The DJIA Down 40% at 8,378: Where To From Here?


What a week! The Dow Jones Industrial Average closed the week at 8,378, down 40% from its 52 week high. The NYSE index, a broader measure of stock market pain closed on Friday at 5,247, a numbing 47% devaluation from its 52 week high. Likewise, the S&P 500 is off some 43% from its 52 week high. Regardless of the stock mix in the indexes, the numbers are sobering. What should Americans make of the situation? Is this a time to buy? Hold? Or sell?

In an Oct. 23 MarketWatch essay titled “Bottom may be in sight,” Peter Brimelow and Edwin Rubenstein advocate buying for the long term. Citing the work of professor Jeremy Siegel, they argue that stocks have provided a cumulative real return of 7% across two centuries (adjusted for capital gains, dividends and inflation). Since historic lows have temporarily lagged the trend line by around 40%, and since the current market is priced near these historic lags, history is supportive of a timing argument for patient buyers. (See the authors' full argument for nuances.)

On the other side of the coin (but on the same day), MarketWatch’s Mark Hulbert argues that the current market’s price to earnings ratio remains HIGH compared to historical data (i.e., data that goes beyond a couple decades). Hulbert finds that the current PE ratio for the S&P 500 index (SPX) is 18.1 — a ratio higher than 79% of the months since 1871. (See Hulbert’s article “How low are P/E ratios?”) From this viewpoint the market looks expensive, especially when one considers that profitability has been high during six of the last twelve months. Remember, too, that profits can get crushed with even modest declines in revenue (i.e., a 5% decline in revenue may produce a 50-90% decrease in profits), setting up a situation where liquidation values become more useful than PE ratios in evaluating a stock’s potential trading range. Indeed, corporate revenue contraction is probable as consumers try to de-leverage in the months ahead and money supply inflation eats away at purchasing power.

If the numbers at hand signaled little more than a bull/bear debate, their consequence might be modest, since bull markets eventually turn into bear markets and visa versa. But there is far more at stake here. If you look at ten year charts of America’s greatest corporations — firms that have been massively profitable over the last ten years — the current economic situation has produced a share pricing environment that has wiped out seven to ten years of price appreciation. If we slide into a protracted recession this will mean that many retirement age Americans will be extracting capital where the dividend yield did not keep up with inflation and the share exit price may be lower than the share entry price.

Dollar cost averaging makes this matter worse for the faithful paycheck investor, since dollar cost averaging only produces its “beautiful outcome” when erratic markets are largely up when invested funds are retrieved. Assume, for illustration, a 10 year “intense” investment history for many Americans, since 1998-1999 was the period of stock market excitement that pulled many new investors into the market and caused old timers to substantially increase their rate of betting on the market. Assume 10% of the total cash infusion went into the market in any given year during the 1998-2008 period. If one uses the broad NYSE index, most investors have been buying stock at a premium to their 1998 entry price except for perhaps a 30 month period in conjunction with the 9-11 era. This means that while the current NYSE index price looks like a breakeven with the early 1998 index value, six years of considerably higher market values during the 10 year period create a higher average investment cost. Thus, a 10 year mutual fund performance report is likely to significantly overstate real world outcomes for steady investors, thus concealing how much REAL money has been lost on paper (and maybe permanently as well). Remember, too, paper losses become greater once adjusted for inflation.

If someone says, ‘Show me the money,’ working class Americans have little to show for their ten year party. The equity in residences is gutted (but not in New York City). The buying power of worker paychecks is being mashed by inflation. The money that should have been in people’s stock accounts has been surreptitiously removed through the gaming of the markets by the proprietary trading platforms used by investment banks and hedge funds.

Where is the money? The wealth siphoned off has been converted into massively elevated salaries, bonuses, management fees, stock options, partner incentives, endless perks, and golden parachutes. While some of the money comes back into the economy through the lavish lifestyles of financial elites, much of it is quickly ferreted away into Swiss bank accounts, offshore hedge funds, investment trusts, and other vehicles out of the public eye. In other words, the greatest robberies in history are just school play compared to what the world has just witnessed.

The America public listened to the piper’s song and thought they could get their share of an enduring Ponzi-style stock market scheme. Now, we’re lemmings over the cliff — at least that’s the case if financial elites don’t find a reason to re-inflate the market. But elites have little incentive to re-inflate stock assets until their financial studies reveal that a substantial portion of the working public have been shaken out of their shareholding positions at disadvantageous prices, and discouraged from re-entering during the basing period. Thus, if the market does get turned around, it will not likely be for the benefit of fair democracy.

All of this bears testimony against the idea of “free markets” where scheming elites can invent financial vehicles that allow the public to reap paper gains in the short term, only to be bludgeoned once the game turns serious. Granted, markets may spring back for a spell because of the excessive monetary stimulation of the federal government. But that’s not the point — that’s just another possible chapter in the story of a manipulated capitalism. What we really need is a new approach that rewards investors not through share price appreciation (a very dangerous game) but by means of a steady and secure participation in the aggregated profitability of American corporate enterprise. Now, there is a recipe for sustainable goodness and a narrowing of the gap between the Middle Class and financial elites. Don’t stand by passively while Wall Street elites grab the hundreds of billions of dollars of corporate profits that belong to hardworking, honest Americans.

The following was a response to a reader who asked about Dr. B's definition of "substantial", and asked for a clarification about how dividend income fits into the reform suggestions in the last paragraph.

The general consensus is that many elites were short the market during the 1929 Crash, and that the market only recovered after they covered their shorts and set up long positions. Regarding more recent market action: there is anecdotal and technical evidence that hedge fund activity increases the up and down swings in the share pricing associated with market sector rotation.

Sector dips reverse direction as "substantial" percentages of novice players become discouraged and forfeit their positions. Certain elites study the dynamics of fear and confidence in market action, and decide upon what constitutes "substantial" capitulation as a reflection of 'the art of the possible' in the evolving economic environment.

Regarding your inquiry about dividends: If one assumes that the real (aggregated effective) rate of price inflation is about 1-1.5% higher than the government's CPI index, one must conclude that dividend income has lagged inflation. This means that there is no real return in the market for most investors apart from share price inflation. As an alternative, I suggest a reconstructed market with rules and features that would stabilize share prices and put the reward for share holding into a form somewhat similar to dividends.