The Aftermath
of
Stock Market Manias
By Ron Sadoff, editor
Ronald Sadoff's Major Trends
Historically,
a waterfall, punishing stock market decline follows a broken
bubble. To date, the market is mirroring this post bubble aftermath.
Below we discuss what could turn this stock market around.
Generally, stocks perform
best when the Fed is easing and the economy is climbing out of
a recession. That's the sweet spot. Equity prices almost always
soar thereafter because corporate profits will soon brighten.
However, there is a
"flip side" to this equation. Once every five or so
decades (1812, 1860's, 1920's and currently after a long sustained
period of prosperity the stock market forms a "bubble."
Such a "mania" is fueled by investor greed. A bubble
is an orgy of exaggeration, greed, overvaluation, speculation
and extreme volatility financed by margin debt.
The entire U.S. stock
market formed a bubble during the 1920's. This speculative binge,
debt financed, pushed stock prices up fivefold over nine years.
Prices then nose-dived over the next three years.
The Japanese stock
market, for fifteen years, was the hottest game in the town.
The bubble then burst violently. Thirteen years later the Japanese
economy is still in a recession and the Nikkei Index continues
to trend lower.
After a long sustained
period of prosperity these bubbles develop and then implode;
in the U.S. (the 1920's) and in Japan (the 1980's). Other factors
that were unleashed as these bubbles were broken: huge excess
capacity, heavy debt burdens and a less than stimulating monetary
policy with interest rates near 0%. The investing landscape that
follows the bubble (deflationary recessions/depressions) is quite
different from the successful and profitable decades that preceded
it. Indeed, the bubble is the pivotal juncture. Investing becomes
more difficult after the bubble implosion.
As prudent money managers
we are continually vigilant against "what can go wrong."
Accordingly, we became even more cautious investors because of
the recent bubble implosion for the Nasdaq.
The last and only time
that the stock market was down this far into a Fed easing cycle
was in 1930. The primary question is whether the economy will
follow its usual pattern of responding to Fed stimulation designed
to lift us out of a recession (as it did following the last ten
recessions) or if the post bubble dynamics will overpower this
expansion.
Our concern is that
the markets are negating all of the Fed's medicine. Furthermore,
the bounce in the economy has been sub-par and is beginning to
fizzle.
There is a force behind
the unwinding excesses that reinforces the negatives. It is just
the opposite of the force that brought about the mania. As the
bubble developed, rising stock prices lead to increased spending
which lifted earnings that pushed up stock prices that increased
capital expenditures which encouraged more debt and leverage,
which raised spending, which increased earnings, all of which
analysts extrapolated far into the future.
To
date the stock market decline is mirroring the pattern of the
other broken bubbles (i.e., 1929). The stock market decline has
been so horrifying it now threatens to weaken consumer spending.
This increases the risk that the United States will enter a deflationary
period. Given that we are now in a post bubble period and that
interest rates are close to 0%, it is a real concern that deflation's
heavy hand will smother this economy.
Remember, deflation
takes place when interest rates cannot be used as the primary
tool for stimulating the economy. As interest rates approach
0%, significant interest rate cuts become impossible. With overcapacity
and heavy debt burdens, deflation forces intensify.
The recent high tech
Nasdaq bubble represents the biggest and most widespread mania
in history. A true mania with all the toppings! If the aftermath
price patterns for these bubbles repeat, the high tech stocks
will follow a downward path for at least the next ten years.
Examples of Bubbles
The
Dow Industrials appear to have also formed a bubble. Accordingly,
we are now in that time slot that is most vulnerable to "something
going wrong."
The first recorded
bubble was the "tulip bulb mania" wherein the price
of a tulip bulb became more valuable that the price of a home!
Over three years, prices multiplied 60 times. Then came a violent
collapse.
Prices soared nine
fold over 1-1/2 years. The bubble was then pierced. Prices then
crashed.
Gold touched $800 an
ounce in 1980 and subsequently broke lower. The price of gold
is still down significantly from its peak nearly twenty-two years
ago. However, the decline for gold, while significant, was not
the free fall, waterfall decline that other imploded bubbles
suffered.
Numismatic coin prices
soared over two years (1988 1990). Rare coin investing was the
mania du jour. A waterfall decline then unfolded.
The pattern for these
broken bubbles is that prices often decline and perform poorly
for more than a decade or two.
What To Watch
It
is clearly observable that once a bubble is broken, a waterfall
decline, lasting several years, often follows. It is not written
in stone that this will be the outcome. We are simply laying
out the pattern, dynamics and aftermath of broken bubbles. Hopefully,
the stock market will soon stabilize and catch up to the actual
business environment, which is still on a slight upward path.
We are focused on two
areas, which will help signal the future direction for the economy
and stock market: housing and commodity prices. Certainly, a
strong housing market has been a significant factor in sustaining
our economy. A continuation of this positive trend will bode
well for the economy and eventually the stock market. The same
reasoning applies to industrial commodity prices. As long as
raw industrial commodities hold steady, it will signal a healthy
economy and sooner or later the stock market will reflect this.
Restated, a faltering
housing market and crumbling industrial commodities will validate
an upcoming recession/depression scenario, which in turn will
reinforce a continuing waterfall stock market decline.
Editor's Note: This
newsletter covers the behind-the-scenes, decision-making process
of an experienced, well-known money management firm, Ronald Sadoff's
Major Trends, 250 West Coventry Ct., Ste. 109, Milwaukee, WI
53217. Ronald Sadoff's Major Trends manages money and investments
for all types of accounts: individuals, trusts, IRA's, 401k's,
pension and profit sharing, corporations, institutions and foundations.
Ronald Sadoff's Major Trends has consistently ranked as one of
the nation's top performing investment advisory firms.
