Rocky Top MBA

CMM February 4th, 2009

There are lots of soothsayers, tea leaf readers, and other such fortune tellers in the world of economic commentary. Their opinions are frequently disguised as elaborate theories rooted in academic and professional perspective. Some are better at anticipating the cause-effect relationship of economic drivers (Jim Cramer) and some are just plain hokey. The later are the equivalent of cheap psychics that pass of mystical powers in the guise of broad generalizations.

I’m not going to tell you what’s going to happen in the next few months, because I don’t know. I have a feeling that things will find bottom and gradually start to improve over the next 9 months. I say this because I  feel confident that a free and uninhibited economy will always grow long-term, assuming population growth and societal advancement. History has shown us many examples of this model working. Operating under that theory, I’d like to share some thoughts and observations on the current economic situation.

Last week was another depressing stretch for the Dow, closing at below 8,000. As a side comment, I think there is a convincing case that the S&P 500 makes a better benchmark for overall economic health, but I’ll use the Dow since it is so frequently referenced by media.  With that disclaimer, it is easy to get frustrated/depressed/concerned when a major index seems to melt away 1% of its asset value in a single day. My question today is about understanding the “value” of the Dow and interpreting the measurements.

I’m a big fan of history, so I think it is a logical starting point for tackling the issue. The Dow Jones Industrial Average (aka The Dow or Dow Jones or Dow) was started by Charles Dow, an editor for Wall St. Journal and founder of Dow Jones & Company. It is the second oldest American index (behind the less well known Dow Jones Transportation index) and represents 30 of the most prominent companies in the world. Data is readilly available starting October 1, 1928 in its modern form, although the report was first published on May 26, 1896 with a recorded close of 40.94. For more information, visit Wikipedia’s Dow Jones Industrial Average article.

On October 1, 1928 the Dow closed at 240.01.  Using this basis for comparison, the Dow grew at an average of 3.02% per year until January 8, 1987. On that fateful day, almost 60 years after that 240 point close, the Dow broke through the ceiling and closed at 2,002.25. A closing above 2,000 was an incredible testament to the American economy. This achievement reinforced that while the economy may flux between “good” years and “bad” years, long-term the economy grew. From a financial planning perspective, this also enforced that money saved for retirement and invested in something like the Dow could be a low-risk way to save and grow money. After all, $1 accumulating growth at 3.02% is worth almost $76 forty years later.

What happened after the 2,000 mark is a phenomenon that I’ve never really had adequately explained. Over the next twenty years, the Dow grew at an incredible pace averaging 7.92%. This caused the Dow to break through ceiling after ceiling as the index shot up from 2k. The Dow topped out on October 9, 2007 at 14,164. While it took 60 years to reach 2k, twenty years later the Dow broke 14k, a 7x increase. There are some potentially convincing arguments for why this happened– my favorite being that advancements in technology increased the access and flow of information, therefore improving the accuracy of the Dow– but no one outside of academics and certain regulators seemed concerned. Most investors, industrialist, and politicians have been punch drunk on the gains that rolled in with this growing economy.

While I don’t really have the necessary data or analytical skills to prove my theory, I think the economy became overheated during this period and economic growth exceeded capacity. Certain elements of the economy became exhausted due to over stimulation and manipulation (dotcom’s in the late ’90s, real estate in ’07, credit and banking in ’08). If you look at the graph below, you’ll see that I’ve taken the historical monthly averages from the Dow starting in October ’27 and going through January ’87. I’ve added a trend line assuming exponential growth through the end of ’08. The results are astonishing. Based on this trend line and previous growth in the economy, the trend line shows the Dow breaking 4,500 at some point in ’08.

In reality, what actually happened was something like this:

Now, I know the math here is a little weak, but it doesn’t take a statistician to see that growth over the last twenty years has far exceeded historical trends. Our trend in the first graph forecasted reaching almost 5,000 by the end of 2008. We actually saw an all time high of around 14,00 in October of 2007. That is 9,000 points or 280% of the forecast.

The core assumption of economic growth is that the economy grows as a function of supply and demand. There are a number of functions that effect supply and demand (population growth, opportunity cost, the free exchange of information, etc), but 280% of the trend forecast means that something major must have changed inside the supply and demand function.

I could keep writing about this for the rest of my life, but I’m no economist. I’m a capitalist, and I want to get back to the profit side of this study (i.e. my job). I will say that I think the economy became over inflated in the last twenty years and bloated with the activities of greed from both Wall St. and Main St. Looking back, we all know the culprits– they’re the same investments and financial systems that we “blame” for the current problem.

I think it is reasonable to expect the market to grow at a rate higher than the trend lines forecasted 5,000. I accredit this assumption to our increasing understanding of the “digital age” and its effect on the flow of information. With the Internet, 24 hour news cycles, and the ever growing rank of academics and professionals in this area, it is no surprise that the market should become more efficient. I also think the market will grow at a rate less than the trend line in the second graph, forecasted at 8,000 at year end. Based on these two models, I assume the Dow to restablish an equilibrium somewhere between 5,000 and 8,000.

In just a few minutes, the Dow is scheduled to open at 8,070 and trade up. I don’t know where the bottom lies, and no one really does with all the tinkering and “market psychology” babble going on in Congress, the White House, and on Wall St. I think a realistic low is somewhere between 6,500 and 7,500 if left to its own devises. This isn’t technical analysis; call it a gut feeling. And my gut says we’re getting very close.

• Economy
• Comments(2)