The Coming End of the US Foreign Investment Bubble
What if we lose?
July 25, 2006
by Eric Janszen
If you go to google and type in "what will pop the internet bubble" the first link returned is a piece I wrote for bankrate.com February 1999. It explains what will pop the tech stock bubble: Credit Squeeze, Bankruptcy, Fraud, and Weakness in the Real Economy. The article comes up first in a google search more than six years later because no one else at the time was making specific predictions on the causes of the impending collapse of the stock market bubble. Now, more than six years later, I'm going to do it again.
Here I'm going to explain the most likely causes of the collapse of the simultaneous bubbles in real estate, equities, and bonds that are the latest asset bubble products of the most recent cycle of the Bubble Cycle System. They all emanate from a single source, a bubble in foreign net acquisition of US financial assets. If you understand the dynamics of events that are likely to collapse the foreign net acquisition of US financial assets bubble and when, you are on your way to understanding the fate of all of the secondary bubbles that it has spawned and the result: a major inflationary recession.
My 1999 Ka-Poom theory, updated in 2006, predicted a post 1990s stock market bubble collapse deflation nadir in the fall of 2001 followed by an inflationary recession that peaks in 2006. The deflation prediction worked, but it turns out that the inflationary recession "Poom" phase didn't occur as I predicted in the current bubble cycle. Instead we have had a kind of mini-poom asset inflation that brought oil and PMs up new 20 year highs, created a housing bubble, not to mention hedge fund and private equity bubbles, and to a certain extent restarted a subdued re-run of the 1990s tech VC bubble, although more so on the US west coast than globally as in the late 1990s. However, this 2002 - 2006 "mini-poom" is not the main "Poom" event, a general inflation that starts when foreign lenders and investors lose confidence in the US as a safe haven and start to retreat from US investment, collapsing the foreign net acquisition of US financial assets bubble.
Nearly everyone believes that such an event is not possible, that no event can occur that sends foreign investors away from US investments and dollar assets. For as long as anyone can remember, when things go wrong in global markets, foreign investors run for US assets, not away from them. What could possibly cause a change in this apparently immutable law of global investor behavior? To understand that, I go back to the fundamentals of the psychology of asset bubbles that were the foundation of my 1999 predictions.
The tech stock bubble was psychologically supported by a repeat of the mass delusion of an economic New Era. The very same term was used four times in the 20th century to explain a temporary suspension of well understood principles of market pricing: in the US in the 1920s, in the US in the 1960s, in Japan in the 1980s, and in the US in the 1990s. Each New Era period ended with a repudiation of the New Era idea that a fundamental change had occurred in the way the economy and markets operate, thus explaining the enduring elevated securities prices. Why re-cycle the old New Era concept? The old New Era tale apparently works over and over again, and will no doubt work again some day.
Mass belief in the New Era myth was supported by the media, elected officials, venture capitalists, and every other institution and organization that benefited. The deluded masses got some crumbs off the New Era cake as well; the apparent free and zero risk money flowing their way as the stock market rose was surely the result of their investment acumen. And why shouldn't they partake in the benefits of the New Era that the experts in the press, and honorable and credible representatives of the US financial system's institutional representatives such as Abbey Joseph Cohen, and even the head of the US central bank, Alan Greenspan, proclaimed as the real deal. Of course, what made the illusion of a New Era possible, and pushed the value of the stock of now bankrupt pets.com to absurd levels, was a hurricane of money, first supplied by the Fed, later by the markets themselves as money was recycled via the public markets back through venture capital and back out through new IPOs. When the wind blows hard enough, even turkeys fly.
As I explained in Panic September 1999, an asset bubble is supported by an underlying belief system, a kind of temporary religion of convenience that evolves during bubbles to explain, as in John Ciardi's children's poem, "Why the sky is green, why trees are blue/Why kittens caw, and crows mew." Faith allowed millions to suspend disbelief and put large amounts of money at risk. When a market is imbued with a misperception of risk, investors begin to lose the ability to distinguish between gambling and investing. The New Era religion even spreads to the Fed itself, in the form of the usual assertions that the masses of investors know best, even when they are in the grips of a mass delusion.
