Analysis Series: Crisis & The Containment Of Crisis

By Daniel R. Amerman, CFA

The ABCs Of Popping A Third Asset Bubble

Movies can have quite predictable plot lines that we know in advance - but we love them anyway. It could be a romance, where the girl is going to end up with the right guy through a series of improbable events, even though that looks impossible to begin with. It could be an action movie, where our tough and underestimated hero overcomes seemingly impossible odds to just barely win in the end, after all.

There are movies that play over and over again in the financial markets and the economy as well, and while the particulars change, the plots can repeat themselves.

In this analysis, we are going to take a look at a market "movie" that has played out twice in the modern era, and follow the A-B-C-D plot line that was followed in each case. We will then take a look at more recent events, see if A-B-C have been occurring, and ask if D could be coming after C for the third time in a row?

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Bubbly Assets & Bumbling Surgeons

Let's say that you are going into surgery, you are worried, and you seek reassurance from the surgeon about what has happened in previous operations of this type. Obviously, what you want to hear about is the hundreds of times his team has done this procedure before, and the great results.

Instead, your surgeon says:

"We've done this twice before, and the patient has died both times. I'm still not sure how to do this, but I am hoping this time will work out better."

Would such an answer change your feelings about the surgery?

A real world example of that profoundly uncomfortable scenario can be found not in medicine, but in the financial world today. As we will explore in this analysis:

1) The Federal Reserve knew years ago that its zero interest rate policies were likely to inflate an asset bubble that would draw in many millions of investors.

2) The Fed also knew that it has never successfully surgically "deflated" an asset bubble before, but there have instead been market crashes and recessions each time the bubbles popped.

3) The Fed helped inflate the asset bubble anyway, because it didn't know what else to do. And it is raising interest rates again despite its poor record in the past, because it doesn't know what else to do in the attempt to return to "normality" for the economy and the markets.

Now, this does not mean that a bad outcome for the "procedure"  is predetermined for this time around. The situation is of course different, as it always is.

The issue here is one of confidence. Are you fully confident in a surgeon who has never successfully completed a complicated procedure before? Should you be fully confident of a central bank in unchartered waters, attempting something very difficult which it has never successfully done before?

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A Video Guide To Bail-Ins

What if there is another major financial crisis? Will the financial system needs to be bailed out again?

There is a problem with doing that, as governments found out about on a global scale with the last financial crisis. It is extremely expensive for governments to use the "front door" and solve financial crises by putting more money into the system.

There is, however, a free and limitless alternative, which is to use the "back door" and reduce liabilities instead. What are these liabilities? Some possible examples include bonds, savings accounts and checking accounts (as seen with Cyprus in 2013).

After the financial crisis of 2008, the G-20 nations (including the United States) agreed to use a "bail-in" methodology in the event of a future global financial crisis, in order to keep such a crisis from bankrupting the nations of the world.

Unfortunately, very few individuals are aware of how this quite different type of crisis "solution" could impact them, and turn upside down many of the core assumptions underlying financial and retirement planning.

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A Continuous Cycle Of Crisis & The Containment Of Crisis

Conventional financial planning is based upon the assumption of financial normality. "Normal" returns are assumed for the long term performance of stocks, bonds, real estate and other investment categories, with the definition for that normality often being based upon the last 50 or so years of the 20th century.

However, a problem has developed over the almost 20 years since then - we've had almost continuous "abnormality". The disastrous popping of the tech stock bubble was followed by the quick growth of the real estate bubble. The popping of the real estate bubble and the financial crisis of 2008 then nearly destroyed the global financial system.

The containment of the financial crisis of 2008 required some of the most "abnormal" market conditions in financial history, including a quick doubling of the federal debt and the use of quantitative easing. Literally trillions of dollars were created out of the nothingness by the Federal Reserve and used to manipulate bond markets and interest rates, thereby forcing rates down to the lowest levels in modern history.

Ten years later, while there is talk of a return to normality, trillions in created money and unusually low interest rates are still here, meaning that we have not once had "normal" markets in the entire time since the financial crisis. Indeed, actual performance in every major investment category over almost the last two decades has been dominated by sequential "abnormalities" in practice.

There is an alternative to taking the usual approach, and dismissing what we have actually experienced over these many years as being aberrations and abnormalities. This alternative, which will be explored herein, is to intensely focus on understanding what has actually been happening - a continuous cycle of crisis and the containment of crisis.

What if this cycle is our new reality? What if in this time of record national debt, soaring budget deficits, trade turmoil, political turmoil and sky high stock and real estate markets - we get another crisis? And what if the government then intervenes to try to contain the crisis? 

This is what has happened in reality twice in a row now - is it really so radical to think it could happen a third time?

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Social Security Purchasing Power &  Quality Of Life In Retirement (Series Overview)

Social Security is not fully inflation indexed, and this is particularly true when we take into account the critical interrelationships between Social Security benefits and Medicare premiums. The in-depth series linked here provides essential information for Social Security decision making as well as financial planning for retirement.

How The National Debt, Interest Rates, & Inflation Can Change Investment Outcomes (Series Overview)

The United States government is heavily in debt, and is going still deeper into debt as the result of high annual deficits. As explored in this series of timely analyses, the large and climbing national debt is likely to powerfully impact future interest rates and inflation.

When we look at future stock prices, or bond prices, or real estate prices - interest rates and inflation will be of crucial importance. The relationships and timing identified in the series linked here have critical implications for the price paths that may be traveled by all the major asset classes in the short, medium and long term.