Friday, October 10, 2008

The Stock Market Going Forward

Good Morning Everyone!

I have a little time this morning so I thought I would say hello. What an opening this morning! I expected a bounce today after the futures dropped to -411 on the DOW. This set us up for a classic snapback rally. This is exactly how it played out. We dropped 680 points at the open and then rallied 500 points in a matter of minutes as buyers couldn't resist the oversold technicals.

This brings me to my point today. Technically we are oversold, but are we oversold historically?

Lets take a look at the DOW since 1929

My Take:

This chart looks at the DOW since 1929 up until Oct. 9th today. Notice the huge run up since 1982. We now sit at 8000 on the DOW, so you need to adjust the graph above.

I think we all need to ask ourselves long term this question: Are stocks really oversold long term at these levels? My answer is I don't think so. The DOW 8000 level is a very important one.

In 1995, the DOW actually sat at only 4000 before the tech bubble started getting started. We hit 8000 on the DOW as the tech bubble really got rolling before peaking at around 10,500. The tech bubble then burst. This combined with 9/11 took the DOW back down to 8000 which is right around where we sit now.

Greenspan then proceeded to drop rates to 1% for an exceeded period of time which triggered the housing bubble. In 2003, as the housing bubble started to roll, the banking regulations became very lax. Investment banks were allowed to leverage up to 30 or 40-1 and lending standards began to vanish. Subprime and Alt-A loans began to soar in popularity, and before you knew it, an $8/hour grocery clerk was able to qualify for a $350,000 house!

This allowed to the DOW to soar to 14,000 as leveraged investment banks were able to lend $40 on every $1 dollar of capital. Profits soared as housing prices went through the roof, and the DOW followed.

Many Americans started making large money simply by flipping homes. It also flowed into other parts of the economy. Mortgage reps, realtors, and banks also shared in the profits. So did retail stores like Lowes, Home Depot, and furniture stores. Commercial properties flourished as prosperity was seen everywhere.

As home equity soared due to rising home prices, Americans then began started tapping into their housing equity and proceeded so spend at unprecedented levels. I-pods, plasma TV's, and Hummers all became necessities for the average Joe versus being a luxury. This spending allowed to economy to continue to flourish.

The Hangover

Everything was great until something inevitable happened. Housing stopped going up in value. Once this started, the tools that were used via financial innovation to take us to new highs started working in reverse. The rest is history.

As investors, we need to start to asking ourselves where the DOW will trade moving forward. One thing is for sure, most of the tools that took us from 4000 up to 14,000 are now gone.

The investment banking model is history. Banks will be only be allowed to leverage up to the standard 12-1 against capital vs. 40-1 going forward. Lending standards have been severely tightened. Credit default swaps will become heavily regulated. The ratings agencies will be gutted and heavily regulated. Venture capital that fuels innovatuion has vanished as fast as the balance sheets of the banks. This will come back, but at much diminished levels.

In this newly regulated world, you need to ask yourself this question: how much money can companies make in this new environment? If companies can't borrow like they used to because the banks can only lend at 12-1, their profits will suffer. Financials will never make the money that they did because their ability to lend will be at much lower levels

Because venture capital isn't flowing, start ups will be fewer and far between. This was the key market that got tech going.

Another thing to consider is if the DOW ends up plunging 50% or more from the highs, how long will it take for the average investor to ever trust the market again. How does the market move higher without the retail investor?

Bottom Line:

My conclusion here is not complete, but I believe the DOW recovery will take years if not decades. The DOW will trade much closer to 4000 than 14,000 IMO because the instruments that took us to the highs are gone.

When I look at this graph, it tells me that the growth since 1982 is "irrationaly exuberent" and does not represent how the DOW has grown historically. With deep regulation and the disappearance of "financial innovation", things will look much different for investors going forward.

DOW 6000 seems much more realistic to me than DOW 14,000.

There is one thing history has shown us, know matter how prosperous or bubbly things become, we always revert to the mean. I see no reason why this time its different.

The DOW has now retraced back down almost 5%. Sell the rallies! What a market.


Anonymous said...

I liked the comment on CNBC this morning, the upside is that we can't have more than twelve more days like yesterday. Otherwise we are at zero. What concerns me is that the fundamental problems that started this crisis are only getting worse. If it was foreclosures that started this all I doubt we have seen the half of it. So how do we find a bottom in the market if we still have the same fundamental problems?

Jeff said...


Great points.

A scary question isn't it? Usually a bottom is seen when no one wants to ever own stocks again and there is a massive running to the exits.

Waht bothers me is we still haven't seen true capitulation like this. This selloff has been brutal but very orderly.

There is a lot of fear. The VIX which measures fear hit an all time high of 70 today. The problem is I haven't really seen a true panic as a result of this fear.

I have many friends he tell me "well, I am not worried, it will come back". Until this mentality changes into "oh my god! Get me out!", I don't think we have found the bottom.

We might have found a trading bottom around 8000 here because these are the lows from the last recession in 2002.

Long term, I don't think we're done heading south here.

ZMonet said...

Thanks for the insight Jeff. I guess the next question becomes, if I don't put my 401(k) money into the stock market because the stock market isn't returning anything like its historical averages, how do we make enough money to retire? Or do you think all of this deleveraging will create deflation that will equal things out a bit? While I feel for the baby-boomers and their situations, a lot of them have pension funds. Pension funds, at least those that will pay for the lion share of retirement, are all gone for post-babyboomer generations.

Jeff said...


