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In February 1995, the U.S. economy was in great shape. The 1990-92 recession had been over for a couple of years, the Federal Reserve was beginning to ease interest rates, the Clinton administration was beginning to make progress on sorting out the United States' modest long-term budget problem and there was this new thing called the Internet that looked as though it might bring some exciting new possibilities.
The stock market, too, was strong, with the Dow Jones Industrial Average broke through the 4,000-point level on Feb. 23, 1995, putting it almost 50% above the bull-market high of September 1987.
That level of 4,000 is equivalent to about 7,800 today, when you inflate it by the growth in nominal gross domestic product (GDP) in the intervening 14 years. In other words, if things were looking as good as they were in February 1995, and the market was moderately bullish as it was then, you'd expect the Dow to be around 7,800.
The Dow surged 2.85% yesterday (Monday), to close at 8,504. But the economic conditions we're looking at today are nowhere near as strong as they were back in the spring of 1995. And that paints a somewhat bleak picture of where the U.S. stock market may be headed.
To get the ultimate doom-laden view, I talked last week with Robert Prechter, who for 30 years has run an investment company based on the Elliott Wave Theory, propounded in 1948 by Ralph Nelson Elliott. I'd wanted to meet Prechter ever since I had seen ads he ran in Barron's back in the bear market days of 1981-82. The Dow was around 800 at that time, and he forecasted that the U.S. stock market was about to enter a huge uptrend, which might last as long as 20 years, and for which 3,000 on the Dow was only the first stage.
"Boy, he's bullish," I remember thinking - it was considered bold at that stage to forecast a Dow of 1,200, which would have been 15% above the index's all-time peak set in 1972.
But Prechter was right.
He was also right in 1987, when he predicted the sharp bull market of that year would end, but that the pullback would be only a temporary problem before the market went on to greater things.
In the late 1990s, Prechter turned bearish, explaining that the "fifth wave" of an Elliott Wave cycle - and therefore the bull market - was coming to an end. He was a few years early, but by following his advice after about 1998 you would have avoided a decade in which your money made an all-in return of approximately zero.
He was still bearish in 2003 - as was I. In cash terms, we were both wrong and went on being wrong for the next four years, as the Dow zoomed from 8,000 to around 14,000. Of course, as he pointed out to me last week, if you accounted in gold, stocks had in fact declined somewhat between 2003 and 2007. It's not the Elliott Wave system's fault that the denominator in the equation - the U.S. dollar - fell out of bed through excessive money printing.
Prechter even managed to call this year's March bottom, expecting a substantial bear market rally at around 6,300 on the Dow, close to the bottom. However, he expects the market to resume its downward trend shortly, ending with a decline similar to the 86% in real terms of 1929-32 as we are in a long Elliott Wave downswing. That would take the Dow down to around 2,000.
Personally, I would not go that far. This does not look like a reprise of the Great Depression, although it could still turn into one with enough policy mistakes - another "stimulus plan," or a big dose of protectionism, for example. However, the downward macroeconomic momentum looks bigger than in either 1974 or 1982, bear markets that both brought real-term drops of slightly more than 50% from previous highs.
The current crisis more closely resembles the British crisis of 1972-75, which caused a drop of 72% from the high, or the Japanese crisis after 1990, which brought a drop of 70% within three years, and led to a long-term bear market that has left that market in its current doldrums, about 80% below its peak. For us to see a similar 70% decline from the Dow high, we'd have to be looking at an index that had fallen all the way down to about 4,400. At that point, it would about as cheap as after the 1987 crash, though still not as cheap as it was in 1982, before the great bull market began.
Bulls will respond that corporate earnings are still above the levels appropriate for a 4,400 Dow, to which I would respond that profits might have further to fall. So far, we have seen only a collapse of financial sector earnings, while non-financial earnings remain close to their 2007 highs, when GDP was also at record highs. A period of higher corporate taxes and slow growth - coupled with consumer spending that's low because U.S. consumers need to save, rebuild their asset base, and pay down their debts - could well cause a further period of earnings deflation, which would return corporate profits to their historical average percentage of GDP - if not to an even lower point.
Where Prechter and I differ is on inflation. He sees a further collapse of asset prices and debt values, with consumer debt and commercial real estate wreaking more havoc on bank balance sheets. That could cause massive price deflation, and a decline - rather than an increase - in the price of gold.
Personally, I look at the over-expansive monetary policy pursued by the Fed for a decade now, and its continuance, and see inflation ahead. Inflation would also help Uncle Sam finance those deficits, so it seems more likely than not.
That difference in opinion aside, Prechter was both charming and fascinating. Maybe we can combine our views, and agree that the deflation will be of the dollar's value, so that prices will inflate in dollar terms, but deflate in such other hard currencies as the euro, the renminbi (China's yuan), or the Brazilian real. We shall see.
The bottom line: While the market could go up a little further in the short term, it's not the time to get aggressive.