What Would A Free Market Look Like In The Current Crisis?

I make frequent reference to the Austrian school of economic thought on this blog. Austrian principles are deeply founded under free market assumptions and that it is government intervention that creates distorions. There are plenty of critics out there, namely Neoclassicals, pure Keynesians and Chicago monetarists that discredit the Austrian school because of it's lack of empircal induction. Yet, the Austrian economists have seen the coming crisis for some time, without the use of highly sophisticated macroeconomic models.

So what would the economy look like if markets were suddenly freed from government intervention?

The very most important thing to distinguish would be the Fed would disappear and along with it their role in micro-managing interest rates along with it. Interest rates represent a crucial part of a free market economy because they are a reflection of time preference. No doubt, considering the debt burden, the inclination of people's time preferences would be to save, albeit, from historically low savings levels. As a result, interest rates would rise to a now undetermined rate. (get the point, why does the Fed magically know where to set interest rates? how do they know people's time preferences?)

The rise in interest rates would then weigh down more burden on those already struggling to maintain payments on their obligations. Defaults would sky rocket across many different sectors.

Who would default

• Most obvious, would be homeowners who bought expensive homes they could never afford at teaser rates
• Consumers who spent frivolously on credit cards and equity lines would likely default on those as well
• Residential and commercial property investors would default on their loans as rents, reserves and prices all decreased
• Students would be scarce to find jobs and likely default on their loans from bloated education costs
• Auto companies, who no longer have viable business models and huge inventories, but have only survived on the backs of taxpayers and reliance on rolling over debt
• Auto suppliers, whose industry must now downsize
  
• Corporations, especially heavily indebted exploration companies who borrowed heavily based on higher commodity prices
• States, localities and municipalities would renegotiate their bonds and severely downsize their service offerings
• Private equity firms and hedge funds, who leveraged their balance sheets to earn excess returns at high prices
• Pension funds, with unrealistically high return expectations and aggressive investment policy
• Finally, financial institutions: banks, ibanks, insurance companies and investment companies who are all interrelated in a complex web

This is not an all inclusive list, yet the list is large and unprecedented. For sake of simplicity, the global effects and obvious government defaults and downsizing will be naively ignored here.

Now That The Most Epic Crash In World History Has Happened, What Next?

The pain involved in this process will be immense! While all of this is occurring, some extraordinary things will coincide.

• Unemployment will sky rocket
• Prices will cliff dive: wages, food, energy, housing, stocks, commodities, commercial property, land, equipment, consumer goods, higher order goods, inventory (you get the picture)
• Taxes will be reduced to very small portions of income on both individuals and businesses
• Poverty will sky rocket
• Crime will increase
  
• Dollars will rise in value dramatically as they become more scarce

I'm sure I'm leaving plenty of factors unmentioned, but the pain involved will be enormous.

Ok, So Now Everyone Is Out Of Work, What Next?

This is where a bit of thinking comes into play. Forget everything you think you know of economics, because it most likely based from some empirical mumbo jumbo about aggregate demand. The real underlying study of economics is Human Action!

Human Action

The above mentioned scenarios are highly likely. As a result, humans will defer to survivor instincts to make a living. This means adjustments will be made IMMEDIATELY.

The process outlined above would adjust extremely quickly, with price and time preference aiding people in making critical decisions.

• A now largely unemployed population would make personal concessions in hopes to find work, even at much much lower wages
• A blow to demand from the preference to save rather than consume would lower many prices of many types of goods
• Lower wages are suddenly not so bad because prices are lower and dollars more valuable
• Those who already had savings, large are small, would now find great opportunity to invest, with more highly valued dollars
• Savers turned investors could buy bankrupt businesses, devalued properties, bargain inventories, equipment, land and other assets
• As investors put money to work at lower prices, business activity increases, as does employment
• Savings increase and time preference shift
  
• Affordability returns and debt is reduced to serviceable portions

Savings & Investment Spur Demand

Price and interest rate determine the preference to invest and save. The reason for the crisis in the first place was an intervention of these preferences, via federal reserve manipulation of interest rates which fueled a credit induced boom. The low rates teased investors to invest when in hindsight they should have saved. The outcome is high prices and malinvestment.

