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What’s the point of your new book—depressing as many people as possible? Quite the contrary. What I am trying to do is get people to safety, rather than being outrageously exposed to the risks in today’s markets. Risks? What risks? For all the frauds and volatility, the Dow was still hanging tough in the 9,000-10,000 zone—at least until Wednesday. It all depends on your timeframe. One of the reasons I am putting my book out now is that I think people do still have time to act. The Dow is still relatively near 10,000. People say you have to hold stocks for the long term. But you can also hold cash. Not necessarily for the long term, but certainly while the major trend is down. Did you say “cash?” “Cash isn’t trash.”  Funny, another reputed “perma-bear,” Jim Grant just wrote something touting the investment merits of cash— I am doomed if I agree with Jim—and he is doomed if he agrees with me! As they say, even a stopped clock is right twice in every 24 hours. But do two stopped clocks ever agree?  Hmmm. That sounds like a two-year old I know—cute and snotty. Any sort of youth sounds pretty good, from where I sit. And in another week, I will have as many gray hairs as Peter Lynch. Let’s get serious here. We are, depending on how you figure it, as much as three or even five years into this bear market. Loads of damage has been done. Why come out with a book about conquering a crash now? Well, when I want to tell people that I have been bearish for a while, I explain that the top occurred in April of 1998 when the A/D line and the Value Line Geometric Average topped out. But most people date the top, as I would, as the first quarter of 2000, when the major averages peaked. I guess a few people even have noticed that the Value Line Arithmetic and the S&P 600 mid-cap indexes, did not top until April 2002. But anyway you want to look at it, the market has had at least three major tops in the last four years—and I think we are bumping up against that third and last top. If you look at all three as part of one distribution pattern, as I do, then we are at the peak of the right shoulder. Which means this is actually a very good time to become bearish, if you haven’t already. So it’s still not too late? Which implies lots more downside— Well, it would have helped most people to turn bearish earlier. The problem is that no one, in 1999 or 2000, outside of my own readership and a few others’ (maybe Jim Grant’s readership) would have been at all interested in selling. I’ve already published all of my ideas for protecting your investments and also for profiting from short-selling in my newsletters and on my website [www.elliotwave.com]. There are many ways to do it. But to get the message to the general public—the only way to succeed with a book is to publish it when at least there is a glimmer of acceptance of your thesis; when it has a shred of credibility—and you can’t do that at a major top. People are buying “Dow 36,000” books at that point. It would be useless to wait another two years, because we should be working our way into the bottom around that time. I think this is an excellent time to publish a book for the average person who has just begun to wonder if maybe stocks do not always go up forever, year-after-year, at a double-digit rate. Maybe. But people have really been sold on the idea that they’re invested “for the long-term.”  Yes, and that is exactly what this book is written to address. There are two chapters in it that explore the current, still-outrageous overvaluation in the market and also the current, still-extremely bullish public sentiment.  There’s no chance I can get you to call the nastiness we’ve been witnessing “the bottom?” No. Well, we may be making a short-term one, but nothing more. We’ve got a really high level of short sales by the commercials in the S&P and we still have a pretty high level of longs in the S&P by the small traders, which represent the public. Those are the kinds of indicators that you would want to see in the opposite position before calling a major stock market bottom—and I would be more than happy to do that, if indicators like that were bullish. But in fact they have gotten worse since the top in 2000. Another indicator that is widely recognized as having gotten substantially worse is the P/E ratio. So you are going to stick to being a contrarian. That got me in quite a bit of trouble in the 90’s. When people ask why, after predicting a massive bull market, I didn’t stay a screaming bull all the way, my response is that I really have a problem with sticking with a crowd that I think is really stupid. That proved a drawback because every century or so you can get the kind of sustained overvaluation that we had in the 1990’s. But I think the piper has to be paid and so I am very patient.  In studying all of the major manias, I had to go back to tulips to find a more outrageous overvaluation. I was fascinated to find, by the way, that none other than Graham and Dodd wrote that the focus of investors in the Roaring ’Twenties was improperly placed, not on earnings relative to stock price or earnings relative to the size of the company or profit margins, but only on the question of whether earnings went up in each reporting period. It just goes to show you that very little changes. We’re going through a repeat scenario—except for extent, which this time is much greater and duration (the mania lasted much longer), which was my big problem.  We’re back to you not believing people could be so stupid, for so long.  