How Evolving Money Affects Investing Markets

         I just finished writing a special report for the month of May that is titled, “How Evolving Money Affects Investing Markets”.

          This week, I want to give you a preview as I think it’s important to understand how evolving money leads to economic seasons and what I believe are predictable investing conditions.

          While the whole idea of economic seasons may sound a bit crazy on the surface, a study of history has one concluding that these economic seasons have repeated themselves over and over again.

The severity and intensity of each season is affected by the currency system that is in place as the economic season changes.

There are many economists who have written extensively on the topic of economic seasons.  Mr. Ian Gordon, of the Long Wave Group, now retired, introduced me to the concepts many years ago.  It was an important “connect the dots” moment for me helping me understand why financial markets were doing what they did.

While economic seasons are predictable, the exact time at which one season ends and the next economic season begins is not precise from a forecasting perspective.  Yet, like the seasons of the year, we know that at some point, summer weather will follow spring weather.

For ease in understanding these economic seasons, we will name them after the seasons of the year: spring, summer, autumn, and winter.  Like the four seasons of the year, each economic season also has its own characteristics.

Here is a brief overview of the economic seasons and the characteristics of each one.  (These definitions are taken from the “New Retirement Rules” book.)

Spring Economic Season

During spring, an economy experiences a gradual increase in business and employment. Consumer confidence gradually increases. Consumer prices begin a gradual increase compared to the levels seen during the previous cycle (the winter cycle). Stock prices rise and reach a peak at the end of the spring cycle, and credit gradually expands. At the beginning of the spring cycle, overall debt levels are low.

Summer Economic Season

During summer, an economy sees an increase in the currency supply, which leads to inflation. Gold prices reach a significant peak at the end of the summer period. Interest rates rise rapidly and peak at the end of the summer season. Stocks are under pressure and decline throughout the period, reaching a low at the end of the summer cycle.

Autumn Economic Season

During autumn, money is plentiful and gold prices fall, reaching a gold bear market low by the end of the autumn season. During autumn, there is a massive stock bull market and much speculation. Financial fraud is prevalent, and real estate prices rise significantly due to speculation. Debt levels are astronomical. Consumer confidence is at an all-time high due to high stock prices, high real estate prices, and plentiful jobs.

Winter Economic Season

During winter, an economy experiences a crippling credit crisis and money becomes scarce. Financial institutions are in trouble. There are unprecedented bankruptcies at the personal, corporate, and government levels. There is a credit crunch, and interest rates rise. There is an international monetary crisis.

          The economist who first discovered that these economic cycles exist was Nikolai Kondratieff who outlined his work in a book first published in 1925 titled, “The Major Economic Cycles”.

          The economic winter season from 1929 to 1949 was particularly devastating.  That period of time we now refer to as The Great Depression.

          The reason the depression occurred was that debt levels were unsustainable.  During a winter economic season or a depression, debt needs to be purged from the system.

          There are only two ways to eliminate debt, pay it down by making principal and interest payments or default on it by walking away from the responsibility to repay the debt.

          It’s instructive to quickly look at each of the winter seasons in US history and then draw a parallel to today.

          Let’s begin with the winter season that began in 1837.  Like the winter season that commenced in 1929 with the crash of the stock market, the winter season that began in 1837 was catalyzed by the Panic of 1837.

          It’s interesting that the winter season of 1837 was preceded by easy money policies.  After the War of 1812, the country was dealing with mammoth levels of debt.  The politicians of the day predictably established a central bank that could create paper currency with a loose link to precious metals.

          This loose link to metals characterizes the money systems in place prior to the first three winter seasons in US history.  Policymakers reduced the backing of the paper currency by precious metals without eliminating the link and making the currency a pure fiat currency.

          This is what happened with the establishment of the Second National Bank which opened for business in January of 1817.  The bank began to issue paper notes that could be redeemed for precious metals.  As typically happens, the bank issued more paper currency than it had precious metals to back resulting in a large increase in the currency supply.

          It was the early 1800’s version of quantitative easing or currency creation.

          It was inevitable that this expansion of the currency supply would lead to a price bubble in some assets.  With the Panic of 1837, stocks and real estate crashed and banks failed.

          The second winter season in US history occurred after the Civil War.  In order to fund the Civil War, President Lincoln and congress changed the banking rules to allow US Dollars to be backed by gold, silver, and US Government debt.  Prior to these changes being made, gold and silver were money.

          These changes resulted in a huge increase in the currency supply and predictably, bubbles formed in real estate and stocks. 

          Stocks and real estate collapsed and banks failed during the Long Depression of 1873.

          The country once again returned to a currency system that was more sound, using gold and silver as currency.

          The Federal Reserve, the nation’s third central bank and the same central bank that controls monetary policy today, was founded in 1913.

          Almost immediately, the Fed reduced the backing of the US Dollar by gold from 100% backed by gold to only 40% backed by gold creating a large increase in the currency supply.

          Predictably, the Roaring Twenties followed this evolution to more loose money policies.  Stock prices, fueled by extremely loose margin requirements, soared.  As did real estate prices with the State of Florida being the site of wildly increasing real estate values.

          The Great Depression followed.  Stock prices fell as did real estate prices and banks failed.

         In each of these historical, U.S.-based winter economic seasons, easy money allowed for the building of debt-fueled bubbles that eventually collapsed.

          It’s also important to point out that in each of these historical examples, the US Dollar was still linked to gold to some extent.

          That brings us to where we now find ourselves.

          There has been no link between the US Dollar and a precious metal since 1971 making the US Dollar a full fiat currency for more than 50 years.  That has allowed debt levels in the private and public sectors to soar.        

          Around 15 years ago, real estate prices began to fall and stock prices followed.  The Federal Reserve’s response has been currency creation literally out of thin air.

          That action has reinflated what I call the “everything bubble”. 

          At some point, the everything bubble will deflate resulting in what I believe could be the worst economic winter season in US history.

          Why do I theorize this?

          Simple, debt levels are far more extended presently than at any time historically.  That will have to make the debt purging process more painful.

          We may now be seeing the beginning of the effects of debt excesses.  Stocks are falling and interest rates are rising.

          I fully expect the Fed to reverse course and ease in a last-ditch effort to avoid a deflationary outcome but history teaches us that is where we will ultimately end up. 

          The question is how much inflation we endure in the meantime.  And, the answer to that question lies with the Fed.

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