Debt Cycles part 2. Long term debt cycle

A warning: This text is long and takes a while to read.

The majority of the long-term debt cycle is largely based on changes in interest rates regulated by the central bank, which make the above-mentioned processes work. Most of it is the sum of changes in short debt cycles. They are mainly based on changes in interest rates regulated by central banks, which reflect the willingness of people and businesses to borrow or borrow money. The short debt cycle will be discussed later. At the end of the cycle, the role of interest rate changes diminishes and the focus is on printing money with the central bank's key interest rates close to zero.

At the beginning of a long debt cycle, the parts of the above equation are much smaller than when the debt bubble bursts in the end. The money supply is often tied to fixed assets held by the central bank. In practice, the amount of debt cannot grow significantly faster than the amount of real assets. This affects the right side of the equation, reducing the amounts on that side. The growth rate of money in circulation and debt remain limiting factors as the money supply is linked to the central bank's fixed assets.

At some point, policymakers will be pressured to increase money supply to improve economic development. This is done by breaking the link between the money supply and the fixed assets. In other words, the amount of money is growing faster than before. The central bank can tighten or loosen monetary policy by regulating interest rates and money supply. The latter is rarely a significant factor. This mostly happens at the end of the cycle.

The long-term debt cycle lasts 60-100 years. In the initial phase, debt and consumption are roughly in balance with money and income. The increase in the money supply allows for an increase in debt, which enables increases in consumption and an increase in wealth. The former allows additional liabilities. Creditors provide additional debt as borrowers ’income, cash flows, and collateral values increase. These increase the willingness of creditors to borrow. Development strengthens itself and the economy grows.

The growth phase lasts most of the cycle. It progresses variably according to short debt cycles. Through the key interest rate, central banks regulate the willingness of creditors and debtors to lend or pay the debt. Total debt is slowly increasing. The peak of the cycle is manifested by high debt levels and / or the failure of monetary policy to generate economic growth. One of the signs of the peak is found in the granting of debt, which focuses more on collateral values than on debtors’ income. Interest rates are close to zero or at zero. Debt service costs are higher than the borrowers' ability to borrow. This reduces consumption. Debt ratios are declining. Too many businesses, households and financial institutions are becoming insolvent. They need to reduce consumption which increases unemployment, reduces people's incomes and increases other problems.

Debt problems are often the sum of many stages. First, the expectations of the general public about large cash flows in the distant future arise. Secondly, expectations arise about the increases in value in the near future and the gains they will bring. Thirdly, the wildest paintings of a glorious future emerge, exploiting the general public and eventually generating the outrageous scams that make money for their developers.

The above development is compounded by the fact that the investments are made by over-indebtedness and future cash flows are not sufficient for debt management costs. The differences between expectations and reality are the greatest when the debt bubble bursts. Prior to this, the positive effects of rising asset prices have been visible and not enough people have understood their unsustainability. Before the bubble bursts, there is usually low inflation and a debt-driven boom. The latter seems more of a boom created by high productivity growth and prudent investment than the absurd euphoria which will be revealed later to the general public. Debt payment begins. Economies can do it in four ways:

1. Austerity
2. Debt reduction
3. Increasing the money supply by lowering interest rates to zero, continuing it with the central bank purchases of bonds as interest rates fall to zero
4. Income transfers

The first two reduce income and consumption. All are necessary, although few are desirable. They also produce less unwanted effects and, when going into excesses, more harm than good. Financial discipline is necessary because there is no extra money. Savings need to be made where they have the least impact on long-term economic growth and quality of life. Excessive savings increase problems. Some economic actors must save. They can be either public or private actors. Without saving, there can be no needed investments in the long run. Some of them can be financed with the central bank´s bond purchases, but not all of them. The reason is that the government usually has too much debt.

Debt write-downs take place through insolvency, debt restructuring and forced asset sales. The latter have the greatest negative effects. Debt restructuring reduces creditors' income because at the same time the prices of assets also decrease, which also means the decreased debt collateral. The ratio of debt to asset values and income is increasing as a result. This leads to forced sales of debts as they are diminishing assets of creditors.

Forced sales lead to the sale of other assets and the payment of bank loans, which reduces the rate of money circulation, which accelerates forced sales, which leads to deflation, i.e. an increase in the value of money if the printing of money does not prevent it. At the same time, paying off debts adds to the problem of paying off debts as they increase as the value of money increases. The value of the business decreases, reducing corporate returns, which in turn reduces production and employment and increases bankruptcies. They lead to pessimism and a lack of confidence which lead to hoarding which reduces the speed of money circulation. The negative spiral feeds itself, shrinking the economy if nothing is done about it. During it, it is difficult to produce sensible indebtedness.

The worst thing that can follow from forced sales is a lack of trust between creditors and debtors. This means that no companies or governments can borrow money. Payment transactions cease to operate and society is paralyzed for hours, days or weeks. Nothing can be bought in stores and people depend on others. At the same time, financial markets are likely to close for longer than regular payments. The former do not happen suddenly but e.g. the stock market is likely to have fallen for weeks or months. The situation has been close before. The lack of confidence was caught up in the days or hours of the previous financial crisis. The situation is recognized by the fact that the prices of all asset classes are falling at the same time. It may not last more than hours and offers the opportunity to buy cheaply when the risks are high.

For this situation, I recommend buying quick-to-eat foods first and taking tap water where it is possible for several days or buy large amounts of water from somewhere. You can then follow which direction the investment prices are going. At the same time, it is worth following the news about the decisions of central banks to put money on the market. If it works, the prices of asset classes will start to rise. The length of the situation depends on how faith returns to the markets.

