Saturday Morning Coffee: History Lesson

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I'll try to represent a vastly oversimplified vision of where we are, with charts. The seventies ushered in the first 'energy crisis' and spawned domestic inflation at rates far higher than we have seen for many years. Fed Chairman Paul Volcker is often credited for breaking the back of inflation with his interest rate hikes.

Subsequently, with a secular fall in interest rates, the greatest bull market we have seen emerged, concurrent with the revolution in information technology and the Internet. Note the end of the trendline...
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But something happened on the way to financial Nirvana, with the development of the Great Bubble, the first of an uncertain number. The SP500 reached unsustainable heights with astronomic price-t0-earnings multiples, and down it came.
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Great fortunes amassed were lost, and the Federal Reserve, led by Alan Greenspan slashed interest rates to stimulate economic growth. Greenspan encouraged the development and use of adjustable rate mortgages, and financial products developed that transferred risk from the lenders (who sold or 'securitized' the products), who took their cut immediately and moved on, to the 'investors', many of whom had no idea that traditional lending standards simply disappeared. The Housing Boom was on.

Americans had the opportunity not only to buy a home, but many engaged in real estate speculation, with the expectation that price extrapolation would pave their financial streets with gold. They took interest only mortgages and bought overpriced (well above two standard deviations of price to family income ratios) property, only to find that when the market turned south, they had huge mortgages, negative equity, AND rising payments as their ARMS reset. Roh-roh.
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Also back in the 1980s, the United States launched a massive defense buildup, part of an arms race with the Soviet Union, which was fighting its own unpopular war, ironically in Afghanistan. Government CAPEX (spending on capital goods) helped fuel economic growth as well. With a struggling economy at home and imperialism abroad, the Soviet Union fell, and the end of the Cold War gave birth to the genesis of the Hot War. The Soviet Union's military might oversaw regional conflicts and stopped them from escalating with brute force. Rolling tank divisions into your neighbors' backyard and ruthlessly crushing resistance has that effect. My boss in the Navy, Captain Thomas Walsh, simply said in the late 1980s, "the fall of the Soviet Union will be the worst thing that ever happened to the United States."

The Hot War resulted at the intersection of rising tensions in the Middle East, intermittent regional skirmishes or outright war between Israel and her neighbors. Amidst this, Osama bin Laden had a messianic vision of an Islamist uprising and a plan to do so.

George Friedman of Stratfor commented for John Mauldin JohnMauldin@InvestorsInsight.com. at his Investor Insight...

The 9/11 attack, as well as earlier attacks, was designed to do two things. First, by striking targets that were well-known among the Muslim masses, the attack was meant to demonstrate that the United States could be attacked and badly hurt. Second, it was designed to get a U.S. reaction -- and this is what bin Laden saw as the beauty of his plan: If Washington reacted by doing nothing effective, then he could argue that the United States was profoundly weak and indecisive. This would increase contempt for the United States. If, on the other hand, the United States staged a series of campaigns in the Islamic world, he would be able to say that this demonstrated that the United States was the true Crusader state and the enemy of Muslims everywhere. Bin Laden was looking for an intemperate move -- either the continued impotent responses to al Qaeda attacks in the 1990s or a drastic assault against Islam. Either one would have done.

The US responded, and continues to do so...see the Defense Index above. With ongoing massive deficit spending and what many see as an unsustainable current account deficit, the US used capital borrowed from the growing Asian Tigers to finance its guns and consumers used mortgage equity withdrawal from the housing bubble to buy the butter.

But something went very wrong on the way to the forum, as in the borrowers of capital often couldn't pay their mortgages as the ARMs reset, and investors started to get burned my the mark-to-market of their assets. The asset bubble started to unravel. Companies (usually financials) that thrive by turning over bonds of various durations couldn't get credit at acceptable terms.

Meanwhile, the Federal Reserve printed dollars at an astonishing rate. In fact, because they expanded the money supply so furiously via competitive devaluation, they had to take M3 off-line, just another 'misdirection'. One result was the incredible shrinking dollar, while Central Bankers like Ben Bernanke boasted of price stability.

Inflation was nowhere to be found, as government statisticians rework the definition of inflation to trim COLAs, but consumers pay more for food, energy, tuition, and insurance. John Williams Shadow Government statistics tells that tale.

All of which brings us to where we are now.

• The Federal Reserve meets to decide rate policy (if you can't fix the structural problem - rising debt needs to fuel growth, uncontrolled spending, slowing economic growth - then throw money at it
• The US describes an open-ended commitment to Iraq (think post World War II Germany) in order to maintain 'stability' and have immediate access to the unstable adjacent oil producing nations
• Gold, in particular, rises as the second stage of its bull market transitions upward, sniffing out Central Bankers plan to print to monetize the debt
• Housing continues to struggle among massive inventory, falling prices, rising numbers of ARMs resets, and falling book values of builders as land values reset
• Consumer spending growth slows

General Petraeus simply asked 'Tell me how this ends.' I'm no futurist, only a chartist, who sees immovable forces (rising debt) and irresistible objects (Social Security and Medicare growth) which will mean delaying and trimming benefits, means testing for benefits, and ongoing lifestyle convergence between the developed and the developing world.

In Iraq, we see a nation with borders but no national identity, a blend of Shia, Sunni (displaced previous dominant), Sunni al-Qaeda (not the original brand), and Kurds, all married to their own needs rather than of any national agenda.

The logical 'solution' for the Federal Reserve will be to talk tough, cut rates, print money, devalue the dollar further until such time as our trading 'partners' (a one word oxymoron) refuse either to take dollars (repricing their goods in Euros or another currency) or repatriate their investments to higher yielding vehicles. Can gold and commodities, measures of inflation, be so wrong, and equities so right? History will tell us.

Good trading and great risk management to all.

Educational use only. Never intended as investment advice.