Maybe that was the wrong word. I should say naïve and uninformed. Then again, I can’t really say that because the leaders of the whole thing were professionals who were on television and writing books and managing money, telling people to pour more and more in, unfortunately. The virtuous circle was virtuous indeed, until it turned vicious. Well, if it was virtuous when stocks were in a bull market, I think people should have the same orientation to their cash when it is now a bull market. They should say, “Oh look how much my money is going up every day or every week as the stock market goes lower.” They can buy more and more shares, so the value of their cash is soaring. Talk about a steep learning curve. As I said, cash? What cash? Isn’t the irony wonderful? Because back in 1981 and maybe in the year or two prior to then, when the stock market was exactly where you should have been putting money— You couldn’t get people to do it for love or money. No and why? Because interest rates were so high. Look at this wonderful return—I am not going to come out of this money fund. I can still recall a July of 1984 special five-page section in the Wall Street Journal interviewing countless economists and other financial spokespeople, who said there was no hope for lower interest rates, there is no hope for lower inflation or for the economy—and of course, again, that was the signal of the bottom. Then, in the late 1990s, we had quite the opposite. Everything was rosy. People are a little less certain right now, but according to the latest poll results I’ve seen, the public in general still believes that they will make double-digits on their stocks annually for the foreseeable future. So they have not changed their orientation. They are still looking up. They have to change their gaze to the downside before you can even begin to consider that we might be heading into a bottom.  So I can’t shake your conviction that this is a major bear? I would say “major bear market” is almost a euphemism because was that a “major bull market” or something even bigger? I use the term ‘mania’ because it was so outrageous and I think that it will be corrected by something commensurate—even bigger than a big bear market. Most bears today talk about a 40% or 50% drop like we had in 1973-’74, 1937-’42, but it will be larger than that. A 50% drop would get you back—assuming earnings did not fall, which obviously is not a good assumption—to about where the market was valued at the top minute in 1929, so I just don’t think that that would be satisfactory. You clearly don’t see earnings, and the economy, rebounding in the second half. Correct. There are always many ironies in the market but when the Wall Street Journal did it’s survey of economists at the beginning of the year and asked when they thought the recession would be over, the majority said around the end of the first quarter. But it is more likely, in my opinion, that the end of the first quarter was about the time that the stock market and the economy peaked out. Now, the economy lags stock prices, so we may have another month or two of relatively positive economic figures. But when the Dow breaks prior lows, that will signal a resumption of the economic contraction immediately to follow. That survey of economists is about the most reliable (if unintended) contrary indicator you could devise.  I will let you be quoted on that one! I am scarcely the first one to make that observation. True. Paul Montgomery has made some fascinating observations in that regard, pointing out that economists’ forecasts have tended to be right about 25% of the time—which is twice as bad as flipping a coin. Then again, I am one to talk. You have made a bad forecast or two.  I was really wrong about how far up the stock market would go. As I say in the preface to my new book, you have to have the sense to read my arguments, look at my graphs and make your own mind up. You shouldn’t act on the basis of “Well, I like this guy,” or “I think so-and-so is right this time.” You have to put your own brain in gear.
That is the most improbable expectation you express in the whole book!  You’re giggling so much you can hardly speak. But Bob, you, of all people, have to know that people want gurus—and never more so than in uncertain times. You’ve been there, done that. Maybe that is why I am disclaiming the position. Or at least asking people to make up their own minds. And that’s why the book contains a couple of dozen graphs. Words are not enough. People really have to see the evidence. And the terrific thing about this past century is that we have such wonderful data on the stock market, P/E ratios and dividends. Things that people did not have in the previous century. So we can go back and see how stretched and overvalued the market really is. Nonetheless, some of the indicators—the ones that are speaking the loudest—are rather subtle. For example? The P/E ratio I think is overused and generally not that helpful. But in studying its history going back 80 years, I think that I have found a very important correlation. When the market rises and then pulls back to a higher bottom than it has hit before, the P/E ratio usually is also higher because investors are a little more bullish. But in those rare cases when the P/E ratio falls to a lower low despite the fact that stock prices bottom at a higher level than their previous low, it is a signal that a long-term uptrend is in force. And that signals a terrific buying opportunity. The last few times that we saw that happen were 1942, 1949 and 1980. Terrific buying opportunities that were all above the previous lows of 1932 and 1974 respectively. Now we have the opposite. We have a lower stock market but a higher P/E ratio—and that just shows people are expecting the market to soar, just as much as their ancestors in 1942 and 1949 and even in 1980 expected it to collapse. And they are going to be just as wrong. They are looking past the recession. Exactly. Bulls argue that P/Es only look high because earnings are artificially depressed by the double whammy of a recession and the terrorist attacks.  