Printing money is a necessary evil so that the financial system does not collapse and there is no depression. It is needed to break the deflationary cycle, but too much printing can produce bad problems. It is not automatically a good or bad thing. As overshoot, it can cause additional amounts of money to be transferred to other currencies, which will increase the prices of imported products. In addition, it can transfer too much money to inflation-hedged investments. It can produce hyperinflation when the value of money falls sharply. Its risk is greatest when the debts are in other currencies and owned by foreigners, but the income of people and businesses are not. Large economies with their own currencies have the lowest risks, but they can also experience hyperinflation.

The end user and uses of printed money mean a lot. Saving the economic system and increasing the growth of economic activity are the main reasons for the pressure on money printing. The end user can be the state, other public actors, companies and citizens. There are many possible uses: investing in tangible and intangible capital such as infrastructure and know-how, maintaining bankrupt companies by buying their loans, buying other assets, direct consumption, savings, etc. The first use is usually to buy loans, without which the economic system becomes too likely to collapse. Economic activity will increase as asset prices rise and the potential for growth-generating investments will increase as the availability of money improves. The rationality of the state and public actors determines the usefulness of the investment.

Ultimately, the question is whether the benefits of printing money outweigh its less desirable effects. In the beginning, it produces the greatest benefits. The more the operation is utilized, the lower the relative benefit. The result is ever-increasing bond purchases. In the end, the situation may be that the disadvantages outweigh the benefits. The relationship between the disadvantages and the benefits of printing money is impossible to determine no matter what central banks or other financial experts say. One common denominator for central bankers deciding on printing is that they have no idea of the undesirable effects of their actions. They are missing from the models they use. The following list tells about possible side effects:

• New massive revaluations of bonds and other asset classes

• Non-functioning price formation in various assets

• The emergence of an interdependence between priting and the financial markets

• Decreased long-term productivity growth

• The growth of zombie-companies and the favoring of large companies at the expense of small ones

• Moral hazard

• Negative side-effect of rewarding fools

• Increased wealth disparities leading to internal conflicts

Money going into government and corporate bonds naturally raises their prices. They can become insane. Market participants buy bonds so that they can sell them to central banks at a higher price. This will raise prices even further. If central banks buy too many bonds, there will be absurd self-sustaining price increases. In the end, prices are so absurd that bonds are mostly bought only by central banks. This means increasing negative real yields on bonds. At the same time, the prices of other asset classes are rising as some of the printed money flows into their prices. Although the intention is to put money into the real economy, the biggest benefits flow elsewhere, to the wealthy.

Excessive monetary pressure means that the prices of bonds are not determined by the market, but the real price makers are in the central banks. It leads to the markets´ dependence on them. They start making their biggest moves depending on how central banks signal the amounts of printed money or bond sales. The latter is a rarer phenomenon, but it happens when central banks believe they have gone too far. The market may crash if this dependency exists. In that case, the catastrophe is ready to happen if the central banks do not stop selling. It might happen anyway.

When most of the money goes to rising asset class prices, the real economy suffers in the long run. There will be no productivity growth because no sensible investment is made and the money goes to other uses. In the worst case, they go into the survival of companies that should go bankrupt. These companies are unable to make investments but keep themselves alive. Maintaining them is the same as peeing on the leg in the winter frost.

Bond purchases favor large companies because small ones are unable to obtain financing by selling bonds. They finance their growth either with the owner’s assets or with bank loans. Smaller companies are better able to adapt to change, but the benefits to the overall economy diminish when purchases favor the large companies. Few of them are as productive as more efficient small businesses paying more for their loans.

Printing money rewards the wrong kind of risk-taking because fools who buy too expensive assets don’t suffer so easily from their mistakes. They get the reward even if they make mistakes paid for by others. In this case, the others are taxpayers who receive the invoice e.g. as rising costs of living. At the same time, executives who have used the cash flows of their companies either for excessive dividends or to buy their own shares are rewarded. When companies are bankrupt because of these acts, the purchase of bonds in cash will save them. At the same time, company executives will be able to increase their share-based bonuses.

Wealth disparities will increase if money is not distributed to citizens. The printed money is then mostly transferred to the prices of the assets, which can cause internal conflicts. The feeling of injustice is growing, although the majority of the population does not understand why wealth disparities are growing. Printing enriches the already rich more than the ordinary people. The latter relieve their pain through violence or hatred towards the former. If the situation persists, politicians may begin to feel tempted to distribute money directly to citizens. This is one sign that indebtedness is escaping central bank control. As an isolated case, the situation is not bad, but the transition to a continuous distribution of money will destroy the currency.

When citizens receive free money, they can put it for consumption, investment, debt repayment or savings. The desired destination for money is private consumption. In this case, some of the money is forced to be saved because it is the result of a bad economic situation. There is little to reserve for extra consumption. Where the money mostly goes depends on the needs and wants of a large section of the population. Different nations can consume, save, and invest in different ways. In the United States, money is more likely to go to investment than, for example, in Europe. This, too, produces undesirable effects, as unemployment can be a prerequisite for access to money. Not everyone wants to go to work because they can get almost the same money for free. Again, an excessive distribution of money does not make sense.

Over-indebtedness generates deficits in the economies and smaller public actors, regardless of whether money is printed. It can also produce currency escape. Capital can look for better returns abroad. The state can create mechanisms to reduce it. One way may be to restrict or prohibit the transfer of currency by imposing high taxes on currency transfers. Smart money always finds a way to circumvent these restrictions. On the other hand, ordinary citizens cannot do it. This increases wealth disparities and tensions between the rich and the poor.

