Equity Market's Slippery Slope

The market has come rapidly back from its lows. Will equities continue to climb? Will we revisit the lows? A look at past markets may help guide us. Historically, unusually rapid and persistent rises in equity markets have been followed by severe and lengthy contractions. The following three periods all had skyrocketing equity prices that continued for at least eight years:

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1. Nikkei from 1970 to 2000. (See graph above). From 1980 to 1990, the Nikkei rose at an average slope of 0.53 or 53% a year. Since 1990, the Nikkei has crashed down to 8627, a 77% overall drop. The fall has been continuous, long and devastating.
2. The Dow Jones Industrial Average from 1921 to 1929 (see graph). During this period, the market rose at a slope of 0.62 or 62% a year. The crash that followed lasted ten years.
3. Nasdaq from 1990 to 2000 (see graph). From 1990 to 2000, the Nasdaq rose with a slope of 0.9 or 90% a year. Nine years later, the Nasdaq is at 1545, a devastating and persistent collapse.

Each of these eras has been characterized by a multi year dizzying climb followed by a protracted decline. It would appear that their crashes lasted so long because it took a great deal of time to unwind the excesses of the lengthy bull markets. Our current market was preceded by an equally mind boggling run. The Dow Jones Industrial Average from 1980 to 2000 had a spectacular run going from 840 to 11,500, a 63% rise on average a year. That's a slippery slope. It went on to ultimately crest at 13,930 in 2007, a 58% average rise over that 27 year period. Contrast that to the "more normal" Dow path from 1900 to 1980, a 0.2 slope or 20% rate of climb (see graph).

From 1800 to 1900, equities went from 5 to 49, a meager 0.08 slope or 8%. (see graph). The stock market crash of 1904 and 1908 came back relatively quickly from their gut wrenching crashes. However, these crashes did not follow long market rises.

The history of equity markets indicates that periods in which the bull market is particularly lengthy are followed by persistent dead markets. We've been in this difficult market for less than two years. If past markets are a guide, this one should continue for a long time and will likely get worse. At a "more normal" slope of 0.2, taking as a starting point of 1980, the Dow should be now trading at 5712. With this trajectory, the Dow would reach 7560 in 2020.

The current market could defy history and recover quickly. For instance, tremendous productivity could advance equities higher. However, previous periods in history have had remarkable productivity with great innovations: assembly line, cars, rails, electricity to name a few and their bear markets have been grueling. Probably the only force that could propel the market out of a prolonged bear market would be inflation, something we may yet see as global interest rates are slashed. Usually collapses in equity markets take years to recover. Central banks are trying to reengineer the global economy at lightning speed. It will be difficult to overcome historical patterns of the equity markets.

Comments

[Mad Hedge F...:]

Can you believe this? 27 out of the 30 Dow stocks are currently profitable. The public perception is that all are losing money, and several are on the verge of bankruptcy

Mar 31 12:30 PM

[PROXIMO:]

"The Dow Jones Industrial Average from 1980 to 2000 had a spectacular run going from 840 to 11,500, a 63% rise on average a year." "It went on to ultimately crest at 13,930 in 2007, a 58% average rise over that 27 year period." Where do you get these percentage rises you use in this article? Do you pull them from thin air or do you make them up as you go along? They render the entire article utterly worthless.

Mar 31 01:16 PM

[970slashX:]

A rise from 840 to 11,500 results from a 13% CAGR over 20 years. Extending to 10/9/07 reduces it to 10% CAGR over 27 years. The equation is simple: divide the ending point by the starting point, take the natural log, and divide by the number of years.

Your approach would give us nonsensical claims like the 80-year average return of the DJIA is 30% (3/30/29-3/30/09).

Mar 31 01:47 PM

[Stephen Ros...:]

To proximo: (11500 - 840)/840/20 = 0.63. Average slope of 0.63 a year.
To 970slashX: I think we're talking about different numbers. I am not figuring CAGR but rate of rise of the slope. What I think has confused readers is the %s given. They refer simply to slope.
The slope and duration of the 1980 to 2007 bull market is similar to that of the Nikkei 1970 to 2000, Dow 1921 to 1929, and Nasdaq 1990 to 2000. The bear markets that followed those three bull markets were severe and prolonged. I believe those bear markets last a long time because equities were priced way beyond normal values. The historical rate of rise in slope has been 0.2 which would put the Dow still overvalued.

Mar 31 04:50 PM

[Stephen Ros...:]

The argument of the paper is that long bull markets end in very long and deep bear markets. This bear market should be especially deep and long because there had been an unusually long and rapid growth in equities. That extraordinary bull run had been marked by companies overreaching: overbuilding, taking on enormous debt, expanding too rapidly. That takes a long time to unwind. This government is trying desperately to shorten the process and ease the pain. It will be near impossible to reengineer the whole economy. The process naturally occurs over years and is painful. The bear markets that have been short (a few years) have occurred after brief bull markets. This one has been long overdue. No bull market has lasted so long without years of pain following.

Mar 31 05:50 PM

[PROXIMO:]

Author--Thanks for the clarifications.

Mar 31 07:44 PM

[Allan Frain:]

Keeping it simple: The point is that the unwinding is proportional to the excesses that preceded it. To call a bottom now one must 1) miss miss or disavow such postulate, or 2) deny the magnitude of recent excesses.

Apr 01 09:19 AM

[babbylon05:]

Would the author like to comment on the possible effect of technological advancement multiplying production capability?

Apr 06 06:46 PM