Ah yes, the unfortunate denominator. If we could just get rid of it and not worry about the fact that earnings are collapsing, then the P/E ratio would be fine. It’s not just that earnings have collapsed, it’s that the “E” has become meaningless, because it has been so abused.  The very concept has been beat to a pulp—but that in itself is part of the what became the tyranny of the equity culture. We can’t even report the true figures anymore. We need to distort them to keep people from being worried. But of course that couldn’t work forever. And the mere fact that it is being exposed is going to be enough to focus people’s concerns. Now that so many people are going to go to jail for misstating financial realities, perhaps the indicator will be restored to its historical range. There is no shortage of candidates for horizontal pinstripes, unfortunately.  Yes, but if we’re honest we all have to say that we were doing many of the same things—or at least closing our eyes to them—in the ’90s. The key to the current crisis of scandals in companies has a lot less to do with any sudden emergence of bad behavior than it has to do with sudden social sobriety and a new-found willingness to examine what was there all along. That’s right. What was a society-wide willing suspension of disbelief in the ’90s is no longer willing—or so gullible. It is actually beginning to snowball in the opposite direction. “Tell us more dirt.” That is a classic bear market psychology. And the exact opposite of the psychology that permitted President Clinton to make it through two terms. He was coated with bull market Teflon. Who wanted to kick out the leader, maybe that would make the whole bubble pop? I also think that the party at the peak of power during the current bear market will ultimately suffer election defeat. So I was fascinated by the drama in Florida as history decided which party that would be. You’re convinced Bush won the White House only to assure his place in history as a second Herbert Hoover? That is right. Although the bull market lasted so long and went so high that it is possible that this bear market will last enough years to wreck the legacy of more than one president. Back in the 1840s and 1850s, there was plenty of misery for several presidents to go around. That was a period of back-to-back depressions and overall difficult times and no President really generated a legacy until after the final bottom in 1859. But Abraham Lincoln, who was elected immediately thereafter, is revered to this day. Just like all Presidents who were elected at bottoms—Franklin Roosevelt was another, Ronald Reagan. I don’t know, it seems those Presidents also had to deal with little things like the Civil War, WWII and the “Evil Empire.” I didn’t mean their times were easy. I just meant that their reverential places in history were assured, because they came to power in the early days of great bull markets.  You said a few minutes ago that when the Dow makes a new low, it will signal the beginning of the next downleg in the economy?  Yes, because the economy lags the stock market quite reliably—quips to the contrary notwithstanding. So I would merely suggest that anybody who has opinions other than mine—and I am sure that means quite a few of your readers—keep an eye on the Dow. I certainly would not wait for any confirmation. There is very little to show for the massive amounts of additional liquidity that the economy has enjoyed in the last year, in terms of a stock market advance. Most of it went into real estate. My colleague, Peter Kendall, went back and studied all of the major stock market tops of the last two centuries and found that they tended to be accompanied by a real estate tops—although there was typically a two-year difference between the tops. In most of the cases, it was the real estate market that peaked second. And it has now been two years since the stock market topped. We have real estate frenzy articles in every paper across the country—or in many of them anyway. So I think that the real estate peak is probably happening this summer. And in some articles you read that real estate is the only thing holding up certain local economies. The real estate boom has clearly encouraged people to continue to leverage up—  I don’t understand it but, yes, people are taking out second mortgages to buy things that they want. For consumption, not investment.  Yes, they are consuming their homes and turning over the ownership to the banks—
At least that means the banks have some hard assets. Maybe. But now they are utterly dependent on the value of these real estate parcels that they own so much of, and that is dangerous. I think that real estate prices are going to go way down, very similar to the way they behaved in 1929-’33. Or 1835 –1842. I just don’t think banks should depend on those values—but they are. We will have to see what kind of decisions are made by banks in human terms. In other words, if the real estate market is falling, do they kick people out of their houses and try to sell them, or at what point do they decide that it is not worth it? Banks generally have pretty wide latitude to use forebearance and avoid recognizing—and doing anything draconian—about their problems for a while.  