Financial Markets Headed Off A Cliff

The stock markets have been turbulent the last few weeks, as everyone is aware. But if you think that we have already seen the worst then you are in for a big shock. The turbulence of the past weeks are as the tremors before an earthquake or the rapids before a waterfall.

The recent stock market volatility has been attributed to the sub-prime mortgage crisis in America. Fears of loss of revenue from securitized mortgage packages due to sub-prime foreclosures triggered much of the losses. But the sub-prime crisis is only one symptom of a far larger credit bubble that will cause a severe credit crunch and economic contraction as it deflates. The credit bubble, essentially the creation of vast amounts of new money in financial markets, supplied the sky-high loans that drove property prices to record highs worldwide, allowed corporations and private equity groups to purchase each other for astronomical sums, and provided the capital to purchase stocks pushing markets to new highs. The credit bubble, since its creation in 2000/2001, is why the world economy has appeared to surge forward at an unprecedented speed and why prices (when you include fixed asset prices, such as property) have inflated so much over the same period. When more money is available to purchase the same assets, people will pay more for them causing prices and markets to rise.

As easily as that money was created, it can disappear. And when it does, asset valuations will be forced to revert to their former positions. The apparent gains of the last few years will be lost. Triggers like the recent sub-prime concerns will spark a wider credit contraction; Fund managers no longer want to purchase risky securitizations. That form of credit is removed from the market. The lenders and funds that rely on these securitizations incur losses. Banks reprice risk higher, raising interest rates, reducing loan amounts, and lending to fewer people. Another source of credit, risky bank loans is lost. Banks revenues are cut and they start taking losses. Now the banks are becoming really risk averse and they think twice about even lending to each other in case one of them fails, so they raise interbank interest rates. Further credit sources are lost. Money pours out of the system. All the while the companies and consumers that rely on these sources of credit begin to hurt as the credit is no longer available to them. Companies scale back expansion plans, affecting employment. Consumers (if they haven't been laid off by their companies) can no longer borrow or spend as much so lower their price expectations, and the value of consumer assets falls (especially high credit assets like houses). It is a vicious cycle of contraction that will have implications for every part of the economy.

When will it all happen? When will we step off this cliff? Well, it has already started, the current market volatility will continue for another several weeks or months at most. But eventually a tipping point will be reached, the market will be spooked and will plummet by a degree that makes recent losses look like nothing. Since February this year I have been predicting a crash around October, and I hold to that. I hope you're holding on to something too, because this is going to hurt.