Around our neck of the woods here in sunny Queensland, Australia, one of the main attractions are miles and miles and miles of almost perfectly unspoiled beaches. Almost all of these are on the open ocean with nothing over the horizon except South America, and that's a VERY long way away. Since they are open beaches, there is almost always a surf running, the only exception coming when the wind blows straight from the west. Inviting as it looks, the water here is not for the uninitiated, there are undertows, rips, and sometimes deceptively large waves. Tourists, especially tourists who are not used to the sea, can very easily get into great difficulties.
The public beaches are patrolled almost throughout the year by lifeguards. They are, of course, responsible for patrolling the beach and rescuing swimmers and surfers that get into trouble. And they do a superb job. But almost as important is their job of "flagging" that part of the beach which they deem safest for swimmers. In Queensland, if you know what's good for you, you swim between the flags.
That is, you swim between the flags when the lifeguards deem it safe to swim at all. When the swell gets nasty, which it often does in late summer when it is cyclone season further north, the beaches are deemed unsafe. And that's when the "red flags" go up.
This week, the red flags have started to go up on global markets.
The most obvious warning came, of course, from the US stock markets. Over the three days between April 13-15, the Dow lost 420 points to plummet to its lowest levels of the year. Other US market indices had similar falls, and this "sharequake" quickly spread right around the world. On the local Aussie market, for example, the All Ordinaries index lost 155 points or 3.7% this week - most of that fall coming on April 14 and 15.
On the surface, these falls are not particularly big. They pale into insignificance, for example, in comparison to the daily falls on US markets in the week leading up to the grand 508 point crash of October 19, 1987. Those were almost as big numerically with the Dow only a fifth of the level it is now. The main difference now as compared to then is that it is nearly five and a half years since the Dow hit its bull market high of 11723. That took place way back on January 14, 2000. The October 1987 crash took place only two months after the Dow had hit its bull market high.
When the smoke cleared from the crash of October 19, 1987, the Dow had come to rest almost exactly 50% below the highs it had set two months earlier. But this time, the Dow has NOT washed out the much larger excesses which saw it soar to a bull market high of 11723 back in January 2000, even after well over five years has passed. At its close of 10087 on April 15, 2005, the Dow is still only 14% below its all time high. The excesses of the bull market have still to be washed out.
The other notable aspect of the "sudden" weakness in US and world stock markets this week is that it occurred in the leadup to the IMF - World Bank - G7 meetings taking place this weekend in Washington. The US and global monetary powers that be do not consider it a "good thing" for markets to be showing distinct signs of weakness as they meet to reassure the world one more time that everything is "rosy". They are hard men to embarrass, as a casual perusal of any of the communiques they issue will amply demonstrate, but plunging markets as a backdrop to the latest photo op does tend to make the smiles look a little forced.
If the sudden weakness on US and world stock markets is one "red flag", the stampede back into Treasury debt paper is another. As it usually does in times of stock market turmoil, capital is once again migrating from "risky" stocks to "riskless" Treasuries. The problem is that those "riskless" Treasuries are still dependent on foreign Central Bank buying to maintain their viability at anything like present interest rates. The closer yields get to their lows of late last year (when the Dollar was at 30 year plus lows on a trade-weighted basis), the closer they get to what is perceived to be their inviolate lows. From there, there is nowhere for yields to go but up. And as yields go up, the value of the Treasury paper goes DOWN.
The red flags keep on coming. The US trade deficit announced on April 12 was a new record of $US 61 Billion - this being accumulated in the short month of February. Bad as this raw number is, it gets much worse when one considers that the February 2005 traded deficit was 33% higher than its February 2004 counterpart. Despite nearly three and a half years of a steadily falling US Dollar, the US trade deficit continues to grow at an ever accelerating pace. By now, it should be (but is not) obvious to everybody that no amount of US Dollar fall will "fix" the trade deficit. This is so for the very simple reason that the US produces very little of real wealth to export. The major US export is US Dollars, followed by US services, especially financial services, and military hardware. It is clear that the only thing that will shrink the US trade deficit is a LARGE fall in US imports, and that will come about when (not if) the voracious US consumer is finally and irretrievably tapped out.
Given the fact that consumer spending makes up from 65% to 80% (the estimates vary) of US GDP, the consequences for the US economy will NOT be pretty.
What is happening, in a nutshell, is that "risk aversion", a trait thought to be extinct, is beginning to raise its very ugly head. That is the biggest "red flag" of all. Through all the swings and roundabouts of world and US markets which have taken place since the stock markets came off their highs more than five years ago, the process of debt creation has accelerated with hardly a pause for breath. This has led to a SYSTEMIC imbalance as big as the specific imbalances in such markets as the Nasdaq and the global telecommunications markets were just before they keeled over. The great beneficiaries of this debt blowout have been the aptly named "HEDGE" funds, which have built positions which now total in the HUNDREDS of TRILLIONS.
Taken utterly for granted in the entire bohemoth which is the modern financial system is the ultimate solvency of the system itself. Sure markets can go up and down, but the Hedge funds don't mind that. The only thing they don't like is markets which stand still. They can make money in either direction. But what is taken utterly for granted in all this frantic activity is that the money so gained will ALWAYS be useful, that no matter what happens it will always connect to goods and endow the holder with purchasing power enough to enjoy the many fine things of life.
The modern financial system in the US, and everywhere else, is built on debt. Both borrowing and lending is an inherently risky activity. The extent to which this fundamental fact is ignored is the extent to which markets become distended and bloated with what is called "liquidity". They have never in history been anywhere near as bloated as they are now, for the very simple reason that we are approaching the climax of more than three decades of "money" based on NOTHING but debt.
For weeks if not months, many knowledgeable and sound market analysts have been issuing warnings about the entirely unjustified level of "complacency" in the markets. What they have identified is a level of "risk aversion" (or more properly the absence of ANY level of "risk aversion") which is TOTALLY inappropriate to the situation. This week, the complacency was holed below the waterline.
Paper markets have stumbled badly. Commodity prices have too, on the prospect that even the still rampant Chinese economy cannot compensate for the now obvious slowdown everywhere else. And of course, if everywhere else does continue to slow down, so will China, as it runs out of eager buyers for what it is producing.
Gold itself, with the exception of the $US 5.80 fall on April 14, has done little again this week. On the week, it is down $US 1.90. The beauty of Gold in the present situation remains what it has always been. Gold is valued as a commodity, but it is valued much more as a medium of exchange. That is why, unlike other commodities, almost all of the Gold which has been dug up in recorded human history stil exists, most of it in bullion and bullion coin form. Unlike a "money" which is supported by debt and nothing but debt, Gold's purchasing power cannot go out of existence. And because of its properties, as "risk aversion" grows, so inexorably grows the attraction of Gold, the one form of monetary asset which is NOT someone elses' liability.
As we say, the "red flags are waving". It remains to be seen how long they have to wave and how obvious the situation gets before a "critical mass" of players in the financial markets notice them and begin to act accordingly. In the meantime, do like the swimmers in Queensland do. When the lifeguards post the red flags, don't go in the (paper market) water.