Alan Greenspan said in testimony before the U.S. Congress Joint Economic Committee June 1999, "But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong." Back in 1929 it was Professor Lawrence, Princeton University who made the obligatory "investors know best" statement, in September 1929, "The consensus of judgment of millions whose valuations function on that admirable market... is that stocks are not at present over-valued. Where is that group of men with the all-embracing wisdom which will entitle them to veto the judgment of this intelligent multitude?"
The mirage of low risk is further enhanced by the observation of market participants that speculative bubbles, even when acknowledged as such, can collapse with little consequence. The reason is that the Fed has as its primary mission to rescue the markets to prevent a knock-off collapse of the real-economy. Market participants see that the Fed has apparently succeeded at this mission over and over. It's human nature to continue to engage in risky behaviors that are repeatedly survived, whether it's free diving that results in 100 deaths per 5,000 divers per year, or investing in assets that one fully expects will certainly get pumped back up again by Keynesian monetary and fiscal policy.
Asset bubbles collapse in increments. Starting in 1999, Fed rate hikes started to lower the wind speed and a few turkeys fell to the ground. Along with bankruptcies and layoffs, as I predicted in my Bankrate.com article, revelations of fraud -- fraud is a standard feature of all asset bubbles, including the real estate bubble -- started to chip away at investor confidence and undermine bubble mass psychology, causing many to start to lose their faith. In the atmosphere of lingering greed but growing doubt that happens at the end of an asset bubble, what economists refer to as a random exogenous event occurs that gets the inevitable panic selling started.
In the case of the stock market bubble, a not so random exogenous event got the ball rolling: April 2000 tax loss selling. Already skittish after a few bankruptcies and fraud cases, market participants misinterpreted the tax loss selling as panic selling. This created actual panic in the market and then actual panic selling. Down it went. Even after the selling started, many -- most famously Abby Cohen and JJ Cramer -- held fast to their beliefs. After all, their reputations were as firmly adhered to the stock market bubble as President Bush's reputation is to the Iraq War today. Fortunately for Cramer, who is a performer versus an investment bank equity analyst, the TV viewing public has a short memory, and neither the time nor inclination to search for the facts. Ms. Cohen, on the other hand, has not been heard from since.
Even though the bubble was down for the count, many stubbornly hung onto their positions. I wrote A Bear Market is Born in April 2000 to let readers know that in fact a bear market had started, that the bubble was over and not coming back. Type "bear market is born" into google and the article is the six link down, and the first that officially announces the start of the bear market. Still, a year later I regularly ran into perfectly intelligent friends who had held onto their Nortel and Lucent and other stocks. Such is the power of belief in these temporary religions of convenience that justify money created by nothing more than liquidity, uninformed risk-taking, fraud, unqualified confidence in the infallibility of government insurance via liquidity, and -- especially in the US -- a sense of entitlement to wealth.
Fact is, we are still in that bear market that I announced April 5, 2000, although at the end of a major Keynesian bear market rally, if you will, as occurred a few years after the US bubble collapse of 1929 and Japan's after 1980.
Stay tuned. You'll be the first to know when it's over, but don't hold your breath.
This brings us to the question of what series of events will end the bubble in foreign net acquisition of US financial assets and the other bubbles -- in stocks, equities, bonds and real estate -- that it has spawned, and when.
With respect to timing, March 2006 was, in my opinion, the peak of risk and complacency in the recovery cycle. That's why I re-started iTulip.com at that time. As to the events that are likely to end the foreign investment bubble, let's start by asking a few key questions.