The problem is that we are heading into a rare monetary event, which is outright deflation. The history of deflation says that prices of all types collapse. Investment prices, goods and services prices, wholesale and retail prices, commodities, stocks, many bonds, real estate and so on. The reason this happens is that people become utterly desperate for cash and capital to pay interest and also to assure creditors that yes, ultimately we will be able to repay the principal. When those forces are imposing themselves upon bankers, I really doubt that they will be able to sit under the shade tree with their mint juleps and say, “We were the good guys.” Because their creditors are also good guys, the depositors are also good guys and they absolutely will have to satisfy them to stay afloat. So the banks will have to get money somewhere. Right, and that means selling off their assets. If people are not paying on their mortgages, the banks will have to get that money somehow. And as you know, the savings rate in this country is zero. Or less. But come on, Bob. What’s going to crumple the real estate market? Their homes are everybody’s favorite asset. Demographic trends are favorable. They’re not making any more land— You hear all kinds of arguments all the time for real estate. A lot of people think it is a common sense thing to say they are not making any more real estate, but that is not the point. The point is how many things are there in the world that people will go into massive debt to own; that banks will create billions and billions of dollars worth of credit in order for someone to own; and that are ultimately consumption items.  No, everybody today knows his house is his biggest investment.  People think it is an investment and maybe in the long, long run it is—but homes deteriorate. Property doesn’t, necessarily, but homes do. So residential real estate is a different ballgame. This is not a case in which you bought some property that maybe in fifty years will have a town built up around it. This is people buying mini mansions and condos that are outrageously overpriced simply because of the credit that has been made available. What’s more, deflation is not usually a collapse in the supply of money. It is a collapse in the supply of credit and I think that we now have so much credit out there, which is being financed at such a high interest rate relative to the productive capacity of the economy, that it can’t all be repaid and we are crossing that line now. People have been worrying about consumer debt levels forever, it seems, yet the American consumer—as my colleague Steve Leuthold has pointed out—has proven ever up to the challenge of going further into hock.  That’s what the anecdotal evidence suggests, yes. I think that it is helpful to look at charts though. For example, the chart in my book of the total debt in the credit market as a percentage of the annual U.S. GDP, going back to 1910. We have had two major swellings in that ratio: The first was in the 1920s, when it got all the way up to almost 260%. The ratio was actually very conservative through the ’40s and ’50s—and even through most of the ’70s, which is pretty shocking. But in the late 70’s that ratio began to soar. Now, of course, we have passed the 1929 ratio and we are up to 300%. Meaning we have total credit outstanding equal to three times annual GDP. And now that we have passed the previous peak level of 1929-30, I think it is time to actually fret about it. But today’s economy is infinitely larger, more complex and, yes, sophisticated than the our grandparents’. So why should this particular level of debt be the trip wire?  It is a legitimate question. Why now? I try to answer that question in my book by saying that the No. 1 reason for me is the Elliott Wave structure. I think if I study 300 years of stock history, I can see what is required for the tipping point to be reached: An extreme run-up to overvaluation and then—the thing I had to wait so long for—the reversal. And I think that is now in place. But even then you have to be patient because the real estate market usually benefits and holds up another two years after that. No. 2, I show in another graph, which traces out the history of the rates of change in the Producer Price Index and the Consumer Price Index. They have been slowing their ascents for a number of years—since the mid ’70s and are now at approximately zero. I think they are still falling and will go under the line, so we are going to see falling prices in general. To me another giant hint—and maybe this is the biggest of all—is the fact that in 1998 junk bonds, which were already at a lower top than in the early ’90s and certainly at a lower top than the late ’80s, began to collapse. Well, they didn’t have Mike Milken around to help them anymore.  My point is that since ’98, when the advance/decline line topped out, I don’t think that is a coincidence that the junk bond index has been falling absolutely relentlessly. This market isn’t stupid. If all is rosy, as we hear from so many corners, it would not be doing this. The junk bond market has been anticipating a severe economic contraction that is going to affect the ability of the companies that issue these bonds to pay the principal. The luckiest people will be the ones who got their principal back through the interest payments. Yet I keep reading stories in the newspapers recommending to the public that they go out and buy junk bonds because they are so depressed. I think that is terrible advice. Okay, your first reason for warning about a crash now is the Elliott Wave cycle. But gosh knows that can be interpreted in myriad ways. Its timing is anything but precise, as you’ve certainly demonstrated.  