Warning Signs, The Economy, Didier Sornette, and You

“We have no Great War.  No Great Depression.  Our Great War is a spiritual war.  Our Great Depression is our lives.  We’ve all been raised on television to believe that one day we’d all be millionaires . . .”

Fight Club

DSC04280

This is the corpse of FDR, brought back to life every 75 years to fight Robot Hitler.  Notice we added a laser eye for this year.

I’ve talked about both the causes (LINK) and effects (LINK) of economic bubbles and economic depressions in two articles that won the Coveted 2017 Wilder Prize for Excellence in Journalism Related to Things John Writes About®.  You should read these articles.  They’re fun and may save your life, if you require expensive medicine from fresh squeezed bats each day and need the cash to pay for bat juice.

But what happens before everything goes straight to hell?  What are the precursor signs before a recession or depression takes hold?  Where are the danger signs that say . . . beware of dragons beyond this point?

mother of dragons

Game of Thrones would not be as popular if this was the casting choice for Daenerys.

Let’s start with definitions.  A recession (and a depression is just a bigger recession) is when the economy starts to contract, and the definition is that this contraction lasts at least two financial quarters.  A depression is the same thing, but there are great dust storms and everyone moves to California and no one bathes for a decade.

Why does the business contract?

Let’s take the last recession.  Everyone wanted houses.  Lots of houses.  In 2007 people were buying houses on speculation that they’d go up in price.  Because houses always went up in price.  And for a few years?  Yeah.  But when houses stopped going up in price?

People stopped building houses, six was enough for the average family.  But if you have no new houses to roof, and you’re a roofing company?  You fire your roofing crew and stop buying shingles.  The people you fire stop making truck payments.  The shingle company stops making shingles, and lays off the factory workers at the shingle factory.

Prices collapse.  Everywhere.  And in 2008-2009 this cascaded throughout the economy.  And the first thing that happened is that EVERYTHING got cheaper.

Perhaps the first sign that things will be going south is that . . . things are going well.  Too well.  It’s like the frat party at midnight before the heaving begins – laughter and joy everywhere.  And everyone believes that this party is different – they’ll escape the hangover gods in the morning.

So what is a gauge of the measure of market intoxication?

The VIX.

VIX stands for . . . Volatility IndeX.  VIX.  Like PEZ®, only with money instead of those small bricks of candy that build a wall of love around my heart (my doctor calls that arteriosclerosis), the VIX was created in 1990 and attempts to predict the market volatility for the next 30 days.  Here’s the graph of the VIX for the last 27+ years, thanks to Yahoo Finance©:

^VIX_YahooFinanceChart

If you look closely, you can see that when the VIX spikes, people are running and screaming in the streets because the economy is collapsing.  But what happens before the spikes?  Everyone is calm.

And, historically that’s been the case.  Everybody is an expert when the stock market keeps going up.

“Taxi drivers told you what to buy. The shoeshine boy could give you a summary of the day’s financial news as he worked with rag and polish. An old beggar who regularly patrolled the street in front of my office now gave me tips and, I suppose, spent the money I and others gave him in the market. My cook had a brokerage account and followed the ticker closely. Her paper profits were quickly blown away in the gale of 1929.” – Bernard Baruch, famous dead trader dude (from Fortune Magazine, April, 1996)

And that’s what that low VIX number tells you.  Everything is great!  Sunny sky and the wind is in your sales.  Not a cloud in the sky.

So, one big signal is that everything is going great.  Not sure how useful that is, but the current VIX is very near an all-time low.  This is why in my (very brave) 2018 prediction (LINK) I said it wasn’t going to blow up in 2018.  Obviously I could be wrong, but as low as the VIX is, I’d expect some upturn prior to things falling apart.  In 2007 the VIX turned up before everything blew up.  So?

My expectation of an economic recession/depression/crack-up number one?  The VIX will turn up prior to the fall, probably at least six months in advance.  So here’s one indicator of future economic downturn, and it’s been shown to work.  Perfect?  Certainly not.  Sudden dislocations (think 9/11) could throw it right out of the window.

Currency and Trade

What else might indicate a coming crack up?  One that was pretty popular was high interest rates.  Back before the FED so tightly controlled the currency and interest rates by buying all of the United States’ debt that’s unsold (yes, this is somehow legal), this was a sign that the party was going to end.  Failing businesses led to banks only lending to the best projects – the ones that could afford high interest rates.  Interest rates were (kinda) set by the market.

I’m pretty sure this one is long gone . . . and not sure that there’s a replacement.  The economy of the United States is such that, if we experience difficulty, other countries experience collapse.  Think the riots in Egypt, Syria, and Libya were spontaneous – no – they were the result of economic trouble in the US.

Another major indicator would be if another currency became as well accepted in the world as the dollar – and imports rose significantly in price.  Sadly, if this happens, the entire economic system is near collapse.  As I’ve pointed out before – the only thing that keeps our currency going is belief.  I can trade two pieces of paper with $100 printed on them to a liquor store owner and have a nice bottle of Johnny Walker Blue© handed to me.  Oh.  It has to be the government that prints the $100.  Not me.

Why?  People (silly people!) believe in the government more than me.  They believe the government won’t print too many.  Just like Bitcoin (LINK) is limited in the total number that will ever exist.  Except governments everywhere print money whenever they can.  Except the Swiss.  I blame it on the cocoa.

Energy

Other signs of big trouble?  Oil above $100.  Oil above $140 is screaming collapse.

Modern economies run on energy.  What would we do without it?

This is from Kentucky Fried Movie.  Good times.

Oil is consumed by every product you buy, generally in the production, packaging and transport.  Because of that, it acts as a general tax on the economy when prices go up.  And because oil extraction infrastructure takes years to get going – high oil prices can distort the economy for years.

Cash Ban

Horrible sign.  Venezuela will look awesome in comparison if this happens.

Math

I’ve mentioned Dr. Didier Sornette before.  He’s a French geophysicist that applied advance math previously used to predict earthquakes to predict whether or not a bubble exists in stocks, and, if so (at least in prior work) how long the bubble had until it popped.  He pegged that we were going to enter a singularity around 2045 or so where all bets are off, based solely on the math.  Don’t know if he still stands by that, but he produces a monthly report at the Economic Crisis Observatory (LINK).

In the latest report, of the sixty stocks in the US he studied, 35% were in a bubble.  That’s up from the previous month.  From this, we’d deduce the bubble is (potentially) inflating.

And Dr. Sornette absolutely called the big Bitcoin bubble a month before it topped.  Pretty amazing.

I’d keep an eye on this work.  It shows that there’s plenty of bubble a brewing in the record setting stock markets around the world.

And be careful.  There may be dragons here . . . .

NOTE:  I AM AN INTERNET HUMOR-DUDE, NOT A FINANCIAL PROFESSIONAL.  Consult someone sane prior to making investment decisions.  Like your Mom.  Or a lawyer.  Or a carnie.

Author: John

Nobel-Prize Winning, MacArthur Genius Grant Near Recipient writing to you regularly about Fitness, Wealth, and Wisdom - How to be happy and how to be healthy. Oh, and rich.