Recognizing a Bubble – Dynamics of Free Money

By Axel G. Merk, GoldSeek

The government has splattered lots of money onto the economy, working hard to reflate the bubble that got us into trouble in the first place. The Dow is back at 10,000. What are you to do? If you are a wealth sustainer, you should not be drawn into the market simply because it has gone up. Instead, take a step back, look at the market dynamics and see what risks you can afford to take. I am not preaching to hide in a hole awaiting armageddon – there are always opportunities, but they may be very different from what the pundits may want you to believe.

When the credit bubble burst, the risks in the market changed. There are those who will perpetually pound “buy and hold!” – stay the course during a crash, but unless your personal ability to bear risk becomes supercharged just as the risks in the markets explode, you should seriously consider adjusting your portfolio’s risk profile to the new market environment. Similarly, investors should only put money at risk they can afford to lose; when the markets are down sharply, odds are you can afford to lose less. Only when you are focused on your priorities can you afford to take prudent risks; otherwise, you become a trend chaser – something that can be hazardous to your wealth.

Obviously, if you are able to predict a market decline, you can take steps ahead of time. One of the most obvious signs of a bubble is when all asset classes inflate in tandem –if everything goes up simultaneously, especially without fundamental reason, odds are that everything comes crashing down together. Many learned this the hard way in the fall of 2008. It didn’t need to be that way: in the run-up to the credit crisis, the private sector created money by increasing leverage –homeowners extracted money from their homes, banks used off-balance sheet vehicles, or hedge funds that used up to 100:1 leverage. I warned in early 2007 that a surge in volatility would trigger a global credit contraction. At the time, few paid attention as market volatility was mostly ignored as a market barometer. But if uncertainty is infused into a goldilocks economy, volatility increases and investors pare down their leverage to adjust to the new environment. More colloquially, the boom leads to the bust as investors become more risk averse.

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