Did you hear it last week? I mean the Giant Popping Sound of the largest financial mania in history as it continues to deflate, ripping through stocks and markets across the globe. Most investors, if they heard it at all, didn't hear it for what it truly is. The gloomy weekend news reports focused on the sudden sentiment change on Wall Street, the terrible market losses -- the worst in 2 years - and increasing investor nervousness about a looming economic slowdown. But few reports put it into a larger perspective. The Giant Popping Sound last week was actually just another step along the way in the ongoing, seismic readjustment that it taking place in the global social, economic and political order. Peter Drucker describes it quite bluntly in the introduction to his book, "Post-Capitalist Society:"

Every few hundred years in Western Civilization, there occurs a sharp transformation... Within a few short decades, society rearranges itself - its worldview; its basic values; its social and political structure; its arts; its key institutions. Fifty years later, there is a new world, and the people born can't even imagine the world in which their grandparents live and into which their own parents were born.

We are currently living through just such a transformation.

Because we are in the midst of the transformation, it is difficult to have a clear grasp of just what is going on. For revolutionary a change, in some ways things seem to be moving at a glacial pace. In other ways, we sense that time is speeding up, and this is punctuated by events such as 9/11 and market drops like last week's that serve as wakeup calls. Drucker's quote does not address financial markets specifically, is focused on the new role of information and information communication technologies (ICT) that are making the world smaller, smarter and faster. The emergence of a knowledge-based economy is having the effect of rearranging traditional power structures, weakening the strong and strengthening the weak. This is reorganizing every aspect of the global society we live in, right down to the current international financial system, the foundation of the world's current organizational structure. Last week's market decline was one small part of this huge restructuring.

Most people view the subject of global economics as disconnected from their daily lives. Part of the reason is that they believe the global financial system to is too complicated for them to understand, so they don't even attempt it. The herd mentality of humanity then comes into play. The global economy does affect the average person's daily life, but not in an easily recognizable way. But refusing to recognize the connections gives many an erroneous sense of the world and how it works. Instead of having a strategy to deal with the massive changes underway, they simply look to leadership for direction on how to behave, or to their equally clueless peers to gauge what they should do. While this can be a safe and profitable strategy at times, now is not one of those times. Nearly everyone is still looking for past trends to continue in spite of the fact that aggressive new trends are already emerging. Leadership is for the most part resting on the laurels of bygone glory days and relying on its incumbent postition to maintain power.

Buy and Hope
Buy and hold became a useful and profitable stock market strategy in the go-go years of the 1990's, but the very same strategy led to devastating consequences in the very same portfolios in the post-Y2K era of market declines. This underscores the need for a different investment strategy that matches with the kind of market this has become. Y2K marked a fundamental shift in the way the world works, and there is no turning back the clock; the world will never be the same again. The fundamental forces of peace, prosperity and growth that drove the great bull market of the 1990's gave way to war, financial insecurity, overcapacity and contraction in the new century. This shift was not temporary, but rather a breakpoint change that demands a new way of looking at the world, and a new way of thinking about investing and wealth preservation. Unfortunately, most are still using trying to use the old strategies that worked so well in the previous era. In this era, rather than "buy and hold" many investors are still practicing what would more aptly be termed "buy and hope." But no wiser would it be to try to practice the investment strategies of the 1990s today than it would be for a farmer to try to plant his crop in the dead of winter. Both shall meet with failure. Since October 2002, US markets have experienced powerful rallies, lulling investors back into a state of complacency that maybe - just maybe - the good old days of buy and hold are back. Over this period of time, the Dow gained almost 50%, and the Nasdaq doubled, recording a 100% gain for lucky investors. But last week's declines are a wakeup call for anyone still suffering from bull market delusions. This is NOT a buying opportunity. Markets rallied for two and one half years but failed to make new highs, confirming the fact that it was not a new bull market but a countertrend rally. Markets neither go straight up nor straight down, but rather find their true value in stair-step fashion. The latest rally was both the most impressive and the most deceptive to date, due to its sheer length. It fooled millions into thinking that the bull is back, got them to commit their hard earned money on the wings of hope, and will forthwith proceed to demolish and destroy it if left in the market. For investors following the strategy of buy and hope, let the buyer beware. Just as a rising market magically creates wealth from thin air, so too is that same wealth destroyed when the market falls.

The charts above illustrate this point graphically. The yawning price gaps represent billions of dollars in market cap disappearing into thin air, some of it likely from your retirement fund. From the bluest of the blue chips (IBM, GM and Ford) to new economy darlings (Apple, EBAY and Starbucks) the market has shown no mercy in its deflationary powers. Tellingly, not even the recent declines in gold and oil, shown below, have soothed equity markets as deflation spreads across all asset classes. But silently and without much fanfare after its devastating declines, the US dollar is rising again in its own countertrend rally, defying conventional wisdom.

Deflation
By definition, deflation means a decreasing money supply. As the money supply falls less money is available to chase the same amount of goods and services, so prices fall as well. Looked at conversely, dollars are worth more because there are fewer of them. But what causes the money supply to decrease?

The definition of "money" is quite tricky. Investors will often say, "I've got money in the market," meaning that they own stocks. Or they may refer to "money" in their retirement account that is invested in bonds. Or even money at the bank which in truth is sitting in a money market account of short-term debt instruments.

Imagine a patriotic investor who "put his money" into GM stocks and bonds with the conviction that GM is a stalwart blue-chip, immune from failure. He believes that what is good for GM is good for America. You can imagine his utter shock when he discovers, perhaps too late, that his "money" has lost over 70% of its value. (GM is down 73% since its Y2K high.) With the realization that he has less money for his retirement, he will be less willing to spend today. Employees of GM who may soon find themselves unemployed may be forced to sell assets to pay off their own debts. This means they bring to market stocks, bonds, possibly their homes, automobiles, books and cd collections - anything to raise cash. They want to get out of the assets while they still have value. The result of this rush to raise funds is deflation, as sellers undercut one another in order to cash in, leading to a self-reinforcing downward spiral.

