently, I and others have been looking at the longer term trend line in the major indices since roughly 1980.  Those trendlines suggest another 10% or so of downside before we are back to that longer term growth level.  It is commonly expected that we could overshoot that level, similar to an expected housing market overshoot on the down side.

However, until recently, I too believed that this was a more recent bubble based on the securitization of credit.  As more fundamental data has shown up (above), I have come to realize that the bubble began before the late 1990′s, and possibly as early as 1980.  If this is true, and we have been in a credit bubble since 1980, will the bursting of the bubble lead us back to the longer term, pre-1980 trend line?

Please have a look at the chart below showing the Dow Jones Index since 1920.  We have had two main paradigm shifts, as a co-worker likes to call it, in the last 30 years.  First was the shift for the credit bubble around 1980.  Then came the shift of the Tech/Internet bubble around 1994.

The Tech/Internet bubble, or paradigm shift, broke around year 2000 and the market retreated, almost to the 1980-initiated trend line.  However, new inventions in credit securitization halted that fall and led to another false leg up in the credit bubble.  Thus, when we hit the 1980 trendline roughly 10% lower from here, we will not be back to a stable level in regards to the credit bubble.  We will merely be finishing the tail end of the retracement from the Tech bubble.

So, how far does that leave us to fall?  Well, the pre credit bubble trend line, since the begginning of the century, puts stable long, long term growth at around 90% lower than where we are now. 

This is a very difficult argument to make.  There tends to be the thought that these larger paradigm shifts have changed the way the economy works.  We make money faster and spend more than ever before, right?  That should continue, right?  It all makes sense emotionally that we have a new, better way of running the economy nowadays and that we have the ability to make it bigger so much easier than before.  Entreprenuership will save us, right?  But logically, I cannot explain why.  The credit bubble acts as a counter argument for every reason I can give. 

Q: What about the improvement of political regimes when Communism was brought down? 
A: We added capitalism to the rest of the world, which all grew on credit.

Q: What about the flattening of the globe and the rapid growth in third world countries such as China and India? 
A: China, India, and other cash-rich manufacturers have been the ones financing this credit by purchasing US Treasuries.  They will feel as much, or more, pain as the Western debtors when Western countries begin to default, or at least contract.  This could either be caused by them, when they stop buying US Treasuries (China is 60% of the market there), or possibly, although not likely, a natural default due to our government nationalizing everything and eventually running out of money.

Q: What about the invention of the Internet?
A: The Internet either acts as an interface for brick and mortar businesses (ie. Amazon) or acts as an method of transfer of information.  Outside of Google, there is not a massive amount of true market capitalization on the back of thriving business models.  Facebook has yet to find a business model that will make them money.  Throw the rest of Web 2.0 companies in their corner and the Internet leaves us with an updated version of the telephone and printing press.  These companies are all capitalized by debt (even the equity they sold was purchased with leveraged debt), so I do not see how the Internet has truly changed any fundamental economic principles.

In conclusion, I see our markets and economy still having a long way down to go and nothing to stop it other than the government subsidizing every bank, company, and industry to try and soften the blow.  There may still be a bubble or two in us (alternative energy?) that could give us one more leg up or at least short term (several years) stability, but in the long run, the credit bubble is over and the markets will eventually price that in correctly.

*image sources: mercurynews.com, CLSA, zfacts.com, Bloomberg

No related posts.