The financial press likes to talk up those occasions when the Dow presses on above 10,000. Such talk lately has become desultory, since it seems every other week the Dow lurches below 10,000 and then manages to climb its way back up. The market has been in this funk since February of this year, when the Dow began its most recent push from below 10,000, all the way to a peak around 11,200, only to fall three times below the 10,000 level since and recover with less and less conviction.
Is the market creating a topping pattern, or is this merely a consolidation period to be followed by new highs for the year? This is the perennial question whenever the market trades sideways, allowing the bulls and bears to thrash out the economic arguments, and ultimately allowing real world conditions to resolve whether the market will break out on the upside or downside.
Investors don’t often appreciate that this situation has persisted for over a decade. The Dow first breached the 10,000 level in the 1990s, on its way to over 14,000 at the peak, but down last year to 6,600 at the low. In other words, the market has traded in a broad range for a very long period of time, and the same questions we are asking about the short term market apply. Is the stock market biding time until it takes off again, or is this some massive topping pattern which will eventually drag the market much lower than 6,600?
The optimists like to say that the history of the stock market in the US is on their side. Time and again during the past 100 years bear markets come to an end and new highs follow. There is actually a real argument at work here: given that the Federal Reserve debases the currency by allowing some amount of inflation every year, and given that the price level of most goods and services rises over time because of this, it is only natural that stock prices should rise with the rate of inflation as well.
The pessimists say that this time is different. The Fed is facing deflation, not inflation, and stocks are especially vulnerable in deflationary times. But if this is true ”“ and certainly there is considerable evidence of deflation in the global economy ”“ why are stock prices even as high as 10,000? What has been holding the stock market up?
The answer to this problem lies with the fact that the stock market is ultimately about pricing the equity of thousands of different companies, and that means that investors make estimates about all the potential profits down the road of a particular company, and price the potential growth or decline in a stock accordingly.
What this means is that investors hold their breath at the start of every quarter when companies announce their earnings for the previous quarter ”“ the very thing the market is undergoing right now. And since earnings have been very good for a very long time for the typical company, the stock market has been able to levitate itself despite the tech bubble collapse, the housing market catastrophe, the credit crisis, and the recent flash crash.
Corporate earnings trump everything in the stock market, and unless there is some sea change in the prospect for corporate earnings, the stock market can push upwards even in the face of a persistent economic recession, or even a depression, which is what many consumers are experiencing. What, then, is the sideways trading we have seen both short term and long term telling us about corporate earnings?
It is telling us that the real battle in the stock market is not with the bulls and the bears, but with the corporations and the consumer. Corporations since the Ronald Reagan presidency have taken a larger and larger slice of the economic growth in this country, to the point where the imbalance is seriously against the consumer. Wages and benefits have stagnated for over 20 years in the US, while corporate earnings have surged. An estimated 30 million people in the US are living below the poverty level, while the top 1% of the population, who are mostly corporate executives and their families, enjoy unprecedented wealth from their stock grants and options.
The sideways trading we are experiencing is expressing uncertainty as to whether the era of corporate dominance at the expense of the consumer is over. Corporations have held the trump cards for over 30 years, having shipped millions of jobs overseas, laid off tens of millions of Americans, held salaries and wages flat, cut benefits, eliminated overtime, increased the workload, and converted employees to contractor status to avoid paying any benefits at all. These initiatives, along with generous reductions in their tax bills, to the point where any number of large corporations pay no tax at all, have fed directly into corporate net income and executive compensation.
In order to maintain their lifestyle, consumers have taken on debt at levels that are beginning to cripple the middle class. The hope that home asset values would increase over time to pay back these debts has now proven a mirage given that home values in the US have fallen over 40% since 2007. With the housing collapse it is now evident that most consumers are heavily over-indebted and have no room for more debt, a sentiment the consumer shares with the banks that no longer see the consumer as a good credit risk.
