Get four of the worldâ€™s gloomiest forecasters in one room and you soon realize: these arenâ€™t teddy bears, and this ainâ€™t no picnic.
By Jeff Sanford
— This article was originally published in Canadian Business. —
Jeff Sanford has worked as a business journalist since graduating from Ryerson University in 1999. He has held staff positions at National Post Business magazine and Investment Executive, a bi-weekly newspaper for financial advisors.
It was a flashy, high-wattage affair that took the trend of economic-news-as-entertainment to a remarkable new level. On a rainy Tuesday evening in early April, 1,500 clearly wealthy clients of Sprott Asset Management filled the ornate Elgin Theatre in downtown Toronto to hear an A-team of economic doomsayers muse about how this recession is going to get much worse yet. The group included a celebriconomist known for his erotic wall art, a formerly obscure Wall Street analyst married to a professional wrestler, and an ex-platoon-commander-turned-financial-historian who divines the cycles of life through market movements.
And so things threatened to veer toward the absurd. But as events go, A Night with the Bears (as the evening was so aptly titled) provided a plausible take on the root causes of our current woes. For the bears, itâ€™s all about the big chunk of consumer debt still outstanding and how that debt is going to be expunged from the system. Itâ€™s a story that is more complex than the Twittering of the newspaper reporters could hope to capture. So while good reasons exist to think there may be a market bottom forming right now, and no end of advisers are suggesting investors get back into markets: Be careful. This downturn is an odd one.
The drastic plunge in economic activity is still sending shock waves across markets. A recent report from the International Monetary Fund suggests total financial industry writedowns will hit US$4 trillion â€” more than many had assumed. And lots of bad news is likely yet to come, possibly enough to swamp this springâ€™s nascent market recovery and make the bounce one of the dead-cat variety.
Those who pass by these bears without paying attention to what theyâ€™re roaring about are putting their wealth at risk.
The big name of the night was Nouriel Roubini, the former Clinton White House staffer who has taken on the sobriquet Dr. Doom for his dour outlook on the economy. Heâ€™s garnered a bit of minor celebrity as a result. (Trendy gossip website gawker.com has been following the prurient interest in his wall art and his rising popularity on the New York party scene.) Also up from New York for the event was Meredith Whitney, the former Oppenheimer analyst who was the first to call the debt crisis at Citibank. Joining those two on stage was Eric Sprott, the namesake of the Bay Street firm throwing the event, and Ian Gordon, a genial former investment adviser from Vancouver who was the grizzly bear at this gathering.
Gordon has become famous for issuing a provocative and much-repeated call in March that the Dow will drop to 1,000 in this downturn. (It closed April 23 at 7,957.) Backstage, before the event, among a swarm of open-bar-bound journalists, photographers and PR people, Gordon chatted amiably about the shattered psyche of the average investor and the need to get out of stocks. â€œI think people are confused,â€ he said. â€œEverybody is hurting.â€ Gordon is not in the least hesitant to counsel stockholders to get out of equities during this bounce in the market. â€œPeople are wondering what to do. Theyâ€™ve got to make this call [whether or not to stay in stocks]. Theyâ€™ve already lost 50% of their money. If they donâ€™t make the right one, then theyâ€™re basically going to lose it all.â€
To Gordon, the reasoning couldnâ€™t be more clear. These days, he runs the Long Wave Group, a company whose business is interpreting the Kondratieff Cycle, an approximately 60-year-long pattern some believe to be particular to capitalist economies. According to Gordon, the K-Cycle is now signaling that we are in a Depression â€” capital D.
The cycle is named for Nikolai Kondratieff, an economist who worked on Joseph Stalinâ€™s first five-year plan back in the years after the Russian Revolution. Charged with analyzing the source of economic growth, in the 1920s he published a book, The Major Economic Cycles, that identified a regular 60-to-70-year event-driven cycle describing economic trends arising from predictable mass-psychological, cultural and economic structures in capitalist countries.
As Gordon describes them, the cycles grow out of the booms and busts that define capitalism. There have been four K-Cycles so far in the postâ€“Industrial Revolution history of western economies. We are in the last part of the fourth cycle, which started in 1949, after the Second World War wrapped up the Great Depression, marking the end of the previous cycle. Each cycle can further be divided into four phases, each roughly 15 years long and corresponding to one of the seasons.
The first 15 years or so of the K-Cycle is analogous to spring: out of the debris and chaos of the previous cycle a new era of growth begins. The seed may be new technology or a group of technologies, creating economic optimism characterized by rising employment, wages and productivity levels. In our current cycle, â€œspringâ€ was the years 1949â€“1966.
But spring always gives way to summer, a point when the economic seeds planted earlier flower into a new economy. This growth creates changes. The resources tapped to fuel the construction and maintenance of the new economic order are stretched. The exponential growth of spring slows. Inflation takes hold. Imbalances build up as growth expectations confront limits. In our current cycle, â€œsummerâ€ was 1966â€“1982, a period when energy prices were spiking and inflation flared. Eventually a drop in output follows, unemployment rises and a severe â€œend-of-summerâ€ recession, the primary recession of the Kondratieff Cycle, occurs. This was the severe recession of 1980â€“82, when the Dow bottomed at 777 and interest rates spiked to double digits.