What the market is so great at is adjusting for these time preferences. The rate of speed at which this can occur is rapid. As human survivor instincts kick in during crises like these, we tend to make common sensical concessions to get by, which are reflected in price. Price is an instrument of supply, demand and productivity. What offsets this is pumping of dollars via credit or base money into the system, making each dollar worth less. During the adjustment phase, dollars are leaving the system by means of default, making each dollar left in existence more valuable, a net benefit and is reflected in lower prices. Oila! Savings are now more valuable to investors.

What About Now, Can The Government Save Us From This Crisis?

The simple answer is no! The government can tax you and devalue your dollars to boost demand temporarily, but in the long run this is unsustainable and a giant ponzi scheme. The government now has untold trillions in liabilities that will never be repaid. I offer two scenarios form the government current course of action:

1. 10 -20 more years of recession, much like Japan, with only brief glimpses of recovery
2. The Fed accelerates the quantitative easing front to 10's of trillions of dollars, effectively crashing the dollar

Either of those scenarios is net negative and put into context far worse than my hypothetical scenario. The current scenario offers only long term despair.

My scenario offers short term despair, possibly one or two years. In my scenario we take responsibility for our excesses and move on. However, it offers greater liberties and honest money.

Which Do You Prefer?

March 9th Market Bottom?

This market is chock full of uncertainty. I mentioned previously that this did not feel like "the bottom of all bottoms" and yet I have still been posting bullish charts. Too many market pundits called the bottom on March 9th. This makes me worry, rarely does that ever happen. The media in general seemed to have gotten it right as well, which really makes me want to take an extra contrarian view. Granted, this rally may have room to run still.

Unfortunately, due to java tomfoolery, I am unable to post an updated chart at the moment, but feel it necessary to mention an alternative count that is gaining popularity (amongst myself). This alternative is that the 666 bottom was NOT an intermediate wave 5 of primary wave 5 of cycle wave C bottom. If it was, it would suggest we are about to embark on a new bull market of cycle degree (which is of large degree, possibly decades). Even if my original count is true, it does not necessarily mean we are about to embark on new highs in the next few years.

My alternative count, which I am inclined to make my primary count considering media was so quick to call a bottom, is that the 666 low was an intermediate wave 5 of primary wave 3. If this is true, then we are in primary wave 4, which has potential to rise above 1,000. However, the end result would be a new bottom of primary 5 of cycle C below 666 (unless truncated).

I have seen only one other Elliottician out there with this possibility. You can view his charts here. The count is not the prettiest, but I'll see if it will make sense in my own analysis later.

There are numerous reasons why declaring 666 a primary 3 instead of 5 makes sense.

1. The cyclically adjusted P/E has not fallen below 10, which historically happens during major bear markets (overshooting).
   
2. Commercial real estate, credit cards, state budget shortfalls and pension funds are still pending epic downturns.
3. Unemployment, though a lagging indicator, is still gaining momentum; even in weekly claims.
4. The government is determined to keep insolvent institutions alive, at the GREAT expense of taxpayers.
5. Consumers are still heavily indebted and impaired in keeping good on payments, and/or have no means to go willy nilly in spending freely and/or take on new debts.
   
6. Consumer confidence is still low and a large cloud of uncertainty is in the air regarding the future.
   
7. There are no significant earnings drivers to look forward to in the next few years.
8. All hope has not been lost. A characteristic of orthodox bottoms is that everyone is bearish and net sellers. That my friend, is capitulation. The bottom on March 9th, all hope was not lost.
   

Elliott Wave is NOT a crystal ball, it is a tool. It is useful in determining trends with other tools to form an opinion. Nothing in this world is certain and it is the intelligent investors duty to be cognizant of different possibilities and outcomes. If the investor is not, then he is subject to what Nassim taleb refers to as the blow up, or "black swan".