Actually, many times it is. There were long periods in the ’80s when a lot of the patterns I saw worked out to the day. The thing I like the most in this book (it is probably only going to make me happy, not anybody else) is a comparison of the advance from 1921 to 1929 to the move, shown immediately underneath, from 1974 to 2000. They look almost identical in virtually every wiggle. The thing about the Elliott Wave pattern, which we say in every paper and every book, is that its timing is elastic and its extent is elastic. What stays the same is form. I did not recognize at the time that from 1974, we essentially were living through the 1920s. But the move was tripled in both time and price. It took three times as long and went three times as high on a percentage basis. But the form was the same, so even I am still learning about the Elliott  Wave at my old age. If you look at the Elliott Wave on a chart of the global bull market—the world stock index—it traces out the textbook pattern. We have had the first leg down. Maybe we will have some recovery. Maybe we will be lucky and get a summer rally. That is fine. It just means that whoever really does want to protect himself or herself is going to have a window of opportunity to do it. But I certainly would not delay. During the mania every surprise was on the upside and during this bear market the bigger surprises are going to occur on the downside when people are not looking, so you have to be early. Just a rally? Most people are still trying to catch the bottom.  Right. People always say bearish is bad. First, I don’t believe that, philosophically. But okay. Say you are a bull and you like stock bargains. Can you imagine the opportunities that you would have had if, in December of 1968, you had exited the stock market and done absolutely nothing but collect interest until October or December of 1974? By then, stocks that had previously been selling at 85 were down to three-quarters of a dollar. After that, when they went to 19, you made real money. In the 1990s, people would try to buy stocks at 140 and hope they went to 190—which was not exactly a great return from a percentage point of view. But if you can buy extremely undervalued stocks, at or near the lows of a major debacle in stock prices, you can make more than enough for you and all your progeny. And thereby, of course, ruin their characters. There are several historical examples of wealthy dynasties founded by people who held cash through the Crash of ’29 and after, finally buying in 1932 or 1933, and building fortunes that lasted through generations. I would not necessarily recommend that but it is better to make money than lose it. But that (horrors!) implies doing more than a little market timing. Well, let me cross my fingers and ward off the vampire. But will that work on all the academic studies saying timing is a crock? They were all done in the late ’90s Using data going all the way back to— 1982, generally. But if they were done by real historical types, they might have used data back to 1949. Just outrageous. There actually are some studies coming out now that show market timing is doing pretty well. My interest is in the social psychology of this and you can generally say that when markets go down or sideways for a long period lasting years, market timing becomes popular and cycles become an important topic among people. Harvard economics professors issue statements such as, “The most important economic tool in the history of the world is the Kondratieff Wave Cycle.” But then, after long periods of advances in bull markets you get the opposite. People say cycles don’t exist. Market timing is a waste of energy. You should only buy and hold. Those are phenomena that are part and parcel of where you are in the cycles. Anyway, it was in October of 1982 that I said we are going to have to switch from a timing mentality to a buy and hold mentality. Little did I know that I should have held a lot longer—but at least I had the idea in a good time. If only you had paid more attention to your own advice. Well I got a lot out of it, but yes the bull market went a whole lot further and longer than I thought. But I don’t know that I should have to be defensive. I don’t remember anyone else coming out with big number predictions about the bull market until the Dow crossed about 5000.  Now your prediction couldn’t be more opposite. And your book makes specific suggestions about ways for investors to find shelter from the bear market/deflation/depression you see? Exactly. I don’t just say “go to cash,” because the questions today are what cash and where do you keep it? Two incredibly important questions. We know from history that at the bottom of major market crashes , they tend to close banks. Let me guess, you don’t suggest a safe deposit box in a New York City bank. No. The fireplace would be safer in the winter. In fact, the book lists the two safest banks in each state. Also, some of the safer banks in the entire country. None of the major money center banks made those lists. The banks tend to be small. They tend to be rather conservative. They tend to have a lot of Treasury bills in their holdings because, believe it or not, some bank managements actually are somewhat concerned and not willing to speculate in derivatives and lend out all of their money to questionable enterprises. In other words, you suggest some of the sleepiest banks in the country— Yes, although as we found out in the S&L debacle, some of the ones that look sleepy from the outside can have an orgy going on inside. So you do need to check the figures. But I also think that if you have substantial capital to protect, you should look overseas at truly conservation oriented banks, most of which are found in Switzerland and Singapore. It doesn’t hurt to be conservative. There is nothing to lose by using these as a safe haven. Of course, you still need a transactional bank, too. Then there is the big question of which currency to be in. That is going to require people to have a market opinion and make a decision. Just to take this one step further, I don’t think it is a bad idea —even though I am not really bullish on the precious metals —to have a position in gold and silver and perhaps platinum, as well. In fact, it is foolish in a world of paper currencies not to. For one thing, it is currently legal.  