Autumn follows, and a new economic phase relieves the pressures of summer. The population is now used to new levels of consumption, and a sense of affluence permeates the culture. There is a key shift in lending, which moves from the corporate sector to the individual. But as personal consumption rises as a result of credit creation, the stock market booms and asset prices climb. The â€œautumnâ€ of the previous 60-year cycle was 1921â€“29. In the current cycle, autumn occurred from 1982 to 2000. That was followed by a period when total outstanding consumer debt rose mightily. In fact, it grew by a factor of 4.5 between 1975 and now, when adjusted for inflation.
This boom in credit creation and the increase in debt outstanding is why we need to worry, says Gordon. â€œThe thing that brings down the system is the debt,â€ he says. â€œThis is what happened in the â€™30s, and it is what is happening again today. In the U.S., the debt-to-GDP ramped up between 1921 and 1929 to about 160%, and today itâ€™s about 370% of GDP, so thatâ€™s more than double. That debt has to be cleaned out of the economy. And while that process is already happening, by my way of thinking itâ€™s going to be a long drawn-out process. Itâ€™s already brought down the banks in the United States.â€
As showtime approaches, the rest of the bears are escorted into the building and into a green room near the stage. In an exclusive interview with Canadian Business, the group fields questions as they munch on snacks and get ready to hit the stage. Each of the four comes around in his or her own way to the same issue: outstanding consumer debt. It is the common thread. â€œU.S. household debt as a share of disposable income 15 years ago used to be 65%,â€ says Roubini. â€œIt became 100% in 2002 and is now 135%. So you have a U.S. consumer that is shopped out, saving less, and debt-burdened. And now theyâ€™re hit by the fall in value of their homes and the stock market. So they canâ€™t use their home as a bank machine.â€
This process is causing American consumers to pull in spending, and that slowdown is shaking the very roots of the consumer-led global economy. U.S. consumers spend less and that leads to layoffs. The layoffs lead to less consumer spending. And so the brutal cycle of debt deflation that helped send the world into Great Depression in the â€™30s is turning again today.
Roubini turns out to be one of the moderate voices this evening. He doesnâ€™t think the world is going to see a Great Depression II. But he does say that this period of debt deflation is going to be the dominant trend in the economy until 2012. He thinks bad news still to come will overwhelm the current stock market rebound. â€œEven those with jobs have to worry about being next in line, so I think the adjustment of consumption is going to continue for a long time,â€ says Roubini. â€œI would be careful about buying into all this good news. I think we have a lot more bad news yet, and I think the bad news will crowd out the optimism.â€ He adds: â€œWe still have months and months of bankruptcy across the board.â€
Also in the green room is Meredith Whitney. When she takes the stage later in the night, she reminisces about her first years in the banking business. The original promise of securitization â€” the practice of bundling up loans and slicing the packages into new securities with better credit ratings (a trend that picked up in the early â€™80s) â€” allowed borrowing to be extended to those with less-than-stellar credit ratings or those who may not have qualified previously. â€œWhen I got into this industry, I believed in the democratization of credit,â€ Whitney recalls. â€œI believed in that idea, the notion that with securitization an immigrant with no banking background could come to North America and buy a house and get credit.â€
Perhaps it was a noble idea. But Whitney has come to rue those early assumptions. As the global banking industry unleashed securitization and created all kinds of new credit, it also created all kinds of new money, stoking demand and sending asset prices soaring. Stocks, houses â€” everything went up as a result of the expanding credit. And while this was considered a good thing at the time, the good times eventually tripped up. The increase in total consumption brought on by the expanding debt bubble raised oil prices, which directed money away from the United States (and from mortgage payments), and the Great Recession got underway.
According to Whitney, the biggest American banks have a long way to go to get out from under this bursting debt bubble. Theyâ€™ve raised money, gone to the Mideast for investors, and asked the government for cash. But that wonâ€™t be enough. Next up will be fire sales on key assets that banks were trying to keep on their books but wonâ€™t be able to. â€œThe government canâ€™t save these companies on their own,â€ says Whitney. â€œThere are too many demands on capital. We havenâ€™t seen even half the demands on capital that are coming. And by that I mean, there are a lot of other people the government is going have to assist in terms of bailouts.â€
She cautions about blindly jumping back into the market while the underlying debt deflation is still taking place. â€œDo I get in now? People are going to be tempted,â€ Whitney says. â€œTwenty-five basis points on a money-market fund isnâ€™t so good when youâ€™ve lost so much money. I think people want to hope, and I think they want to believe this is a recovery. But thatâ€™s scary. We might have a first quarter that lures people back in, but you have to be really careful about what you own. In terms of blindly buying equities, I think thatâ€™s a big mistake.â€
According to Eric Sprott, what weâ€™re seeing isnâ€™t a recession or a depression, but an outright collapse of the postwar economic order. â€œIâ€™m a CA, and Iâ€™m seeing a lot of questionable financial assets on the balance sheets of banks,â€ says Sprott. â€œI think it will take 10 years to get this off the books of the banks.â€ Demographic forces, meanwhile, will conspire to work against any government action. â€œThere was a net withdrawal from U.S. Social Security the first time this year, the first year the baby boomers could collect,â€ Sprott notes. â€œAnd so itâ€™s going to get worse. And I donâ€™t even think the promises to the elderly are going to be met. We know that the United States has an accrued liability of US$55 trillion. There is no way to maintain that.â€
Not until the global economy completely breaks down and rebuilds on a more sustainable footing will the world enjoy a new boom. Rising oil prices are likely to accompany any recovery and will check any further growth that might have taken place along a path similar to the hydrocarbon-dependent economy â€” you know, U.S. suburban McMansion construction and widespread SUV ownership (along with the financing that made it all possible).
