By: Roshawn Watson
We've been having a nice little stock rally lately. As of yesterday, the Dow stands at 10322. Still, the shocking warning of market analyst Robert Prechter is still being discussed all over the net. He predicted that the Dow will drop precipitously to below 1000 within the next six months. Do you believe him?
That Stupid D word again
Prechter's premise is that stocks are presently overvalued and that we will soon enter a deflationary period. Yes, there's that dreaded "D-word" again. Deflation means that the prices of a wide variety of assets sharply decline in tandem. Both real estate values and stock prices rapidly declining would be an example of deflation.
During deflationary periods, there is a vicious cycle. For example, financial institutions dump discounted assets to generate capital and are hesitant to lend money. By aggressively selling, the value for the remaining assets on their balance sheets are driven down even more. In fact, that's the major contributor to the price decline: it is an effort to attract those scarce dollars. The problem is that when prices decline due to lack of demand, they can go well below the cost to produce that product. Consequently, companies employ cost-cutting measures such as decreasing the production of the poor-performing products and laying off employees. Decreased number of paychecks can further decrease demand for the products.
During deflationary periods cash is king because there are too few dollars in circulation. During deflation, one may be able to find a Mercedes for half-price, expensive restaurants will close, and industries catering to those who spend frivolously will shut down. Prechter also explained:
"In a deflationary environment, the last thing you want is to own any financial asset.If you stay out of stocks, real estate, gold and other commodities, which will all come down together, then you can preserve your purchasing power [in cash] for the next great buying opportunity."Prechter Is Not Alone In His Opinion, But Does That Make Him Right?
Prechter's opinion is still a minority opinion. However, he is not alone in his prediction of a brewing economic disaster. Richard Russell of Dow Theory Letters has also called for a monstrous decline although he doesn't advocate a specific Dow target. Financial author Robert Kiyosaki has recently predicted that the Dow will soon hit 5000 as well. Art Laffer also predicted that we are on the brink of economic collapse next year.
Radical predictions get our attention.Radical predictions from high profile analysts and money gurus are sometimes deemed more credible than moderate (hedged) predictions, for why would these experts risk losing their credibility by their prediction being proven incorrect unless they are certain they are right?
Pure Absurdity or Pure Genius
For the Dow to drop to 1000, dramatic changes would need to occur.
1) Earnings for the whole index would have to drop by over 60%
2) The price to earnings ratios for the whole would have to drop to about 5
3) Dividends would need to be dramatically cut.
The likelihood of these occurring concurrently or in tandem is very low, as it has never happened before (even during the "Great" Depression). Nonetheless, Prechter argues deflation and social unrest will diminished our perceived values of these assets within six months. Before dismissing his opinion, there are two additional considerations.
Do you remember all of the hoopla about those exotic investment vehicles two years ago? It was these complex derivatives transactions that got AIG, Lehman Brothers, and other financial and mortgage firms in so much trouble. The recent financial reform bill in many cases doesn't force banks to spin off their derivatives businesses. Personally, I don't feel that any bill can adequately legislate away all of the inherent risks in the system anyway. Interestingly, there is an estimated $700 trillion in exotic investments that is still in our financial markets today. Although presently it is business as usual on Wall Street, the concern is what happens if some of these investments implode as they have before. As we saw with CDOs (collarteralized debt obligations) between 2006-2008, it's hard to sell investments that no one wants.
Another consideration is taxes. In Will The Economy Collapse in 2011, I discuss famed economist Art Laffer's argument that there is an acceleration of economic activity this year because Bush's tax cuts are schedule to expire next year. He argues the wealthy control their magnitude, location, and the timing of their income and have chosen to increase that activity this year while the taxes are lower. Since Geithner repeatedly promises that taxes will be increased on the top 2 tax brackets, Laffer argues there is precedent for economic activity to decline next year, as during the first 2 years of the Reagan presidency (until Reagan's tax breaks took effect). In fact, a growing number of lawmakers are voicing concerns that the expiration of the tax cuts next year will damage our "fragile" economic recovery. Of course, a dramatic decline in economic activity could make the aforementioned low earnings a reality.
My point is just because a prediction is seems completely improbable doesn't mean that it is impossible under certain conditions. While I am not arguing that we have such conditions presently, it is notable that so many pundits are so bearish right now (bonds, stocks, gold, etc.). I certainly don't predict the Dow will drop to 1000 within six months; however, few predicted that the Dow would drop by 50% between Fall 2008 and March 2009 either.
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What are your thoughts?
Do you find this prediction absurd or annoying?
Why do you think we gravitate towards extreme predictions?
Have You Recently Increased Your Cash Allocation?
Are You a Bear or a Bull?
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