So many believed prices always go up and many a trader and fund have perished for that belief. I contend to not be one of them. Instead I try to remain objective, but even this in such a volatile market is no easy task.

Overall, my investing strategy is to use Austrian economic theory, fundamental, socioeconomic and technical indicators such as Elliott Wave in forming broad opinions about the economy and the market. In terms of individual securities Benjamin Graham's theories remain king in my opinion.

As soon as I get the chance I will update this alternative wave count in chart form.

Note: my chats could be much better should I pay for Stockcharts.com's services (sigh).

One final bit of history. In 1932 the stock market bottomed after a perilous journey down, with several corrections up along the way. A new bull market of large degree started at that point, but it took over a decade before the 1929 highs were seen again.

2009-03-27 $SPX Update

Yet again I'm at the drawing board with Elliott Wave. Again, this posting is just exercise for me, but hopefully it proves insightful. Here is the latest count:

(Note: StockCharts.com has wicked awesome tools, but their free service only goes as small as daily charts. Intraday is necessary for exact subwave counts. I would love me a free chart service like this on an intraday level.)


Intermediate wave 1 is close to its top, there seems to be forming a long winded ending diagonal before the real correction of intermediate wave 2 begins. But wave 2 is coming shortly, so I included some Fibonacci retracements. I'd love me a 61.8% retracement for a nice buying opportunity.

Remember, my previous wave 4 scenario was proven invalid, which means that we are in a substantial bear market rally, with 5 waves up. Seeing that wave 2 is only beginning, those looking to get in should do so now with this buying opportunity while the eating is good.

How much upward movement is there really?

Well, assuming 850 as the top of wave 1, and assuming wave 3 extends 1.618 times wave 1, and assuming wave 2 has a 50% retracement; then wave three would extend to 1,068. And after that, assuming a 38.2% wave 4 correction and wave 5 equal in length to wave 1, an ultimate top of 1,139 would be in the cards.

Of course that is just one of the many ways this rally could unfold, but what's important is to recognize the upside potential.

On a final note, I am a beginner with Elliott Wave. I am posting these charts here for exercise purposes and to determine if the EW is a useful tool.

Sytem Crisis; Not Just Systemic

Yesterday I made the (radical) argument that what this crisis is really about is a system crisis, mainly that our currency regime is a fiat based credit system that is wholly unsustainable. Slowly, this message is coming to light from more widely recognized figures including Peter Schiff, Steve Keen, Ron Paul, Mike Shedlock and even a few commentators on CNBC (surprisingly, there are intelligent conversations on occassion). Now add to that list Mr. Black Swann, Nassim Taleb, where he discusses precisely this issue when Mr. Taleb Goes To Washington:

Now that the catastrophe is here, Taleb's anger at the economic establishment that drove us over this cliff—and populates the Journal's conference—makes him a representative figure of ordinary people. Like most Americans, Taleb is seething with rage about the financial establishment's role in bringing the about credit crash. "Nobody saw the crisis coming," he says. "Bernanke, all these guys, I want them out. They proved incompetent, they crashed the plane."

THANK YOU! It puzzles me that after all this time the majority of pundits still believe that the same figures who DID NOT see the crisis coming believe that they can guide us out. The reality is Bernanke & Co. were the chief orchestrators of this crisis through interest rate intervention and massive government spending.

In private, Taleb takes a specific kind of glee in the wreckage of modern finance. He has been arguing for years that the "adult supervision" in the financial system—the worthy academics, regulators, and heads of the large banking institutions—has been deluding itself with talk of a great moderation. To Taleb, the supposed stability brought about by complex financial derivatives, global banking connections, and accelerated flows of capital was a mirage masking the accumulation of massive amounts of hidden risk.

...

