Panic as investors start to catch on…

As Ron Burgundy said in Anchorman, ‘Boy…that escalated quickly. I mean that really got out of hand fast.

Indeed it did. It was a wild night of trading on US markets last night. The S&P 500 was down 3% at one point, before finishing just 0.8% lower. US Treasury yields plunged on fears of lower economic growth while gold momentarily surged US$25 an ounce and closed out the session up nearly US$20 an ounce.

An afternoon rally saved Wall Street. Apparently — and this is really pathetic if there’s any truth to it — rumours surfaced that Janet Yellen thought the US recovery was on track, despite worries coming from Europe.

There were no such comments from Mario Draghi in Europe. As a result, European stocks took a beating. French and Spanish stocks fell more than 3.5%, while German and British bourses fell nearly 3%. But the rally in the US came after Europe closed for the day.

So what’s all the panic about?

Nothing in particular, it seems. Or nothing and everything, all at once. More succinctly, these panic liquidations represent a psychological shift in trader positioning. It’s representative of complacency giving way to risk aversion. And it has given way big time in the past few weeks.

You can see this change in the volatility index, the ‘VIX’, in the chart below. Also known as the fear index, you can clearly see the ‘fear spike’ since the start of October. This comes just a few months after volatility levels were the lowest since early 2007.

Investors volatility index

In other words, something has clearly changed in the mindset of the market. In the short term, it’s probably gone too far…and you can expect to see a rally soon and a diminishment of the current high levels of fear.

But you should take the surge seriously. This is the highest level of fear since the euro crisis of 2011. Except now there’s no discernible crisis. That’s the worrying bit. The market is saying that something is wrong. It’s not immediately apparent, but something isn’t quite right.

Maybe it’s fear of the effects of a slowing global economy…an economy that has a truckload more debt weighing on it than it did before the last downturn. The Telegraph in the UK reports:

Morgan Stanley calculates that gross global leverage has risen from $105 trillion to $150 trillion since 2007. Debt has risen to 275pc of GDP in the rich world, and to 175pc in emerging markets. Both are up 20 percentage points since 2007, and both are historic records.

Yep, debt levels are a major problem. And they become a very big problem when economic growth slows. That’s because to service debt, you need to generate growth. When growth stagnates or falls, the debt servicing burden becomes a problem. Debt-to-GDP ratios rise and there is less money left over in the economy for investment, wages and consumption.

Debt, especially unproductive government debt, has detrimental long term effects on an economy. Let it grow large enough and it will eventually choke an economy into recession/depression.

That the only apparent response to a slowdown in a debt-based monetary system is to increase debt levels tells you something is seriously wrong with the world’s system of ‘wealth creation’.

The only question now is how long it will take the Federal Reserve to start back-tracking on its ‘interest rate hike for 2015’ talk. After they do that, I wouldn’t be surprised to see them dip into the QE playbook…again. The big question though, it whether it will be too late to inject another round of confidence into the speculating community.

They’re wheeling Janet Yellen out to speak at the end of the week, so we may get an idea of just what the Fed is thinking. Yellen must be careful to retain the market’s confidence. That the US Federal Reserve has no idea what it’s doing is beside the point. What’s important is that the market thinks the Fed knows what it’s doing. Yellen must keep this con game going at all costs.

Good luck with that. When you’ve got a bunch of panicked, slobbering trader yahoos in your face desperate for some sign that you’ve got it all under control, any minor slip-up can be dangerous.

When traders panic, liquidity disappears in the blink of an eye. That’s because confidence creates liquidity, and fear destroys it. And right now it’s the fear of huge debt levels consuming economies that is weighing on traders’ minds.

Why it’s happening right now, when the issue has been around for a while, is irrelevant. The important point is that the punters are beginning to wake up to the risks. The only question is how much longer the Fed can continue to pull the wool over everyone’s eyes. Can another bout of QE do the job for another six or 12 months?

Whatever they do, they’re ultimately fighting a losing battle. I made this point in the August issue of Sound Money. Sound Investments. with a little help from some long dead economists, Knut Wicksell and Ludwig von Mises.

In their own unique way, they both described how large debt levels push down the ‘natural rate of interest’. The larger the debt pile becomes, the more the natural rate of interest falls. Mises went on to say that trying to solve the problem of high debt levels by trying to abolish interest would prove catastrophic.

His point was that you need a rate of interest to generate price signals across an economy. Without a rate of interest there is no difference between the value of a dollar today and its value in 100 years’ time. Here’s a snippet of what I wrote back in August:

In response to a low natural rate, Mises cautioned against trying to push interest rates so low that it virtually abolished interest payments. Doing so, he said, would lead to consumption of capital and a sharp deterioration of living standards:

‘”…there cannot be any question of abolishing interest by any institutions, laws, or devices of bank manipulation. He who wants to ‘abolish’ interest will have to induce people to value an apple available in a hundred years no less than a present apple. What can be abolished by laws and decrees is merely the right of the capitalists to receive interest. But such decrees would bring about capital consumption and would very soon throw mankind back into the original state of natural poverty.”

In other words, abolishing interest would be a catastrophe. Yet that’s exactly what central bankers are trying to do. They’re trying to push you out on the “risk spectrum” and “chase yield”. By doing so, investors push up asset prices to such an extent that they are, in Mises terms, valuing a future apple no less than a present day apple.

The point is this: Central bankers do not have a clue what they are doing. In the short term, their actions have what seems like a positive effect. But they are doing untold long term damage by encouraging more and more credit creation.

It’s only a matter of time before everyone catches on.


Greg Canavan+
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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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