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Mark's Market Blog

9-26-09: Balloons and Ketchup

By Mark Lawrence

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The market dropped a bit this week, just to let us all know that it knows two directions. It would be surprising if the market did not resume it's fed-turbocharged climb next week.

S&P 500 March 2 2009 to September 25 2009

Last week I called this market a bubble. Turns out many analysts agree with me, and think Bernanke is inflating a bubble on purpose. The thinking is that a smaller bubble will help dampen out the recession, keeping it from becoming a full-on depression. The reasoning: depressions are socially unpredictable and lead to things like Hitler. I think this is faulty reasoning. Economists think the great depression was caused by an asset bubble followed by poor economic policy - in other words, the great depression was caused by economists. I think the great depression was caused by industrialization and the dust bowl: industrialization meant fewer people were needed to manufacture the goods that people needed, the dust bowl meant that low skill farm jobs disappeared, tractors and combines meant those jobs never came back. This was a generational problem - the farm and hand production jobs of the 1800s never returned, our population had to move from farms to cities and retrain to run machines instead of pick apples and cut wheat by hand. WWII supplied the money to build the new production lines, and the production requirements to enable training workers for the new jobs.

Today in my opinion we see a similar generational problem: computer control and robotic production means fewer and fewer people are needed to make the products we need, and cheap shipping across oceans means the low skill jobs that are left are all moving to low wage countries. All the boost of Wall Street and the biggest banks will not change the fact that many of the jobs lost in the developed countries will never come back, and will only slowly be replaced by very different jobs requiring very different skills. In the last 30 years the UAW has lost two-thirds of their total jobs, and these jobs are never coming back. Cars in the future will be more and more made by robots, not UAW workers, and the parts that must be hand assembled will be made in Mexico, Brazil, China, the Philippines for $2 per hour, not the $75 per hour in wages and benefits that UAW workers have been making, and not the $45 / hour that non-UAW workers in transplant auto factories have been making.

The result of this: we will have persistent high unemployment for one or two decades due to a profound mismatch between the skills required for the new jobs and the skills that older workers have. This high unemployment means the economy will have far fewer consumers and will be very slow to recover. The high growth rates of the 1990s that this country enjoyed due to the huge productivity gains of computerization will not return for 10 to 20 years, minimum. Many of the workers that are left behind will be unemployed and under- employed for the rest of their lives, having to take jobs paying perhaps half to a third of the wages they had made in the past, when they can find jobs at all. This is what recessions are all about: reorganizations of our fundamental economy. In recessions things change forever. This is a major recession, perhaps still to be a depression, and the changes will be proportionally large. The key to a reliable income in the future is education, not union membership. All the unions in the country can't change the simple fact that there are a couple billion people out there willing to perform low-skill jobs for $2 - $5 per hour.

How severe is the actual world-wide recession? I'm not a big believer in government numbers. There's a simple thing to watch, however: container shipping across oceans. Currently container prices are down to 2160, 17% of their 11,783 peak 18 months ago. Shipping volume is down to half. There are over 600 container ships empty and parked just off Singapore. No one books a container ship unless they have cargo to ship, and it takes over two years to build a new ship, so it's considered that this market is completely devoid of speculation. There's a simple truth: transoceanic shipping is down a lot, and showing no signs of recovery. The Baltic index, shown to the right, shows the cost for a container. The price peaked in June at 4300, still only a third of the all-time peak, due to China stimulating their markets and importing a lot of iron ore and coal. The price has been dropping since, in spite of our "recovery." Last December the index dropped to 650, below the cost of fuel and crew - that's when ships started getting parked and new ship orders canceled.

US economists are generally divided into two schools, called "salt water" and "fresh water." The salt water guys are mostly on the coasts, the fresh water guys are mostly in the mid-west at Chicago and Minnesota. Fresh water guys used to think that the Fed controlled interest rates, and interest rates controlled everything, so as long as the Fed maintained rational interest rates everything would be fine. Salt water guys thought that government spending was also important. However, from about 1985 until 2008, we had "the great moderation," a time when markets grew nicely, recessions were small and easily contained, jobs were plentiful. During this period the two schools of thought didn't fight much, as there was little to fight about.

Unfortunately, now we're in a deep recession, almost a depression, that no one predicted. In fact, it was worse than that: in the 90s there were many papers published claiming that depressions were no longed possible (cue Greek chorus. . .). Today, things are in complete disarray, and economists are questioning if they actually know anything at all. Their previous models were all based on "the efficient market hypothesis," a belief that large markets discounted all knowable information and always got prices right. As late as 2005, Alan Greenspan was stating that there was no housing bubble, prices were raising because more people could afford homes and interest rates were down. Whenever efficient markets were questioned, someone would do a statistical study with the conclusion that 2 quart bottles of ketchup cost twice as much as 1 quart bottles of ketchup, so sure enough, the markets were getting it right. However, no one asked if the price of ketchup makes any sense. When oil was $145 / barrel, we heard Malthusian arguments about oil running out. Today oil is $70 per barrel, and many think a more realistic price is $40 / barrel. $145 / barrel oil in 2008 was a market mistake, just as houses doubling in price from 2003 to 2006. The truth is becoming more clear: there are a few huge players in the market that can make big differences in price levels. These huge players include OPEC, China, and the US Fed.

When we compare the chart of our current market to that of the 1929 crash, we'll see that they're strikingly similar. The 1929 rapid 48% collapse of the DOW, although much briefer in duration, produced a similar price pattern to that of the slow-motion crash in 2008. The total collapse of 53% from the October 2007 closing high to the March 2009 low was similar to the 1929 crash. Our recent rally of 51% since March in the DOW has been virtually identical to the five-month, 48% rally which followed the 1929 crash.

Dow 9-3-1929 to 4-21-1930Dow 7-2-2008 to 9-25-2009

What happened after the 1929 rally was simply horrific. The DOW quickly tanked 26%, and by July of 1932, ultimately collapsed by a total of 86%. The graph above is the left-most three squares of the graph below. If our current market continues to follow the 1929-32 pattern, the DOW should move quickly back to 7200 and finally to a low of 1400 in early 2012. Should this scenario play out, "buy and hold" investors will simply be destroyed. Following the Great Depression, the DOW didn't return to its 1929 highs until 1954. Using history as a guide, today’s "buy and hold" investors who bought in 2007 can look forward to breaking even some time in 2032. I don't know that I expect the DOW to drop to 1400, but I certainly don't expect it to stay anywhere near its current 9665 level - I expect in the next year or so the DOW will drop to well below 6000.

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