What Will Cause The Next Big Market Drop?

Quick – what was the second-worst U.S. stock market drop since the 1930s? What caused it? It wasn’t the pricking of the tech bubble in the early 2000s. It was the bursting of the oil bubble in 1973. Fossil fuels have been the life blood of economic growth for the entire time that economies have been growing – almost 200 years – and they have been responsible for many of their ups and downs.

Q3 hedge fund letters, conference, scoops etc

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Could the bursting of an oil bubble devastate the economy again?

After the Organization of Arab Petroleum Exporting Countries (OPEC) imposed an embargo on the export of oil to countries that supported Israel during the Yom Kippur War in 1973, oil prices shot up by a factor of four. This caused the U.S. stock market to decline more than 45% over the 21 months from January 1973 to September 1974.

Before the oil bubble burst in 1973, the U.S. had become used to cheap oil. Sales of automobiles were booming. Cars used gasoline extremely inefficiently, as if oil were as cheap as water. The fourfold increase in the price of oil, followed by another threefold increase in 1979-80, wreaked enduring havoc on the U.S. economy – particularly its automobile manufacturing and related sectors – initiating the rust-belt phenomenon that has continued to eat away at the U.S. economy and psyche to the present day.

U.S. automobile manufacturing failed to respond in an agile manner to the increase in oil prices. It assumed – as an expensive marketing study performed for General Motors concluded at the time – that “the American male will never give up his big car.” As a result, more fuel-efficient – and more reliable – small Japanese cars made inroads into the U.S. market and now dominate it. Meanwhile, GM and Chrysler received a bailout, approved by President Bush in 2008, that – according to Time magazine – cost U.S. taxpayers $11.2 billion.

The 1970s oil bust had, arguably, even more far-reaching negative economic consequences in the U.S. than the Global Financial Crisis of 2007-2009, and certainly more than the consequences of the tech bubble and bust of the late 1990s and early 2000s, which may even have been positive. It drove a decade of high inflation, ending with interest rates nearing 20%. It prompted President Carter to deliver a pessimistic speech in July, 1979, often referred to as the “malaise” speech. Carter’s pessimism gave way to the election of an optimistic President Reagan, who promised an exhausted electorate “It’s morning in America!”

But the long-lasting effects had not ended – far from it.

Bethany McLean’s warning

Bethany McLean has a good record of analysis of financial problems. She was one of the first to point to Enron’s shaky financial situation in a 2001 article in Fortune magazine. She later co-authored with Peter Elkind The Smartest Guys in the Room, a book about the Enron debacle that was made into a popular movie of the same name. One of the best books about the financial crisis, All the Devils Are Here, published in 2010, was co-authored by McLean and Joe Nocera, at the time a New York Times columnist.

Last month, on September 1, Bethany McLean published an opinion piece in The New York Times titled “The Next Financial Crisis Lurks Underground.” In that article, McLean argued that the oil and gas fracking boom that has produced such huge quantities of those fuels in the U.S. in the last few years is on shaky financial ground.

McLean’s article was so startling that I read not only her new book, Saudi America: The Truth About Fracking and How It’s Changing the World, but also another, more in-depth history of the fracking industry by Gregory Zuckerman, The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters. (Unfortunately, the latter book’s account ends in 2014.)

The fracking industry, McLean argues, uses Enron-like financial shenanigans to produce the appearance of profits. “The attitude is invest-and-flip,” she says, “not buy-and-hold.”

“I view it as a greater fool business model,” one private equity executive told McLean, “But it’s one that has worked for a long time.”

Read the full article here by Michael Edesess, Advisor Perspectives


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