It has been a bad December for the stock markets, but pundits across the land are predicting a recovery in the new year from this terrible drop. Short-term market fluctuations are unpredictable, but the reality remains: owing to decades of funny money the market has got far ahead of its equilibrium value, which is now around 11,000 on the Dow, half the present level. It is worth examining what a world with Dow 11,000 will look like.
Dow 11,000 isn’t just a random number. The Fed changed monetary policy definitively at its meeting in February 1995, and on the same day, the Dow Jones Industrial Index broke through 4,000 for the first time — with the Fed changing its policy decisively to an easier trend, it was natural for the market to rise. Since stock prices should rise approximately in line with the economy’s expansion, that Dow 4,000 is equivalent to Dow 11,000 today, taking account the rise of around 175% in nominal Gross Domestic Product between the first quarter of 1995 and today.
So, if the Dow were around 11,000 today, it would be at the same relative valuation as it was in February 1995. That was not an ultra-low level; the Dow was almost 50% above its peak of October 1987 and after all, that day in February 1995 was the first time the Dow had ever reached the exalted level of 4,000.
The world of Dow 11,000, after the next bear market and perhaps partial recovery, will have quite a lot of our current economic landscape missing. Far too many Fortune 500 companies have overindulged in stock buybacks, leaving them in some cases with no equity at all. As the stock market decline continues, many of those companies will be forced to recapitalize themselves, generally at share prices far below where they bought back shares. For some of them, this emergency recapitalization will prove to be insufficient, and a second recapitalization will prove unavailable in the market. At that point, those companies will be forced to file for bankruptcy. The chances are, the victims will include some very large names indeed.
The self-immolation of the Fortune 500 will be a major cause of the market’s drop to Dow 11,000. We must however realize that many of the factors causing trouble in 2008 are not currently present. Housing has not become over-extended, and lenders to housing have remained much more cautious than in the last cycle. Thus, there is no great overhang of residential real estate waiting to blight the U.S. economy, as there was a decade ago.
If investors’ losses on stocks are only comparable to the last downturn, and investors’ losses on residential real estate are much less, then it is unlikely the recession will be as painful as was the Great Recession of 2008-10. Provided the recession occurs while the political and Fed stars are in their current alignment, it is also unlikely that unemployment will rise as far as it did in 2008-10, or that economic recovery will be as sluggish. Productivity growth will continue at its current healthy rate, so overall output will rebound quickly from any decline and redundant workers will be absorbed quickly.
The only caveats to this are the behavior of the Fed and the U.S. electorate. If the Fed, possibly goaded by President Trump, panics at the continued stock market decline and lowers interest rates back to around zero, where the real interest rate is negative, then the economy will return to its sick condition of 2008-16. Productivity growth will cease, and although the stock market decline may temporarily reverse, job creation in the economy will disappear. New investment, which has been steadily re-orienting towards productive uses, will revert to overpriced real estate, non-functioning tech boondoggles and yet more pernicious, destructive stock buybacks.
Furthermore, if the political alignment changes, and a regulation-happy Democrat President arrives, imposing additional costs on business, then the recession will become deeper and more severe. Clearly, if both unhappy events occur the economy will be in a real mess, with recession combining with a new dearth in productivity growth.
Now examine what I believe to be the most likely case (in this area I am an optimist!) with interest rates close to where they are now, or even a little higher (perhaps around 1-1.5% above the rate of inflation) while the Dow is at 11,000. For those contemplating the market drop to get there, this may seem like a frightening prospect. However, overall such an environment will be good news, not bad.
The most important difference from the environment of the last 20 years is that the Fed would no longer be distorting interest rates and through them the entire capital market. When interest rates are set through a government-fiat process in this way, capital investment decisions get distorted and capital flows, not to the investments that make most sense in terms of productivity and growing the economy, but to the investments that can best take advantage of “funny money,” usually because they use a lot of capital, but do not deploy it very effectively.
Thus, in our Dow 11,000 world it would no longer be attractive for companies to repurchase their shares in large volumes – the cost of debt and equity capital would be too great to be balanced by the modest short-term earnings boost from doing so. There would no longer be gigantic pools of hedge fund and private equity fund money, seeking to invest in spurious speculations and vapid tech me-too operations – it would have become too difficult to collect more than modest such funds, so only the best investments would get financed. Real estate in the largest cities would no longer command a gigantic premium; in New York for example the current glut of ritzy multi-million dollar apartments will lead to a dearth of new building, a decade of price declines, and a healthy move out to the suburbs, as in the 1950s.
A further consequence of our new Dow 11,000 world will be a re-balancing of the wealth distribution. Asset prices would be much lower, capital scarcer and borrowing more expensive, so there will be far fewer billionaires and the explosion in earnings of the Top 0.01% will reverse. With luck, the most corrupting tax loophole of the very rich, the charitable tax deduction, would also be closed, ensuring that the rich pay the tax they should and eliminating much of the economically damaging and left-propagandist “non-profit” sector.
For ordinary folk, the prospect of Dow 11,000 is at first sight daunting. They have savings and pension plans that are invested largely in the market, and the prospect of those plans halving in value from their current level is highly unattractive. However, two factors mitigate the damage. First, we have all been hearing from “experts” that the projected return on stocks over the next 20 years will be much lower than currently – a matter of 3% or so. That would mess up our retirement plans in any case, because pension plans and our own savings for retirement are predicated on getting a healthy 7-8% on our money.
However, if the 3% return takes the form of an immediate halving in value, followed by a reversion to the normal 7-8% return (taking us back to the 3% return level in 15-20 years) that is much better for our retirement plans than a steady 3% return. While our immediate pension pot is halved, new contributions are made at much lower stock prices, and then make healthy returns until our retirement. 15-20 years out, we will be better off; the pre-2019 money will be worth what would be expected at a 3% return, while post-2019 money will be worth much more. Only those poor souls like myself, already close to retirement age, will suffer a loss beyond what we expected.
Even for us, however, there is another advantage. In the Dow 11,000 world, the bankruptcy of social security, currently expected in 2033, probably will not occur. Social security and other pension schemes have been growing steadily more unsound since 1995 and especially since 2008, because productivity growth in the economy has been so much below par. However, in the Dow 11,000 world, capital will be properly allocated and productivity growth will return to its healthy normal level. There will be additional economic growth beyond what is currently expected, and Social Security and indeed Medicare systems will become steadily more solvent. The Social Security bankruptcy date of 2033 will recede further, into the mists of the distant future. Since Federal revenues will also be higher than expected, budget deficits will also decline, returning the U.S. fisc to its healthy state of the 1990s. So even us old folk whose retirement savings pots are damaged can take heart: social security will remain there for us, so long as we live.
The world of Dow 11,000 involves some short-term pain, but in the long run we will all be better off. So above all, let us not allow Congress, this or a new President or the Fed to ruin it by re-distorting an economy that has been distorted by silly interest rates for far too long.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)