First, he says, we have to unmask the charlatans of risk like Myron Scholes. To Taleb, Scholes is the Great Oz in this Emerald City because his work on options and derivatives allowed the whole of the financial system to adopt poorly understood products-like the ones that brought AIG down-that hide risk. To Taleb, Scholes' academic work, which enabled the widespread use of complex derivatives, was like "giving children dynamite."

"This guy should be in a retirement home doing Sudoku," Taleb says. "His funds have blown up twice. He shouldn't be allowed in Washington to lecture anyone on risk."

With complex derivatives unmasked and, in Taleb's vision of the future, outlawed, the next step is to create a more robust version of capitalism. Taleb calls it Capitalism 2.0. Robustness begins with a dismantling of debt. Leverage was the gas that inflated the financial system until it was too big, too fragile, and too volatile.

Over the past 20 years, the financial system has grown ever more complex. Building on a greater computing capacity and communication speed—"Bank runs now take place at the speed of BlackBerry"—Taleb recognizes that the financial system now possesses an efficiency that creates volatility. That cannot and will not go away.

We cannot have both debt leverage and a hyper-efficient system—the volatility is just too great. What Taleb explains—which no one else does—is that efficiency is already a form of leverage. A highly efficient system removes slack and magnifies small changes. Think of the efficient system as a high-performance aircraft. Each minute of steering input creates a rapid and violent shift of course, speed, or altitude. The system itself is souped up even before you add the debt. Once you do, the pilot is equally jacked up and twitchy, creating an explosive combination. Now imagine that fighter jet trying to fly in a 1,000-plane formation, and you get an idea of the world financial system in the 21^st century.

We can't erase the technology that created the planes, so we'll have to make sure we fly sober, maybe even with an onboard computer that dampens the controls. That means getting rid of the debt. It's that simple.

A deleveraged financial system is a stable one, especially if we increase the redundancy within the system. That's an idea Taleb has taken from biology. But in finance, redundancy means two things: not having players in the game who are "too big to fail" and not allowing anyone—from the individual to the institution—to play with too much money. Redundancy means have cash on the side, not risking it all, and not becoming dependent upon financial assets for your economic well-being.

Did the conference see things Taleb's way? Not really. Back at the office, many of the financial leaders present had teams of analysts working on the government's newly proposed plan for toxic assets. Instead of deleveraging, here was a plan to use more leverage (provided by the government) to solve the excesses created by leverage.

Although Taleb was impressed with Geithner, his anger has hardly dissipated. "The center of the problem is that they don't know the center of the problem," he says. "They have not yet entertained the idea that what we may be witnessing is a total failure of a way of doing business."

Unfortunately, Mr. Taleb's wise words will not be taken seriously in the near term. The sad truth is the government believes they can save the system and that they must DO something. Their solution is the same as the problem, more leverage. Taleb is right; financial institutions are great in number, but concentrated in power, a destabilizing factor.

We now have turned to the road towards the "great repudiation". In this a refer to a complete overhaul of the current currency regime on a global scale. While this is welcome, what worries me is that the move will be towards more of the same, just with a different controller, I.e the IMF.

Monetary Shenanigans

Before beginning what will be a radical call, readers should know my last two posts regarding Elliott Wave predictions were and will still be experimental. My counts were wrong, I'm still learning and posting them here is more for my own experience.

Now, onto the topic of the day...monetary shenanigans and the endgame that will result. Please look back on my post, Debt Overhang Haunting; What Ails Bernanke's Sleepless Nights. It is there that I introduced the extraordinary leverage inherent in our credit based (fiat) monetary system. The Austrian economists dating all the way back to Mises and Rothbard have been preaching the dangers of paper money and have been persistent proponents of honest 100% gold money standards. They knew, even way back in the 1970's when all traces of money tied to gold were dissolved that monetary collapse was iminent. The result was persistent currency debacement and more recently massive credit extension.

