THE BEAR'S LAIR Armageddon - or a bumpy landing?
By Martin Hutchinson
How you view the stock market crash of last week depends on your understanding
of the past 13 years. If you thought the Dow Jones Industrial Index at 14,000
reflected real values, you doubtless think the crash is an appalling event,
leading to a depression of 1930s dimensions. If like me you believed the
progress of the Dow from 1995 on was part of an enormous and destabilizing
monetary bubble, you are relieved and thankful that it is finally drifting back
to terra firma, even if the landing is a bumpy one.
In the early part of 1995, the Dow Jones Industrial Index was trading just
below 4,000. The US economy was in its fourth year
of recovery from the 1990-91 recession and inflation was low. A mild tightening
by the US Federal Reserve had raised bond yields more than 1% and bankrupted a
number of foolish derivatives speculators, including Orange County, California.
On February 23, then Fed chairman Alan Greenspan appeared before Congress in
his biannual Humphrey-Hawkins testimony and announced that he had finished
raising short-term rates; his next move would be towards easing.
What he didn't tell Congress was that the policy of easier money would be in
force for the next 13 years, during which time MZM, the St Louis Fed's Money of
Zero Maturity, which can be used as a proxy for the more generally followed M3
(discontinued by the Fed in 2006), would rise by 8.8% annually compared with a
5.1% annual rise in nominal gross domestic product. Normally, a rapid and
continued rise in money supply would result in inflation. In this case, it
coincided with the effects of the Internet in permitting cheaper international
outsourcing, so resulted only in asset price inflation. The stock market took
off into the stratosphere in late February 1995 and has never looked back.
In the very long run, the price of stocks should move approximately in line
with the rise in nominal GDP. If stock prices move far out of line with nominal
GDP, the ratio of stock prices to GDP increases to a level at which the stock
market is clearly overvalued, and eventually it corrects itself. In early 1995,
the stock market was if anything rather high; it was 40% above the 1987 peak
that had seemed at the time an unsustainable bubble and had led to a famous
one-day crash. Thus, inflating February 1995's Dow Jones Industrial Index of
just under 4,000 by the 95% increase in nominal GDP since 1995 gives a current
"rather high" stock price guideline of Dow 7,800.
The stock market has never traded at its 1995 value, inflated by nominal GDP,
from that day to this. It got down to 7,800 briefly in early 2003, but at that
time the early-1995 inflated value was only around 6,000. Thus stock prices
have been consistently overvalued for the past 13 years. The drop in the past
few months has not been a sink into depression that would rival the 1930s
disaster, but the end of a perilous high-altitude balloon ride, taking in
several thunderstorms, that is now returning to Earth. The collapse in stock
prices last week suggests it will make a bumpy landing, but on the plus side,
once the Dow gets down to 7,800 it will again be decent value.
Most important, the long-term value of real returns on holdings of US common
stocks will reassert itself; if you buy a broad portfolio of stocks at Dow
7,800 and hold it for a decade or more, it will on average return you around 8%
or so in real terms. That comforting equation is definitely untrue for those
deluded optimists who brought stocks at around the twin peaks of 2000 or 2007;
they may well not see a positive real return on their money on a consistent
basis until well into the 2020s or even the 2030s.
That 7,800 mark is a reasonable estimate for a "midpoint" of where stock prices
should be. To see where a "low" might take us, we should perform the same
exercise for the growth in nominal GDP since the Dow's low of 776 in mid-1982.
Since that date, nominal GDP has risen by 340%, so an equivalent of the 1982
stock price low would be 3,421 on the Dow. That gives a very pessimistic
outlook for the future Dow trend from a current level that is still well over
You can cheer yourself up by performing the same calculation on the 1932 Dow
low of 41.22, which gives a potential bear market low of no less than Dow
10,032. You should however remember that the Dow's 30 stocks represented a far
greater portion of the economy in the heavy-industry-oriented business world of
1932 than they do today. The New Deal itself was pretty destructive of stock
market values; as late as 1949 the Dow at 167 was equivalent to only 8,924
today, below its 1932 low when adjusted for the intervening growth in the US
economy. Apart from reminding us that the 1982 low was well below that of 1932
in real terms, that should caution us against taking these calculations too
seriously. Nevertheless, it suggests that if the Dow gets down to 5,000 in this
bear market, it should bounce well back up again thereafter, and not stay down
at that unpleasant level. For holders of US stocks, that should be reassuring.