Websites such as Craigslist are examples of the new ICT that Drucker speaks of that are not only making the world smaller, but chipping away at its current structure by contributing to deflation. The no-nonsense Craigslist does a thriving, grassroots level classified advertising business in cities across the US and around the world for person-to-person transactions. The service itself is deflationary since its ads are completely free. This is great for users but it is costing the traditional suppliers of classified advertising services -- local newspapers -- tens of millions of dollars in potential advertising revenue. News of its existence has spread like wildfire by word of mouth, meaning the big ad agencies on Madison Avenue also missed out on millions in potential revenue as well. This kind of pressure will cause the traditional providers to change their business models or to perish.

The seeds of deflation have been visible for some time now. Zero down/0% financing schemes for car and house purchases not only lower the initial cost of purchase, but also increase the likelihood that these assets will come to market again at vastly discounted prices as unqualified buyers are forced to liquidate them because they can't keep up with their monthly payments. Mega discounters such as Wal-Mart exploit cheap Chinese products and labor for the ostensible 'benefit' of consumers, but end up putting domestic manufacturers and retailers out of business, causing unemployment. Wal-Mart may create some new jobs, but they are fewer and at lower wages than the jobs they destroy - a deflationary trend. While the housing market is still inflating rapidly and approaching mania status, the seeds of deflation are being sown here as well. For an idea of what this market will look like in 5-10 years, one need only look at the chart pattern drawn out by the Nasdaq over the from 1995-2005. Trees don't grow to the sky.

Preservation is Growth During Periods of Deflation
From our perspective an intermediate top in the market was confirmed with the Giant Popping Sound heard round the world last week. In this environment of falling prices for commodities, assets, and good and services, simply holding onto the measure of value of these items, i.e. cash, is an intelligent investment decision. As prices fall, the value of money increases. This is a simple strategy for the time being. Preservation is growth during periods of deflation.

But just as buy and hold did not work forever, neither will this strategy. The key to consistent investment profits is being flexible and adjusting your strategy for the prevailing times. At the end of the day, all money, including the cash in your wallet, is simply an illusion. Other individuals, banks and businesses accept it because we all share the same collective illusion. As Bernard Lietar points out in his book The Future of Money (Published in the UK, not available in the US - try abebooks.com), you believe it because you know I believe it, making it not a belief, but a belief about a belief. Beliefs may be strong and unshakable, but beliefs about beliefs are much less so. A rumor or a seed of doubt can shatter the illusion effortlessly. At one time we all shared the collective illusion that Enron was the 8th largest company in America, and that the Nasdaq was fairly valued at 5,000. Just as those illusions were shattered, the day will come when the U.S. dollar is sneered at with derision. When that day comes, you will no more want to be a holder of the USD any more than you want to be a holder of GM today.

But that story is for another time.

Popping the Bubble is a Process
Watching the remains of the financial mania unwind over the last several years, I have come to understand that the popping is a process, one which will take many years to unravel and complete. Like old habits, old beliefs die hard. This process is far from over, and some of the most spectacular and destructive declines in the stock market and the housing market are yet to come. Unfortunately, many investors cannot bear to part with securities in which they have a loss. They somehow feel that until they sell, the loss is not real, and as long as they hold the stock there is the opportunity, however remote, to recoup the loss. This is a fallacy. Money is fungible, meaning if you lose it one place, you can make it back somewhere else and the money is exactly the same. Past losers are likely to remain future losers, but other vehicles and opportunities exist where there is still money to be made. These vehicles will be the subject of next week's installment.

They say that no one rings a bell at the market top, but that is not true. This bell has been ringing for the last 5 years for those with the ears to hear it. Unfortunately, the more dangerous the situation becomes, the more the toll of the bell becomes obscured and overpowered by the din and clatter of simply making ends meet. Or perhaps it is just that the siren sound of the false bull market is more powerful. In either case, it is important to note that all financial manias - i.e. bubbles - see a final bottom below their original starting point. Page 80 of Robert Prechter's Conquer the Crash shows charts of the Dutch Tulipomania in the 17th Century, the South Sea Bubble in the 18th Century, and the Great Depression Dow in the 20th Century, which bears this out. According to Prechter, by the time this deflationary process finally comes to an end, the Dow will come to rest below 1000, and gold under $200. This means that we're still less - far less - than half way to the bottom, so there is still time to use your free will to get out, before it is no longer a matter of choice.

As we look to the future, beyond the end of the end, there is something equally important to remember. As the bubble bursts, a void is being created in the lives of the participants (individuals, corporations and nations) that are sharing in this experience. What will rise to fill that void, when it becomes clear that consumption is not a way to sustainable growth and that money for nothing was all along an illusion? The rise of Adolf Hitler came during a similar time in Germany; FDR in the United States (see Rooster year) leading to a terrible clash of values that engulfed the globe in World War II. Should the global financial system collapse once again, what will rise to take its place? How can we be active participants in this transformation rather than simply unknowing actors? This will be explored in future articles.

This is Part I of a three part series examining the opportunities and pitfalls of living through the Great Transition. Part II looks at more immediate, concrete, and aggressive ways to profit from falling prices in the markets. Part III examines the housing bubble and why you should stay away from it. Part IV looks at money in general and the U.S. Dollar specifically, while Part V examines some scenarios for the future. To subscribe to future updates, please click here.

I welcome your comments on this article. Post them below or email me directly.