-Caveat Lector- from: http://www.pei-intl.com/TOPICS/READY.HTM <A HREF="http://www.pei-intl.com/TOPICS/READY.HTM">The Next Crash - This Time ItÍs Different? By M </A> ----- The Next Crash? Beware the Ides of March If you think all bull markets are the same you better take a look at this chart! By Martin A. Armstrong Princeton Economic Institute © Copyright March 20th, 1999 ------------------------------------------------------------------------ During the 1970s, the birth of the floating exchange rate system forever altered the world economy. The very basic incentives that drive capital flows around the globe were changed dramatically. Most universities to this day have failed to recognize the significant impact that the floating exchange rate system has had upon every aspect of our economic environment. At PEI, we have been very fortunate. Being the first multinational corporate advisory firm to emerge in the post 1971 era, we had nothing less than a front row seat from which we have been able to observe the dramatic changes within the behavior of capital itself through the actions of our clients. It has been through working with our clients from every continent that observation and experience preceded theory. And through it all, we have come to respect the observations of Adam Smith as expressed so eloquently in his "Invisible Hand" back in 1776. Smith’s work revealed through observation that each person or entity contributes to the function of economy by pursuing his or its own self-interest. In the pursuit of economic survival, the natural course of the business cycle is determined. When one sector within the economy becomes very profitable, competition expands to the point that profits are ultimately squeezed and a contraction begins to unfold. This process of boom and bust is a natural occurrence within any economy. While socialism, communism and government regulation have all sought a common goal to control this natural process, nothing can or ever will succeed in such an endeavor. The very nature of the business cycle is far too complex for governments to understand. Their attempts to control the economy only serve to highlight their own failures that inevitably clash with every directional change. What Smith observed within a small domestic economy, we have observed first hand in a modern global economy. The introduction of the floating exchange rate system has altered our perspective of value, distorted our sense of direction and above all increased the amplitude of the boom bust cycle itself. Prior to 1980, manufacture within America had declined as high taxes and militant labor unions combined to drive both capital and investment away from its domestic shores. This trend altered the economy of the United States as a whole while regional changes completely altered the economic environment of states and cities forever unleashing what many called the urban plight. Places like New York City completely changed as it lost the once proud status of being America’s biggest shipping port. The labor unions of New York attempted to ban container shipping in a futile ploy to halt progress and retain jobs within a changing industry. The militant attitudes of the labor unions sought to defy the business cycle, but only succeeded in driving the shipping industry out of New York as it moved to places that proved to be more competitive. With the election of Ronald Reagan as President, suddenly the sense of competition entered the national debate. While many fought Reagan’s tax reforms, in the end his policies restored America. Instead of bucking the business cycle, America began to embrace it. While manufacture had continually migrated away from America with every tax hike, suddenly not only did Americans bring back some of their own manufacture, but foreign companies flocked to open their US subsidiary. The auto industry that had been shrinking, exploded as Japanese and German companies found it more tax efficient to be within the United States than outside. While Reagan tapped into Adam Smith’s "Invisible Hand" by making America competitive on a tax basis compared to all other industrial nations, there is little doubt that the floating exchange rate system itself also contributed greatly to the changing face of America and indeed the world. Suddenly, foreign exchange fluctuations were rising generating a new risk to multinational business. To reduce that risk, industry began to view that a manufacturing base within the same currency zone reduced the risk of foreign exchange loss as well as the loss of market share. In this sense, the global economy became much more global as both industry and capital began to diversify internationally. By 1985, the capital flows of investment and industry had combined to drive the US dollar to all time historical highs. Even the once mighty British pound fell to nearly par with the dollar reaching $1.03 by February of 1985. The sharp rise of the dollar between 1980 and 1985 raised great concerns within Washington about the ability of America to remain competitive given the 57% decline in most currencies. It was with this concern, that the birth of the G5 (now G7) took place in September 1985. The group of five leading industrial nations met in New York in an attempt to force the US dollar lower by 40% to effect a reduction in the US trade