Looking Forward To Dow 11,000

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.

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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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