2009 looks like another Bear year
by Martin Hutchinson December 29, 2008
In 2008, we have seen a Bear year of close to record-breaking proportions. The current record holder is 1931, when the Standard and Poor’s 500 Index was down 41.9%; a bad day this week could easily take it below the 853, at which its 2008 drop would equal that record. The market has by far beaten my definition of a “Bear Superbowl” – a 25% stock market decline. The question now for Bear fans is 2009: if that, too, is a Bear year with a stock market decline, then the 2000s (2000-02, 2008-09) will be the first decade with five years of decline since the 1930s.
Economically, the prospects for the early part of 2009 look a little better than they did a month ago. The flood of cheap money into the system has caused a renewed upsurge in mortgage refinancing, which has benefited consumer income statements if not balance sheets. The sharp decline in commodity and energy prices has fed into consumer prices, which by dropping 1.2% in November allowed personal incomes (down only 0.2%) to produce a rise in real spending as well as an increase in the savings rate. Durable goods orders (excluding transportation) were up in November, when they had been expected to be down.
In other words, the economic decline, which had appeared to be accelerating to an alarming rate, has slowed considerably. If President-elect Barack Obama injects stimulus into the economy early in the New Year, the recession may bottom out and economic recovery become apparent by the late spring. Presumably, that would be accompanied by some kind of bounce in the stock market.
That may seem like good news, but it really isn’t, because the imbalances that caused the economic decline would still be present. House prices would have been stabilized by the cheap mortgage money, but would still be above their long-term equilibrium, and expensive in terms of earnings. The savings rate would have been suppressed, so would still be far below the level at which the U.S. economy is self-sustaining without endless infusions of capital from Asia and the Middle East. Budget deficits would be creating difficulties in the Treasury financing market, forcing up long-term interest rates.
Most important, the recent increases in the U.S. money supply would be working their way rapidly through to inflation. Conventional Bernankeist wisdom is that only deflation is a threat now, that rapid increases in the money supply are needed to combat a decline in money’s velocity and that those increases can be withdrawn quickly when inflation looks like turning up.
One look at the statistics will tell you that’s nonsense. The broad money supply, for which the St Louis Fed’s MZM series (which takes into account currency, checking, savings and money market accounts but not certificates of deposit) is the best available proxy, has risen at an annual rate of 16.6% in the last two months or 10.1% in the last year; removing that amount of money quickly is clearly likely to be difficult. More startling still, however, is the behavior of narrow money in the form of the monetary base, which had been increasing at 3-to-4% per annum in the period to September, but has gone completely haywire since then, increasing at an annual rate of 990.9% in the three months to December. No, that’s not a typo, in those three months the monetary base has been increasing at almost 1,000% per annum. Over the last year, its average rate of increase is 86% per annum, but that reflects nine months of gentle increase followed by explosion.
A rapid 10% decrease in broad money is probably impossible without wrenching the economy into a deep recession; a halving in the monetary base is certainly impossible without collapsing the banking system. Hence, the excessive increases in money supply will not be withdrawn, though the pace of increase will presumably be moderated. The Fed will not reverse course when inflation appears, but will instead act feebly as it has in every inflationary manifestation since 1995. Inflation will thus get a good grip; based on the usual temporal relationship between money supply increases and inflation we should expect consumer prices to be increasing at an annual rate of more than 10% within 18 months of today.
Outside the United States, the picture is remarkably similar. All major monetary authorities have indulged in excessive monetary creation; pretty well all major governments are joyfully giving in to the temptation towards “fiscal stimulus.” In the e-Euro zone, for example, euro M3 (another broad measure of money supply) increased at an annual rate of 20.8% in October and will very likely have accelerated in November as interest rate declines only began on November 9. Thus the recessions underway around the world are likely to see reversals as quick as that in the United States, so that by the middle of 2009 the global economy will appear to have resumed growth.
Worldwide, the end of economic shrinkage, gigantic budget deficits and the beginnings of inflation’s reappearance will cause both a reversal in commodity price declines and a sharp upward movement in the gold price. They will also produce a crisis in the world’s bond markets, as discussed in this column November 12, as the extraordinarily low yields of recent months prove to be wholly unsustainable. There will be a flight to index-linked bonds that will overwhelm those relatively illiquid markets and a flight to gold that will completely overwhelm that relatively small market (total investor demand for gold in the third quarter of 2008 was a mere $30 billion, according to the World Gold Council.)
Before resurging inflation has spread from economists’ discussions to a matter of daily public concern, the bond market collapse will once more bring turmoil to the world’s financial markets. This time, governments will be unable to provide either monetary or fiscal assistance, because their monetary and fiscal profligacy will have been the root of the problem, not a possible solution to it. President Bill Clinton’s electoral strategist James Carville once expressed a wish to be reincarnated as the bond market, because it had more power than presidents. In the second half of 2009, we are likely to see the full power that a collapsing bond market can wield.
The result of bond market collapse will be a second downward leg of the recession, its power proportional to the excessive monetary and fiscal weapons that have been used in the attempt to escape from the first leg. It is likely to be deeper than the first downturn, and much more prolonged, since the normal forces producing rapid economic recovery will be thwarted by “crowding out” in the capital markets and the high real interest rates necessary to fight inflation.
Andrew Mellon in 1929 claimed that the best way to fight recession was to allow a liquidation of all the excesses of the previous boom as rapidly as possible after which economic growth could resume. Mellon’s method produced sharp recessions but short ones; the 1920-21 recession, for example lasted less than a year even though it was quite deep. Our less stringent methods of dealing with recessions, in particular our abandonment of monetary and fiscal discipline, are likely to cut short recessions only in the very short term. If fiscal and monetary stimuli are excessive, the recession returns, fortified by a burst of high inflation, wreaking more damage than a Mellonian recession and lasting much longer. The price of indiscipline by politicians is thus high, and is paid by the populace as a whole.
The forecast for 2009’s stock market derives from the economic forecast. In the early months of the year, the market may well be quite strong, as the recession appears to bottom out and investors seek “bargains’ at levels that appear cheap compared to the bubble of 1996-2007. However, later in the year, as reality begins to dawn, the market will once again be weak. I have calculated previously that the stock market’s equilibrium level can be assessed as the Dow Jones Industrial Average 4,000 level reached in early 1995, inflated by nominal Gross Domestic Product. That would give a current figure of around Dow 7,900. However the bond market collapse will provide an extraordinary shock to the system and will send the stock market far below its equilibrium level, perhaps to as low as Dow 5,000 or even 4,000. At the end of 2009, the market will probably be lower than today, but still dropping.
Thus 2009 is likely to be another Bear year, making the 2000s the equal of the 1930s in their destruction of investor value.
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