Are you implying that may change? Well it is good to take opportunities when you have them. For example, back in 1998 I recommended to my subscribers that they look into a bank which at the time was ranked by more than one source as the single safest bank in the United States. I opened an account there and a number of subscribers did as well. Then, a few years later it announced that they were taking no more out-of-state accounts. They are conservative and want everything under their little umbrella. So those doors closed. Unless you act when you can, you may find some doors closing to you.  Let’s switch focus to institutional investors. Your economic and market forecasts imply very rough times ahead for portfolio managers.  Very difficult. But the first thing they can do is protect their own cash. Believe me, I sympathize with, for instance, mutual fund managers who have to be heavily invested all the time; in organizations where being a “bear” means somebody who is only 92% in stocks. It will be very difficult to weather the kind of thing I see developing simply by being a good stockpicker. There is an old adage that says 60% of stocks go up in a bull market and 90% go down in a bear. That is an over-generalization, but it does roughly indicate how difficult it would be to choose stocks that buck the trend to a degree that would keep you from losing money. It is not easy. But there are managers who will hedge with options, for example. Of course, that is a cost, as well. But if you can do that with leaps or options and you are willing to bear the cost of rolling your hedges over for 2, maybe 2 ½ years, your fund will do a lot better. Of course, if you are a hedge fund manager, you don’t have a problem because you can play the downside, as well. There are many managers who are very good at that. In fact I have a great strategy in the book for people who don’t agree with me. It’s a market neutral strategy whereby you pick some of the best money managers in the country or in the world who have proven their ability to pick stocks on the long side and give those managers half of your capital. Then you give the other half to managers that have a proven track record of picking overvalued, ridiculously priced stocks for selling short. So whichever turn the market takes, one side should make a lot of money and presumably the other manager won’t lose a lot, because of his expertise. So there are many ways to approach this without just saying, “short General Electric,” which was a great idea in late 2000. I’m getting the impression you’re not a big fan of banks and financial stocks here.  I really am not a stock picker, but one group that has benefited from the credit bubble is the banking group and at some point they will also reap the other side of the bell curve. You devote several chapters to the Fed and the credit bubble’s role in setting the stage of the deflation you see developing.  I tried to adopt a neutral tone in that discussion, avoiding hyperbole and epithets or anything of that sort. What I tried to do was relay as they say the true history of money in the United States. And the Fed plays a major role as the money and credit engine. It is not quite as nefarious, certainly from the point of view of intention, as many of its enemies declare. Most of the people in the Fed and most of its fans among economists believe it is there to do good things. But it isn’t doing good things in the long run because every major credit inflation has always ended in a commensurate bust. And this is the greatest credit inflation probably in the history of man. Isn’t it supposed to act as a governor on the system, smoothing things out? That’s supposedly one of its jobs. But the story of the Fed from the beginning is a history of making credit easy to obtain. They rarely purposely go in and make credit difficult to obtain. They only do that, in fact, when they are forced to the wall as they were in the early ’80s for example, by the inflation trend. Another of the Fed’s jobs is to monetize government debt so the government can get money for nothing. No small matter. Most folks are absolutely convinced that the Fed would do whatever it takes to fend off another depression or deflation—and that it would inevitably succeed.  I have no doubt it would try, but what we have now is a massive amount of credit outstanding relative to the actual money— and today money is really only the federal reserve notes in circulation. Which are nothing but government IOUs.  That is the tricky part because the dollar itself is nothing but a credit against future tax returns and you’re only promised another dollar in its place. In other words, the dollar is actually a mental construct, whereas through much of history, money was actual physical money. The Fed’s primary role used to be creating Federal Reserve notes to monetize the federal government’s bonds. And by monetize I mean turn it into money. So the government borrows but in actual fact gets money in return that it can go out and spend. Yet the borrowing never goes anywhere because it is a reserve of the Federal Reserve bank. But that role has actually diminished substantially. The much greater role of the Fed in the last 25 years has been to facilitate the expansion of credit. It used to be that banks were required to hold a certain percentage of their deposits as reserves. They could not lend them out. Very quietly in the early 1990s the Fed de facto removed the requirements to hold reserves. They did that by saying, you only need to hold reserves against checking accounts. So every night banks sweep their checking accounts into other accounts—and so they don’t need any reserves. This has allowed banks to lend out all of their deposits. What then happens is that those loans get deposited in other banks and those other banks say, look, we’ve got all these new deposits. Isn’t this nice? And they lend them out, so the multiplier becomes infinite. The only question is how much debt service can the economy stand? I think the answer today is “no more.” We are at the limit. But as I say in the book, money is a big ocean. Central bankers are pretty ingenious. Maybe there is something I am missing. But I doubt it. We have just witnessed the termination of the great mania of the 1980s and ’90s. All prior great deflations were preceded by exactly such a mania.  