In the Long Run...
More than a great line from an Eagles song, today's title expresses my desire to step back from the daily myopia and see where we are in the grand scheme. So I offer this chart:
This is a yearly chart of the Dow Jones Industrial Average since the turn of the century. That was the turn from the 19th to the 20th century (1900, in other words). This was created by drawing a trendline between the 1929 and 1999 highs (2000 would also work well, I believe). Then a parallel line was added using the 1933 opening level as the starting point. Some of the interesting characteristics of this chart are first, that even though the data points preceding the 1929 peak were not taken into consideration when drawing the upper trendline, the data points of the earliest years in the 20th century are quite neatly contained by this line. Second, momentum peaks precede actual price peaks by a full decade! Talk about an early sell signal! Note momentum peaks in 1955, 1989 and 1997 being followed by price peaks in 1966, 2000 and 2007. Third, in hindsight, we should not be surprised by the violent drop witnessed last year after the failed breakout in 2007 above the previous peak in 2000. Third, notice that the 34 year moving average has contained most selloffs (the 1930's being the key exception). Anyone who bought at or near this average during the last 75 years and held on has likely made tremendous profits. Fourth, the major exception to this observation (the early 1930's provided a fantastic buying opportunity of multi-generational proportions anywhere during the year of 1932 and through most of 1933! In other words, there was an 18-month period when buyers who were not shaken out during this time (this is no mean feat, by the way) would have experienced massive profits for their lifetimes even if they had purchased at the highs of the year for 1932 and experienced an immediate 50% drawdown!
"That is all well and good!", you say, "But what does this tell us about the future?" OK, first of all, 15,000 is likely a pretty substantial area of resistance for the foreseeable future. "But that is 50% higher than where we are today!". Yes, but the flip side of that equation is that 3,000 is the low end of the range of possible expectations. So does a potential 50-100% gain justify risking a 60+% loss? I would argue that it doesn't. "But how likely is it that we will go that low?" I will address that point a little later. But first, I want to point out the current year's action has the initial makings of a reversal. Of course, the year is nowhere near over, so this can change, possibly drastically. But 2009 has seen the DJIA hold support at its 34 year moving average, roughly a generational support line. And this rally has also brought the Dow back above its 2002-2003 lows, if only by 5% or so. The next few months will be critical for the next few years potential for the market. If the Dow cannot hold above its 2002-3 lows, then a visit of the lower end of this channel becomes a high probability. At least, the likelihood that the 8,000 level (give or take a few hundred points) will become a significant area of resistance unlikely to be breached in the next few years. If the market can hold its recent gains for the next few months, then a return to the upper range of the channel around 15,000 over the next few years will be quite possible. But notice that when the market reached the upper end of the channel in 1929, it was 25 years before that level was exceeded. This would imply that 15,000 may not be seen much before 2025.
Now, what about the likelihood of a return to the bottom of the channel? If we compare today's environment to that of the other where the Dow touched the bottom this channel are they different or fundamentally similar? In the early 30's, we had excess capacity leading to declining pricing with a large debt burden producing significantly abnormal levels of defaults. This seems to parallel our current state of the housing market perfectly, as well as many other areas of economic and financial activity, such as consumer credit and government debt. So while there may always be a small chance of seeing stock prices touch the lower end of this channel, the next few years will see a much greater likelihood of low stock valuations.
Finally, this chart should indicate that a drop of the Dow to 3,000 in the next 5-10 years is entirely in the normal range of expected outcomes for our economy and financial system. At such a point, the risk/reward would be so heavily favorable with 15,000 + points of upside with only hundreds of points of downside risk, that anything less than a fully invested position would be short-sighted. So while many prognosticators may forecast extremely dire consequences should we see stocks trade at this level, most likely Dow 3,000 would not indicate systemic collapse. Sustained levels below that would indeed indicate that a 110 year advance has been broken and that the "system" itself is vulnerable. Let's hope that we do not witness such a fall, but be aware and cognizant of the fact that more than one year below this key level is a likely indicator that the worst has come to pass.
