The Next Depression

Whenever the next depression arrives, it will be severe. The FED has kept rates way too low for far too long. The critical result in the economy is malinvestment. The critical financial result is that leverage is too high, with mispriced securities and loans of lower quality, susceptible to default. Corporate leverage is elevated. Reminiscent of the 1920s’ boom in closed-end funds, often leveraged, a broad array of leveraged ETFs are invested in stocks. The first such was in 2006 and now there are 200 of them. Margin debt is at a peak.

The federal government is leveraged to the hilt and beyond. Overall consumer debt is stable, but some sectors are over-extended, like subprime auto loans. The odds are that loan quality has deteriorated under the surface. The cryptocurrency explosion is a sign of excessive risk-taking. Another sign is the low credit spreads on junk bonds. The tax cut, the excess liquidity, the ever-rising stock market, the crash in real estate followed by a resurgence, and the likelihood of more tariffs all remind us that the 1920s looked great in 1928 before ending badly in 1929. The 1920s, as now, also was an era in which the price level seemed tranquil but was hiding the Fed’s inflation.

The triggers for severe financial market declines are usually international shocks that relate to currency and trade. Domestic shocks such as the unanticipated failures of some companies or an earnings shortfall can also cause investor sentiment suddenly to deteriorate. Frauds coming to light will do it too. Some crypto shares are frauds, perhaps a great many, but the publicity is not enough yet to curb investor speculation. Unexpected political events and wars are wild cards that usually are net negatives.

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7:30 pm on January 23, 2018