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
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.
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?
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.