Tax increases are one way to raise more money for the administration to distribute. They are less popular with the public than printing money because they are better understood. The lower amount transferred from salary to personal account is a signal of higher taxes. The same applies to the taxation of consumption. It is easy to read the tax rate on trade receipts. The same is true when higher taxes are passed on to product prices. If the withdrawals are large, they will lead to tax planning for large capital. Ordinary citizens cannot do it as effectively. People can move out of the country or move to places with lower tax rates. The latter applies to countries that do not have common national taxes. There are numerous tools for tax planning, but the former are perhaps the most important.

Debt Cycles part 1. Introduction and Short term cycle

 Debt is, at its simplest, a promise to repay a sum of money borrowed later. It may involve interest and other debt service charges. Payment of interest usually means an extra portion of the amount borrowed that is payable over a period of time. The creditor wants the interest rate to be higher than the cost of borrowing and the rate of inflation. It wants the value of the money to be depreciated in excess of the total amount of money repaid and interest over the loan period. In other words, real returns must be positive. A sensible debtor wants a used debt to bring a positive real return. Sometimes it makes sense to take on debt with a negative real return to avoid complete economic collapse. In other words, the debtor buys time to get his finances in order.

The debtor becomes insolvent if he is unable to pay the debt. To do this, he has to provide collateral. The creditor must make a probability assessment of how well the debtor can pay his money back, either directly from the debtor or by redeeming the collateral. The more uncertain the repayment and the lower the security, the higher the interest the debtor will have to pay. This happens when the creditor understands the situation of the debtor. At the peak of debt cycles, creditors’ lack of understanding of debtors’ ability to repay is at its greatest.

The best understanding of the role of debt in the economy is obtained by looking at remittances in the big picture of the economy. In the following equation, the sources of money are on the left and the uses are on the right:

Money + Liabilities + Income = Consumption + Assets + Savings

The equation is bidirectional. For example, consumption is the income of the counterparty. Some of the increased money supply from the left side can be consumed, some can be used to buy assets or put into savings. When the central bank tightens its monetary policy and interest rates rise, debt is often reduced. This reduces consumption and / or the purchase of assets which reduces revenue. The opposite phenomenon occurs when the interest rate decreases. It will increase the amount of debt which is likely to increase consumption which will increase revenue. Both are self-reinforcing series of events. By looking at the varying amounts of the parts of the equation, you can see how the debt cycles are progressing.

Short debt cycle

Short debt cycles normally last 3-8 years. The length depends on the previous cycle and some other factors like changes in central banks´ interest rate policies. The further it progresses and / or or the deeper the economy goes down the longer the next one will last. What I mean is how much excesses people, companies and central banks have made. The worse the over-indebtedness, the longer the damage will be repaired. The short debt cycle is also called the general economic cycle. As I mentioned earlier, central banks regulate short debt cycles mostly by either tightening or loosening monetary policy. This is mostly done by raising or lowering interest rates. Exceptions arise mainly from the bursting of a debt bubble at the end of the long debt cycle.

Short debt cycles can be divided into four parts: growth, peak, decline and recession. Growth starts at the beginning. Interest rates are low and borrowing is easier. Demand for interest-sensitive products such as housing and cars is growing first. Growth is initially rapid. Unemployment is falling and the average working week is lengthening through rising demand and output growth. Inflation remains low despite debt increases and economic growth. The best investment targets can be found in equities. The situation for commodities and inflation-hedges is deteriorating. Later, economic growth will slow temporarily. Inflation will remain low, interest rates will fall and stock prices will calm down. The decline in the prices of commodities and inflation-protecting assets is slowing down.

At the end of the growth, the pace accelerates. Wages are rising faster and production capacity is coming back. Inflation is accelerating, consumption is peaking and interest rates are rising. Equities make their last rise in the cycle before falling, and inflation-hedged investments perform best. The peak is coming because the economy has overheated. The latter will lead to tightening of the central bank's monetary policy. Liquidity is declining and interest rates are rising. Economic growth is starting to decline. The amount of money is shrinking and the growth rate of debt is declining. The stock market will start to decline before economic growth goes into the red. Eventually the recession will hit.

Economies are in recession on average 10-12% of the time. During them, economic growth will average -3%. At the beginning of the recession, the economy is shrinking. At the same time, the prices of shares and inflation-hedged investments are falling. The central bank is not loosening its monetary policy and inflation is falling. In the end, the central bank fears recession and deflation, so it loosens its monetary policy. Interest rates fall and stocks rise. Commodity prices are low, as are inflation-hedged investments. With low interest rates and rising stock prices, we are moving from a recession to the beginning of a new cycle.

The operation of short cycles depends much more on external factors such as major natural disasters like pandemics and wars. The latter are wars between great powers and neighboring states. Less often, export bans like OPEC`s regulation of oil production have effects on cycles. Utilizing short debt cycles in investing requires skill which most of us do not have. I cannot recommend anyone to take advantage of them. It is easier to understand longer cycles.

One of the best signs of a recession is the shift of the yield curve to negative. It refers to a situation where the interest rates on longer government bonds are lower than those on their short-term bonds. This usually occurs about 12 to 18 months before the recession. The exact timing of interest rates does not tell the future recession. This indicator is not easy for an investor to take advantage of. It may be used as a signal to increase cash position for future investments. It can be seen as an indication that the leverage should not be increased. Stock prices can also predict a future recession 6-12 months before that, but they are a more uncertain indicator. They can be used more to invest in other asset classes.

