Looking Forward To Dow 11,000

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.

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(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 ...

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