Unfortunately, the days of high returns in the stock market are over IMO. They may return a generation from now.

We are already seeing severe deflation as assets like housing, commodities, and cars plummet. The deleveraging is part of this process although they are not two in the same.

Its going to be difficult to find places to invest for many years going forward IMO.

I think after the deflation is done, you will then see a period of severe inflation due to the throwing of money out of helicopters by the central banks of the world.

The US has spent over $1 trillion throwing money at this problem. This is extremely inflationary long term.

As a result, one area down the road to invest in will be fixed income because interest rates will have to go way up to fight inflation.

Bonds and CD's paid 10% a year or more in some instances in the early '80's.

Fixed income could outpace stocks for years going forward.

I wish I could paint a rosier picture, but thats kinda how I see it.

johndaniels said...

Jeff: agree that we will see something in the neigborhood of high 5,000's to low 6,000's on the DOW as the 'debt money' is eradicated from the system, through one measure or another..the government will eventually throw up its hands, and the taxpayers will refuse to bailout the tanking Bank of AMerica...the next major shoe to drop. gov't wouldnt let them fail? they may not have a choice, "him or me" syndrome.

Jeff said...



That is right around the corner.

The gov. always chooses themselves in the long run. If the bond market forces them to stop spending, the banking system is in deep trouble.

Theat shot across the bow the other day when yields shot up told me the bond market has had enough with government spending.

The Bank of AMerica is about to be told to pound sand! This G-7 summit is critical this weekend.

We could see a big boom in the markets if they don't come up with a solution.

johndaniels said...

it will be an intersting weekend, to say the least! too bad i'll be stuck with the "systemic news corp" ..ill be out of town and all i'll have is TV! i think some big things are gonna happen with the 3 day weekend,...

Jeff said...


I agree!

The meetings this weekend should be dramatic IMO.

The financial system hangs in the balance. It will be interesting to see what they come up with.

Have a great weekend traveling!

Avl Guy said...

Jeff, good use of history there.
Let’s be cautious about thinking too linearly; let’s ask: Are people today regretting the ugly part of the bubble. e.g. the ‘bursting’? Yup.
And are they also regretting all the business & job expansion created or the (unsustainably supported) sense of wealth they felt from 2002-1007? NOPE!
So how long will this ‘new mentality’ really last? Recidivism is a b#1ch, and American voters are now decades removed from tolerating long-term economic pain and sacrifice as endured in the 1970s, 40s & 30s.

Economic instability brings political instability. Unemployment troughs always lag market troughs. When joblessness kicks in next year, will memories of the downsides of bubbles be forgotten?
How long before today’s ‘pro market-regulation’ dems get tarred & smeared with the label, ‘pro-stifle’? Will too much bubble-free suffering send the ‘pro-stifle’ folks in the White House & Congress packing, starting in 2010, after voters taste just one full year of painful high unemployment?
We may be a few years too early whistling past bubbleland’s grave. But what’s the mechanism to reinflate a bubble tomorrow – and in a new sector that is immune to today’s deleveraging? Maybe it will be the combo of rebuilding public infrastructure in 2009-10 and bubble-lizing the economy via privatization of all this fresh new Green public infrastructure. Maybe we’ll flip flop between bubbles & austerity.

I can’t see the 50-million plus self-indulgent boomers suddenly reigning themselves-in from here to eternity. Not after losing $ trillions this year in stocks plus more $ trillions in house wealth; I see them deciding to toss Obama under the train, and the herd stampeding towards every and any wealth bubble they can sniff out. Timing-wise, I don’t see Paulson-Bernanke-Obama-Volker or McCain successfully diffusing the debt unwind and deflation in 2009 to satisfy the crying boomers. So maybe 09 will be quiet and the rollercoasters kick-in 2010.

Jeff said...



I agree.

I don't know if they can stop this deflation train. I don't think there is a enough money out there to sustain this massive credit bubble.

I think the bond market would stop the government if they attempted to prop it up.

This thing is exploding and I don't see how you can stop it.

They couldn't even hold it until after the election. So much for the so called plunge protection teams. There is obviously no such thing because they certianly would have tried to hold this plunge off until the election was over.

The baby boomers are going to learn a big lesson. I hope they enjoyed their 20 year credit binge.

As for another asset bubble, I think its years away. There is no money out there to blow it up. The consumers and the banks are broke and the leverage is gone.

There will always be another asset bubble, but its years away IMO.

The next fortune will be made buying distressed assets. I think thats where all the private equity flows next. Fortunes will be made from the carcass from the housing bubble.

Avl Guy said...

I agree that it's hard to see how they could stop the deleveraging [other then the ususal way which is to have a huge non-nuclear war].

However, I dont see all these global economies (except Iceland)keeping the regulators unleased on their markets...and everyone quietly licking their wounds for 2-5-10 years. That's not how human beings's far too rational.

There will be big multiple attempts to re-animate leverage and blow some asset bubbles...just too hard to see what they might be (other than securitizing and privatizing fresh green public infrastrusture).

Anonymous said...


The chart seems to be incorrect at the end. On Oct 9th, Dow closed at 8579. But the chart is drawn above the 10,000 intersection.

Jeff said...


The one thing I could see is alternative energy if oil prices start soaring when inflation comes back.

You are right though, the pigmen always have a new game up their sleeve. I am sure they will find something to run with.

Jeff said...


The market crashed 2000 points in the couple weeks so I apologize for it not being updated.

I made note of that in the post.