Recessions are poorly predicted. This is true for both amateurs and professionals. The latter manages to predict a recession when it is underway. According to an IMF research paper, between 1992 and 2014, economists out of 153 recessions in 63 different countries managed to predict only 5 in April of the previous year. Instead, in October of the recession, economists correctly predicted 118 times out of 153 recessions. It can be said that economists ’predictions of a recession are not worth reading or listening to.

World leading economy cycle part 3 Dropping from the top and brief overview of the whole cycle

 Reaching the peak probably includes a double-digit number of short debt cycles and usually at least one long debt cycle. I will discuss the peak and fall in more detail later, in a long debt cycle. The road to the top leads to the sowing of the seeds of the fall. Prosperous times increase people’s incomes which makes the cost of labor more expensive. The competitiveness of labor is declining. The smartest, disadvantaged nations know how to select the ways that work best for them from the ways produced by the top nation, which further reduces its competitiveness. Copying is easier and faster than developing anything new which improves their competitiveness at a lower cost.

Newer generations will replace those who have raised the nation to the top of the world. They are accustomed to wealth without as much effort as previous generations. They have not experienced time without wealth. They demand more of their free time which reduces work ethic. More money and less work will lower the nation’s productivity compared to its competitors. If it lasts long enough, the country's relative situation will deteriorate too much.

The reserve currency position of a leading economic country allows for a high debt burden. Consumption and borrowing capacities are growing first, leading management and citizens to believe in a strong economy. The country is growing its army and fighting to maintain its leading position in the world more than is necessary. In the end, the former consumes more government resources than brings benefits. At the same time, citizens are spending more on borrowed money. The former will improve the chances of the country and its citizens to borrow abroad as the reserve currency strengthens. They increase wealth disparities. Citizens' ability to cooperate deteriorates as the wealthy safeguards its interests at the expense of others.

The decline begins as the peak surpluses turn into declines and the interests of the rival nation strengthen. The central bank’s ability to increase debt and economic growth will be lost and at the same time the nation is hit by a recession or depression. This leads to the printing of money which leads to an excessive depreciation of the reserve currency. The relative position of the poor is deteriorating more than the prosperous, increasing the popularity of political extremism. The former require the latter to take action to reduce wealth disparities, i.e. they want income transfers by raising taxes. The wealthiest transfer their wealth to safety with a lower tax rate, which further weakens the position of the poor.

These factors reduce productivity and the wealth distribution is reduced. In the worst case, the result is totalitarianism like Hitler's Germany. At the same time, a rival nation can challenge a leading economic country, which increases the potential for military conflict, which in turn increases the number one country’s spending that it cannot afford. It has to choose between either military conflict or avoiding it. The decline is further in the long debt cycle.

Brief description of the progress of the cycle

The cycle of a leading economic country follows the same formula. It begins with a new world order and ends with the birth of a new one. In the beginning, the leading economic country will determine the creation of new rules. It has the most power. Now such actors are e.g. The IMF and the World Bank. In the end, power is gone. The next leader contributes to the renewal of the rules or orders the creation of new ones. If a new world order emerges through military conflict, then the most likely new leader is its winner.

The economic situation of the leading country is the best at the beginning of the new world order. The country probably doesn’t have much debt. The debts of others to it are much greater. In the coming decades, the country will prosper. It develops as short-term debt cycles fluctuate, so does the economic growth. During fluctuations, economic agents become slightly more indebted on average until a large-scale debt bubble is created, for which the country's main economic operator, usually the central bank, will have to lower interest rates to zero. At the same time, it will have to grow its money supply, otherwise it would result in massive bankruptcies and / or long-term deflation. Excessive monetary pressure leads to hyperinflation and / or other economic catastrophe. A suitable amount of printing is difficult to accomplish in the long run.

Debt bubble management tends to weaken the financial position of taxpayers in relative terms the most because they have been used by the smart money. The latter usually has so much power that it does not have to pay as high a price as it should. Taxpayers become bitter towards the rich which adds to internal contradictions. The bitterness is also compounded by the fact that money supply is increased until its benefits to the national economy go to zero. The purchasing power of the people is declining as the prices of various asset classes rise despite non-existent economic growth. At the same time, income disparities are widening.

Too much bitterness can lead to the division of the people which can lead to a civil war. Another option is for the people to find a common enemy and fight against it. Whatever the conflict, it will eventually lead to debt restructuring and a renewal of the political system. After these, a new world order is born. Although the above-mentioned course of events present themselves mainly as separate events, many take place at the same time as possible wars and political reorganizations.

World leading economy cycle part 1. Rise to the top

A leading economic country dictates the basic rules of the world economy. Others have to follow them if they want to cooperate with it. They are more likely to run into financial difficulties if they try to deviate from the rules it creates. They can also ensure that weaker economies do not catch the lead. The United States has been acting ruthlessly for a long time. The same is expected from the nation that dictates the rules next time. The cycle includes three phases: rising to the top, staying there, and falling. Operating at peak includes a reserve currency cycle. The leading country changes after the country has gone through the cycle. This is as natural an event as the rain in England. The duration with its stages is about a century. The rise and peak are slow, but the decline is fast compared to them.

The more economically developed a state is, the more it is hoping weaker states will follow the rules of the market economy. This means that more developed countries should make sure that weaker countries do not exploit practices that are unfavorable to them. This is especially true for the biggest competitors. The closer the countries are in the development cycle, the more this matters. The United States should not care about Bangladesh, but China is another matter.

