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On May 8, 2009, the Dow Jones Industrials closed at 8,574.65. That was 31.0% above its closing low of 6,547.05 set on March 9. With stocks having risen so strongly in such a short period of time, notions that a pullback could be warranted assuming that the market got ahead of actual economic developments was reasonable. However, one market analyst used the occasion of the stock market’s steep rise to proclaim an apocalyptic message that stocks faced a ‘deflationary collapse.’
Historic experience has shown that markets often swing to excess. Frequently, market prices diverge from underlying fundamental factors such as profits and expected profit growth, as psychology breeds self-reinforcing processes that have little connection to fundamentals. Not unlike severe market swings, market pundits can also go to excess in their predictions. More than likely, the bold call made by technical analyst Robert Prechter will wind up far off the mark.
On May 14, Prechter stated that stocks could plunge to half their lows of March 9. He dismissed the recent rally and told CNBC, “Our models are (showing) right now that it is a much bigger bear market than most people realize, something along the lines of 1929-1932.” He added, “Deflation is coming, it’s going to lead to a depression.” In other words, one could take the price path of the Dow Jones Industrials from its September 3, 1929 high of 386.10 and plot its progress through the Great Depression and voila: A destructive collapse in value began in late September 1930 that culminated with the Dow’s falling to 41.89 on July 9, 1932.
Nonetheless, there is good reason to put aside the gospel of fear. In his seminal work, The (mis)Behavior of Markets, Benoit Mandelbrot observed, “Pictures can deceive as well as instruct. The brain highlights what it imagines as patterns... Human nature yearns to see order and hierarchy in the world. It will invent it where it cannot find it.” Consistent with Mandelbrot’s findings, a recent study published by Bloomberg.com revealed that technical analysis has done a poor job in predicting the market’s future. On May 4, Bloomberg.com revealed, “Of the eight strategies, stochastics, Bollinger bands, relative strength, commodity channels, parabolic systems and the Williams %R indicator generated buy and sell signals that resulted in losses between the S&P 500’s peak of 1,565.15 on Oct. 9, 2007, and its March 9 trough, the data show. They did worse as the index then rallied 30 percent through last week.”
If one examines the larger macroeconomic factors, one finds some important differences from the Great Depression:
• The U.S. is not locked into a gold standard that precludes an expansionary monetary policy.
• In response to a collapse in the money multiplier, the Federal Reserve has expanded the monetary base even more dramatically than the velocity of money has slowed. Hence, the money supply has actually risen unlike during the Great Depression.
• The federal government is engaged in a record fiscal expansion that will likely produce several years of annual budget deficits in excess of $1 trillion.
To be sure, there remain substantial risks. There remains a real possibility of fresh shocks from overseas e.g., Eastern Europe’s troubled financial system, a continuing fall in trade, the failure of a major U.S. financial institution, a suppression of consumer spending on account of rising unemployment, and a possible currency crisis down the road should the Federal Reserve fail to tighten sufficiently quickly once a sustainable—not any—recovery is underway or foreign capital flows to the U.S. government diminish on account of the nation’s rising debt. But for now, those are only risks. At the same time, there has been some indication that some economic sectors are beginning to stabilize. The rate of economic contraction is slowing. Nevertheless, it remains to be seen whether those hints of stabilization are a false dawn.
Finally, even as a stock market collapse along the lines of what Mr. Prechter suggests is likely does not occur, there is a strong possibility that U.S. stocks could face a “lost decade.” In such a situation, sluggish economic growth, an uncertain fiscal outlook, pressure on the U.S. dollar, and risk of inflation could tend to lock stock prices in a range below their October 2007 peak through at least October 2017 or longer.
There have been two occasions in which the Dow Jones Industrials failed to reach its pre-recession level for 10 years or longer. Those seminal economic events were the Panic of 1907 that produced a credit crunch and severe recession in which real GDP fell 10.8% and the Great Depression in which real GDP contracted by 26.5% in the 1929-33 timeframe. In addition, following the collapse of Japan’s twin stock market and real estate bubbles, its Nikkei 225 Index has remained well below its peak close of December 1989 for more than 19 years.
The last recession to come close to producing a “lost decade” for stocks was the 1973-75 recession. Then, it took 9 years and almost 10 months for the Dow to return to its pre-recession peak. Given that the current recession is already steeper than the 1973-75 recession (a real 3.3% decline in GDP vs. the 3.1% decline that took place during the earlier recession) and the damage that has occurred to the nation’s financial system in the wake of the housing bubble that burst beginning in Summer 2007, a “lost decade” remains a plausible scenario. Should such a scenario play out, it would have a profound adverse impact on private retirement saving and investing at a time when the nation's Social Security program is coming under increasing pressure due to a mismatch between cash inflows and outflows brought on by its pay-as-you-go framework in the face of ongoing demographic change.