This situation, ironically, gives the consumer the ”œleverage” to turn the tables against the corporations. Consumers have no choice but to cut back drastically on their spending, to default on their debt, or to do both. Both are now happening, though spending cuts far exceed defaults because banks are loath to accept the existential damage of writing off all the consumer loans that are already seriously delinquent. The result of this is that consumer spending has never really recovered in this depression, despite what retail sales numbers may say, because what growth in sales has occurred has been provided by initiatives like the Cash for Clunkers program, the $8,000 home buyers credit, or the freed up cash from homeowners in default on their mortgage who have not yet been forced out of their homes.
Wall Street analysts and financial media don’t want to believe that the era of cheap credit they have known all their lives is over. The banks and corporations can’t accept that a permanent shift has come to the US economy, which is operating on half of the credit that was available up to 2007 when the securitization process and the shadow banking system still functioned. Even the Fed does not want to accept that the support it has given to the mortgage securities market or to the commercial paper market represents a permanent role for the government. The Fed keeps trying to pass these duties back to the private sector, and persists in the illusion that the securitization market is going to pop back into life any day now.
These are further reasons why the Dow keeps holding its head above 10,000. Wall Street in particular wants desperately to believe that the good old days are going to return. It cannot see that a regime change has come to the markets, one in which corporations will be increasingly on the defensive, hounded by governments everywhere looking to raise tax revenue, and assaulted by a permanent buyers strike from consumers adjusting to their own drop in living standards.
As for the banking sector ”“ which is enormously profitable compared to most any other industry ”“ the long slow slide to mediocre profits as the norm has begun. Both banks and consumers are ripping up credit cards as fast as they can be paid off. Individual investors are fleeing the stock market and along the way pulling their money out of asset pools run by the banks. Trading is a lot more risky now that volatility has returned to the market. The equity extraction business called home equity lines of credit is shrinking quickly now that home equity is falling, not rising. Other equity extraction businesses, like High Frequency Trading, are bound to be outlawed the next time another flash crash occurs. Corporate mergers and acquisitions are withering on the vine because cheap financing is gone and buyers have to pony up cash instead of debt to buy another company. All in all, there isn’t any main line of the banking business that isn’t under assault, and the big banks in particular may be toast if consumer defaults accelerate, especially strategic defaults where the consumer walks away from a mortgage even though they can continue paying it.
Another reason corporations don’t want to accept the regime change that is staring them in the face is that the mad race to ever-higher returns on equity is finished. The days of 15%, 20% or even 30% ROEs are coming to a close, and eventually corporations will be bragging about their 5% ROEs. This is perhaps the most painful adjustment of all, because it hits corporate executives right in the pocketbook. Much smaller ROEs will lead inevitably to much smaller executive paydays.
All of these pressures on corporate performance will sooner rather than later push the Dow closer to 6,600 rather than 14,000. And when 6,600 is broken, what then? Between Dow 1,000 to Dow 6,600, there are no natural buyers of stocks, because the move up from 1,000 was a moon shot straight through the Reagan, Bush I, and Clinton years. There was no significant consolidation in the markets during this entire period, which says that the market is well overdue to revisit this area, and perhaps retrace the move all the way back to Dow 1,000.
Most people, especially professionals in the market, think it preposterous that the Dow could fall as low as 1,000. That level was last seen at the very start of the Reagan years. But think about it: the market has already begun to unravel the great credit boom that began under Reagan and continued all the way to 2007. The total level of credit available to the US economy is shrinking to what was normal in the 1980s, and corporate profits are shrinking accordingly. The standard of living for the average American is collapsing as well, especially for the baby boomers who have no money saved for retirement other than some worthless tech stocks and an overvalued home. Why shouldn’t the stock market adjust in a similar manner? The Dow has already lost about 8,000 points from its peak when it fell to 6,600, so what are 5,600 points more?
For the moment, the idea of the Dow at 1,000 seems fantastical and absurd, but if and when it happens (and the odds favor when, not if), everything will look perfectly sensible afterward. We will all wonder why the Dow could possibly ever have traded above 10,000, and why we didn’t sell our shares back then when we had a chance. But of course, who was going to sell their shares on an idea that back then was considered fantastical and absurd?