Comparing the Dow with CPI, and with debt

Dow now, and then - "Brief Encounter"

Discussing the Dow, I have previously suggested that instead of looking back to 1929, we might use the period 1966 - 1982 as a comparator. I've adjusted January 1966 and December 1999 to = 100 and oddly enough, the beginning of September 2009 sees the Dow past and present at a fairly similar point.

Is it too fanciful to say that we're now in the equivalent of about 1976?

Gold and the Dow - chart

Bonner: 1966 - 1982 , and Dow 5,000

Bill Bonner, in the Daily Reckoning, confirms what I've said here many times: we need to measure investment performance in inflationary terms, and done that way, the last cycle ran from 1966 to 1982. The implication for us now?

We only bring this up to warn readers: these major cycles take time. So far, the Dow has only gotten down to the ’66 TOP. Now, it has to get to the ’82 BOTTOM…adjusted for inflation. Where would that be?

Well….as we recall, the Dow was barely at 1,000 when the bull market began. And if [we] adjust that to consumer price inflation, we come to a 2,000 – 3,000.

However, the 1982 bottom was higher than the 1932 bottom, so I'm hoping it will be no worse than 4,000. Having said that, the levels of governmental and personal debt now are quite unprecedented.

Here's the graph I did last October, again:

Dow update

Adjusted for CPI inflation, the Dow is now back to where it was in December 1995.

This is still above the peak of the previous long cycle, ending in January 1966 - and still over 4 times higher than the low of July 1982. We only think of it as catastrophic because we got used to more recent, wildly inflated valuations.

I'm still hoping that the end position will be no worse than 4,000 points - a drop of 45% from today's close.

The next wave of bailouts

It's not just the banks that are short of money. Many US States and local authorities are also suffering financial problems, and this is affecting the trade in their bonds, i.e. their borrowings on the money market. ("What are bonds, exactly?" - see here.)

Michael Panzner reports that municipal bonds ("munis") offer a better yield than US Treasury bonds, but the difference is still not enough to pay for the extra risk. Professional investors are short-selling "munis". i.e. betting that they will fall in price. A steep fall may indicate imminent bankruptcy, and some say this is on the way for many authorities, as Mish reported at the end of December.

So, what will happen when the US Government is seen to be buying everybody's bad debts?

People (even here in the UK, where we tend to wait patiently for our wise rulers to solve all) are beginning to worry about inflation, and are thinking about investing again. An article in Elliott Wave International warns us not to be panicked into parting with our cash, and reminds us:

... there are periods when inflation does erode the value of cash. I mean, look at the seven years leading up to the October 2007 peak in U.S. stocks: big gains in the stock indexes, while inflation was eroding cash. No way did cash do as well as stocks during that time.

Right?

Wrong. Cash outperformed stocks in the seven years leading up to the 2007 stock market high. That outperformance has only increased in the time since.

Since this is the view I took and communicated to clients in the 1990s, you will understand that I didn't make much money as a financial adviser. But it was certainly good advice, even if it was based on strongly-felt intuition rather than macroeconomic analysis.

Not that analysis guarantees results, in a world where the money game's rules are changed at will by politicians with a host of agendas that they don't share with us ordinary types. But my current guess is that the stockmarket will halve again in the next few years, when compared with the cost of living.

Fun with extrapolation

Since the 1990s, the stockmarket has been showing such freakish returns that many thought we were in a "new paradigm", whatever that means.

So I've looked at the Dow adjusted for CPI since late 1928, and calculated max/min lines on the basis of the highs in 1929 and 1966, and the lows in 1932 and 1982, to see just how unrepresentative the last decade has been. If we saw a return to these imaginary trends, the next Dow low could be less than half the present value. If, if, if...

Coincidentally, Jim Kunstler is predicting much the same:

By May of 2009, the stock markets will resume crashing with the ultimate destination of a Dow 4000 before the end of the year.

But I think it may take longer than that. The Elliott-wavers are looking for a final upwave first. Having said that, the last 10 years have been out of all comparison with the 70 years before.

Is gold a hedge against inflation?

There are problems with using gold as an insurance against inflation.

1. Governments interfere with it - from making it the legal base of their currency, as in the US Constitution, to making it illegal to have any, as in the US in 1933; from guaranteeing the exchange rate of gold against the dollar (post WWII) to the Nixon Shock of 1971, when the gold window was closed.