What might shake the confidence of foreign investors and reveal a fundamental weakness in the structure of the risk/return system of financing that has been supporting the foreign investment bubble? What event might uncover major flaws in the thinking of market participants, who up until then collectively believed they are earning returns on investment at fully insured risk? Will an investor experience the events as sudden and unexpected, like a man who is one minute sipping a glass of wine on the patio of a posh hotel in Beirut and the next running from missiles and bombs raining down around him?
Foreign investors believe that the US is the best place to achieve the highest returns at the lowest risk. As this report by the Treasury Department from 1997 shows, foreign investment in the US has been increasing for a long time, with some periods of slow growth and other periods of rapid growth, but no periods of decline.
"The long-term trend has been for an increasing rate of growth in foreign investment in the United States, with the 1994-1997 period representing a period of inflows unprecedented in our history. This growth is due in part to variable factors, such as a recently strong dollar, a strong U.S. economy, and upheaval in some foreign markets. However, it is also strongly influenced by basic, underlying structural changes in the international economic environment which have, and will continue to have, the effect of facilitating international investment, such as the reduction of regulatory barriers, the reduced costs of international transactions and securities safekeeping, the increased flow of cross-border information, and the trends towards standardization and increased transparency in market practices worldwide."
My thesis is that the period rapid growth in foreign net acquisition of US financial assets from 50% of issuance in 2001 to 80% in 2006 represents a bubble. As in the case of all bubbles, belief in its foundations is for a while self-fulfilling. Real estate is a good example. The believers' valuation process is tautological: the value of housing is rising because prices are rising, attracting more money, causing prices to rise further. Similarly, as foreign investment pours into a US market, such as the stock market, prices and returns rise. Here in the US, the belief held by financial institutions, individuals and the government is a religion of convenience that US investors and creditors will not slow their rate of acquisition of US assets, never mind sell them, both for the reasons given by the Treasury department above and because the US and its creditors are like Siamese Twins; one cannot separate from the other without causing the demise of both.
Not so. Part of the answer to how the bubble in foreign investment in the US ends can be found in an article in a Foreign investment Magazine article Foreign investment to fall, states AT Kearney report in October 01, 2002. In it, foreign investment in the US was due to decline unless the following conditions were met.
The most of the conditions necessary to prevent a fall in foreign investment in the US as indicated in the study were indeed met between 2002 and 2006, leading to an increase in net foreign investment.
1) Recovery of the US economy: Keynesian economic policies created a "recovery," although foreign central bank purchases of US sovereign debt were a key component of the recovery and bubbles in assets, especially real estate, resulted.
2) Global and regional trade initiatives: These trended toward less protectionism and lowered trade barriers, increasing the attractiveness of US markets to foreign investors.
3) Deepening of Japan's recession: While Japan's recession did not deepen, it did not start to show meaningful and apparently sustainable recovery until late 2005. Japan received significant foreign investment over the past few years, but not to the detriment of foreign investment in the US, and the Bank of Japan has been by far the largest lender to the US.
4) Middle East conflict: Conflicts in the Middle East at least as far as they impact the performance of the US economy and markets were neutral to positive over the 2001 - 2006 period.
5) Regional impact of Argentine crisis: The crisis indeed eased over the period.
What about today? Nearly all of the conditions necessary to prevent a fall in foreign investment in the US as indicated in the study have recently reversed.
1) Recovery of the US economy: The economy is faltering, as indicated by a rapidly slowing housing market and automobile market
2) Global and regional trade initiatives: Trade barriers and protectionism are rising: "World trade talks faced a bleak future after collapsing in acrimony Monday, with the European Union singling out United States for blame for refusing deeper cuts in farm supports."
3) Deepening of Japan's recession: The recession in Japan appears to have ended: "Japanese economy turns a corner"
4) Middle East conflict: "US sends more troops to help quell Baghdad violence" and "Oil above $75, Saudi warns of broader Mideast war"
5) Regional imact of Argentine crisis: Argentina is in such good shape, the IMF is struggling to find anyone to lend money to: "Argentina’s phenomenal growth rate, more than twice that of the region, cannot remaine unnoticed indefinitely"
I add the following additional three conditions that exist today that increase the risk of a "Poom" type event.
