E The Boy Who Cried Gold: Time To Listen

Part I. 

Investors have had a rough 2016 thus far with almost all indexes crashing. I always see more opportunity on the short side than the long side due to the simple notion: there is just not enough strength to push equities and assets such as real estate higher. 

The media has furiously blamed China and Saudi Arabia for their economic troubles, since as history shows everyone denies their own involvement in what has gone wrong. But is this the accurate?

If China coughs; the whole world gets sick - this is of course true in our dynamic world and economies with globalization. But investors seem to forget one critical event that happened. Undoubtedly history has showed causes asset prices to plummet and the economy to recede: the Federal Reserves rate hike. 

As I outlined in my previous article, almost everytime after a rate hike, the economy is followed by a recession. Why? Because when the Fed artificially lowers rates then artificially raises them, its intervention alters the economy. 

The Austrian Economic Business Cycle Theory (ABCT), which was brought into existence by Ludwig Von Mises and built upon by Fredrich Hayek and Murray Rothbard, is absolutely the most empirically accurate and logical measure of how the Fed causes the boom and bust. 

Here is an example of the ABCT:

Suppose the economy is growing steadily at 4% GDP and long term interest rates (30/yr) are at 8%. The Fed decides the economy isn't growing fast enough and rates are higher than liked. The Fed cuts rates to 3% and reduces reserve requirements of the banks, increasing the money supply. The lower rates encourage business borrowing and expansion, especially in manufacturing and higher order goods such as construction, commodities, etc. And also consumer debt expands greatly for the citizens such as student debt and auto loans, credit card debt and mortgages, etc. The added debt and consumption spurs growth higher making GDP increase from 4% to 5.5%, and now because the corporate profits increase and the stock prices of these companies trend higher and higher, making the owner of assets wealthier (the rich get richer effect). A mania and boom is here.

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Disclosure: This is a column I wrote in my recent newsletter issue.

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David P. Goldsmith 4 years ago Member's comment

Very interesting. I was not familar with the ABCT before this. Thanks for sharing, Adem Tumerkan.

Gary Anderson 4 years ago Contributor's comment

We haven't been kicking it as to velocity, even with low rates, Adam. I look at it this way, banks won't lend if long rates aren't higher. The big banks are already pulling out of the mortgage business. The new demand for bonds as collateral in derivatives markets makes it unlikely that long rates will go up in boom or in bust. Something needs to be retooled in the financial system or we will have, unlike the Austrian libertarians observed in the past, slow growth, then bust. Boom and bust seems so dated!