Now, Where's That Other Shoe?

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The stock market tanked more or less on cue (see "When (and Why) the Bubble Must Burst" from Feb. 9, 2000. Volatility followed the mini-crash. Now the markets appear sedate. Everything's cool again, right?

Wrong.

iTulip.com's predictions on the stock market since 1998 assume that a financial bubble formed in the US in 1995. In order to develop, a financial bubble requires a special set of occurrences, just as a hurricane requires a special set of weather conditions. These are described in detail in "All Financial Manias Develop More or Less the Same Way."

Briefly:

A pivotal event, such as the end of a war (e.g., WWI for the 1920s bubble or the Cold War for the 1990s bubble), creates a general atmosphere of optimism in the host country.

A new technology or discovery (e.g., the Radio in the 1920s and the Internet in the 1990s) provides a hook for financial speculation. Significant changes are experienced by everyone in physical landscape, as in the 1920s when skyscrapers first transformed American cities. Imagine how it felt to walk for the first time among these giants. You'd conclude that anything is possible.

The conduct of commerce also changes. New ways of buying goods become available during these periods, such as installment credit in the 1920s and online credit card purchasing in the 1990s. Everything seems new and anything appears possible, including the apparently endless prosperity. Into this mix add loose monetary policy, justified by apparently endless increases in productivity, provides the essential fuel.

The current stock market and credit bubble was fueled by excessive money growth starting in 1995, after which the usual self-fulfilling bubble dynamics took over. At some point the system begins to produce its own fuel, just as the rotational force of a hurricane draws up into itself the water it needs to grow. A financial bubble becomes a self-fulfilling and self-sustaining system. The press, industry analysts, bankers, brokers, and others build fortunes and careers by the engaging the masses in the mania. Public leaders provide needed confidence. A surge in capital gains tax revenue turns politicians into market boosters. Even after the current bubble became self-fulfilling, it was enhanced indirectly by the response of the Fed to the Asia currency crisis in 1997, as well as Asia capital flight directly. The worlds' central banks' response to the Russian bond crisis in 1998 and then concerns about Y2K leading up to the end of 1999 each increased the external bubble fuel supply further, as additional liquidity was added to the financial system.

Research on past bubbles tells us that the deflation is a process of several stages, not a single event. In the current instance we experienced the first-stage drop in April and some volatility. Now we're in a relatively quiet period. The mechanics of the process dictate that a credit crunch should develop shortly, if it hasn't already. An innocuous story in last Tuesday's Wall Street Journal is key: US Banks' Trend of Tight Lending Continues Through Summer, Fed Says:

"More lenders tightened standards in the second quarter than at any time since the peak of the Asian currency crisis. For the third survey in a row, none of the surveyed banks said they eased lending practices. A sizable majority of banks that had tightened their credit standards cited 'a less favorable or more uncertain economic outlook, as the reason. Lenders also expressed a "reduced tolerance for risk" in their responses."

These rocket scientists can't imagine a future in which foreign central banks don't give a damn whether the United States has a strong dollar or not.

Big deal, right? But this story must be viewed in the context of four others from the past week:

Heating-oil futures vaulted to their highest levels since the Gulf War at the New York Mercantile Exchange amid fresh fears of a supply shortage this winter.
The U.S. savings rate hit an all-time low of -0.2% in July, as consumer spending rose twice as fast as personal income for the month.
The weakening euro is putting more pressure on Europe's central bank to raise interest rates. But hints that Europe's economy may be heading for a slowdown have put the bank in a bind.
The Commerce Department said Thursday that orders for durable goods slumped 12.4% last month, the biggest decline since the department began tracking orders in 1958.

To glue it all together, the following WSJ story is likely to go down as the What Me Worry? story for the next 10 years: Most Experts See US Current Account Gap as Remote Risk for Dollar.

"A country's current account deficit reflects the extent to which it is consuming foreign goods and services in excess of its own exports. As the deficit swells, so does the country's foreign debt because the consumption is financed by foreigners. That can prompt foreign lenders to worry about the country's ability to repay the debt. In southeast Asia in 1997, for example, such worries precipitated sudden capital outflows, which threw many economies into recession.

"Foreign central banks aren't going to sit back," said John Makin, a principal in the New York investment firm Caxton Corp. "By suggesting plausibly how much of a dollar depreciation or appreciation of foreign currencies would be required to eliminate the current account deficit in the United States, you really suggest reasons for its sustainability."

These rocket scientists can't imagine a future in which foreign central banks don't give a damn whether the United States has a strong dollar or not, as will be the case following a collapse of the U.S. credit bubble economy. Post-collapse, consumer demand will fall off rapidly and demand for imports with it. The United States may over a period of years slowly and painfully turn from a sexy capital importer to a relatively mediocre goods exporter. The United States has over the past 10 years become a maker of high-quality fantasies, from Hollywood to Wall Street, but relatively low-quality and low tech goods. The strong dollar has for the past ten years meant that the United States has not only exported inflation but productivity as well. With a relatively poorly educated and deeply indebted workforce, the United States has exported the image of high-tech manufacturing prowess that actually belongs to Asia and Europe. The United States may find itself begging Asians and Europeans to buy its less sophisticated and outdated products. This will become far more obvious after the U.S. economy goes into recession, U.S. corporations lose their sex appeal and the U.S. consumer goes into a heavy debt paydown and savings mode.

In any case, that all comes later. Now we're now ready for the next to last stage: liquidation. How might this unfold? Check this space Tuesday, Sept. 12.

ERIC JANSZEN is the Executive Director of Osborn Capital, LLC, an angel investment firm in Lexington, Mass., and also is the founder of iTulip.com.

Posted 09/07/00