The world economic order is collapsing and this time there seems no way out

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urope has seen nothing like this for 70 years – the visible expression of a world where order is collapsing. The millions of refugees fleeing from ceaseless Middle Eastern war and barbarism are voting with their feet, despairing of their futures. The catalyst for their despair – the shredding of state structures and grip of Islamic fundamentalism on young Muslim minds – shows no sign of disappearing. 

Yet there is a parallel collapse in the economic order that is less conspicuous: the hundreds of billions of dollars fleeing emerging economies, from Brazil to China, don’t come with images of women and children on capsizing boats. Nor do banks that have lent trillions that will never be repaid post gruesome videos. However, this collapse threatens our liberal universe as much as certain responses to the refugees. Capital flight and bank fragility are profound dysfunctions in the way the global economy is now organised that will surface as real-world economic dislocation.

The heart of the economic disorder is a world financial system that has gone rogue. Global banks now make profits to a extraordinary degree from doing business with each other. As a result, banking’s power to create money out of nothing has been taken to a whole new level. That banks create credit is nothing new; the system depends on the truth that not all depositors will want their money back simultaneously. So there is a tendency for some of the cash banks lend in one month to be redeposited by borrowers the following month: a part of this cash can be re-lent, again, in a third month – on top of existing lending capacity. Each lending cycle creates more credit, which is why lending has always been carefully regulated by national central banks to ensure loans will, in general, be repaid and sufficient capital reserves are held.

DYI Quick Comment:  Alan Greenspan removed all reserves requirements theoretically banks are able to create unlimited credit.  Of course it will never be unlimited as there are limits to how big of a debt bubble before it all goes bust.

 The false boom that follows seems to justify the lending. Property prices rise. Companies and households grow overconfident about their prospects and borrow freely. Economies surge well above their trend growth rates and all seems well until something – a collapse in property or commodity prices – unravels the whole process. The money floods out as quickly as it flooded in, leaving bust banks and governments desperately picking up the pieces.

DYI:  The majority of the economic growth from 1980 when the prime interest rate peaked at 22% until the Great (on going) Recession of 2008 was an illusion.  The majority of the so called growth was pushed by ever growing amounts of debt by a very accommodating central bank that almost continuously lowered rates since 1980.


I doubt that the party has ended for when the next downturn arrives the Fed's will move to negative rates.  This will have the negative effect of distorting our economy by malinvestment.

 Malinvestment is a mistaken investment in wrong lines of production, which inevitably lead to wasted capital and economic losses, subsequently requiring the reallocation of resources to more productive uses. 

During the housing boom massive over building along with substandard homes being build. Many of those homes 10 to 20 years from now will end up being tear downs as their useful life will have ended.  Of course before that occurs all of the owners of these will properties will experience the term "money pit!"  Wasted capital and economic losses just one of the many examples of malinvestment.

The best way to revive the economy is to allow interest rates to rise to a level that the market dictates.  Real business' who's returns that have a high probability of overcoming the interest rate threshold will be funded.  All of the others will slowly (and some much faster) die freeing up residual capital to be reallocated to more productive uses.  Alas, currently I see no reformation of thought at the Fed's, Congress or any of our Presidential contenders.

Interest rates will eventually rise despite the Fed's intervention leaving nominal rates below the inflation rate.  This will occur in the 2020's as the cost of Social Security and Medicare rise to massive proportions as the Boomer's age signing on to these social programs.  The only way these unfunded liabilities will be paid is by raising taxes, deceasing benefits, and PRINTING the remainder.

BACK TO TODAY

The possibilities of a world wide deflationary smash is brewing.  So far the U.S. is the lone wolf of growth (what little there is) but with more and more countries falling into recession and some into outright depression the weight of their numbers could very easily dip the U.S. back into recession.

LOWER RATES

The ever growing possibility of a world wide recession looming U.S. Treasury securities will rally.  In this scenario don't be surprised to see the 10 year Treasury under 1% and the Grand Daddy 30 year Treasury bond under 2% with notes of less than 5 years negative.

Currently today DYI's averaging formula has thrown us out of the stock and bond markets as these two assets have been priced to the moon.  Both are way above their historical averages so much so despite our formulas liberal allocation (up to 100% above the average) we have been "kick out" of the market.  Stocks (S&P 500) as measured by price to dividends is 109% above its long term average of 1871.  Bonds (10 year Treasury) as measured by price to interest is 114% above its average since 1871.

The true investor is an individual who is steeped in the use of valuations and history as his guide leaving all other methods to speculation.  Speculation is neither immoral nor illegal as a general rule not very fattening to the purse.  I'll leave the speculation to others and sit out the stock and long term bond markets waiting for better values.  With valuations so extreme today it is not the return on your capital but the return OF your capital.

OUR TWO PORTFOLIO'S REMAIN DOGGEDLY DEFENSIVE  

AGGRESSIVE PORTFOLIO - ACTIVE ALLOCATION

Active Allocation Bands (excluding cash) 0% to 60%

83% - Cash -Short Term Bond Index - VBIRX

 17% -Gold- Precious Metals & Mining - VGPMX

  0% -Lt. Bonds- Long Term Bond Index - VBLTX

  0% -Stocks- Total Stock Market Index - VTSAX

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Maximum Aggressive Portfolio

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83% Cash - Hussman Strategic Total Return Fund - HSTRX

17% Gold - Tocqueville Gold Fund - TGDLX

  0% Lt. Bonds - Zero Coupon 2025 Fund - BTTRX

  0% Stocks - Federated Prudent Bear Fund - BEARX

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DYI