deficit. That fateful meeting, would unleash a cataclysmic sequence of events that to this day have continued to alter the world economy as a whole casting a shroud of mystery and confusion over even simple investment decisions. The G5 failed to understand one very basic and simple point about the world economy – that capital always moves according to its own self-interest (Invivible Hand). The floating exchange rate system not merely influenced manufacture to move from one place to another, but it also provided the same incentive for investment capital to move based upon a view of the underlying currency value. The G5 may have intended to simply lower the value of the dollar to reduce the trade deficit through the devaluation of American labor in terms of international competitive standards. Nonetheless, the G5 overlooked the shift within the makeup of the international capital flows themselves unleashing perhaps the greatest mistake since the introduction of socialism. Prior to 1971, 90% of net capital movement had directly been linked to trade flows. With the introduction of the floating exchange rate system, capital investment also began to move. In the process, investment capital far exceeded that of everyday trade flows and now capital investment became 90% of total net capital flows. The entire driving force of the global economy had been completely altered – a little known fact overlooked by governments eager to exercise their power. The G5 manipulation and intervention into the foreign exchange markets succeeded in driving the dollar down, but at what cost? The sharp decline in the dollar between late 1985 and 1987 produced a major economic disruption known as the Crash of 1987. The G5 failed to take into consideration the fact that by lowering the value of the dollar, they not merely lowered the cost of American labor, they also created foreign exchange losses for anyone investing in US assets. Thus, the Crash of 1987 took most people by surprise. The underlying economic conditions were sound. There was no material change in corporate earnings. All the fundamentals remained quite solid. Yet despite the strong fundamentals, the US share market collapsed by slightly more than 40% in the short span of two months between August and October of 1987. The confusion released by the Crash of 1987 was stupendous. Stock markets around the world collapsed in a state of panic. No one knew what sparked the crisis and governments everywhere remained embarrassed and befuddled. We received a flurry of phone calls since our models had successfully predicted the crash and the magnitude right down to the precise day of October 19th. One of those calls was from Washington and we found ourselves in the middle of a political game of - Who done it?. It was no easy task to turn the heads of those in power back upon themselves. But through the evidence that we provided, at last a glimmer of hope appeared on the horizon. It became abundantly clear that international capital acted in its own self-interest according to the risks expressed through the eyes of its own currency. The distortion unleashed by the G5 turned bull markets into bear markets as illustrated above for the US bonds in dollars and yen. While the Brady Commission could not lay the blame for the debacle directly at the doorstep of the G5, they did manage to highlight the issue of foreign exchange as being the spark that ignited the Crash of 1987. For nearly 6 years thereafter, the G5 remained silent about foreign exchange. No more was the market subjected to boastful outcries that "we want the dollar down by 40%." While the blame was never quite placed upon anyone in particular in a public forum, the folly of the G5 and their attempt to manipulate the world economy was very much the hot issue behind closed doors. The effects of the Crash of 1987 have proven to be far more enduring than most would consider. The artificial lowering of the value for the dollar on world currency markets left an enduring bad taste for risk in American assets among particularly Japanese investors. Where Japanese investment in US government bonds had risen to nearly 25% of the total national debt prior to the Crash of 1987, the continued capital withdrawals in the post 1987 era caused that investment to shrink to a mere 7% within a few years and it did not return in force until the post 1995 period. In the process, Japanese capital retreated back to Japan where it sought domestic investment. That trend set in motion another boom cycle that culminated in the bubble top of December 1989 centered directly on Tokyo. When the Japanese economy peaked and the Nikkei crashed during 1990, international capital flows were disrupted once again. This time, the capital flows shifted to South East Asia causing the next boom cycle to climax by 1994. The burst of the Asian investment cycle in 1994 began quietly at first. The peak for Asia in 1994 corresponded to the beginning of the current bull market in the United States and Europe. As capital continued to leave Asia attracted by the lure of profits in the US and Europe, the void left behind finally exploded into the currency crisis of 1997. While 1994 marked the turning point for capital flows away from Asia and back to the US and Europe, it would be the proposed introduction of the Euro that began to split the