Will the Real Market Bottom Please Stand Up?

As I mentioned last week, I expect the market to find a temporary bottom at some point this year and to stage a significant rally. However, I expect that this rally will prove to be a bear trap, as the market will then fall far more to find its true bottom a couple of years from now.

I don’t base this prediction on any sort of economic theory, but rather on history. Prior to the Federal Reserve Act of 1913, economic contractions were short and violent affairs. The Panic of 1907, for instance, was over and done with in a single year. The panic spelled the end of the Knickerbocker Trust Corporation, and many small regional banks failed and wiped out their depositors. This kind of “liquidation” of struggling companies was viewed as a necessary evil back then. No one likes liquidation, but it does its work quickly.

Things are different these days. John Maynard Keynes came along and theorized that all economic downturns were caused by “insufficient demand.” He argued that politicians needed to juice the economy with easy money to get consumers spending again. The fact that Keynes’s theory is nothing more than math piled on top of a foundation that’s part conjecture, and part shaky definitions, did not stop it from becoming popular. Similarly, the fact that Keynes’s prescription of juicing the economy with easy money does not seem to actually prevent recession — but, rather, prolong it, until it becomes far larger and more devastating — has not caused it to since fall from grace. Politicians get elected on promises to give money to their supporters and Keynes’s theory makes it their primary mission to do so.

This is why Keynesianism never goes out of style.  After the advent of Keynesian theory and the empowering of central banks to create as much theory as deemed necessary, the character of economic downturns changed. Instead of being short and violent affairs that occurred with appreciable frequency, they became rare events that dragged on year-after-year. Since the true bottom for the stock market is only found at the end of the crisis, every rally that occurs before then is merely for suckers, and will ultimately take buy-and-hold investors down even further.

Since this crisis is still rather early in historical terms, I’ve been expecting for the market to find a false bottom and begin to rally. Despite the fact that I’m a market bear, the single-mindedness of this downturn has surprised me. Every week or two, the Dow seems to find a new low and I think to myself that the market will probably start to rally; then comes next week and the Dow is trading still lower. So many down weeks in a row have built up a powerful (albeit temporary) upside on the stock market. People seem to be waiting for any sign of good news to get back into the market, and that’s exactly what we saw yesterday.

Citigroup’s CEO sent a letter to shareholders saying that the company seemed to be earning a profit for its first 2 months in operation in 2009. It wasn’t an official profit, and, given that Citigroup’s losses have been on a series of asset value write down rather than traditional losses, that hardly seemed to signal that the worst was over. The market rallied anyway. The Dow Jones raced up 5.8% and the NASDAQ was up a scorching 7.1%. In a market hungry for good news, this letter to shareholders was enough to set things into motion. Similarly, gold broke below $900 an ounce as investors figured that they wouldn’t need to hold it anymore, now that the worst was over.

Obviously, its far too early to tell whether this bottom is going to last, but gold presents an attractive opportunity. The Dow could find a new low in the next few weeks and send those same investors back into the yellow metal, or the economy could start to improve which would quickly bring inflationary fears roaring back. The central banks of the world have been injecting new money into the world’s monetary system at an unprecedented rate in an effort to use inflation to mitigate the losses on the balance sheets of the world’s banking system. Investors have been comfortable holding these currencies, despite these inflationary policies, because they figure that the “velocity” of money (i.e. how many times it changes hands in a year) slows down in a recession. Since monetarist theory says that you only see price inflation when you seen an increase in the amount of money multiplied by its yearly velocity (with no corresponding increase in the supply of goods), price inflation will become a very real concern if people figure that the recession is ending.

In either case, gold is going to gain.

I believe that this crisis is going to be another stagflationary scenario similar to the 1970s; central bankers will ease rates and print money to stave off a market decline, which will then stoke inflationary fears as the market stages any recovery in nominal terms. This will prompt central bankers to start contracting the money supply, which would then send the market back down. The 70’s saw the true end of the crisis when short-term interest rates where raised to 20+% and held there for a couple of years, which also allowed the forces of liquidation to do their dirty work, and the crisis ended. I believe this crisis is going to play out in a similar way, except I don’t feel the ending will be the same. The United States has far too much debt to flirt with high interest rates this time around.

The world’s monetary system is on the verge of collapse from over-expansion and right now, everybody is trying to re-inflate it. How this crisis is going to end is anybody’s guess, which is why I stick to be being a gold investor. Gold has a tremendous upside in this environment, regardless of what happens next. Technicians are calling for gold to find a new support point around $850, but I’d encourage people to get in now. $900 an ounce is an extremely attractive buying opportunity.