This week the Dow Jones Industrial Average did what it couldn’t do last week – it found the courage to close over 15,000 points for the first time in history. The chart below compares the Dow’s performance to Real and Nominal GDP; a discussion follows.
In terms of today’s dollar, the DJIA has 500 more points to go before reaching its 2007 high-water mark, and then another 400 points to regain its core objective – Nominal GDP.
That brings an interesting question to light: Is it possible for the DJIA to be over-valued, and in fact irrationally exuberant, when it has not yet reached its objective (Nominal GDP)?
The short answer is: Yes, it is very possible. One quick reason is massive government spending programs that aren’t part of the stock market, like green energy “investments.” While some of this activity is indeed reflected in GDP, companies like Solyndra and A123 battery aren’t likely to be included in the DJIA or S&P 500 any time soon. And when you consider the trillions being thrown around by governments these days, it’s easy to figure that GDP will never correlate exactly to major stock market indexes.
Reality is a lot of things – exactness isn’t one of them.
But that doesn’t mean there aren’t legitimate correlations to stock values. I have written many times about the value of stocks, economic reality, and manipulation of major market indexes (see: Market Manipulation). The action zone is an excellent technique to illustrate the current status of the Dow’s value based on its historical trading multiples.
The chart below is the same as the one shown above. The only difference is the entire action zone, the average range the DJIA has traded in the last 20 years, is shown. It includes three lines: a high (red), middle (yellow), and low (blue). See below.
A few things are easy to see. First, the Dow clearly trades above and below its historical averages all the time. The action zone lines, therefore, are not absolute limits, but a range of reason used to gauge whether “the market’s” value is high or low. Such a view can also help investors identifiy appropriate points to buy and sell.
It is also clear that the Dow spends little time trading at the action zone mid-point. The yellow line indicates “fair value” in a stable economy. It is a point that the Dow should be trading around in an economy like this one – not a boom and not yet a bust.
Investing success is most easily had if the bulk of transactions are made within the range of reason that is the action zone. It defines the Dow’s current value based upon the historical averages it experienced during times of economic expansion, stability, and recession. The action zone is a tool to help investors make their own decisions consistent with their objectives.
So it’s easy to see that the Dow is high here. But can it be considered irrationally exuberant when it is still 1,000 points away from the market average (Nominal GDP)?
That should be more clear in a moment, but first a reminder: Investment is not about buying at the lowest and selling at the highest. That’s speculative trading. Investing is about buying low and selling high. Investing is long-term, and trading is short-term.
The advice and commentary in these blogs are directed from a long-term investment perspective to long-term investors.
That said, few things are for certain: 1) Everyone is different, and each has their own risk tolerances, objectives, and timelines; 2) It’s easy to buy low and sell high if you can see them; 3) Patience is a virtue with success; 4) and most importantly, the best decisions to buy, sell, or hold are not inside some big box financial advisor or stock broker. They’re inside you.
No one cares more for your money than you do, and no one will do a better job managing you money than you will. This, of course, is not to mention that the Wall Street establishment is way too devious to play it straight. That’s why they’re always the last ones to tell you that the bottom will fall out of this stock market the first moment it can.
How can I be sure?
Because “the market” has no foundation, no fundamental basis for its current valuation. Again, the Dow is currently valued above the pinnacle of the tech boom when Real GDP growth was 6%. The current economy has no Real growth, no boom, and unlike in the Clinton ‘90s, fiscal governance is on a chartered course to bankruptcy.
Fiscal and monetary mismanagement do not make the economy and/or stock market stronger. And that’s what we have.
In fact, just this week Federal Reserve chairman Ben Bernanke said this, “Even if we can’t indentify, and I’m fully willing to admit that there will be times when we can’t identify a bubble or some other mis-evaluation, our hope is to make sure the system is sufficiently robust.”
In other words, according to Bernanke the Fed might not see an asset bubble being created in the stock market, but that doesn’t matter. As long as he keeps pumping trillions of dollars of new cash into financial institutions, well, then he’s doing his job. It doesn’t matter that he’s handing that money to those who are creating the stock market bubble. No. The only thing that matters is keeping them “sufficiently robust.”
I wonder how much Wall Street is paying him.
Of course Bernanke pointed out several of the obvious – that free money makes banks less efficient, more risky, and more prone to huge loss and bailout. For those reasons Bernanke established higher capital reserves for major banking institutions, and is looking for help in Congress to expand the Dodd-Frank financial regulation to impose even higher capital reserves for, as he says, “the largest, and most complex Wall Street firms.” This effort is to make institutions that are too big to fail, “safer.”
This from a guy who can’t see the asset bubble going on in the stock market right now; perhaps that is the “mis-evaluation” he was willing to admit to.
Not me. Stock market inflation is easy to see. The Dow Jones Industrial Average is up 15.4% so far this year, some 25% over “fair value”, and the economy (GDP) has barely grown.
How is this possible?
Money – and to be specific, the money Bernanke is printing via quantitative easing and handing to the Wall Street establishment in order to make them “sufficiently robust.”
And what do Wall Streeters do with that new money?
They invest it in well diversified portfolios (sound familiar?), which besides making them more money, enhances their capital reserves at the Fed’s request. This action artificially forces the DJIA and S&P 500 to inexplicable heights. New record highs are then used as advertisements by the Wall Street establishment to entice idle capital off the sidelines from skeptical investors. It’s their version of dangling a carrot in front of a horse.
Sadly, more evidence appeared this week that their campaign seems to be working. The Wall Street Journal reported that “small investors” are rediscovering margin debt to buy marketable securities that they don’t have the money to buy outright – “reaching levels not seen since the financial crisis.” (See: Investors Rediscovering Margin Debt, May 9, 2013.)
And guess where Wall Street gets that money to lend investors?
Yes, the money from quantitative easing (QE) is being used to make banks and bankers rich, to inflate stock market indexes, and to entice “small” investors to bite off more than they should reasonably chew. This only adds more fuel (money) to the fire (an already inflated stock market.)
It’s like the Fed and Wall Street are working together to fleece the investment public. And even though Bernanke may think he’s smarter than to let that happen, no one knows how to manipulate the market and jibe the system more than the Wall Street establishment.
Caution to investors who trade patience for risk in this market.
To be “all-in” on this market – let alone 125% or 150% with margin debt – is nothing short of crazy, and that includes people 25 years of age. No age is a good time to buy into over-valued and fragile markets; certainly not without first acknowledging a few fair minded considerations.
Consider that the Dow sits 3,000 points above its normal average trade in a lackluster and slowing economy (a.k.a. asset bubble.) Consider also that central government spending must decrease by at least $1 trillion per year to be “balanced,” a point in which revenues and expense are equal. Break-even government, or better yet surplus government, would reduce GDP and immediately shine a bright light on the fact that this stock market is extremely over-valued. Consider further that global Market conditions are deteriorating and the world seems ever close to another nasty warfront. And finally consider that it took the Dow almost 6 years to get back to where it was the last time irrational exuberance was in vogue.
To buy in here is an extremely risky proposition. Here’s the chart again.
Now, if you ask me if the Dow can keep going to 16,000 – I’d say yes, absolutely. But the higher it goes the faster it will drop when correction ensues.
And all that takes is one false move. Stay tuned for that.
In times like this asset allocation is key, cash is king, and 15-51 portfolios are better than anything Wall Street has to offer.