capital flows once again. The bulk of the hot money began to shift toward the Euro markets reaching its zenith on July 20th, 1998. As the massive leveraged positions of long Europe and short America came unglued in late 1998, the US marketplace was propelled to new highs while Europe floundered in the wake of its former glory. Still, the boom cycle in America remains in a very delicate position. The very forces that propelled it higher have vanished. The rebound from the September 1st, 1998 low was purely one of unwinding the derivative positions of short the S&P against the long positions of the German Dax. This unwinding of complex spread positions yielded the illusion that real buying support had reemerged. In fact, there was little courage to be found in September or October of 1998 among bulls. Sentiment had turned negative and doubt now filled the air. Even the maxim of "buy dips" began to sound hallow. Nevertheless, as illusion gave way to calm, the false sense that America would not be effected by events outside its borders led to yet another buying surge. Today, people are quitting their jobs to stay home and trade stocks. Newspapers tell of stories of how many are earning $10,000 per day trading options. Insane newsletter writers tout the virtues of selling puts to the unexperienced public generating the very fuel necessary for any panic by magnifying the potential selling power. The unsound mania of a boom cycle has reached the shores of America once again. In the process, we must remain cautious of those four fateful words that have been the ruin of so many that have gone before us – "this time it’s different!" Once again, the divergence between a domestic perspective and that of an overseas investor has appeared on the horizon as was the case in 1987. Illustrated above is the Dow Jones Industrials expressed in US dollar and in Japanese yen. The chaos that has been unleashed in the foreign exchange markets, in the wake of both the introduction of the Euro and the collapse of Russia, has seriously distorted and confused international capital. When viewed through the eyes of the Japanese, the July 20th, 1998 high for the Dow Jones Industrials has NOT been exceeded. Unless the Dow is scoring new highs in all currencies, there remains the threat of some foreign investors turning into net sellers. Illustrated above, you will find the Dow Jones Industrials plotted according to 8.6-month intervals beginning with June 4th, 1929 in accordance with our Economic Confidence Model. The current high is the period beginning July 20th, 1998 and ending April 8th, 1999. According to our timing models the next major directional change should take place at this time. This trend, when analyzed in dollars exclusively, would imply that the high has perhaps just been established as of March 19th, 1999. A closing on April 8th BELOW 9,337.9 would technically confirm such a possibility. Again, when viewed from a pure dollar perspective, it would appear that a decline of six (6) subsequent 8.6-month timing periods would fulfill an ideal cyclical perspective. This suggests that a high at this time should be followed by a decline into the 8.6-month period beginning November 14th, 2002. The first 8.6-month Bearish Reversal currently resides at the 5,170 level, which corresponds roughly to technical support in the 5400 level going into 2002. However, looking at this purely in terms of dollars could prove to be a serious mistake. Given the bearish perspective revealed by our models in terms of dollars, we must then consider the impact upon the market should the dollar remain in a bull market going into 2002-2003. After considering the state of crisis in Japan, the likelihood of a China devaluation and the collapse of European dreams for true economic reform, indeed the fundamentals point to such a dollar bull market. We must also consider that the ONLY trend capable of creating a recession in the United States demands a strong dollar. The dollar always rises during recessions such as the 1973-1975 period as well as the 1980-1985 period. A strong dollar raises the cost of American labor thereby reducing profits and competitiveness of American based operations thereby increasing unemployment while unleashing an economic recession. The impact of currency upon domestic assets is at the very least profound. The complexity of this relationship is often as perplexing as quantum mechanics compared to the logical world of Newton. In quantum mechanics, logic breaks down as complexity increases due to wave motion and interference. Within the global economy, the observations of quantum mechanics have a strange sense of relevance. The interaction of various capital markets bombard the global business cycle causing at times infinite possibilities in the midst of confusion. Where objects under Newton have logical paths, quantum mechanics accepts the principle that a known predefined path does not exist. Objects can at one moment in time exist at point A and then in the next instance at point B without a clear understanding of the path traveled. Such complex behavior is caused by wave interference. As markets move, they too impact other markets. A bull market in one sector tends to draw in capital from other sectors thus impacting the business cycle as a whole as well as on a sectorial basis. The activity