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Author Topic: Crowding-In  (Read 1103 times)
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August 06, 2014, 12:48:02 AM

The phenomenon of "crowding out" explains lots of price action on the stock market. Crowding out is basically when the government goes in and starts buying up stuff, and borrows money to do so, draining liquidity out of the system, driving interest rates up.

As you can see, normally, around a war there is a period of no gains in the stock market. Note, NOT a crash. Just flatness within a range. Also there is typically inflation, although note in the past this was generally not money-supply inflation, but price inflation, caused by scarcity as resources are diverted to the war effort.

How can stock prices not bubble up when all that inflation is going on? Well, its partially due to uncertainty, which helps keep prices down. But its also due to crowding out: The government sucks up most the money, so not much of it is left for stocks. And the amount left, generally isn't invested in stocks, because companies have a hard time keeping up with the massive interest rates themselves, think of the internal rate of return. So the market remains flat, despite the inflation.

Then the government pays back the money at the end of the war, rates fall, and there's nowhere near as much demand for credit. So, its AFTER the inflation do stocks start making their big gains.

Also note, the inflation is generally permanent. In other words, once scarcity goes away, there has to be more money made in order to compensate for the increase in supply just to keep purchasing power flat; look what happened when they didn't do this: The Great Depression.

However, this is all old news. I'm saying that the phenomenon of crowding-out died with the free markets. When the Fed stepped in with ZIRP, there can be no crowding out since the rates are fixed at 0, and you can never run out of liquidity because the fed will just keep printing even more.

So, if there were to be a world war right now, not only would there not be a crash, but there would be a huge rally in the stock market, as all those bonds have to bought out with fresh money to preserve ZIRP. This flushes the system with liquidity, and also causes inflation. The stock market thus turns into an supply-inflation-protected savings account, as well as benefiting from the scarcity effect. Finally, with ZIRP, stocks won't have to compete with any rate whatsoever.

So that begs the question, why the absolute heck is the market selling off. I think it might be irrational fear, and people misunderstanding the new normal. BTFD.

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