1) The Fed can move to contain inflation and protect the dollar and cause a recession, or allow PPI inflation to continue to push its way into the core inflation rate. Both cases make the US less attractive to foreign investors.
2) Oil exporting countries (pdf) decline to continue to sell oil to the US for political reasons and sell to other importers, such as China, and at the same time reduce purchases of US financial assets.
3) The US markets experience a Long Term Capital Management style crisis that requires a liquidity injection by the Fed, except that oil prices are $75 versus $20 as then.
Given these existing pre-conditions for a loss in confidence, the current foreign investment bubble, based on the belief that the US is the best place to achieve the highest returns at the lowest risk, will start to end with some random exogenous event. The event will occur, someone will start to sell, then others will follow. A singular event is needed, a trigger that is both visible and highly symbolic.
Here it is important to point out that the decline in the rate of increase in foreign investment in the US in the late 1970s and the US loss of the Vietnam war in 1975 were not coincidental. If the US loses economic and political control in the Middle East, make no mistake, confidence in the US and in its markets will rapidly decline. Nations that appear to be Siamese Twins, inseparable without mutual mortality, will be revealed for what they are, not twins or brothers nor even friends, but nations with mutual interests, whose mutual interests will then be so weakened they are no longer significant. Other trade and investment relationships will become more important. Nations such as China, for example, have already hedged this risk by cutting energy deals directly with Russia, Iran and Venezuela and opening export markets that can in aggregate compensate for a drastic loss of revenue from exports to the US.
Two main points that indicate that we may be heading down this path. First main point, I believe that Melvin R. Laird is correct that the Vietnam War was lost because by the time the US came to the realization that it needed to "Vietnamize" the war, that is, gradually withdraw and hand the fighting over to the parties with an interest in ending the war and support them financially versus try to win the war with US military might alone, it was too late; US public support and thus the required financing for it was gone, and the opportunity for a constructive withdrawal was lost with it. This appears to be repeating itself in Iraq, although this time by the intent of US foes; the insurgents know that if they can delay "Iraqization" long enough, US public support and thus the required financing for it will disappear. Further, Iraq is not Vietnam; the political and historical context is far more complex and intractable, calling into question whether "Iraqization" was a feasible policy in Iraq the first place. In any case, there is mounting evidence that the US has already run out of time in Iraq.
Briefly, in addition to the article noted above, US sends more troops to help quell Baghdad violence, Iraq suffered a major setback in "Iraqization" last week when The Boston Globe reported, "US commanders this spring gave the Iraqi government the key task of supplying food and fuel to its own army, but after a few months of serious mismanagement, the United States resumed supplying Iraqi troops in the volatile Anbar Province, according to US officials." A June 6 memo sent to the US Secretary of State Condoleezza Rice by US Ambassador Zalmay Khalilzad states: "More recently, we have begun shredding documents printed out that show local (Iraqi) staff surnames. In March, a few staff members approached us to ask what provisions would we make for them if we evacuate." This report comes from a credible source, Middle East Online, by Immanuel Wallerstein, Senior Research Scholar at Yale University (author of The Decline of American Power: The US in a Chaotic World - New Press).
The US embassy in Iraq is shredding documents and its Iraqi employees are asking about United States evacuation plans. The specter of the chaotic airlift of Vietnamese employees from the US embassy in Saigon in 1975 looms large enough on the minds of the Iraqi employees of the US embassy in Baghdad that the US ambassador felt compelled to so inform Washington -- further evidence that the window of opportunity for "Iraqization" is closing, not opening.
Then there is the question of public opinion here in the US. Support for the war is declining. This July 4 article American Majority Says Iraq War Pointless shows the typical results of many polls. Asked if "All in all, do you think the situation in Iraq was worth going to war over, or not?" the percentage polled who said "No" increased from 50% to 54% in the past six months. The majority of Americans no longer support the war.