becomes more complex under a floating exchange rate system when currency trends magnify and distort global perspectives thus causing a cascading effect across the entire global spectrum of capital flows. Under a fixed exchange rate system, currency fluctuations do not enter into the equation of determining net capital flow movement. However, the floating exchange rate system increases the complexity for business decisions exponentially. Between 1992 and 1995, despite the decline in the Nikkei, the rise in the value of the Japanese yen caused European and American investors to view Japan as the best performing market. Subtract the value of the yen, and the Nikkei under-performed considerably. The same is true for the trend in Europe between 1995 and 1998. If you subtract the decline in value of the European currencies the bull market becomes less impressive to the foreign investor. With the expectations of the Euro replacing the dollar fading into oblivion, the fate of European investment on the part of foreigners has been sealed - Europe has enetered a clearly defined bear market. The complexity of wave motion within the global economy is identical to that found in physics. An illustration of this complexity can be achieved by conducting what has become known as the Double Slit Experiment using water or even light. If you obstruct the flow of water and then introduce a single slit in the obstruction, the resulting wave motion created by the released energy is quite clear and very predictable. However, introduce a second slit and suddenly the released energy waves from both outlets clash and interfere with each other. The waves of opposite energy cancel each other out as waves of like energy combine and magnify into a completely unique wave formation with greater amplitudes. The predictability factors for each wave of energy vanish. The source of energy behind the new combined wave is chaotic in appearance while the complexity produces the illusion of random behaviour. In fact, nothing is random at all; it is just too complex for single linear logic to follow. This principle from physics applies in economics as well, particularly in our observations of net capital movement. A wave is defined as the movement of energy. A wave in the ocean is actually energy passing through the water – it is not the water itself that is moving. Watch a floating bottle and you will see it rise and fall with the waves as it remains at nearly the same location. The business cycle operates in the same manner. The energy in this case is the movement of capital around the globe from one economy to the next and one market or sector to the next. Like the bobbing bottle, individual markets rise and fall as the energy moves in and then retreats generating what is commonly referred to as a bull or mrket market. This is the very basic explanation for the rise and fall of the business cycle that has often been dubbed the boom/bust cycle. A strong bull market in one nation attracts capital internationally thereby causing a concentration in energy within a particular market. The degree of complexity today has been greatly increased due to the introduction of the floating exchange rate system. Previously, investment capital tended to concentrate within its own domestic market with comparatively minor overseas investment. Today, global asset allocation models have been introduced in order to achieve what many believe to be a diversified portfolio that is less volatile from an international value perspective. This means that should the view of the underlying currency change, the allocation of investment capital will also change despite the domestic view of the asset. Domestic investment can be overwhelmed by external capital flows. Thus, under a floating exchange rate system, we no longer have the single slit situation of predominant domestic investment. Unfortunately, we have multiple slits through which global capital flows pour clashing into each other to yield a far more complex wave structure within the global business cycle. The question of whether we will see a major crash of significant proportion that would take the Dow Jones back to 3700 by 2002-2003 or a moderate correction of 6000-5000 will be determined exclusively by the international reaction within net capital flow movement. A strong dollar that continues to rise dramatically into 2002-2003 would not merely cause a similar recession in the US such as that of 1980-1985, but it could very well impact commodity prices thereby perpetuating the deflationary trend into 2002-2003 simultaneously. An illustration of the dollar’s impact upon the US share market between 1980 and 1985 is of extreme relevance to our current situation. You will notice that the Dow remained fairly sideways between 1980 and 1982. It did not decline significantly despite the fact that interest rates exceeded 20%. The reason for this major feat of strength was directly related to the rise in the dollar. As domestic investment capital fled the share market moving into bonds, foreign capital moved into the US market based upon the reduction in taxes and the firm dollar. The Dow Jones Industrials reached its low in 1978 from the Japanese perspective compared to 1982 for the domestic American. Between the 1978 low and the peak in the dollar in 1985, the Japanese investor realized