Nobody enjoys playing a real game of hot potato -- after all, the potato is too hot to want to hold for long. But that's the game that investors in financial companies are playing now. Who wants to end up holding the IOUs? Bob Prechter explains why this is a particularly lousy game to play now that the U.S. government has gotten into the game, trying to shore up the financial system, because most people have only one strategy left to win this game. He writes about it in this excerpt from his most recent Theorist.

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Excerpted from The Elliott Wave Theorist, by Robert Prechter, published August 5, 2009

 

It seems obvious to me that financial markets don’t believe the vocal hyperinflationists’ runaway inflation scenario, at least not yet. Taken together, real estate, stocks and commodities have fallen 50 percent from their respective highs. I believe that these markets reflect a hidden revaluation of the entire stock of dollar-denominated IOUs. Even though the authorities are using force and other people’s money to keep certain debts marked to face value rather than to market, the shadow market for debt—as represented by the prices of investments—has decreed that the entire debt stock is in fact worth half what it used to be worth, regardless of what bonds say on their face.

Let’s look at it another way: A dollar can buy twice as much property, commodities and stock as it could at the times of the most extreme stock, property and commodity prices during 2005-2007. In other words, every dollar is twice as valuable as it was just a few months ago. If debt values have not imploded and all their face values are valid, then all the outstanding IOUs are twice as valuable as they were two years ago! Do you believe this to be true? If it is true, then the $50t. of dollar-denominated debt now has $100t. worth of purchasing power in terms of 2005-2008 prices for investments. But values don’t come for free. There must be something wrong with this picture; and there is: Many of these IOUs have lost value, to the point that they are worth in total just what they were beforehand in terms of property, commodities and shares of stock. In other words, overall, they have lost half their dollar value, just as stocks and property have. Evidence of this fact is in the inability of some IOU-holders to sell their holdings at face value. Investors are too skittish to trust their value, and for good reason.

Unfortunately, no one knows exactly which IOUs are worth less or by how much. The Treasury and the Fed have been giving privileged holders of ruined debt stunning, unearned boons. On the backs of current savers and future taxpayers, they have, for example, bailed out European banks that held AIG’s debt-insurance contracts as well as domestic and foreign investors, including the Chinese government, who held debt backed by Fannie Mae and Freddie Mac’s overvalued mortgages. Political rules constantly change, so no one today can be sure whose IOUs the authorities will protect next. Thus, although the value of outstanding dollar-denominated IOUs has fallen by half, no one is quite sure which debtors and creditors in fact are going to be held responsible for the damage. There is no free market to tell us. Investors are hoping and praying that the IOUs they own will be made good. Hoping and praying is not a good investment strategy, but in cases where there is no market for your holdings, it is all the strategy you have left.

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Get on board now for the next Theorist. Bob Prechter puts out his Elliott Wave Theorist once a month, mid-month. The September issue is scheduled to publish this week. To get his economic, financial and market insights, sign up now to subscribe to the Theorist here.

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