By Martin Hutchinson
Contributing Editor
Money Morning
Since sinking to a 12-year low of 676.53 on March 9, the Standard and Poor's 500 Index had risen 24% -- the best such short-term rally since 1933. But this isn't 1933 and you shouldn't trust the rally. Happy Days are NOT here again, at least not yet.
The 1933 rally came after a record-breaking decline. Real gross domestic product (GDP) fell by 25% during the Great Depression and the Dow Jones Industrial Index fell by almost 90%.
What is less well known, however, is that valuations remained depressed for well over a decade after 1933. In 1949, when the Dow was selling at a price-to-earnings ratio (P/E) of just 7 times, it was cheaper in terms of earnings, net asset value, and GDP than it had been at its 1932 nadir.
This time around, the S&P 500 index fell 58% from its 2007 peak to its March 9 bottom at the superstitiously significant 666. Of course, 58% is nowhere near as much as 90%. To recover from a 58% drop the stock market must rise by 138%, but it must rise by 1,000% to recover from a 90% drop.
So it is not surprising that in spite of inflation and enormous economic growth, the Dow did not reach its 1929 level until 1954.
The other difference between 2009 and 1933 is that the 2008 stock market peak was both higher and more prolonged than it was in 1929, which was a mere blip by comparison.
Radio Corporation of America - 1929's equivalent of Cisco Systems Inc. (CSCO) or Google Inc. (GOOG) - never got above 28 times earnings in that market, and the Dow spent less than three years within 50% of its peak value of 381.17, only passing 200 in December 1927, and finally falling below that level in August 1930.
In this market, the Dow was above 7,000 - within 50% of its 14,164 peak - continually from May 1997 until February 2009. Because the 2000s market was more overvalued for longer for a longer period of time, it has further to fall, even without a "Great Depression" economically.
The current rally has been based on signs that the U.S. banking system is not about to expire - a development I wrote about in an article entitled "The Top 12 U.S. Banks: From Zombies to Hidden Gems" in late February.
Apart from the very largest banks, which gorged themselves on the most foolish and ill-designed products of the derivatives business, the banking system is suffering from a normal real estate downturn and is coping well with the high levels of loss that downturn has brought. With short-term interest rates well below long-term rates, banks' ongoing lending business is currently exceptionally profitable.
The U.S. economy, as a whole, has stopped falling with ever-increasing velocity and may actually be beginning a lengthy "bottoming out" process. Had politicians avoided meddling with the monetary and fiscal systems of the globe, devoting trillions of dollars to bailouts and stimulus, the bottom we are approaching might well be somewhat deeper, but we could at least be sure that it was indeed the bottom, with recovery to follow.
In Asian countries such as Korea, Taiwan and Singapore, where stimulus has been modest, and in China where it has created only a modest budget deficit, the sharp recession caused by collapsing exports is already coming to an end. (China, however, has a major banking and real estate problem that could still cause trouble down the road.)
But in the United States, we can have no such assurance. Monetary policy, which was far too expansive in 1995-2008, reached expansiveness of extraordinary dimensions after last September's crisis, with the monetary base doubling and broad money expanding at a rate of more than 15%. Fiscal policy has produced record peacetime deficits - deficits that are more than double the previous peacetime record. The Federal budget deficit in 2009 will be double the 2007 balance of payments deficit, which had previously been thought of as a critical and dangerous imbalance.
With imbalances of this size, there can be no assurance that a recessionary bottom will be followed by recovery, quite the opposite. Japan has now suffered near-recessionary conditions for almost two decades with a weak recovery in 2003-07. And that modest recovery is now being followed by a new recession as the Japanese government foolishly resorted to more wasteful public spending and debt.
Fiscal stimulus stimulates nothing in a country where public debt is already 160% of GDP; instead it increases uncertainty and crowds out risk-taking private capital.
The most likely scenario for the United States is a recession, or near-recession, that lasts for a decade with the economy unsuccessfully struggling against the twin problems of surging inflation and a budget deficit that crowds out private capital investment. Either real interest rates will be high to combat inflation or inflation will rage out of control.
In such an environment, the outlook for stocks is bleak. The high stock prices of 1996-2008 have gone, and they will not return. When the excessive monetary expansion began in the spring of 1995, the Dow was at 4,000. That is equivalent to a level of 7,800 today when you inflate it by the increase in nominal GDP since 1995.
