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Why the DOW could Hit 14,000 this year -- and 8,000 in 2009.

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The Goldilocks Economy

Why the DOW could Hit 14,000 this year — and 8,000 in 2009.

Once upon a time there was a stock market in New York.  Beginning on May 7, 1792, it used to meet under a Buttonwood tree in lower Manhattan.  By March 8, 1817, the New York Stock and Exchange Board, or NYSE had settled down for business.  Decades later, in 1882, an enterprising young journalist named Charles Henry Dow created his new Customer’s Afternoon Letter.  He would later rename it The Wall Street Journal in 1889. Along the way, he also invented the Dow Jones Industrial Average, a handpicked price-weighted collection of the 12 biggest US companies at the time.  The time was May 26, 1896.  Over the years, the DJIA was expanded by the WSJ editors to represent 30 of America’s blue-blood stocks.  The movers and shakers that represented the overall American economic machine.  The Dow closed on that fateful opening day at 40.96.  On Saturday, May 26, 2007, 111 years later, the DJIA stood at 13,507, up 32,977%. 

Of course, the DOW was created before the Federal Reserve Board was invented in 1913. Prior to that, booms and busts would occur, but the prices of pretty much everything that Americans consumed tended to stay fairly constant over the decades and centuries.  Even stock prices.  Before the FED came into being, pretty much everything was traded in pieces of eight, gold and silver coinage.

By the time that World War I came along, the FED was busy pumping out newly minted dollars, but it’s real growth period would have to wait for another 25 years until WWII broke out.  From the 1940’s onwards, there was no looking back, and the FED began cranking out new “liquidity”  (econo-speak for money) with abandon.  There would never again be a great depression caused by a shortage of ready money.  Instead, the spectre of rampant inflation would rule the day.  And so it has been ever since.

What does this have to do with the price of the DJIA, or General Electric’s stock, or even supermarket-bought eggs, for that matter? 

Everything. 

As the number of physical and notational dollars in circulation went up, the price of everything denominated in these dollars would rise too.  Everything else being equal (and it seldom is), if the number of dollars, say, doubles, but the amount of goods and services produced doesn’t, then the price of everything will double as it will take twice as many pieces of paper to but the same thing.  Zimbabwe and South America know all about this phenomena – as did the Weimer Republic in pre-Hitler Germany.

Inflation encourages rampant speculation.  It drives the bubble mentality, and causes the mis-allocation of investments – along with government tax policy — by confusing the investor as to what is really going on in a marketplace versus what is happening to the medium of trade — the currency — that the transactions are rendered in.

People who buy bonds tend to be wiser and a bit smarter than those folks who buy stocks.  At least they tend to be a bit more conservative with their money.  They tend to avoid the roller coaster ride of the stock market.  They like stable (boring?) returns and the safety in knowing that they get paid before any shareholders do.  Especially in bankruptcy court.

Today’s bond investors are willing to pay more money to buy a short-term return than they are willing to invest in the long term.  The more people buy a bond, the higher its price becomes — and the lower it’s interest payment or yield will be.  Whenever the yield inverts, that is, the under-1-year T-Bill pays more interest than, say, the 10-year Treasury note, trouble lies ahead.  In just about every instance since WWII, when this has happened, a recession is less than 18 months away.  And it’s happened in 2007 once again.  This means that the savvy bond investors don’t see the long-term future through rosy glasses. 

And they are usually right.

Then again, there is the 4-year presidential boom-buts cycle well documented by Yale & Jeffery Hirsch and their Stock Trader’s Almanac. It seems like the money supply — and the good times that follow — seems to grow fairly rapidly just before the presidential elections.  And it slows down just afterwards.

This means that whichever party wins in November, 2008, they will likely be facing a serious recession encouraged by falling house prices, retiring baby boomers, tightening money, and a crashing stock market. 

Finally, the world is awash with dollars. 

Still the dominant global currency — all commodities from gold to oil to pork bellies are traded in dollars –  the US has been printing ever more dollars to pay for its federal budget deficits.  These flow into the hands of the people who promptly spend them on Wal-Mart imports from China and overseas oil. 

Saudi Arabia and the Asian countries can spend these dollars mostly only in the US.  And they are doing so by pouring into the stock and bond and commodity markets.  This drives prices up and the cost of running the Federal Government jumps, and the whole cycle repeats itself again.  All these fresh dollars can’t be spent back in the USA.  Some are used by the central banks of other countries as “official reserves” which back up the printing of more Yen, Renminbi, and Rials.  This, in turn, drives up inflationary growth in those countries. 

A worldwide bubble grows.  Eventually, a top will appear.  When the overseas investors finally get spooked, they cut back on US stocks and load up on US bonds, backed by the full faith-and-credit of the US government and its 700 overseas military bases in 36 countries.  Eventually, they may just want back their own money — paid in their own currency, driving the dollar down and sending dollar-denominated oil through the roof. 
High oil prices are an anathema to the stock market.  Oil costs permeate everything: food, clothing, manufactured goods.  Like a tax, expensive oil raises the costs of doing business.  Unlike a tax, there are little offsetting benefits.  But the tipping point is still a way off.

In the meanwhile, the stock market should continue to grow and the Goldilocks economy should continue to happen.  Enjoy the 14,000 DOW while it lasts.  Maybe even 15,000.   But don’t count on the rest of the ‘teens.  At least not in the United States.  And when the US catches a cold, the rest of the world has historically come down with pneumonia…
Of course, like any good economist, I could be completely wrong.  And I hope for my sake that I am!

Written By

Mr. Easton teaches University economics and is passionate about technology and entrepreneurship. He is rosy about the long-term future: ‚??The glass isn‚??t half full, it‚??s overflowing!‚?Ě

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