Historic experience has shown that markets often swing to excess. Frequently, market prices diverge from underlying fundamental factors such as profits and expected profit growth, as psychology breeds self-reinforcing processes that have little connection to fundamentals. Not unlike severe market swings, market pundits can also go to excess in their predictions. More than likely, the bold call made by technical analyst Robert Prechter will wind up far off the mark.
On May 14, Prechter stated that stocks could plunge to half their lows of March 9. He dismissed the recent rally and told CNBC, “Our models are (showing) right now that it is a much bigger bear market than most people realize, something along the lines of 1929-1932.” He added, “Deflation is coming, it’s going to lead to a depression.” In other words, one could take the price path of the Dow Jones Industrials from its September 3, 1929 high of 386.10 and plot its progress through the Great Depression and voila: A destructive collapse in value began in late September 1930 that culminated with the Dow’s falling to 41.89 on July 9, 1932.
Nonetheless, there is good reason to put aside the gospel of fear. In his seminal work, The (mis)Behavior of Markets, Benoit Mandelbrot observed, “Pictures can deceive as well as instruct. The brain highlights what it imagines as patterns... Human nature yearns to see order and hierarchy in the world. It will invent it where it cannot find it.” Consistent with Mandelbrot’s findings, a recent study published by Bloomberg.com revealed that technical analysis has done a poor job in predicting the market’s future. On May 4, Bloomberg.com revealed, “Of the eight strategies, stochastics, Bollinger bands, relative strength, commodity channels, parabolic systems and the Williams %R indicator generated buy and sell signals that resulted in losses between the S&P 500’s peak of 1,565.15 on Oct. 9, 2007, and its March 9 trough, the data show. They did worse as the index then rallied 30 percent through last week.”
If one examines the larger macroeconomic factors, one finds some important differences from the Great Depression:
• The U.S. is not locked into a gold standard that precludes an expansionary monetary policy.
• In response to a collapse in the money multiplier, the Federal Reserve has expanded the monetary base even more dramatically than the velocity of money has slowed. Hence, the money supply has actually risen unlike during the Great Depression.
• The federal government is engaged in a record fiscal expansion that will likely produce several years of annual budget deficits in excess of $1 trillion.
To be sure, there remain substantial risks. There remains a real possibility of fresh shocks from overseas e.g., Eastern Europe’s troubled financial system, a continuing fall in trade, the failure of a major U.S. financial institution, a suppression of consumer spending on account of rising unemployment, and a possible currency crisis down the road should the Federal Reserve fail to tighten sufficiently quickly once a sustainable—not any—recovery is underway or foreign capital flows to the U.S. government diminish on account of the nation’s rising debt. But for now, those are only risks. At the same time, there has been some indication that some economic sectors are beginning to stabilize. The rate of economic contraction is slowing. Nevertheless, it remains to be seen whether those hints of stabilization are a false dawn.
Finally, even as a stock market collapse along the lines of what Mr. Prechter suggests is likely does not occur, there is a strong possibility that U.S. stocks could face a “lost decade.” In such a situation, sluggish economic growth, an uncertain fiscal outlook, pressure on the U.S. dollar, and risk of inflation could tend to lock stock prices in a range below their October 2007 peak through at least October 2017 or longer.
There have been two occasions in which the Dow Jones Industrials failed to reach its pre-recession level for 10 years or longer. Those seminal economic events were the Panic of 1907 that produced a credit crunch and severe recession in which real GDP fell 10.8% and the Great Depression in which real GDP contracted by 26.5% in the 1929-33 timeframe. In addition, following the collapse of Japan’s twin stock market and real estate bubbles, its Nikkei 225 Index has remained well below its peak close of December 1989 for more than 19 years.
The last recession to come close to producing a “lost decade” for stocks was the 1973-75 recession. Then, it took 9 years and almost 10 months for the Dow to return to its pre-recession peak. Given that the current recession is already steeper than the 1973-75 recession (a real 3.3% decline in GDP vs. the 3.1% decline that took place during the earlier recession) and the damage that has occurred to the nation’s financial system in the wake of the housing bubble that burst beginning in Summer 2007, a “lost decade” remains a plausible scenario. Should such a scenario play out, it would have a profound adverse impact on private retirement saving and investing at a time when the nation's Social Security program is coming under increasing pressure due to a mismatch between cash inflows and outflows brought on by its pay-as-you-go framework in the face of ongoing demographic change.