The leading economy is in many ways the leader of the world economy. It has the largest share of world trade, is the most competitive, controls the main financial center, is a leading technology developer and industrial country, has the best education, a reserve currency, and has such a strong military power that it cannot be shaken by war. It is also likely to be a ruthless economic actor that will discipline other countries, if necessary militarily, if they threaten its interests.

Rise to the top

There are several roads to the top, but together they are the most efficient way to get there. Wealth can be created by harnessing domestic intellectual capital to develop the products and services that others want. It can be created by finding natural resources within its borders that can be resold to other nations at a higher price than the cost of exploiting them. In addition, there is a third way.

Imagine a country where tariffs on industrial products have averaged 40 to 55 percent for decades, the majority of the population is not allowed to vote, votes are bought, elections are cheated, and the government does not hire workers without the permission of those who bought the votes. In addition, the state economy is on the edge, the country has gone bankrupt and foreign investors are being discriminated against, especially in the banking sector, and shareholders cannot vote if they are not citizens of the country. It also has no competition law. It allows cartels and monopolies and does not care about foreigners' intellectual rights. What is this country? The answer is the United States in the late 19th century.

Lie, steal, and cheat. These three commandments of striving for the position of a ruling state in the world economy run counter to those who believe in Western values ​​and the rules of the game in a market economy. These are often necessities for those aspiring to become dominant economies. The three commandments have also been China’s means as it strives to become a leading economy. Warfare requires a bit of explanation because people perceive it mainly as a military conflict. In this context, it means e.g. a currency war, one way of which is to manipulate the exchange rate to create. In addition, it means protectionism, etc.

Getting to the top doesn’t just mean breaking the rules. It means improving the factors that are important for the economy at home. The journey to the top requires e.g. a large workload, a people whose vast majority adhere to common rules of the game, cooperation between citizens and government, high-quality education, finding new ideas from abroad, importing top foreign professionals when needed and investing heavily in the necessary infrastructure and high quality of leadership.

The above will lead to a prudent investment of capital, high productivity and the creation and the use of new competitive technologies. These will increase the country’s share of world trade which will require a strong army so that trade is not jeopardized. The above factors attract large amounts of foreign capital, which reaches the country's stock markets, foreign exchange and credit markets. Eventually, they will become more attractive than in other countries, so in the end, the reserve currency will also be held by a leading economic country. The reserve currency has its cycles.

Bubbles, Booms and Crashes part 7. I found one, what should I do?

When a bubble or boom is found, it is clear that most investments are too expensive. It is difficult to recommend any investment. Using leverage is even less recommendable. Extremes can last longer and grow higher or decline lower than anyone thinks. They are unpredictable and not easy to predict. The peaks and crashes of bubbles and booms may seem clear in retrospect, but few succeed in predicting them. Don’t try to time peaks and crashes.

It does not mean that you should not do anything. Bubbles and booms are good moments to consider selling investments that are too expensive. Not everything is worth selling at once. It may make sense to diversify your sales of the most expensive investments. This makes sense because prices are rising higher than expected. Tax consequences should be taken into account. At the same time, people can sell their loss-making investments to reduce taxes.

Uniform proposals cannot be made for all asset classes. For example, more time should be set aside when selling houses. They are not worth buying unless you get them really cheap. The same applies to other real estate. Easy-to-sell assets such as securities require a more individual approach. Short selling, i.e. the sale of other people´s securities, is difficult to recommend because of their negative risk / reward ratio. The profit can be 100%, but the loss can be several hundred percent. Options that take advantage of price reductions are another matter, but my expertise is not enough to make any suggestions.

Once a bubble or boom is identified, the investor´s cash reserve increases, because it makes sense to start selling little by little. The buying should not be rushed. As cash reserves grow, you have to be patient as temptations to participate in the boom increase as prices continue to rise further than expected. You can pay off your debts if you have them. At the same time, it is worth increasing cash position, because sooner or later prices will crash. Then you get good investments with low prices. Lack of cash in a collapse lowers long-term investment returns. Everyone should match their money supply to their needs. For example, the age of the investor matters. The older the investor, the smaller the portion of the assets is worth investing in. There are plenty of other reasons, but I won't go into them in more detail.

The crash is a good time to buy. It may take a long time for the bubble to move from the top to the bottom. Smart money makes sure it gets to sell as much of its bubble-priced assets as possible to others. It can take years to profit from being right. Prices are also falling lower than anyone expects. Crash of more than ten percent or more than fifty percent are normal in equities and in alternative investments such as commodities and currently popular cryptocurrencies. I do not recommend the latter to anyone as they may become worthless.

In crashes, it makes sense not to sell everything fast and it is not worth trying to predict the bottoms either. They can take years or decades before prices return to the previous peak. There is no hurry. Although the rise may be rapid at first, prices will remain far from previous peaks for longer after the bubble. Tax consequences can also be considered during collapses if possible. Cash reserves during crashes are useful, because you might have to sell your best assets during them. Nobody will buy your worst investments during them.

Bubbles, Booms and Crashes part 5. Their exponential growth and long-term effects

The growth of social epidemics like bubbles is exponential and nothing happens overnight. They can last from days to decades. Unlimited growth has a certain profile to which four parts can be attached: the slow onset of low exponents, the rapid rise of high exponents, the peaking of rising exponents, and the decline. The first profile is clearest when not restricted or regulated. The profile changes with restrictions and regulations. Exponential growth in stock or house prices are difficult to monitor because each has a different impact on epidemics. Therefore, it makes more sense to follow the exponential changes in other figures such as money supply.