This is a yearly chart of the Dow Jones Industrial Average since the turn of the century. That was the turn from the 19th to the 20th century (1900, in other words). This was created by drawing a trendline between the 1929 and 1999 highs (2000 would also work well, I believe). Then a parallel line was added using the 1933 opening level as the starting point. Some of the interesting characteristics of this chart are first, that even though the data points preceding the 1929 peak were not taken into consideration when drawing the upper trendline, the data points of the earliest years in the 20th century are quite neatly contained by this line. Second, momentum peaks precede actual price peaks by a full decade! Talk about an early sell signal! Note momentum peaks in 1955, 1989 and 1997 being followed by price peaks in 1966, 2000 and 2007. Third, in hindsight, we should not be surprised by the violent drop witnessed last year after the failed breakout in 2007 above the previous peak in 2000. Third, notice that the 34 year moving average has contained most selloffs (the 1930's being the key exception). Anyone who bought at or near this average during the last 75 years and held on has likely made tremendous profits. Fourth, the major exception to this observation (the early 1930's provided a fantastic buying opportunity of multi-generational proportions anywhere during the year of 1932 and through most of 1933! In other words, there was an 18-month period when buyers who were not shaken out during this time (this is no mean feat, by the way) would have experienced massive profits for their lifetimes even if they had purchased at the highs of the year for 1932 and experienced an immediate 50% drawdown!
"That is all well and good!", you say, "But what does this tell us about the future?" OK, first of all, 15,000 is likely a pretty substantial area of resistance for the foreseeable future. "But that is 50% higher than where we are today!". Yes, but the flip side of that equation is that 3,000 is the low end of the range of possible expectations. So does a potential 50-100% gain justify risking a 60+% loss? I would argue that it doesn't. "But how likely is it that we will go that low?" I will address that point a little later. But first, I want to point out the current year's action has the initial makings of a reversal. Of course, the year is nowhere near over, so this can change, possibly drastically. But 2009 has seen the DJIA hold support at its 34 year moving average, roughly a generational support line. And this rally has also brought the Dow back above its 2002-2003 lows, if only by 5% or so. The next few months will be critical for the next few years potential for the market. If the Dow cannot hold above its 2002-3 lows, then a visit of the lower end of this channel becomes a high probability. At least, the likelihood that the 8,000 level (give or take a few hundred points) will become a significant area of resistance unlikely to be breached in the next few years. If the market can hold its recent gains for the next few months, then a return to the upper range of the channel around 15,000 over the next few years will be quite possible. But notice that when the market reached the upper end of the channel in 1929, it was 25 years before that level was exceeded. This would imply that 15,000 may not be seen much before 2025.
Now, what about the likelihood of a return to the bottom of the channel? If we compare today's environment to that of the other where the Dow touched the bottom this channel are they different or fundamentally similar? In the early 30's, we had excess capacity leading to declining pricing with a large debt burden producing significantly abnormal levels of defaults. This seems to parallel our current state of the housing market perfectly, as well as many other areas of economic and financial activity, such as consumer credit and government debt. So while there may always be a small chance of seeing stock prices touch the lower end of this channel, the next few years will see a much greater likelihood of low stock valuations.
Finally, this chart should indicate that a drop of the Dow to 3,000 in the next 5-10 years is entirely in the normal range of expected outcomes for our economy and financial system. At such a point, the risk/reward would be so heavily favorable with 15,000 + points of upside with only hundreds of points of downside risk, that anything less than a fully invested position would be short-sighted. So while many prognosticators may forecast extremely dire consequences should we see stocks trade at this level, most likely Dow 3,000 would not indicate systemic collapse. Sustained levels below that would indeed indicate that a 110 year advance has been broken and that the "system" itself is vulnerable. Let's hope that we do not witness such a fall, but be aware and cognizant of the fact that more than one year below this key level is a likely indicator that the worst has come to pass.
posted by Matt Butler at 10:59 PM
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