How Low Can This Market Go?

As we stated last October (the month of the stock market’s peak); “the stock market is a sideshow, it can adjust to the economic reality very quickly as it did in 1929 (especially with credit losses already in place).”

Only misconceptions about the Great Depression cause a dismissal of the similarities. Commodities are correcting sharply as forecast. The U.S. Dollar has gained double-digits against other currencies while the Yen is “soaring to 13 year highs.”

The U.S. stock market (DJIA) has fallen below the ‘line in the sand’ described in March. And European countries are faring much worse as expected.  Even our forecast for Mega Thrift is becoming more plausible.

How Low Can It Go?

As mentioned in April of 2007, “When the effects of inflation have been extracted, the DJIA is much more cyclical than Wall Street promoters would care to admit.”

Steve Williams of Cycle Pro has updated his inflation-adjusted Dow Jones Industrial Average chart (below) which we previously cited. The recent sell off seems insignificant when viewed over the last 200 years. Our target is unchanged; we expect the market to swing to the lower end of the trend channel. 

On the way to the bottom, the market must relieve bearish sentiment (make you forget your fear). It can only do this through sharp powerful rallies (where we all laugh for a day with CNBC on how close we came to the brink). We have described these as “rocket-launched (oh they’ve saved us) bear market rallies.” Investors who cheer these sharp up moves as a sign of the bottom should take note of the chart provided by Tom Denham from Elliotwave.com below.

Inflation - Negative Over the Next 5 Years

Because of high debt levels, we have continually warned of a deflationary collapse. Now according to Nouriel Roubini,

Finally, and more important, yields on Treasury Inflation-Protected Securities (TIPS) due in five years or less have now become higher than yields on conventional Treasuries of similar maturity. The difference between yields on five-year Treasuries and five-year TIPS, known as the break-even rate, fell to minus 0.43 percentage points. This is a record. Since the difference between the conventional Treasuries and TIPS is a proxy for expected inflation, the TIPS market is now signaling that investors expect inflation to be negative over the next five years, as a severe recession is ahead of us.

TIPS are signaling negative inflation for the next 5 years and inflation below 1% for the next 10 years! Therefore we would like to reiterate our call to investors to preserve their portfolios with U.S. Treasury Bills (interest bearing cash). Higher returns require more risk, which in our view will not be rewarded in this type of environment.

Only The Treasury Can Print Money

We suspect even the U.S. Treasury will be eventually challenged by this crisis. As we stated in January, we expect long term obligations of the U.S. Treasury to rise in yield. And while the Treasury can print money (which will lead to higher inflation in the long run, no doubt) other entities without the power of the printing press may not be able to raise cash to cover their interest payments.

Remember the Panic of 1837 (that led to a 7 year depression) which we compared to our present times in May 2007? In the paper, The Depression of 1839 to 1843: States, Debts, and Banks, John Wallis notes that “Pennsylvania, Maryland, Indiana, Michigan, Illinois, Arkansas, Louisiana, Mississippi, and Florida all defaulted on their debt in 1841 and 1842.”

Five of these ended up repudiating all or part of their debt.

Comments

[bosun.j:]

It can and will collapse. It's about to get very ugly.

2008 Nov 04 08:38 AM

[NOWHEREMAN:]

Oil will hit $100 or more before the end of December, what will that do to your deflationary projections? Above $150?

2008 Nov 04 08:56 AM

[NOWHEREMAN:]

Robert Prechter screwed up big time in 1987, are your readings better than his?

2008 Nov 04 08:58 AM

[peterthepai...:]

deliciously bearish...we love that which scares us...but

it is - fools rush in! - though...innit!

2008 Nov 04 09:32 AM

[y3115y:]

The PE was 7 in 1982 while long bond yielded 16%.
The PE is 12 today, will go higher when Co earning is down. But long bond rate is 4.5% today. If we sell stocks, we have no place to hide. Please tell if we may not go down to 5000.

2008 Nov 04 11:21 AM

[sorgmot:]

Based on the very interesting chart above, we make a low of 2000 for the DJIA in 2018 which is 1/7 th of the high in 2007. The total drop is taken in the same ratio as shown in your 1930's chart above.

The USA will have lost the reserve world currency status by 2018 and will be a hopelessly indebted nation by 2018

2008 Nov 04 02:49 PM

[st_marmi:]

I do not know what are the sources of Mr. Williams but his graph of the inflation-adjusted Dow Jones shows that he assumes that the index increases 10 times in about a century. This means an inflation-adjusted return of approximately 2.3%
If the premium for holding stocks is supposed to be so low then it is not surprising to assume that the Dow should go as low as 2000.
I wholeheartedly prefer to think that the figures given by Jeremy Siegel or in the book "The triumph of Optimists" are more reliable. Then one should expect stocks to deliver a real return of approximately 6% (in the very very long run) and maybe the Dow will never see 2000 again

2008 Nov 04 03:28 PM

[Teutonic Kn...:]

Heeding Sorgmot's comment above, wouldn't it be an interesting idea to take a fast down, surgical drop of the Down to say around 2000 in a year or so, and then et us start the gravy train all over to the next bubble again? In this way the prolonged agonizing pain and suffering of unemployment and devastation of millions (here in the US and elsewhere around the world) would at least to have been shortened if not avoided.

Anyone has any comments on this idea? Do we really HAVE to have to go to 2018 to hit that magical 2000?

2008 Nov 05 12:54 PM

[Olga:]

great site, the best ever i have seen, and so accurate.

thanks a lot

2008 Nov 12 03:05 PM