Social epidemics rarely grow steadily. They do not follow a normal distribution and their growth cannot be predicted, although claims to the contrary are normal. The exponents vary at different time intervals. They can take a backseat even if the general direction is upwards. There may be variations in the exponents due to the time of measurement. For example, the weekly variations in the current Covid-19 pandemic are so great that it is not worth looking at daily exponents but at weekly readings.

One of the most important things to monitor is the change in exponential growth. In other words, the progression of epidemics can be monitored by observing exponential changes at regular intervals. A significant slowdown in growth is a sign that the epidemic is fading. This cannot be seen from the individual figures. Sometimes epidemics end in single exponential peaks. The following fictional exponents tell of acceleration first and then decline:

1.0, .1.1, 1.3, 1.6, 2.2, 3.2, 3.8, 4.2, 4.3, 4.0, 3.2, 2.4, 1.3, 1.1, 0.9, 0.7...

In the first phase of an epidemic, the exponent is often a little over one for a long time and does not change much before collapsing or moving on to the next phase. Most of the epidemics are not progressing further. The second phase distinguishes the most contagious epidemics from others. Initially, exponential growth accelerates. It is significant and ongoing. At the same time, the critical mass of the epidemic is reached, that is, it becomes unstoppable for a moment. The exponent is often the largest after that moment and may decrease momentarily before turning back up. The trend continues until there is a gradual decrease or a short steep peak with a potentially record exponent. The former is the most likely option when the epidemic is contained and the latter when it is not affected. The peak is followed by a decline, which in most cases is on average steeper than an increase in economic epidemics.

Long-term effects

Bubbles, booms and crashes have long-term effects. The true nature and duration of the resulting collapse is impossible to assess in advance. One significant factor is how banks operate during a bubble and/or a boom. The second is the source of the money. In addition, the actions of central banks and other regulators are significant factors. In the best case, the collapse will be cleared quickly and in the worst, the consequences will be visible for decades. The more bubbles in different asset classes, the longer the footprint. Declines can be short if not all investments instruments are expensive. Therefore, the dot-com boom of the 21st century did not leave large traces in the U.S. economy as bonds and real estate were affordable.

The devastation of the banking crises caused by the big bubbles and/or booms is awful. House prices will fall by an average of 35%, stock prices by an average of 55%, GDP by an average of 9% over the next two years and unemployment will rise by an average of 7% over the next four years. Without banking crises, the devastation will be smaller on a larger scale, although stock markets, for example, may fall more. The problems without the banking crises can be repaired in a few years. The flight of foreign capital exacerbates problems if it has played a significant role. Roughly speaking, the smaller the local market, the greater the devastation that may result from the outflow of foreign capital.

The aftermath of the Japanese boom tells the harsh language of the consequences. Individual investors may never overcome their losses. The Nikkei index has not reached its previous peak of more than 30 years ago. Property prices also peaked decades ago. Even long-term index investing is not worth it when the boom overheats. The aftermath of the Japanese boom is an example of the crash of simultaneous stock and real estate booms. Not all countries will recover even in several decades. The consequences can be complete changes in societal structures such as the transition from market economies to planned ones.

Bubbles, Booms and Crashes part 3. Psychology

 Bubbles, booms and collapses are social epidemics and follow their principles. Epidemics have three components: the right people, the right message, and the right environment. They are influenced by several psychological factors such as social proof, authorities, scarcity principle, excess self-regard, and the illusion of availability. They increase both the attractiveness of the message and the effects of the environment on bubbles, booms and collapses. Different people have different effects on both individuals and large crowds.

The messages from the bubbles and booms are simple and engaging. They say everyone gets rich easily and quickly without much effort as long as they invest in new ideas. The message includes attractive predictions of a rise in the pattern “Bitcoin rises to $ 500,000 (now about $ 40,000)” “This time it’s different” is another message available in large-scale bubbles and booms. They often also contain a message of a carefree tomorrow and the prosperity of the nation. The message often has some truth in it, but its significance is exaggerated. The realization of the message is often far in the future, even though the masses believe in sudden enrichment and rapid change. One message is that those who do not participate in the boom are stupid.

Bubbles, booms, and crashes will not occur without massive social proof in which herd behavior is rampant. During booms, it produces a desire to buy the same investments or consume like large crowds. Crashes create a desire to sell and reduce consumption while others do the same. In them, many have to do so because they do not have enough money to consume. Roughly speaking, the closer and more people produce social proof, the more confident the individual becomes and acts like others.

Even large numbers of people can be made to act like a small number of people as long as the latter has credibility. People have an inherent belief in authority. In bubbles and booms, a small number of lucky fools can make millions while believing in the goodness of nonsensical investments because they have happened to succeed fabulously for a short time. Usually these ”authorities” tell the general public what they want to hear. They can get rewards from people like them or the media. In addition, the masses are demanding so-called anti-authorities who tell them they are wrong. They are most often people who have been enriched by the old rules and have not agreed to pay the prices produced by the bubble or boom. They are considered losers during bubbles and booms.

The scarcity principle means that the less a person has something or the harder it is to obtain it, the higher the value. In addition, it works in the other direction. The bubbles and booms in some investments have a shortage of supply relative to demand. Large-scale bubbles are mainly affected by the other side of the coin, i.e. the fact that money moves fast and enriches a large crowd. The above raises both the prices of investments and increases absurd consumption. At the same time, the real economy is growing strongly which raises the above. Too much money significantly increases stupid investment and consumption decisions.

