Cycle of Credit expansion and Credit bubble burst: How to Profit from Stock market Schizophrenia


 Lunacy dominates world stock markets, as a tug of war ensues between fear and greed. For two wildly fluctuating months, stock and real estate markets bounced down the stairway that easy credit built. Then on Tuesday, greed was king for a day. The market exploded into one of its biggest rallies in half a century, with the Dow Jones industrial average closing up 10.9%.

Does the rally signal a bottom in this schizophrenic market? Well, unfortunately there’s no way to know except in hindsight.

Sowing the Wind & Reaping the Whirlwind

We don’t need hindsight to know that the current meltdown was inevitable. It is the consequence of events that began a century ago with the birth of the engine of 20th century boom and bust: the Federal Reserve. Nor were the effects of the new central bank immediately apparent.

The effects of credit expansion didn’t show up the next day or the next month. It took more than a decade for the credit creation to result in the Roaring Twenties and the Crash of 1929. Again, the famous October 29 market selloff didn’t cause an economic catastrophe the next day…or the day after that, or even the year after that.

It took three years for the Great Depression to truly grip the nation, triggering more government action – the abandonment of the gold standard and massive federal bailouts. Again, the results weren’t instantaneous. It took decades to inflate another boom, and reach the monetary crises of the 1970s.

Economic theory can predict the consequences of credit expansion, but only in hindsight can we see the timing as the consequences unfold. Today’s economic storms are the consequences of seeds first planted a century ago. And once again – as the credit bubble collapses – new seeds are being sown.

The official budget deficit for the fiscal year that ended September 30, 2008, was $455 billion, but most private analysts say the current fiscal year will end with a gap of one trillion dollars. How are the presidential contenders planning to deal with rising deficits?

Both John McCain and Barak Obama promise tax cuts and increases in government spending. It won’t show up tomorrow, but vast government deficits ahead guarantee that price inflation will demolish the purchasing power of the dollars that fearful investors are so eager to lend to the U.S. government.

When will the market bottom, and when will price inflation roar? We won’t know that except in hindsight, but both will happen.

Buy When Blood is Running in the Streets

But how deep should the blood be? Only value investing can provide the clue.
As markets are gripped by fear or euphoria – plunging one day and soaring the next – it’s clear that very few are following the advice of the most successful long-term investors of the past century. Money masters like John Templeton, Benjamin Graham, Peter Lynch and Warren Buffett piled up enormous profits throughout one of the most tumultuous centuries in history, and their advice is there for all to follow.

Benjamin Graham, said it clearly in The Intelligent Investor, “Don’t get carried away by enthusiasm. Don’t get carried away by despondency. …Know in advance that you are going to have to live through bear markets.”

Let me re-tell Graham’s parable from his book, The Intelligent Investor.
Imagine owning shares of a small business that cost $1,000, and every day your partner named Mr. Market knocks at your door and announces what he thinks those shares are worth that day. He offers either to buy your shares or sell you more at that price. Even though the business is trudging along without significant change, each day his opinion is wildly different. Frequently Mr. Market’s enthusiasm or his fear seems completely divorced from anything happening in the business and his valuation seems ridiculous. One day he offers to buy or sell you shares for $2,000 each, and a week later he makes the same offer for $500. Should you let Mr. Market’s wild enthusiasm or shaking fear determine your view of the intrinsic value of the business?

That’s obviously irrational. As Graham puts it:

The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. …He would not be far wrong if this motto read more simply: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.”

Since we can never know in advance whether shares will be higher or lower tomorrow, the only rule to follow is to accumulate them when they are significantly underpriced by value analysis. Mr. Market is definitely letting his fear override his reason, and is making us offers that become increasingly difficult to refuse. As was the case after 1929, there are great opportunities being born out of the chaos. Don’t let Mr. Market’s trembling hands cause you to lose sight of the outstanding values he’s offering.

A sound and lasting investment strategy requires searching for assets that have true value and will retain it – those include all types of commodities that will rise in price as money falls in value, currencies that are not being debased, and ownership of profit-making companies that have not fallen into the trap of trying to leverage profits through debt.

 by John Pugsley, Chairman and Co-Founder of The Sovereign Society


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