Saturday, February 21, 2009

Dow at 7,365. Next Stop 6,000?

South of 7,500

At the end of another particularly brutal financial week, the Dow Jones Industrial Average closed at 7,365.67.

Last year on 20 Feb 2008, it was at 12,427.26. It peaked during 2007 at just over 14,000.

The U.S. stock market is looking to halve itself from its high water mark in less than two years. Is the worst of it over? Maybe not yet.
The market runs on hope. If there is none to go around, it will keep on dropping.
Douglas MacIntyre,

We are about to enter the land of “how low can you go?”

Next Stop: 6,000?

The drop to 6,000, if it happens, was not unpredicted. Mike Whitney made the prediction back on 24 July 2008, in the blog Dandelion Salad, when the market was still at 11,349. He was not alone. Ian Welsh also picked out 6,000 for a market bottom back in October 2008 in the blog FireDogLake, based on a bear market valuation of 7 times Price to Earnings (PE) ratio. However, what if the earnings of our major corporations dwindles even faster than the market re-evaluation? CNBC featured Ron Ianieri on 19 November 2008 talking about a “triple bottom” and how the Dow was about to go through such a market bottom at the time, and said that the market would head downwards to 6,500. He also raised the spectre of the U.S. dollar falling from a AAA credit rating. Also on 21 November 2008, Bespoke Investment Group surveyed their readers and produced a consensus that said that the Dow at 6,000 was the most likely target for a market low during 2009. While its sampling of 675 readers is an unscientific survey, it indicates a popular consensus: the Dow is going to get hammered in 2009.

I’ll Take Global Financial Crisis for 5,000…

Yet would that be the bottom? Other predictions have the Dow down to 5,000, such as that by equity strategist Peter Boockvar, as reported by Bloomberg back on 23 October 2008. Michael E. Lewitt of Hegemony Capital also raised the spectre of Dow at 5,000 on 13 November 2008. Yet such predictions seemed to be made only by the fringe. Also, the advice of Mr. Lewitt of Hegemony Capital was that the “greatest opportunity is in the segment of the leveraged bank loan market limited to large capitalization borrowers with the capability of amortizing their senior debt over the next few years.” Leveraged bank loans? As the greatest opportunity for today’s investors? Thus, some predictions can be written off as self-serving or producing spurious conclusions based on the evidence and logical sequence of the prior arguments.

Sheepish New World

Of all the bears, Bill Gross probably did the best at outlining why the Dow is headed south. Back in December, he outlined four fundamental reasons the economy cannot go back the way it was. But paramount to it was this observation:
We will not go back to what we have known and gotten used to... We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come...
— Bill Gross, PIMCO
Bill and other bears have been wrong in the past. He had predicted the Dow to drop from 8,500 down to 5,000 six years ago, and instead, it peaked at over 14,000. The problem with prognostication is that by studying the market, we affect the market. By getting people to observe what is going on, sentiments change: consumer confidence or fear arises, corporate risk taking or conservativism sets in, and the government may decide to involve itself or wash its hands of entire industries.

The global market is complex. It cannot be summed up simply by the Dow Jones Industrial Average as if that was the pulse of the planet. Yet it is a key indicator of the health of the global economy.

“For, just as a lake is, at times, stirred to its very depths by a storm, so also the market is sometimes thrown into violent confusion by crises, which are sudden and general disturbances of equilibrium.”

— L. Walras, Elements of Pure Economics 1874: p.381
What is occurring is a stochastic shock to the economy. All equilibrium theories are upset. Instead, it is the time of rapid changes. If a stable prosperous economic equilibrium is bedrock, we are currently on the liquified loam of an economic 8.0 earthquake.

How are people reacting? Much depends on the information made available to them. There is a need to not panic people needlessly. Yet there are also fortunes being made, or lost, depending on whether consumers are informed of the present status of their investments. Each day, we are hearing about companies which we used to shop at just last year, or last week, which are now shuttering or scaling back dramatically. The Madoff scandal and banking failures show that the lack of information to the individual consumer can cost them their entire investment principal and savings.

In such times, there are theories to predict how people will behave. You can read about equilibrium with state-contingent markets, and many other economic social theories. Yet as the variables become more and more unstable, it will be increasingly hard—not impossible, but difficult—to predict behavior of individuals and groups with reasonable certainties. Polls that might have stood for the opinions of well-defined groups for years might rapidly shift within a single year. The most predictable thing to predict at this point is uncertainty.

This is History Calling. No, It is Not 1929 or 1931.

2009 will be unlike any other year in history. No other crisis ever before faced by humankind had 6.7 billion people to bear the cost, or shoulder the weight. No other crisis ever before in the history of the world had such technological capability, or such energy, educational, health and food requirements.

Expect that something unexpected will emerge from this global situation. Terrible outcomes. Yet also truly wonderful possibilities. For all of the dour possibilities of the Dow heading to 6,000 or as low as 5,000, some new, more sustainable, fundamentally sound basis of the global economy may emerge.

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