2. Central banks claim to hold it, then (it is widely suspected) lend or sell it surreptitiously.

3. There is so little of it, that speculators can have a significant effect on the price, especially if (as appears to have happened in recent years), the speculation has been powered by vast amounts of borrowed money.

Below, I give three graphs, all comparing the price of gold per ounce in US dollars with inflation as measured by the Consumer Price Index (and that's another can of worms). It's clear that gold has a very volatile relationship with inflation and can spend a very long time above or below trend.

In the fourth graph I divide the Dow by the price of gold. It seems obvious that gold is a contrarian position for equity investors, rather than a simple hedge against inflation.

Currently, the Dow has come back to something like a normal ratio to gold, but past history suggests there will be an overshoot. And gold itself seems above trend over all three periods chosen; which suggests that both still have a way to fall in nominal terms, but the Dow more so.

(N.B. gold prices to the end of 1967 are annual averages, then monthly averages to the end of 1974, then the price is as on the first trading day of the month; all gold price figures from Kitco).

If the 2003 reflation hadn't happened?

What if the banks hadn't gone for broke from 2002/2003 onward?

In the above graph, I show the Dow, adjusted for CPI, up to 19 November 2008, with an extra: the gold line is the same as what actually happened from the beginning of 1966 to November 1974, adjusted proportionately to the height of the boom at the end of 1999.

Interpreted and represented in this way, even the worst of the crash so far has not caught up with the mid-70s: the Dow closed last Wednesday at 7,997 where 32 years before it would have been the equivalent of 4,911. If that period of history were to repeat itself, the Dow would take another 7 years of whipsawing towards its low of 3,988 in today's terms.

So in my view, the monetary expansion of the last 6 years or so, has merely delayed progress a little. The drunkard has had a few more to put off the hangover.

The reality goggles are smeared

This project of mine is echoed by Eric Janszen of iTulip. His graph and red line suggests what I've been saying recently, that the Dow's trend (if it has one) could be to 6,000 points, with an overshoot to 4,000.

My independently-researched version:

iTulip's:

It's really hard to see the past in our own terms. I'm trying to do it using the Consumer Price Index, which opens another can of worms about the composition and weighting of that index, especially since (I understand) it affects government statistics and benefits. However, you have to start somewhere.

The first thing to note is how freakish recent years have been. If you connect previous start-of-month highs (August 1929, January 1966) and extended the line, you'd expect the recent Dow highs of 1999 and 2007 to be no more than 10,000 points.

And as for the lows: the drop from 1929 to 1932 was 86% "in real terms"; from 1966 to 1982, 73%; and so far since 1999, 46% - but this last from an amazing historical high. And the 350%-plus American debt-to-GDP ratio is quite unprecedented.

So the history of the last 80 years offers no clear guide as to what could happen next. If proportionately as severe as 1932, the Dow could dive to about 2,100 points; if like 1982, just below 4,000. BUT the second of these great waves crashed rather less than the first, so maybe the third will be even more merciful, perhaps a top-to-bottom fall of only 60%, i.e. end up at c. 5,900.

I note that the Dow has closed tonight at 7,552.29. What a fast fall we've seen - will it spring back sharply and then recommence its decline, as in previous cycles, or is it popping like a balloon?

Methodology

I've noted the Dow as it stood on the first trading day each month, starting October 1928 and ending November 2008 (plus where it stood yesterday - 7.997.28 - since we've seen a further steep fall). Then I've noted the historical CPI as at the end of the previous month in each case. Then, looking at the latest Dow figure, I've adjusted historical Dow figures accordingly (i.e. Dow then/CPI then, times CPI now).

Sources: Dow: Yahoo! Finance; CPI: InflationData.com

UPDATE

iTulip today also reproduces its graph on holdings at the Federal Reserve bank, underscoring the point that the current crisis has features that we can scarcely compare to anything in the last 80 years. Except that it's unlikely to be good news.

Looking back, looking forward

UPDATE: "This secular bear market will last a lot longer and be much deeper than anyone thinks. Sadly, very few are prepared for it." - Mish.

This gels with what Marc Faber was saying quite some times back, that the market had further to drop than many people thought. Equities may seem to be fair value in terms of multiples of their earnings, but when the earnings fall, valuations have to be reassessed.