Saturday, March 7, 2009

What's Going Down

There's something happening here
What it is ain't exactly clear. . .

Paranoia strikes deep
Into your life it will creep. .

Stop, hey, what's that sound
Everybody look what's going down.

-Buffalo Springfield, "For What It's Worth", 1967

What's been going down is the stock market, even more than the economy. Why? Among the greatest investors of all time was Warren Buffett's mentor at Columbia, Benjamin Graham, who observed about the stock market that:

"In the short run it’s a voting machine, but in the long run it’s a weighing machine."

So here's the analysis of the only three asset classes of interest to Econblog Review (EBR) in this time of crisis: the general stock market, Treasury securities, and gold. As gold is a proxy for the anti-dollar, foreign currencies may be discussed in this context.

The general belief at EBR is that many chickens have come home to roost, but that financial asset prices are "sticky" and do not yet reflect the equilibrium scenario, which smells like a lot of chicken poop.


Here is a long-term chart of the stock market as judged by its most familiar measuring-stick, the Dow Jones Industrial Average. (Click on it to enlarge.)

Even unadjusted for inflation, it is clear that the 2002 low has been broken. Worse, the velocity of the descent exceeds that of the 2000-2002/3 bear market and equals that of the Great Crash of 1929-32 in velocity. Indeed, 17 months from the stock peak, this downturn at least equals that of the Great Depression. Adjusted for significant deflation then and some inflation in our time, there is no doubt that the current crash is worse than then, again at the 17-month mark.

The only other parts of the chart that look similar are the 1970 and 1974 lows. Adjusted for inflation, each of those market bottoms was followed by lower lows, especially after the 1980 and then the 1981-2 recession.

So whether this is more like 1931 or 1973/4, even if we are at or near an intermediate-term stock market bottom, history suggests the strong possibility of a better buying opportunity later.

Now, let us examine the stock market as a long-term store of value. From

The horrifying point here is that the inflation-adjusted Dow has only just now reverted to the previous all-time highs, in 1929 (!) and1966.

Given the disastrous performance of such metrics as corporate dividend cuts, consumer confidence, global economic performance, massively high debt levels in society as a whole, in other worlds a sea of troubles, that the Dow is only now at a record valuation except for the past 15 or so years is a warning sign. Dow 2000-4000 is a real possibility.

Note: The Short web site has several interesting charts.

Who could imagine
That they would freak out in the suburbs!
(No no no no no no no no no no
Man you guys are really safe
Everything's cool) . . .

And they thought it couldn't happen here
(duh duh duh)
They knew it couldn't happen here
They were so sure it couldn't happen here
But . . .

Frank Zappa, "It Can't Happen Here"

No, we guys were not really safe re the economy or stock prices, and yes, a long-term period of poor stock market returns can happen here, even starting from today's valuations. Japan's stock market halved from its market peak of 39,000 in 1989. It is way down from that half-the-peak, to little over 7000, twenty years after the peak. Look at the inflation-adjusted Dow in 1932-3. It was below the 1921 bottom, which itself was far below the 1900 level.

Looked at another way, if the Dow was at 900 in 1979, then in the subsequent 30 years it has return 6.8% yearly at its current price. Adding in dividends gives about a 10% yearly return.

What if the Dow were now at 3000? We would still be looking at a 7+% compounded annual return.

The S&P 500 yields about 3.2%. At major market bottoms, yields have been in 6-7+% range.
Given poor current prospects for dividends, and given a very high stock price:tangible book ratio, there is no fundamental reason to expect this to be a stock market bottom.

In other words, while the stock market will gyrate, given the obvious technical breakdown of the stock market, the poor current and short-term outlook for the economy, the weak state of the major financial institutions, the lack of fiscal discipline out of the Federal Government, etc., the stock market is riskier than it was a year ago. If the stock market were a stock, it would be a stock to avoid or to short-sell on moves upward.


Gold remains in a structural bull market. Its nominal price remains above its 19790-80 bull market high, which is a positive sign. However, most commodities are in major bear markets. The Economic Cycle Research Institute's Future Inflation Gauge fell again in February to the lowest level since 1958.

Following the 1958 recession, the U.S. experience several years of stable prices until the Viet Nam War and Great Society programs led to a ramp-up of inflation and began the structural bear market that began in 1966 and bottomed in 1982. During that time gold rose about 20 times in price.

To this observer, the chart of gold is worrisome. It continues to give a negative year-on-year return, has become popular beyond sophisticated investors, and simply is not a currency. Thus, it is speculative in an ultimate disaster case, and perhaps is best considered as a necessity to have physically on hand or in a secure, accessible location in a foreign country in case of breakdown of the world's monetary system. However, so much deficit spending is proposed by the Obama administration, along with frank monetization of debt out of the U.K., that the case for potential significant inflation has strengthened. A much higher gold price to keep pace with inflation and perhaps to reflate global economies is very possible.

Hedges against the dollar can be considered by buying the depressed securities, BZF and ICN, which are interest-bearing investments in the currencies of Brazil and India relative to the U.S. dollar. Both countries avoided toxic derivatives, have large home markets, are not mature enough for their people to have fallen prey to the Merchants of Debt, are not involved in any wars, and have democratic governments that from this observer's perspective in Florida appear to be more prudent than our Federal Government. However, the charts on each of these securities is weak, with ICN's better and currently our favorite.


Here is a real conundrum. A 5-year T-note at a 2% per annum yield gives a positive and significant return against current deflation, where almost everything for which prices vary is on sale; however, there is now a 1% per annum default risk premium on U.S. Government securities, so that the "real" nominal yield is only 1% per year.

A tentative suggestion is to buy no new Treasuries longer-term than 2 years other than for quick trades and to consider selling on strength. Given the real possibility of renewed panic a la last fall, a re-test of the December lows in yield (highs in price) of Treasuries of all durations is possible.

Treasury-equivalents such as Ginnie Mae securities, whether purchased individually or through the Vanguard or Fidelity mutual fund families, may well be superior to straight Treasuries at this time, though investors need to understand the general principles of mortgage-backed securities before investing in them.


The fundamentals of capitalist principles are strong, but the fundamentals of the economy are weak and weakening. The technical structure of the stock market is poor. There are numerous stock market metrics that are nowhere near trough historical valuations.

There really is nothing new under the sun.

If you began with the equivalent of one dollar the year Jesus was born in Nazareth and looked for 1.5% interest compounded annually, you would now own all the world's current financial worth, approaching 100 trillion dollars. Thus there is no reason to assume that any particular rate of return should occur, or should even be positive in nominal terms, much less in today's situation where debt defaults by previously apparently credit-worthy borrowers are happening and are likely to accelerate.

In plain language, the needs of the many to eat, be clothed and be housed will trump the desires of those owning that theoretical construct called capital are going to win out during hard times.

Common stocks are far riskier than are cash or bonds. Given how much our current situation resembles that of the early 1930s and Japan post-bubble, maximum caution is strongly advised.

Copyright (C) Long Lake LLC 2009

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