It’s over in the stock market. But the real estate market is still chugging along. Credit is still plentiful. But the stock market is a leading indicator of all these trends. And by some measures, there has been a substantial reduction in the availability of credit. Commercial paper and of other measures of corporate loans are way down. But credit is popping in real estate and the consumer arena, so the overall trend is still rising. However, if you look at the rate of credit growth over the last 20 years, you will find that it has been slowing in the last few years. That’s an indication of an approaching reversal. Also, the most important thing I do is try to find evidence of a reversal of the psychology of people. All you have to do is pick up a newspaper today to read about the amazing frenzy in real estate. The last time we read about that was 1989. Particularly in Japan but also in California.
Just before Californians started abandoning their houses (and mortgages) by mailing their keys to their banks. They even had second and third generation mortgages in Tokyo. You committed your grandchild to taking over the payments after you and your son were gone. That was a credit bubble! What are your psychology antennae telling you about the public’s response to the now almost daily revelations of corporate cupidity and fraud? We have been writing steadily for the last few years, and particularly since 1998, saying that we were going to have financial, corporate and accounting scandals. I even wrote in The Wave Principle of Human Social Behavior back in 1999 that one of the characteristics of bull markets is that people get very active in terms of construction and they build large buildings, especially skyscrapers—but that when bear markets come along, people destroy buildings and blow them up. Don’t you wish you hadn’t written that? Obviously, I had no idea where or when that would happen. Or of the horror. But that has been how it has worked in history, whether in WWII in the 1940s or in 2001. Of course, when you really study history, you see that there have been long stretches in many societies in which buildings were just allowed to deteriorate. There are some areas in Europe where they basically haven’t built anything for 100 years. There were periods in Italian history when 300 years went by without anybody putting up a new building in many towns. All of these trends have been flowing and they are a reflection of the energy level in people and the direction of that energy. I think the stock market is a direct meter of that social mood. When it is pointing up, people love their leaders, they like their corporations, they produce more. That is why the economy expands. They also have more children generally speaking because they are feeling more ebullient. They wear more exciting clothes and listen to exciting music. But when the social trend goes down, all of those other trends go in the opposite direction. Wait a second. The birth rate didn’t go up in the U.S. in the ’90s.  No, actually it is very subtle. If you want to get into it it is a lot of fun. They had more children in the 1980s. The trend in procreation actually tracks the advance/decline line, not the Dow. So you actually get technical divergences near the top. And, if you think of the A/D line as a better representation of the overall experience of people in the country than, say, the Dow’s 30 stocks, that makes perfect sense. Interestingly, the A/D line did not get above its high of the 1960s in the ’80s and ’90s and neither did the demographic trend. But the trend was up through most of that period. Yet you call the stock market a perfect meter of the social mood? Well, the stock market is a direct meter of social mood. It reflects the trend of human sentiment in the aggregate. It is the leading indicator of so many social events—whether you are talking about war and peace or elections or nuclear testing. They are almost in perfect sync with the Dow adjusted for inflation. A lot of analysts contend that demographics control the stock market, but I think that is easily disprovable if you take a little time to do it. What we do have, though, is a nearly perfect correlation between the conception rate—not the birth rate (you have to move it back a year)—and the advance/decline line going back as far as we have figures, which is the 1920s. So the stock market is a leading indicator of all kinds of activity that show up later as history. Leading, because the mood shows up more quickly in the market than in other human endeavors? Right. It reflects the current mood. But when people become more ebullient, for example, it takes time for a lot of plans to be carried out. People were more ebullient through most of the ’80s and then even more so in the ’90s. But it was not until the ’90s that you began to get peace treaties and the Berlin Wall coming down and Soviet Union’s Communist party giving up power. Religions actually trying to resolve disputes that were 500 years old. The exercise craze. All these things were amazing. We listed them as they occurred and said, enjoy them, they are the fruits of the positive social mood. But when the trend turns down, you begin to get conflicts that result in polarization in social areas of all kinds that lead to conflict. But again, those results lag the downturn in the markets. So you have plenty of time to notice that the trend is down; to realize, “Oh, that could mean some approaching social danger so maybe I should keep my eyes open.” You see a grand cycle, in other words, sweeping society from flag-pole sitting to bread lines. Yes, well put. Not exactly a positive message here. Why should anyone want to buy your book to depress themselves?  