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Generational Dynamics Web Log for 18-May-06
Worldwide stock market selloff partially triggered by quirky housing effect

Web Log - May, 2006

Worldwide stock market selloff partially triggered by quirky housing effect

A substantial week-long selloff in stock markets around the world is resulting from a number of things coming together.

The market selloffs on Wednesday were dramatic. The Dow fell almost 2%; European stock markets fell 2-4%; and as of this writing (midday Thursday in Asia), Asian stock markets are falling 1.5-2%. And this is after a week that's been generally down anyway.

A number of analysts are blaming this partially on the trouble in the housing market. The housing bubble appears to have burst last October, housing sales and housing prices have been falling, albeit slowly, and this has helped cause the current stock market meltdown according to the following logic:

With home sales down, more people are renting, pushing rents up.

Housing costs are a big part of the government's computation of the Consumer Price Index.

Therefore, the CPI is higher than it really should be, since the high rental costs are making it artificially higher.

The higher CPI makes it look like inflation is returning. There was a new CPI report this week, making it look like inflation is increasing.

Thanks to the apparent rise in inflation, the Fed will continue to increase interest rates, more than they would otherwise.

The further increase in interest rates is bad for business, which will depress corporate earnings, and that sparked the selloff.

This chain of logic, which I gather is widely believed among analysts, really makes almost no sense at all, but it's probably as sensible as any analyst reasoning we hear today.

It always amazes me that inflation is the only danger that analysts even think of. That's because inflation was high during the 1970s, and so they think that's all that can happen.

This is Generational Dynamics in action. The generations of people who lived through the 1930s Great Depression are pretty much dead and gone today, and today's analysts and financial managers have never personally seen anything like it, so they don't even bother to think of it.

I remember well in the 1950s, when I was growing up, and also in the 1960s and 1970s, analysts were actually worried about things like price/earnings ratios and the danger of another stock market collapse.

The turning point was the "false panic" of 1987. The stock market fell over 20% in one day, and then recovered quickly. Alan Greenspan, who had just taken over as Fed chairman, was given the credit for the quick recovery, because he reacted quickly and loaned large amounts of money to financial institutions to get them through the crisis.

As a result, younger generations of investors, analysts and financial managers concluded that there wasn't any danger from stock market panics. The Fed can just do what Greenspan did. Right?

What these people are too dense to realize is that in 1987 the market was just coming out of a long period of low price/earnings ratios -- that is, stocks had been underpriced for most the preceding decade.

But today, price/earnings ratios have been astronomically high for over a decade, and stocks today are waaaay overpriced, more so than even in 1929. So what worked in 1987 can't possible work today, just as it couldn't have worked in 1929.

New Fed Chairman Ben Bernanke has repeatedly said that there's no danger of a stock market crash at all. This coming from a guy who used to be Professor of Economics at Princeton, but even so doesn't have the vaguest idea how long term trends work.

I summarized all this in my essay, "Ben S. Bernanke: The man without agony." I contrasted Bernanke's "What? Me worry?" attitude with Alan Greenspan's much more sober and somber attitude.

Long-time readers of this web site know that I frequently quoted and analyzed the statements by Alan Greenspan many, many times in this web log. I really enjoyed Greenspan's statements because there were so nuanced and insightful. Analysts used to claim that Greenspan was inscrutable, but that was never true; they just didn't want to hear what he had to say, just as they don't want to hear about price/earnings ratios any more. In fact, Greenspan was always very precise and very clear, and he managed to convey his agony over the possibility of a coming stock market crash in a way that didn't risk allowing his words to trigger a panic.

But I have little desire to read Bernanke's speeches. His speeches are so shallow, they almost fall to the level of investment firm boilerplate. This is a guy who, typical of people in his generation, really has no idea what's going on.

Consumer price index (CPI) from 1870 to present, with an exponential growth trend line. The CPI is 185 in 2003, and 2010 has a trend value of 129.

Consumer price index (CPI) from 1870 to present, with an exponential growth trend line. The CPI is 185 in 2003, and 2010 has a trend value of 129.

As for the danger of inflation, Generational Dynamics tells us, as we've been saying since 2002, that we're in a long term deflationary period, and that prices will be falling by 30% in the next few years. This assessment is based on the adjoining graph of CPI from 1870 to the present, along with an exponential growth trend. What most people don't seem to understand is that almost all growth trend values must maintain the long term trend; this is the law of "Mean Reversion," that we've discussed before. Since the CPI is well above the trend line today, it has to start falling soon, and stay below the trend line long enough to balance things out.

I hope you understand that, dear reader, and if you do, then you're smarter than Ben Bernanke, because he doesn't have a clue.

So with the market meltdown going on the last few days, is this the "big one"? Well maybe, or maybe not. You can't predict the exact date of a stock market panic until it happens. Maybe the markets will be steady for a while, or maybe they'll even recover.

But Generational Dynamics tells us that a stock market crash is coming, and coming sooner rather than later.

There are many factors that are negatively affecting the stock market today, and they all have to do with reduced monetary liquidity worldwide. Here are some examples:

The Fed has been raising interest rates, which reduces business earnings.

With interest rates going up, mortgage rates have also been going up, and that leaves consumers with less money to spend, which negatively affects business.

A federal law that took effect in January requires credit card companies to charge consumers three times the minimum payment that was required last year. This has the same effect as the previous point.

International oil prices have gone, in the period of a few years, from $25 a barrel to $35, then $45, then $55, then $65, and recently $75 per barrel. This affects the cost of doing business, and it also affects takes money out of consumers' pockets, once again leaving them with less to spend.

Oil, food, metals, and other commodity prices have been going up because China has been sucking everything up. This has the same result as above.

China is appreciating its currency, and since much of what we buy today comes from China, this means that many consumer goods are more expensive today.

So there's a lot going on today.

What's also happening is that investors are becoming increasingly nervous and risk-averse. Think of it this way: During the 1990s stock market bubble, investors were so risk-seeking that they'd go for anything, no matter how ridiculous.

Well, the opposite is happening today. Investors are changing from risk-seeking to risk-averse, and they're continuing to be just as irrational as ever. "Irrational exuberance" has been replaced with "irrational revulsion."

At some point, this risk-averseness will trigger a stock market panic. It might be next week, next month, or next year, but it's coming, and sooner rather than later.

Generational Dynamics has been predicting since 2002 that we're entering a new 1930s style Great Depression, and that stocks will fal to the Dow 3000-4000 level, most likely by the end of 2007. (18-May-06) Permanent Link
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Generational Dynamics Web Log for 18-May-06 Worldwide stock market selloff partially triggered by quirky housing effect

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Generational Dynamics Web Log for 18-May-06
Worldwide stock market selloff partially triggered by quirky housing effect