However, 1995 was not a bear market low. It was far from it. The market had been rising for four years since its 1990 bottom and was almost 50% above its 1987 peak, just before the "Black Monday" crash.
Thus, even if the economy had the growth prospects of 1995, a level of 7,800 on the Dow would be a reasonable expectation, not for a bear market low but for an equilibrium value. If you then take into account the markedly worse expectations for the U.S. economy resulting from excessive fiscal and monetary stimulus, 7,800 is too high.
Take the 1949 P/E multiple of 7, and apply it to a recovering earnings level of say $60 on the Standard and Poor's 500, and you get an S&P of 420 - equivalent to a Dow of around 4,000.
The market is no longer hugely overvalued with the Dow at 8,000, but any rally will be temporary, and we can expect an eventual low well below the 6,547 the Dow reached last month.
[Editor's Note: When it comes to banking or global economics, there's literally no one better than Money Morning Contributing Editor Martin Hutchinson - a former investment banker with more than a 25 years experience. Hutchinson has proven himself to be a market maven and he is currently offering investors an opportunity to make $4,201 in cash in just 12 days. You can also subscribe to Martin's new investment service, The Permanent Wealth Investor, by clicking here.]
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I am not sure if I have seen more spot on reporting on the economy. I also worried in 1995 when the market took off from high to ridiculous. Everyone started talking about the new economy and the new rules for valuing stocks whose P/E ratios were out of sight. Retirement money was flooding the stock market with the development of new retirement plans with greater options. This era is no different than the 1920s and 30s. Excessive money chasing too few goods ran to dot com companies then to oil companies then to real estate and finally financials where it could be disposed of and lost in the blink of an eye by chasing rampant speculation. You now have a generation that has no clue as to what bad times look like and thinks it can borrow itself into prosperity. It is a guarantee that at best, with democrats growing the government and nationalizing industries, we will follow Japan. The most likely outcome, though, is worse because this country no longer has any national pride to pick itself up and work for the good of our country.
Some pertinent thoughts here, but is this really responsible financial journalism? One's thoughts about the financial health of a company or to avoid a certain investemt is what advisory services are about, but "bailout bombshells" and "bomb shelter for your money" are vivid over-visulizations of disaster. I for one do not see this as 1929; there are many distinctions from those days. Even though I could be wrong, I do not see a Dow at 4000.
So, tell us more about what to buy, what to study, and what to avoid, with a little less drama on the "gloom and doom" possibilities. Of course the possiblity exists, but we didn't get hijacked and don't need the Navy to rescue us, yet. The is no need to emulate the "Cramer" model of financial journalism! Be well.
Martin:
You must be a consumate bear where any good news is just an aberation!
Do you look at the market in mostly a negative way?
Gary
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I agree with you and Tray G. There is more bad news out there than good and many have not experienced what can happen. In the UK in the mid-seventies and the early nineties house prices on average by 40% (I 'lost' that amount in the seventies). Most people in the UK deny this ever happened because they feel happier deluding themselves (head in sand and lack of experience).
The debts are enormous and any expansion in credit will make them worse and toxic loans will increase.
Those saying we are over the worse mostly have a vested interest in usu believing that. How many examples of people building up a share/market when they are selling heavily do you have to have?
The era on which we have embarked is neither '29-'43 nor '69-'82, though it does have a distressingly analogous collapse in consumer liquidity. This era's added distinctive ingredient is national debt to GDP ratios reminiscent of the end of WW2, when the consumer had lots of liquidity. The double hit of consumer collapse and vertiginous debt-GDP ratios is a new and truly ominous challenge. We are still a long way from completing the deleveraging requisite to economic health, Until that is done, we'll be living in the '30s, the '70s, or worse.
Looks like at this point the government will have little choice but to cut government expenses like government payrolls and subsidies to balance the budget which seems to most reasonable strategy in this scenario, without it stagflation or inflation will hurt the econonmy.
There seems to be some sloppy reporting here. Yes, to recover from a 58% drop, the market must rise by 138% but to recover from a 90% drop, the market would have to rise by 900%, not the 1000% claimed in this article. Make sure your numbers are right, Martin. Without that, you're less believable
My greatest concern is the competition for capital of government with the private sector. On that score, Martin is on target. Ultimately, with shortage of usuable capital, higher interest rates and inflation will govern the day. Time after time, lower interest rates have pulled the U.S. economy out of recession. This has the potential to occur again, but not if inflation threatens and results in upward movement in interest rates.
Joseph C.