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How to Prepare for the End of the Credit Bubble

By Bill Bonner on April 8, 2014

From the desk of Will Bonner:

The Internet is down at the family ranch in northwestern Argentina, where dad is spending time this month.

So, there’s no regular Diary issue from him today.

Instead, here’s a classic from the archives – about why you need to prepare for the end of the bull market in US stocks.

How to Prepare for the End of the Credit Bubble

The end will come – sooner or later – for the big bull market in US stocks… and for the debt bubble. But it didn’t come yesterday. Will it come today or tomorrow? We don’t know. All we know is you want to be prepared.

Today, we explore the time that land forgot. That phrase doesn’t really make any sense, but we wanted to try it out anyway. We’re talking about the space on the calendar filled by “eventually” and “sooner or later” – that part of the future where things that can’t last forever finally stop.

Specifically, we wonder about when and how the biggest debt bubble in history finally blows up. Recall that Planet Debt added $30 trillion to its burdens in the last six years – a 40% increase. That can’t continue forever.

But how does it end? Inflation… deflation… hyperinflation… hyper-deflation?

To make a long story short, a bubble can’t blow up without a lot of “flation” of some kind. And with a bubble so big, it’s bound to be a humdinger. Most likely, we will see “flation” in all its known forms. And maybe in forms we haven’t heard of yet.

Buying High

You can argue about what effect QE and ZIRP have had on the economy… and what the effect will be when they are withdrawn. But there is no doubt that microscopic interest rates have done their job.

People who could borrow at the Fed’s low rates did so.

Washington borrowed more heavily than ever before – just to cover operating expenses. Corporations borrowed, too – mainly to refinance existing debt at lower interest rates and to buy back shares (raising the price of remaining shares and, coincidentally of course, giving management bigger bonuses).

The most recent figures we have are from the third quarter of 2013. Those three short months saw $123 billion of buybacks of US shares – up 32% from the same period a year before.

If that rate were to persist throughout 2014, it would mean nearly half a trillion dollars devoted to boosting corporate stock prices, coming from the same corporations that issued shares in the first place.

Is management stupid… or just greedy?

The sage advice of “buy low, sell high” doesn’t seem to have sunk in. At the bottom of the crash in 2008-09, reports Grant’s Interest Rate Observer, hardly any US corporations availed of the opportunity to buy their own shares at a bargain price. Now that prices are high again, almost all of them want to buy.

Surely, that is also something that must end… especially if rates rise and the cost of carrying new debt to fund new buybacks rises. It doesn’t take a lot of imagination to foresee what will happen when it stops: Stock prices will fall.

The “Poverty Effect”

First, credit expands, and asset prices rise. Then credit shrinks, and asset prices fall. Asset prices typically foreshadow consumer prices.

After so much inflation in credit, we’d expect to see a helluva deflation when the bubble bursts. All of a sudden the Fed’s treasured “wealth effect” would become the “poverty effect” – with consumers cutting back on expenses, investments and luxuries.

This would be normal, natural and healthy. A debt deflation doesn’t create bad debts or bad investments. It just forces people to own up to their mistakes.

Businesses go broke because they can no longer borrow nearly unlimited funds at nearly invisible yields. People can once again default… and have plenty of company in doing so. The $5 trillion in paper wealth that came into being – almost magically – as the stock market rose… suddenly disappears from whence it came.

There is no mystery about the credit cycle. Wealth created “on credit” goes away when the credit is cut off. Then you find out who’s made the most serious mistakes.

The open questions are: How big can this bubble get before it explodes? And how will central bank meddling affect the outcome?

The first question gets the obvious reply: Who knows?

The answer to the second question is more nuanced. Central banks are still at it – led by the US and Japan. The government and corporate sectors are still willing borrowers.

Governments are borrowing to cover their deficits. Corporations are still borrowing to buy back their shares. Stock prices are still rising. But there are now signs that momentum is leaving the market. Our advice: Get out while you still can.

Regards,

Bill

Editor’s Note: If you also believe that the rally in US stocks will come crashing down, check out the free report our newest analyst at Bonner & Partners, Braden Copeland, has put together. Braden has identified six specific stocks to buy when markets crash again – what he calls his “Open in Case of Emergency” list. To access this list, follow this link.


Market Insight:

How Do You Say “April Fool” in Japanese?
From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

On April Fool’s Day the Japanese government raised the sales tax from 5% to 8%.

The last time the Japanese government raised the sales tax – this time from 3% to 5% – was in 1997. The move was promptly followed by the economy plunging into a recession… and the political ruin of the prime minister at the time.

Given that the last increase in the sales tax was such a disaster, you may be asking why the government hasn’t learned from its mistake.

It’s all to do with the scary amount of government debt.

Japan has government debt of more than 1 quadrillion yen. (That’s fifteen zeros, in case you were wondering – or ¥1,000,000,000,000,000.)

In dollar terms, 1 quadrillion yen is a bit less than $10.5 trillion. But more important, Japan’s public debt load is at more than 200% of GDP – the highest debt load of any developed nation relative to the size of its yearly economic output.

Japan’s politicians are clearly terrified about this massive debt burden. So terrified that they’re willing to risk economic harakiri in an attempt to raise revenues.

It will certainly be interesting to see what effects the sales tax hike will have on economic growth. In the second quarter of 1997, following the last sales tax hike, annualized GDP growth fell 3.9%. And a similar fall in output is forecast for the second quarter this year.

This shows what a high-stakes game Japan is playing. It also shows that, sooner or later, too much debt can become a major problem.

P.S. Insane levels of government debt are a problem throughout the developed world – including the US. When the next crash comes, it has the potential to be far worse than the 2008 financial crisis. To learn how to protect yourself… and even profit… go here.

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