For Gordon, this would be according to cycle. As the Kondratieff winter sets in, fiat currencies break down and thereâ€™s a big move away from dollar-denominated assets toward gold. He suggests getting out of stocks altogether, since this bear market will be as bad as the 1982â€“2000 bull market was good. â€œPeople at the financial firms donâ€™t have a clue â€” they always say â€˜Sit and hold, sit and hold,â€™ like they always have,â€ Gordon says. â€œTheir strategists are saying that it always comes back, because it always has, in recent memory. But this is the one point in the cycle when it doesnâ€™t come back. Itâ€™s the only time in the long 60-to-70-year cycle that stocks get absolutely beaten up.â€
For Gordon, winter deepened in mid-2007, when two Bear Stearns funds (the High-Grade Structured Credit Strategies Enhanced Leverage Fund and the High-Grade Sructured Credit Strategies Fund) tried to sell some so-called toxic assets the bank had stored on its books through years of manufacturing securitized debt products. In that process, debt was bundled into various tranches: the triple-A-rated securities got paid first, and the toxic waste, the lower tranches, were stored on the books of banks like Bear Stearns, which turned out to be stuffed to the gills with the leftover risk from a generation of credit creation. That bundle of debt began to weigh on Bear Stearns, and when the venerable Wall Street investment house tried to sell it, the market balked.
Gordon points to that as the moment the debt bubble burst. â€œWhen Bear Stearns couldnâ€™t sell that sub-prime debt in 2007, that was it,â€ he says. â€œIn 1998, I said we were in a bull market like the one between 1921 and 1929. And we called it right on. But that moment in 2007 marked the real end of the cycle. This is a major one. This is going to send us into an economic winter. Itâ€™s playing out just like I said it would.â€
Gordon also suggests this downturn is going to be worse than it had to be. â€œIf Greenspan had let it go in 2000 after that first peak, it wouldnâ€™t have been so bad. The housing bubble didnâ€™t go into excess until 2001. You would have still had a housing crash. But it wouldnâ€™t be on the level weâ€™re seeing now. The debt was increased by 30% between 2000 and 2007.â€
There are few western economists who follow K-wave theory. Gordon seems to be one of the leading voices on this, and so take the theory for what you will. But Gordon has no problem calling the current market recovery a dead-cat bounce. He points out that after the initial market crash in October 1929, stock markets rallied 50% through April 1930; only then did the market turn and take its big dive into the Kondratieff winter. â€œThis rally is just like the one in 1929,â€ says Gordon. â€œGold is the only thing that holds value through a period like this.â€
If the global economy is indeed moving deeper into a Kondratieff winter, weâ€™ll realize all sorts of cultural shifts as well as economic ones. Weâ€™ll see a call for more regulation and an end to the short-term boom-and-bust cycle. Politically, there will be a shift to the left. Big Finance will take an even bigger hit than it already has. But eventually we will move through it, debt excesses will be expunged, and out of the wreckage a new long-term cycle will emerge. Gordon expects that by 2020. And the capitalist countries (along with the rest of the world, including pseudo-capitalist countries like China and Russia) will have moved through another cycle of boom and bust.
According to Gordon, who is 66, it is no surprise that the boom-bust cycle is about 60 years long. This is the meaningful life of one person, and it seems about the time it takes for a culture of free citizens to get over the traumas of the last bust, to lay the foundations for a new boom and to then repeat the mistakes of the past. The Greeks called this habit â€” of assuming that nature had been overcome and repeating the mistakes of the past â€” â€œhubris.â€ Suffering boom and bust, perhaps, is simply the cost of living as an economically free human.
As for Kondratieff, he had the misfortune to live in a country that tried to limit human freedom and stop boom and bust through a centrally planned economy. That works even less well than capitalism. Kondratieffâ€™s ideas made him a high-ranking Soviet, but eventually they (and he) fell out of favour with Stalin. The economist was arrested in 1930 and sent to a labor camp, where he died in 1938.