Second main point: We have no reason to believe that the Iranian leadership is not kidding about its intention to destroy the state of Israel. We can only speculate on its ability to carry out the threat.God's army has plans to run the whole Middle EastIf this threat has any credence, you wouldn't know it from watching oil and gold prices as Secretary of State Condoleezza Rice arrived in Lebanon today in the first American on-the-ground diplomatic effort to resolve the conflict between Lebanon and Israel. I agree with Dow Jones' MarketWatch's Charles Nedoss, senior account manager at Peak Trading Group in Chicago, "People are a little enthusiastic about some kind of a ceasefire."
July 23, 2006 (The Sunday Times)
Hezbollah, the group at the heart of the Lebanese conflict, is the spearhead of Iran’s ambitions to be a superpower, says Iranian commentator Amir Taheri
‘You are the sun of Islam, shining on the universe!” This is how Muhammad Khatami, the mullah who was president of Iran until last year, described Hezbollah last week. It would be no exaggeration to describe Hezbollah — the Lebanese Shi’ite militia — as Tehran’s regional trump card. Each time Tehran has played it, it has won. As war rages between Israel and Hezbollah in Lebanon, Tehran policymakers think that this time, too, they can win.
“I invite the faithful to wait for good news,” Iran’s President Mahmoud Ahmadinejad said last Tuesday. “We shall soon witness the elimination of the Zionist stain of shame.”
When Ka-Poom Theory was conceived in 1999, the Middle East peace process appeared to be moving forward. Peace in other areas of conflict, such as in Bosnia, had been negotiated. The idea of a "preemptive war" led by the US had not been invented. The notion of a US led invasion of Iraq would have been dismissed as ludicrous. The prediction of a 9/11 type attack on the US would have been dismissed as paranoid and insane. The world was a very different place. Now, when coming up with a theory as to how the bubble in US foreign investment might end, one must consider not only unlikely events, one must consider possibilities that once only the cruelest imagination could conceive.
We have to consider the possibility that the US loses control of the Middle East and that fundamentalist Islamic dictatorships, headed by Iran, win.
Then it's a whole new ball game. In that case, the nation with the largest negative balance of trade, the largest net external debt, the least domestic and personal savings, the greatest dependence on oil imports from the Middle East and the worst political relationships with the fundamentalist Islamic dictatorships that will be in charge of it, loses.
Back in 2001, a year after liquidating stocks before the dot com bubble popped, besides buying treasury bonds, I sat mostly in cash and searched for the next thing to invest in. I noted that precious metals -- silver, gold, and platinum -- were trading at deflationary prices: silver below $4.50, gold below $270, and platinum below $450. As I wrote in an article soon to be re-printed as a chapter in The American Bubble Economy by John Wiley and Sons, all were trading at around 15% of inflation-adjusted peak prices. I asked myself this question: What is the chance that the price of these metals will decline from these historically low prices toward zero compared to the chance that their prices will increase even to, say, 30% of their inflation-adjusted peak prices -- double in price -- given the reflation program that was certain to kick in to keep the US economy from sinking into a deflationary depresssion?
As of mid-March 2006 when I restarted iTulip.com, I ask myself a similar but revised question: If net foreign acquisition of US financial assets has grown from 50% to 80% of issuance over the past several years, and this growth is largely responsible for funding US trade and fiscal deficits, as well as consumer spending that represents 70% of the US economy and housing that has created more than 43% of all private sector employment since 2001, what is the chance that this will continue to increase from 80% toward 100% versus level off or even decrease, given the eight conditions that exist today that make a "Poom" type event more likely?
What it really comes down to is this. If you believe that the US has a worse than 50% chance of losing economic and political control in the Middle East, you want to hedge the risk of the inflationary recession "Poom" that will result. And soon.
As in April 1999, you've been warned.
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