It is my opinion that the debt outstanding has reached critical mass and the interconnection between credit and assets are now too great. Private citizens balance sheets are in tatters. The Fed and economists, still in denial in their ivory towers, believe they can save us again. Look at the facts; global zero percent interest rates are here and yet the credit system is still locked. Asset prices will fluctuate as they are inherently led by human action, but eventually they will revert towards their fundamental values, which no doubt means lower prices. In the meantime the government and central banks assume to make huge power grabs at the expense of your liberty.

The question that comes to so many minds is "how will all of this be repaid?" A worthy question; the answer...it won't, it can't! It will only be repaid after a currency regime reform, the inciting action being massive uprising after years of pain have failed to solve of of the real problems. It's impossible to say when, but it is not a matter of if. Policy makers may miraculously find a way to kick the can down the road and create the perception that the economy is sound, but this ponzi scheme has an eventual bursting point.

In fact we're already seeing hints of this coming reform at hand as just this week the Chinese announced they will be diversifying their currency and suggest a new world reserve currency via IMF paper. While a new currency is certainly in the works, solving the underlying problems of paper currency with new paper currency is just plain silly and simply shifts political power from a national to global scale.

I am not alone in this thought. Please consider the viewpoint of former IMF economist Gunnar Tomas...The End of Mainstream Economics:

Gunnar:

Yes, I remember that while visiting Iceland in 1982 I was invited by someone in the know to present ideas to the Icelandic Chamber of Commerce.The key to successful economic management, I suggested, was to maintain some appropriate balance between paper wealth and real wealth, the production generated by the economy. I likened this to a ship's superstructure, where the ship is production and the superstructure is paper — if the superstructure's growth is excessive, there comes a point in time — and circumstances that cannot be specified in advance — at which the superstructure will overturn the ship. That is what is happening now and has been going on since 2007.

Egill:

You have argued for a very long time that this system, the world monetary system, was fatally flawed.

Gunnar:

Yes, absolutely.

But in this business there is something else that one discovers early on; namely, that if you are in a position of responsibility in the world monetary system and management, in the world's central banks, the International Monetary Fund etc., then you must always go with the stream if you plan on continuing in that position. This has completely destroyed all professionalism in central-bank management here in Iceland and elsewhere. You must go with the stream and never go against it.

Gunnar:

The system has collapsed and it cannot be rebuilt on the foundations that were put in place with Paul Samuelson's ideology in 1942. It is very difficult to change something like this. I have collaborated for many years with colleagues in an economics group known as Gang8. Icelanders can look it up on the Internet. The group includes economists from Europe and the United States, a total of ten or so. I said to them,

"There is no point debating these issues with those whose livelihood depends on them being sound. We must wait until everything goes to hell in a handbasket, if you excuse the language, and then we will give them our telephone number."

It is awfully arrogant to put it like this, but that is the situation we face today. There is talk here in Iceland of calling on foreign experts to give advice on how to reconstruct the economy or the monetary system. And, lo and behold, they come with these same ideas. In the United States we see how George Bush responded to the unfolding US economic crisis. Barack Obama is taking the same approach. One must realize that this system cannot be salvaged.

It is fundamental nonsense to view money as a factor of production. Money plays many roles, but we live on what we produce. We do not live on paper money that we create as a superstructure on the foundation of our production. We live on what we produce, and with loan indexation we impose a burden on the production sector, monetary costs that have no basis in rational thinking about wealth creation and its financing. Keep interest high and index loan principal, and you impose corresponding cost burdens on production. Loan indexation is completely illogical if you look at it from the vantage point of wealth creation. But it looks eminently sensible to moneyed individuals and pension funds.

I suggest reading the article in full. Production and money are way out of whack!

Revolution!!!!

If I had a publicly recognized voice, this video surely would encapsulate my thoughts and opinions.



I do however listen to those with voices and the message is clear; from humble bloggers to radio hosts the vast majority are PISSED!!!!

Please, don't take the message of this video lightly.

