In this post, we'll take a look at the Ka-Poom Theory, a framework for investing in "bubble" economies -- economies driven by the creation of asset bubbles.

Ka-Poom Theory: What It Is

Ka-Poom Theory is a theory that postulates how the asset bubble cycle works -- meaning how bubbles are created, destroyed, and reborn. It was developed by Eric Janszen, former venture capitalist who now writes commentary at iTulip.com.

Ka-Poom Theory offers the following framework for understanding bubble cycles:

1. The Bubble is created. Ka-Poom Theory posits that the creation of the bubble is a result of interest rates being kept too low by the central bank. This is the same conclusion reached by the Austrian Business Cycle Theory.

2. Also like Austrian Business Cycle Theory, Ka-Poom Theory expects the bubble to begin deflating at some point. In addition, though, Ka-Poom Theory expects a "black swan event" -- an unpredictable, external, outlier event that has a monumental impact and, in the context of Ka-Poom Theory, a deflationary effect. It does not, however, cause a deflationary spiral. Thus, Ka-Poom Theory refers to this state as disinflation.

3. The central bank will respond to disinflation with inflationary policies that will take approximately 12 months to impact the markets. The period of disinflation will be erratic.

4. The black swan event is the "ka" of the Ka-Poom Theory. The "Poom" is the subsequent re-inflation of the money supply. Deficit spending and inflationary policies initiated by the Fed dictate to what sector the re-inflation of the central bank will go.

Ka-Poom Theory posits this is what has been happening in the US economy since the dot com bubble, and thus is the current framework for understanding thus US economy.

Assumptions of Ka-Poom Theory

The most critical assumption the Ka-Poom Theory makes is that the central bank has the power to inflate the market at will, invariably. In other words, Ka-Poom Theory is based on the premise that if the Federal Reserve wants to inflate and create higher prices, it can -- by printing money, buying up assets, working through the credit market, or inducing foreigners to sell Treasury bonds and dollar holdings. It also assumes that the results of the central bank's actions are not instantaneous; the gap between their policy enactment and the corresponding re-inflation of asset prices is a period referred to as disinflation.

Because of this assumption, Ka-Poom Theory is essentially a framework for understanding how a planned economy works.

Implications of Ka-Poom Theory for Traders and Investors

To the extent that Ka-Poom Theory is valid, a few deductions can be made for traders and investors:

1. The period of disinflation -- what Ka-Poom Theory argues we are in now, which is characterized as the period between the Federal Reserve's policy enactment and the corresponding effects -- is deemed to be erratic. Janszen prefers to stay out of the market during these times.

2. In a debt-based bubble, the long-term bond market will likely be where the arbitrage opportunity is, in the sense that bond prices will fall as the market begins to re-inflate.

3. In order to understand what sectors will be set to inflate -- where the next bubble will be found -- Ka-Poom Theory looks at government spending to lead the way.