Is it monetary inflation or is it credit expansion? That's a question that Bob Prechter has been thinking about for a few years now. The more credit that gets pumped into the system, the bigger the credit implosion will be, he says. And the more he looks at price charts for bonds and utility stocks, the more Bob is reminded that they reflect expanding credit rather than dollar inflation. All of which points back to another year in the life of the United States before the Great Depression. In this excerpt from the May issue of The Elliott Wave Theorist, he explains why 2007 looks a lot like 1928.
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Excerpted from The Elliott Wave Theorist, published April 30, 2007
There is an important event for believers in perpetual inflation to explain: the trend of yields from bonds and utility stocks. In the 1970s, prices of bonds and utility stocks were falling, and yields on bonds and utility stocks were rising, because of the onslaught of inflation. But in the past 25 years bond and utility stock prices have gone up, and yields on bonds and utility stocks have gone down. Once again, this situation is contrary to claims that we are experiencing a replay of the inflationary 19-teens or 1970s. Those investing on an inflation theme cannot explain these graphs. But there is a precedent for this time. It is 1928-1929, when bond and utility yields bottomed and prices topped in an environment of expanding credit and a stock market boom. The Dow Jones Utility Average was the last of the Dow averages to peak in 1929, and today it is deeply into wave (5) and therefore near the end of its entire bull market. All these juxtaposed market behaviors make sense only in our context of a terminating credit bubble. This one is just a whole lot bigger than any other in history.
Some economic historians blame rising interest rates into 1929 for the crash that ensued. Those who do must acknowledge that the Fed’s interest rate today is at almost exactly the same level it was then, having risen steadily—and in fact way more in percentage terms—since 2003. So even on this score the setup is the same as it was 1929. Remember also that in 1926 the Florida land boom collapsed. In the current cycle, house prices nationwide topped out in 2005, two years ago. So maybe it’s 1928 now instead of 1929. But that’s a small quibble compared to the erroneous idea that we are enjoying a perpetually inflationary goldilocks economy with perpetually rising investment prices.
As to whether the Fed can induce more borrowing by lowering rates in the next recession, we will have to see, but evidence from the sub-prime and Alt-A mortgage markets suggest more strongly than ever that consumers’ and investors’ capacity for holding debt is maxing out. I see no way out of the current extreme in credit issuance aside from the classic way: a debt implosion.
Nevertheless, we must also recognize the fact that the market is a dynamic system. It does not seek equilibrium or revert to a mean. It has no limits as oscillators do. Optimism and pessimism are not bounded. So hedge funds could go to 3x leverage, or 5x, or 100x. Total dollar-denominated debt could go to $50t., or $60t., or $400t. And the Dow could go to 20,000. But further credit expansion would merely mean postponement of the implosion, not negation. The size of the bubble will simply relate to the size of the collapse.