Elliott Wave Update-$SPX

In my previous post...$SPX Wave Count I flexed my Elliott Wave ability and predicted we still have one more leg to the downside before a significant bear market rally (wave A). I have since then updated the chart with interpretation and also included an alternative wave count, one I think others have (falsely) come to conclusion as. Here is the update:


This interpretation remains unchanged except for where the expected bottom will be. In the first chart the expected bottom was much lower at 583. Now that has been adjusted to 663 because of the large wave 4 correction. The possibility that the 803 top was a wave 4 remains intact because it DID NOT retrace any of wave 1, which bottomed at 804 (of minute degree). Following the guidelines of wave equality between waves 1 & 5 is how I reached the conclusion of 663 as the bottom, assuming wave 3 is extended. There could also be a possibility of a truncated fifth wave where wave 5 does not pass wave 3's bottom. So 663 is my target for the (5) of c wave bottom.

Here is the alternate interpretation, of which I maintain is invalid and hence this rally has been a sucker's rally:

This chart interprets the March 9 wave up as wave 4 of (5) of c. However, there is one large problem with this interpretation; wave 3 of (5) would be the shortest in length, which is in direct violation of Elliott Wave rules that states wave 3 is NEVER the shortest actionary wave.

For these reasons, I expect the bottom has not yet been made, at least of intermediate degree. Also of significance was the failure of the $SPX to break its 50 day moving average and there seemed to be too much acceptance of a low being made. A real bottom would be much more fatalistic, with sweeping hopelessness.

$SPX Wave Count

I have become a recent student of The Elliott Wave Principle. For those unfamiliar with Elliott Wave forecasting, it is a form of market analysis based from fractal patterns. Specifically, it forecasts that the market obeys predictable patterns that form waves of different degrees, ultimately ending in progress. The wave structure is 5 up, 3 down. Here is a simple illustration:

The general pattern is easy to follow, however there are several variations to this that I will not take the time to explain. The above illustrates a complete wave in upward trend, where waves 1, 3, 5 are all actionary in mode and 2 and 4 are correctionary. Waves A, B and C are the correction to waves 1 - 5. Notice that waves 1 - 5 and A, B & C are all subwaves within I & II. So in principle, if this drawing were to continue, it would span in a large uptrend of 5 waves until it reached III (stated 5 of III).

The usefulness of forecasting Elliott Wave patterns is in identifying trends of larger degrees. Remember, waves of all degrees are occurring at the same time, so trends of smaller degrees will confirm larger degrees.

I have been tracking the progress of the S&P 500 for a month now and charting the waves. My conclusion (humbly confirmed by the posts of other bloggers and commentary of experts) is that the $SPX is currently in its final stages of of cycle wave C. Waves of different degrees are given different names to differentiate them. A "cycle" wave is a relatively LARGE degree.

If this count is correct, expect 5 waves up. While this is good news certainly for at least a good part of 2009, it should be taken into account that the "A-B-C" decline from the 2000 high is part of a "supercycle" correction, where 2000 marked the supercycle wave V orthodox top. Which means there is still a long road of correction ahead, some of which will be large countertrend rallies.

I believe we are entering the midst of one of those countertrend rallies. A characteristic of bottoms is a loss of all hope. It's certainly close to that, with even our [sic] admired new president spreading gloomy messages. Considering, below is my interpretation and expectation of what may follow:

A few important points to note:

• the "c" at the 583 bottom is of cycle degree, which means that the upside potential after the bottom is 5 waves UP!

• The wave 4 of minute degree we are currently in is still occurring. I could be wrong about this and it could be wave 1 up, however I contend that makes little sense.
• On the next wave down, look for diminishing volume.
  

While this chart is not advocating our economic troubles are not nearly close to over, it does suggest technically a SUBSTANTIAL rally is here or not far away. So, for those brave enough, get you wish list ready to finally make good on and enjoy the ride!

Update: The projected bottom wave 5 of (5) of c is missing the (5), which indicates the completion of 5 waves down of intermediate degree.