The excessive self-regard manifests itself as excessive faith to one’s own beliefs, qualities, skills, and possessions. Faith of an increasing mass of investors strengthens with the bubble or boom to the heights rarely seen, which raises the prices of “hot” investments. At the same time, larger and larger sums of money find the above items. Faith is not even shaken by failures or losses. They are explained by bad luck or some other absurd reason, and in the worst case, the ego is further inflated. Losses and failures increase the need for investors to look for sources of information that emphasize their own beliefs and skills. One major factor in the bubbles and booms is that investments become more valuable in price as soon as they are purchased.

The excessive self-regard also increases booms and bubbles, with big money portfolio managers acting as one of the reinforcing factors. One of the truths of their work is this: "It's better to lose money like others than to do something different." Many of them protect their own jobs. This is reflected in the so-called hidden indexation of funds, where the investments of the active portfolio manager resemble the benchmark index, differing slightly from it. This also applies to other moments, but the phenomenon is at its strongest in booms due to reflexivity.

The overemphasis on egos is not limited to investors. It manifests itself in central bankers and other regulators. The majority of central bankers have had a long career believing in the theories they have learned and the models they have used. They work well most of the time while increasing regulators’ confidence in them and themselves. The performance of theories and models in the short term increases the excesses of bubbles and booms as well as the devastation resulting from crashes. It is important to ask whether the actions of central bankers and the models they use have a positive net effect?

The illusion of availability means that people give more value to stimuli that are better available. Availability can be both an external and an internal stimulus. It can be improved by an increase in the number of stimuli, recency, or characteristics. Examples of the latter are surprise, novelty, ambiguity, and threat. The illusion of availability is reinforced by the media reporting on fortunate individuals who quickly enriched and took advantage of the new message. The media is full of half-truths or misunderstandings about the basic principles of investing. The illusion of availability is at its strongest when a bubble or boom reaches euphoria. It is also strengthened by other psychological factors.

Avoiding the negative effects of the psychological factors of bubbles, booms, and collapses is not easy. There are a few good rules of thumb to reduce the effects. When you find that a security or asset class is more popular in your immediate circle than others, it is a likely sign of bubble prices. Combining the former with a new economy or investment vehicle should be seen as a bigger alarm signal. Never believe words that contain the message, “It’s different now,” whoever tells you so.

Don’t listen to people who do not have a proven track-record of investing at least a decade above the market average talking about future returns or losses, or who promise high double-digit returns on investment, even in the medium term. Their numbers in public will increase during booms and bubbles. At the same time, the number of people who are wrong is growing. During booms and bubbles, it is even more important to listen to people who have done better than average for several decades. The same is true during a crash. Also, don’t believe people who predict the “end of the world” during them.

Don’t believe yourself if you do not have a better-than-average return rate, or think you’ll be able to achieve high double-digit returns in the medium term. Don’t let your ego make you believe you are right when the price of an investment collapses well below the amount you paid. This is especially true of the losses caused by the crash. You don’t have to prove you’re right by immediately putting more money into a losing investment. This is a mistake because there is no need to quickly return an erroneous investment with the same investment target. It is safer to take a breather and think about what went wrong.

Do not look at the price of a security before making a cash flow statement. Your subconscious can steer the end result towards it when its availability is high. Do not look at the price you paid when making a new cash flow statement for your investment. Your investment does not know how much you paid. The price you pay may not matter at this time.

Bubbles/Booms and Crashes part 1

 The section is intended to describe larger-scale bubbles / booms and collapses, not individual stocks, bonds, or other investment products. Some of the lessons also apply to individual investing vehicles. I use a bubble when I talk separately about the insane price of an asset class. The boom describes the general euphoric economic conditions.

Almost all bubbles and booms contain too much cheap money, positive emotions, too little fear of losses, moral hazard, an abundance of amateur investors into the market, an euphoric consumer sentiment, a sense of the new age, and positive political factors. Before long, the bubbles burst. This often involves shrinking money supply, negative emotional storms, excessive fear of loss, and the negative effects of political factors. Explaining bubbles, booms, and collapses by individual factors or patterns is absurd but annoyingly common.

Bubbles and booms are causing insanely high prices for different asset classes. Prices can be so high that no one can imagine them. For example, Japanese real estate prices rose tenfold in the 1980s and stock prices 6-7fold at the same time. Common to the booms and bubbles is the increased peak prices much higher than previously expected. Yield expectations become mathematically almost impossible. The insanity can be outlined by calculating what kind of returns should be obtained at current prices, even over the next couple of decades. When you start talking about double-digit percentages that don’t start with one, it’s certain that a boom or bubble won’t last.

Bubbles and booms are about excessive demand compared to supply. In crashes, supply is excessive compared to demand. Price bubbles are more likely to occur in assets where supply is limited or demand is high. One of the former is Bitcoin and one of the latter is commodities. Bubbles, booms and crashes are self-reinforcing events. Both are also impossibilities for mainstream economists. They are explained by external shocks. Bubbles, booms and collapses are not uncommon. There have been many bubbles and booms in the last three decades: the Japanese real estate bubble, the Asian economic boom, the dot-com bubble, the U.S. real estate bubble, and the Chinese real estate bubble.

In the current situation, in January 2022, many can assume that they will also see inflated bond prices or a tech bubble. Bubbles and booms, to my knowledge, have not been mathematically defined by anyone. They have no precise definitions. Their prices are at unsustainable levels, which will fall drastically in the end, causing prices to collapse and major economic damage. This section looks at the extensive bubbles and booms that have a strong impact on the economy and their characteristics. I will briefly review the special features of stock and real estate bubbles later.