The implications of stocks finally returning to some reasonable long-term value
are highly positive, so much so that it may be difficult for this column to
remain appropriately bearish. For investors, dividends will now be a
substantial part of their return, so they will no longer be prepared to allow
management to goose stock prices artificially by a combination of huge stock
option grants and buybacks. For the economy, projects will get financed based
on a true cost of equity capital, not on an artificially low equity cost. For
those saving for retirement, returns will be both higher and more assured,
reducing the risk of suddenly finding themselves on the point of retirement
with a devastated portfolio and no way to replenish it.
For the United States as a trading economy, equity costs worldwide will
increase, and it will no longer be possible to finance major investment
projects in low-wage economies on the basis of 20 or even 30 times earnings.
Consequently, the true costs of outsourcing will be clear, including the
additional cost of capital from investing abroad. The result will be more jobs
remaining in the United States, as lower US capital costs offset higher US
There are however three problems. First, there is a legacy from the decade of
overvaluation. Just as the housing bubble left many people worse off than they
should have been, by trapping them in a house they could not afford bought at
the top of the market, so the equity bubble has sucked many retirement savers
into believing that they would have enough funds for retirement, when in fact
their savings had been inadequate.
In terms of public policy, this is particularly a problem for money purchase
pension funds, which were around 97% funded in aggregate at the end of last
year, and must now have a funding gap of 20% or more. This will result in more
corporate bankruptcies throwing pension funds on the Pension Benefit Guaranty
Corporation, and bankruptcy of the PBGC itself, requiring yet another bailout
by the hard-pressed taxpayer.
Second, there is the damage done by the sharpness of the fall itself - more
than 20% in under two weeks. This is particularly a problem for market
professionals, who will have believed themselves hedged using the "Value at
Risk" system or one of the other discredited Wall Street hedging metrics. In
reality, risk management as practiced on Wall Street is wholly incapable of
dealing with such sharp movements, which occur not "once in a million years"
but about every two decades or so. There will be further bankruptcies.
Finally, and most insidiously, there is the bad public policy that governments
feel entitled to inflict on us whenever market crashes occur. The idea that no
bank should be allowed to fail is pure moonshine (though by all means, small
depositors, but not large ones should be protected). The idea that US$700
billion should be diverted from productive use into propping up the price of
detritus from the last bubble, at prices above those prevailing in the market
if Federal Reserve chairman Ben Bernanke were to have his way, is utterly
disgraceful. It demonstrates that neither President George W Bush himself, nor
Treasury Secretary Hank Paulson (who was conflicted owing to his Goldman ties
and should have recused himself) nor Bernanke are fit to be left in charge of a
Neither presidential candidate has covered himself in glory during this crisis.
Democrat Barack Obama has been as vague as possible, leaving cynics like myself
worried that he really does intend to appoint ex-Weatherman William Ayres as
Treasury secretary, while Republican John McCain has expressed himself mainly
by senile rantings against Wall Street, together with a proposal to pour yet
more public money down the rathole of dead investments.
Thus we are left with the danger that the crash on Wall Street, caused largely
by government's incompetent meddling with the nation's money supply, will
result in still more socialist restrictions on the free market together with
gigantic subsidies to politically connected crooks. Should this happen, the
market decline will truly turn out to have been the first phase of Great
Overall, however, one can remain optimistic that Obama, the likely winner in
November, will turn out to be an intelligent and reasonably sensible moderate.
Thus in a week when the whole world has turned bearish, not to say frightened
out of its wits, it behooves this column to take a more rational approach. The
stock market has finally come to its senses, and with the above political
caveat the US economy will be the better for it.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)