Dow Reaches New Heights - Is The End Near?

 |  Includes: DIA
by: Derrik Lattig

On March 5th, the Dow Jones Industrial Average soared to a record closing high, closing above the previous record of 14,263.54 last seen on October 9, 2007. For many investors, the commemorative domestic milestone was an indication of a clear-cut economic recovery, and they rushed in to join the party in eager anticipation of more gains. For others, however, the mark is only the tip of the iceberg, and the lack of excitement was more than conspicuous, possibly warning the advent of something much larger to come.

For the record (no pun intended), the historic mark that everyone is talking about is in nominal terms and doesn't take into account the impact of inflation, which has increased more than 10% during the past five years, according to the Bureau of Labor Statistics' consumer price index (CPI), but who's counting anyway? Nevertheless, the DJIA has shown growth that was virtually non-existent five years ago -- it has now gone 521 calendar days without a 10% decline -- and has created a bull market that celebrates its fourth birthday on Saturday. While some investors are overjoyed, pointing to the number as a direct signal of a recovering market, others are not so optimistic. Many analysts fear that the recent high point is only a phenomena created by various market influences, some of which I will touch on later in the article, and is not an accurate forecast of the current economic weather.

The latest word on Wall Street is that many investors are expecting a bear to run through and correct the overly inflated bull market, predicting a decline of as much as 5%. Although this may seem like nothing more than apprehensive speculation, the numbers don't lie, and if history is ever a good predictor of the future, we must pay attention to it. Only five of the 11 bull markets recorded have ever lived to celebrate their fifth birthday, according to S&P Capital IQ. The average bull market's age? 4.5 years. Historically, shortly after stock market records have been achieved, there has been a subsequent downturn, but just how big is, at best, arbitrary.

Another thing that could potentially hurt the current bull market: popularity. If the market keeps going up and people view it as seemingly invincible, it could suffer from the newly coined term, "The Apple effect." The tech giant was hovering around $700 per share in September of 2012, only to fall 35% to a disappointing current price of just over $400; it was over-loved and overbought. Although many analysts' estimates predict Apple increasing its market share in the next few months, it will likely never be the number one stock in the market again like it once was.

So what exactly pushed the DJIA over the all-time high, and why should we fear that a bear market is soon on the way? Well, to discuss every single pressure that impacts the various indices would not only be borderline ludicrous, it would be nearly impossible. For the sake of brevity, let's look at the recent increase from a more synoptic perspective.

Total employment in October 2007, the last time the DOW reached its peak, was in the range of 138 million. Today, it's 135 million. The unemployment rate during the DOW's last climax was an amazing 4.7 percent, compared to a dreadful 7.9 percent today. Americans, on average are making less money, are less wealthy and are not nearly as monetarily comfortable as they were five years ago. The only other explanation for the recent increase has to be overall economic growth, but sadly, it's not. The economy has grown since late 2007, but at an extremely weak rate. Real GDP, which takes into account the effect of inflation, is about 2.5 percent higher than it was in October 2007. On an annual basis, that's a dreadful growth rate of 0.5 percent, which is less than population growth during the same time frame. Not only that, but since 2007, our national debt has risen an astonishing 83% in just 5 years -- increasing from 9 trillion to just over 16 trillion. So how in the world is our economy doing so well? Some analysts will argue that companies are reporting earnings never seen before, that stocks are cheap --- price-to-earnings ratios are much lower now than they were in 2007 -- or that unprecedented cash piles are being reported by these large public entities. All of these are factual statistics, but the reality is that they are not accurately representing WHY all of these numbers are so high. So why are they? Well, many reasons, but the main one is quantitative easing.

For those unfamiliar, quantitative easing is a program started soon after the economic collapse of 2007 in order to stimulate economic growth. The Fed has been buying up trillions of dollars in bonds to stimulate the economy and subsequently, has driven down yields and interest rates. In layman's terms, it's the Federal Reserve's way of saying, "We're printing money, and lots of it." Since 2007, Ben Bernanke and the Federal Reserve have pumped trillions of dollars into the market, with very little productivity growth to back it up, and have recently announced the third round of the program in September of 2012 -- which will continue to buy Treasury bonds and mortgage backed securities at a rate of $85 billion dollars per month. But what happens when the Federal Reserve stops this promulgated program?

"The next step is where it will get interesting," said Mike Murphy of Rosecliff Capital. "Will the Fed be able to pass the baton to the economy and will the economy be able to run with it?"

To break it down in much simpler terms, one must go back to their basic college economics course and recall the dreaded supply and demand and curves -- I know, you thought it would never apply to the real world! Obviously, the process is not as simple as your basic supply and demand graphs, but the principles are the same.

Each time you add a new dollar to the system, increasing the supply, it decreases the value of each existing dollar by just a little bit, decreasing the demand. This process is better known as "inflation." Bill Gross, the manager of the largest bond fund in the entire world at PIMCO, has been quoted as saying that he believes that more quantitative easing could result in a decline of the U.S. dollar of up to 20 percent. If this prophecy were to actually take place, it would be catastrophic for not only the U.S. economy, but the world's economy. Once an inflationary spiral gets going, it is really difficult to stop and to cap it all off. Our nation's public debt is growing at a rate never before seen in history! GDP is the primary indicator of our nation's productivity growth, but if you were to take out the increase of money supply caused by quantitative easing, the real GDP growth since 2007 would not even break 1%.

So what can we do about it? Sadly, nobody really knows. The primary income of the United States government is the tax revenue it generates annually, and that can range from $2 trillion in a bad year to $2.5 trillion in a good year. Compared to the public debt, that's a debt-to-income ratio of nearly 8 to 1! Could you imagine the looks you would receive if you walked into a bank today, asking for a loan with that type of debt? They would laugh at you, tell you to walk right back to where you came from, and question your sanity. It's as simple as that, so why are we not doing the same with the government?

I do not claim to have any genius eccentricities or clairvoyant attributes that allow me to predict the future, but I think we are all smart enough to realize that if you're pumping money into an already lackluster economy and driving the public debt to new heights, there are going to be some serious repercussions. According to Money Magazine, 78% of Americans will experience a life-altering event in any given 10-year span. Most analysts predict that with the current economic status, we will experience another recession between 2013 and 2015, and the damages could be worse than ever before. I only hope that what I write is nothing more than speculation based economic forecasts and historical trends -- it would truly be one of the scariest times in our nation's history if it did. But the numbers don't lie, and if there is any single thing that I do know for sure, it's that the first step to fixing any problem is first acknowledging that there is one.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.