a 245% gain compared to an 80% gain for the US investor. The German investor scored a gain of 322% for the same period while the British investor received a gain of 365%. Thus, the strength of the dollar helped to mitigate the decline in the US share market. Only after the worst of the recession came to an end in 1982, did we see a mass return to share investment among domestic Americans. By 1983, the Dow had at last decisively penetrated the 1,000 barrier that had prevailed since 1966. The future is always impossible to determine. All we can do is to gather as much evidence that is available in an attempt to overcome the most difficult of all quests – the determination of the next path. While quantum mechanics has given up on trying to determine the path of objects, hopefully logic has not completely forsaken us in the realm of global capital flows. When we filter the Dow through the eyes of international currency perspectives, we have determined that there are two windows that open prior to 2002 where a potential low could form. The first period actually begins April 9th, 1999 and ends December 27th, 1999. The next window appears to begin June 6th, 2001 and end February 22nd, 2002. This is based upon the 8.6-month timing interval interfaced with all global currencies in a matrix correlation. When we then take this perspective and pass it through our models that are designed to specifically target when panics will occur, the results are quite startling. The next panic cycle that is due on an 8.6-month timing interval begins April 9th and extends into December 27th of this year. This raises the risk factor considerably and we must therefore respect the fact that a potential important high could be forming right here in March of 1999. Given the fact there are no substantial underlying derivative positions that will be unwound during the next crash, there remains an increased risk that the percentage decline could be much worse during the next financial shock. Fundamentally, this tends to support the potential for a panic cycle during the next 8.6-month interval. Specific forecasts will be provided to our subscribers exclusively. It is sufficient to state that the high in the US share market may be in place as of March 19th. The failure to push higher beyond mid April will provide a warning that this next financial shock may be underway with a near-term target objective for a low during the first two weeks of May. It is entirely possible that a correction of significant magnitude may develop along the lines of 1987 in excess of 30%. Such an outcome would most likely produce a low that would hold and a basing pattern into 2002 could develop similar to the 1980-1982 period. A moderate correction of only 23% or less would still leave the potential for a more prolonged decline that would extend into 2001. In conclusion, predicting the next path is always a challenge. Determining the major shifts within the global business cycle, such as July 20th, has been comparatively easy since we need only forecast one single wave outcome. Changes in trend for the net capital flows can be quantified on a grand scale. However, at the micro level there will be two basic choices for capital even during a net inflow to the dollar – bonds or equities. A shift toward bonds may produce a short-lived crash like 1987 but a general uptrend for bonds into 2001. A shift in capital flows that remain confident for equities could still cause a blow-out to the upside, but even this would appear to be unsustainable beyond 1999. Given the personal Japanese experience with bubble tops in equities, one can hardly expect fresh buying at these levels in the Dow. Therefore, the stakes have been raised. The risks of another crash expand with each passing day. The ever changing sea of international politics also threatens the sustainability of the market for any new event is more likely to spook the crowd than suddenly cause a surge to new highs. While there are those that now quote our target of 2007 for the next peak in the business cycle as the end for the current bull market, such confidence is likely to prove nothing but folly. For between here and 2007 lies the risk of a serious contraction as the underlying capital flows shift beneath our feet. This current bull market began in 1982. It is 17 years old in US terms and 20 years old from the Japanese perspective. Consequently, the failure to produce a sustainable rally beyond mid April, may in fact now begin to reveal the fallacy of those i nfamous words – "This time it’s different!" ------------------------------------------------------------------------ ----- Aloha, He'Ping, Om, Shalom, Salaam. Em Hotep, Peace Be, Omnia Bona Bonis, All My Relations. Adieu, Adios, Aloha. Amen. Roads End Kris DECLARATION & DISCLAIMER ========== CTRL is a discussion and informational exchange list. Proselyzting propagandic screeds are not allowed. Substance—not soapboxing! These are sordid matters and 'conspiracy theory', with its many half-truths, misdirections and outright frauds is used politically by different groups with major and minor effects spread throughout the spectrum of time and thought. That being said, CTRL gives no endorsement to the validity of posts, and always suggests to readers; be wary of what you read. 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