The social trend is something, objectively, to be concerned about. The trend of the market per se is not. All you need to do in a market is be on the right side. That is hard enough to do, but it is certainly nothing to worry about. You just want to be right. The social mood is a more difficult issue, because a negative social mood has negative social effects. You need to keep your eyes wide open as to where you live. For example, if you live in the Middle East right now, you might want to move. You could have said that, just as validly, 10 or 20—or 100 or 200—years ago.  Definitely. But during the bull market it was a relatively safe place. Every year there was another peace initiative and another President trying to negotiate a peace plan. The only time there was active conflict was the Gulf War. And that came immediately on the heels of a three-year bear market, which you can only detect in the Value Line index from the ’87 high down to the ’90 low and in the pattern that lasted until January ’91.  The wall of worry seemed have a pretty solid foundation back in 1990. Not just the mideast, but the S&L mess and a very sick banking sector in this country, for instance. Yes, and I was concerned prematurely because I thought that we had peaked out. But as soon as the market made a new high, I said, “Well, I guess we have more upside to go because the market is the leading indicator, the mood meter. It was a sign. A great one. The 1990s turned out to be a long period of good times for many people.  Unless you turned cautious too soon.  Clearly, as I said. But I had already proved that I can be as bullish as the next guy. Maybe more so. Maybe that is one reason why people should pay a little bit of attention to what I’m saying now.  Okay, but why should they believe a stock market technician—or guru, even—has any special insights into the sociology of human events?  I’ve written 10 books now. But if I were going to recommend any book to anybody or if somebody were going to burn all the libraries and only one book were going to survive, my book on what I call “Socionomics” is the one I’d choose. [The Wave Principle of Human Social Behavior and the New Science of Socionomics] To me, it is the only book I have written that really matters. It is nothing less than an attempt to change the basis of the entire profession. My Yale degree was in psychology, and I have no illusions that I might actually do it. Nonetheless, it is edging its way into the academic world a bit, and going into a second printing. I have gotten perhaps a dozen endorsements from real live Ph.D.-holding professors. I think it offers an important insight that anyone interested in what makes history, what makes the economy tick and what is behind collective social human behavior should be curious about.  Your point, basically, is that sociologists shouldn’t try to understand the world in terms of cause and effect? Unlike in the physical sciences, cause and effect are not simple reactionary responses in human social behavior. They are not the same. There is a cause and effect in human society, but it operates under different rules from billiard balls. Paul Montgomery puts it well when he says the difference is that conservation of momentum doesn’t exist in human society because people can change their minds. So it is an immaterial mental state upon which you are depending, not a physical object. I think that the wave principle best describes the rules under which cause and effect operate in human society. My socionomics book recounts my investigations into many realms of modern research in biology, psychology, physiology, mathematics and related studies in finance that I believe all tell the same story: The primitive forces of the brain, the pre-rational portions, which are the limbic system and the primitive brain stem, are in control of certain human activities. Including leader selection, fighting versus fleeing, sexual activity and the one that I think matters to this study, herding behavior. As independent as we all like to be, we have all felt sweat break out when the market is going against some leveraged position we are holding. And we’ve all felt induced—just like the gazelle on the plain who sees another gazelle suddenly begin to bolt—to follow the herd. He says to himself, “I don’t know what the problem is, but he is afraid—and I might get killed if I don’t join him. I need to run, too.” Those are not cogitated reactions. They are visceral. They come from thought patterns that were developed through aeons of evolution to keep the species alive. It is very hard to fight those impulses—and you have to understand that you even have them in order to have any possibility of surviving the market battle.  So survival of the fittest in biological or ecological terms has left us particularly unfit for negotiating market shoals?  Entirely. I think there are limbic system impulses wired into human beings to save our lives that are utterly maladapted to financial speculation because they will make you do the opposite of what is best. Which may explain why so many otherwise perfectly rational professionals found themselves caught up in the mania, even if they recognized it for what it was.  Yes and I don’t exclude myself from that formula either. I have experienced the same types of impulses as anyone else. But what does give me, or anyone else who understands what is happening, a leg up is that you can use your neocortex much better to deal with it.  Thanks, Bob.

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