A Coin in the Fusebox

It must be hard being a perma-bear. It is quite possible that it won't be hard for too much longer, but today it must still be hard. You would think that individuals working at a company named PrudentBear would be perma-bears. But, really, they are probably just contrarians - they may have to consider a name change when equities ultimately revert to the mean and then overshoot ... when they are once again attractively priced at the same time that most investors have lost faith in the stock market.

When this will happen, no one knows, but if history is a guide, it is unlikely that a reversion to the mean can be avoided - it probably isn't different this time.

Since the 1990s, David Tice and Doug Noland of Prudent Bear have been making the case that equities are overpriced while at the same time shedding light on the credit excesses of our structured finance world. With the exception of the transition from the Nasdaq Bubble to the Housing Bubble, they've gotten little attention from most investors.

In some ways, it must be like being a Gold Bug - you know you are right, or at least that your argument has great merit which goes unacknowledged - you just hope that you live long enough to be proven right, and that it doesn't drive you crazy.

Doug Noland publishes the Credit Bubble Bulletin - a weekly look at the world's credit markets, which seem to grow more and more grotesque and distorted with each edition. While some of the bond and bank credit statistics may be a bit dense for many readers, the concluding commentary never disappoints.

Doug was interviewed on last weekend's Financial Sense Newshour (this link will take you directly to the mp3 file). Here are some of the highlights of the interview:

• The traditional measures of money supply (M1, M2, etc.) do not include credit created via mortgage backed securities and other contemporary finance instruments - these numbers are not very useful in determining the amount of "money" that exists in the form of credit in the system.
  
  
• The flood insurance analogy is quite appropriate for today's widespread use of derivatives used by hedge funds to offset speculative risk - when flood insurance is readily available, people build more homes by the river. The distinct difference between flood insurance and derivatives is that the increased purchase of flood insurance does not increase the chance of rain.
  
  
• After the last few years of Fed policy, there is a perception of unlimited liquidity - hedge fund borrowing for leveraged speculation, home mortgage finance, etc. - anybody can get a home loan. This has changed the way everyone thinks, but it is unprecedented and can not continue.
  
  
• In the sixties Alan Greenspan once said that Fed policy in the 1920s was like "a coin in the fuse box" and this is what led to the Crash of 1929 and the Great Depression.
  
  
• We are in the middle of a classic case of Austrian mal-investment - after the 2000 Nasdaq bubble burst, the bubble moved to mortgage credit, which enabled a housing boom, that led to excess consumption, which led to the huge trade deficit.
  
  
• California real estate has to go through some wrenching adjustments - it is better to have it sooner than later - the Fed can continue to stimulate the economy with low mortgage rates, and this has been very successful, but this will continue to impair the "real" economy. There's no avoiding the pain associated with adjustments like this - that's why you don't want to let it get to this point. The Fed should have reigned in these excesses earlier - they can't allow hedge funds and housing to become a mania, or the current account deficit to get to $700 billion. Once you get to this point, everyone says it's too big and we can't do anything about it - that the system is now too fragile and that we can't afford a recession.
  
  
• Greenspan's references to Adam Smith and the "Invisible Hand" are ridiculous, because the last few years have had nothing to do with free markets - it's all about intervention and speculative excess enabled by the Fed.
  
  
• The problem with today's environment is that the system continues to create more and more non-productive credit (government borrowing and home loans) instead of productive credit (business investment that gets repaid with profits). The problem with this is that when a crisis does occur, you realize that the underlying economy is vulnerable because it is based on rising asset prices, credit, and consumption - there is lots of debt, but not enough real productive economic value.
  
  
• When the inevitable financial crisis occurs, the Fed should choose to support the dollar rather than to support the housing bubble. That was the difference between Japan and Argentina. Japan supported their currency and dealt with the long painful asset price adjustment in equities and real estate. In Argentina, the currency collapsed and it was a wipeout - bondholders are still trying to recover their money.
  
  
• The economy may well surprise on the upside in the near future, since mortgage finance is now completely out of control and it is, unquestionably, very effective in stimulating the economy.
  
  
• The mortgage finance bubble has got to be brought to a stop - these things just don't die off on their own - that's the mistake that the Fed made, they thought that things would just calm down and they didn't. Once things get this hot they don't just calm down.
  

Doug has been saying these same sorts of things for quite a while now. If you ask today's real estate millionaires, they'd probably say he was crazy, just like the dot com millionaires probably said he was crazy in 1999. Time will tell.

More and more, it looks like when the fuse blew in 2000, it was replaced with a coin.