Independent thinking is a golden characteristic for the investor. During bubbles, booms and crashes, it is more important. During them, there are more empty suits who come up with at least one credible reason for nonsensical prices or the “end of the world” like “we live in a time of low interest rates.” At the extremes of cycles, mass hysteria causes large losses for investors. At other times, watching large crowds is less dangerous. Medium returns are reasonable and there are no major upheavals threatening investor assets. You must be able to identify mass hysteria by yourself. The content of the book helps with that, but it does not remove the importance of independent thinking.

Deeper anatomy of cycles

 

Deeper anatomy of cycles

The introduction briefly discussed the anatomy of cycles and found that the main directions of economic cycles were ascending. In the long run, growth is steady, but in the shorter ones it fluctuates around a long term growth rate. For example, the average growth rates of developed economies are about two percent over decades. Annual growth can be well above that or go negative. Almost all cycles exaggerate the lengths of both their ups and downs and the pace of change.

Defining stages is not rocket science. All stages are not inevitable but also necessary. No precise scientific definition has been made. It is up to you how you define the different stages of the cycle, but I personally use the following stages:

1. Rise after reaching the bottom
2. The peak
3. Decline after peaking
4. The bottom

The rise starts from the bottom, pointing upwards past trend growth towards the top. That is the slowest stage. The duration is often multiple compared to the decline. Long cycles can last decades and medium ones from a few years to a decade. They do not mean continuous upward movement but may include both lateral movement and shorter descents. The annual rate of increase on the basis of the peak exceeds the average trend growth. This is not to say that the rise in individual years could not be slower than the trend between bottom and peak. The rise is usually the fastest after the bottoms and before the peak. Long cycles almost always rise higher than previous peaks.

The lengths and durations of the rises depend on the bases and declines of previous cycles. The lengths of the cycles and their phases cannot be known in advance. Mass psychology is unpredictable and the size of madness or reasonableness cannot be predicted in advance. They cannot be determined by mathematical formulas, even if attempted. Share prices, real estate and commodity prices do not follow pre-defined limits. They can multiply in a short time or drop more than 80%. The best examples of the above are the sevenfold increase in the Nikkei Index in 1980s Japan and the more than 80% decline in the Dow Jones Index from 1929 to 1932. Investors with bad timing will never get their money back. This is true at least in Japan where previous peaks have not been reached.

During the ups and downs, positive emotions and negative emotions like jealousy become stronger. The latter is most evident in the minds of outsiders. Emotional states reinforce themselves until they are close to or at their extremes. In addition to jealousy, positive psychological factors are at their strongest point towards the end of the upswing. The factors are e.g. social proof, the illusion of availability, the illusion of scarcity, and new, old displacing authorities. The number of people staring from the side and suffering from envy is at its highest. Many of them think, "How can a neighbor's fool, John Doe, be able to make that much money, even if he doesn't understand anything about investing?"

Social proof is at its highest, with the largest possible group believing that they will get rich with little effort because others around them believe the same. Everyone is starting to get tips from their environment. They can come from neighbors who have never invested but have started making money. They can also come from co-workers or close relatives. The availability of positive signals from elsewhere is increasing.

The end of the ascension also brings forth new, old substituting authorities. In this case, you will find several new investors who have made a lot of money. The general public is starting to listen to them, even though their success as investors has only lasted a few years. Old authorities that have succeeded in the market for decades are ignored as having seen their best days, as senile, as incomprehensible about the new economy, and as longing for the past. Without their warnings, the enthusiasm created by the positive factors would be smaller. Most of the time, they’re finally right, even though some of them are trying to make money in the final moments of the rise. In particular, central bankers and other regulators need to be silent if they are not prepared to act at the same time. Without action, they will allow investors to do stupid things because they show acceptance of high prices.

The further the ascent progresses, the more creations of financial engineers will appear. There is always a new popular investment vehicle that is a new form of “alphabet” (SPAC, MBS, CDO, etc.). What they have in common is complexity. Some of them can only be described with reports of thousands of pages. They are usually combined with hundreds of junk papers that no sensible investor would buy individually. They are sold as great investments. Even credit rating agencies cannot or will not have time to go through the content properly. In other words, they are classified as safer than what reality ultimately tells us. The pile of crap is always crap, even if it is coated with gold or has a great name.

They can be considered obvious scams and they are, but the big boys mostly survive with remarks or small fines compared to the damage done to customers. The caravan passes and the million-dollar bonuses move. They recommend investment vehicles even when they themselves are selling as fast as they can without crashing their price.

Market peaks are not always a single spike up, followed by fast decline. A larger decline may begin much later. Bankruptcies or forced sales of new market gurus must be seen before the big fall. The peaks include excessive lending and borrowing, the apostles of the new economy, the growth of economic scams, etc. The intensity of the peaks varies. In developed economies, the peaks of cycles are often the result of euphoria or bubbles, depending on what designation you want to give them. In them, nonsense goes further. I'll come back to the bubbles later.

The falls are faster than the rises. A decade’s rise usually causes a few years of decline, but it can be faster. The duration depends most on the previous peak and the resulting rise and the reasons associated with it. The more exaggerated the peak, the longer the decline, at least in terms of length. In most cases, the decline is below the average trend line. The decline may not be prolonged over time. The signs of the start of the invoice are e.g. the departure of the apostles of the new economy to the rear left, the increase in the mention of financial scams in the press, the revelation to the general public of the weaknesses of the new creations of financial engineers, etc.

During the descents, negative emotions and joy of harm become stronger. The latter is visible to non-market participants. The “what I said” reaction is most common near the bottom. The bottoms also contain an increasing amount of bankruptcies. Panic describes the mental state of several actors, although the situation does not get worse. The situation is escalating rapidly, but the worst is passing by.