Stock market crash more likely than new recession

September 28, 2011

By Martin Hutchinson
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The U.S. stock market may be ahead of the economy. That suggests a crash is more likely than a “double-dip” recession.

There are many ways to value stock markets. A simple one is to compare an index to nominal GDP. What ratio counts as high is a matter of debate, but 1995 is a good starting point. The Dow Jones industrial average first climbed above 4,000 in February 1995, being then almost 50 percent above its 1987 peak. It was 38 percent below the level of December 1996, when Alan Greenspan warned of irrational exuberance.

If the market’s value had increased in line with nominal U.S. GDP since 1995, the Dow would be 105 percent higher, at 8,200. That may sound low, but it is only middling. Inflating the Dow Jones index’s bear market low of 777 of August 1982 gives a current level of 3,600.

Even after its recent decline, the market remains far above these levels. The outperformance certainly owes nothing to superior economic prospects. Rather, ultra-low interest rates together with increased leverage have inflated corporate profits. Also, modern communications technology has enabled multinationals to profit from low-cost global sourcing. Finally, money-supply expansion, with the St. Louis Fed’s broad money supply measure up 262 percent since 1995 compared to GDP’s 105 percent increase, has inflated all asset prices.

Interest rates must eventually rise, to prevent inflation and the decapitalization of the United States through low savings and capital outflow. This will raise the cost of capital compared to labor, thus putting millions back to work. Normalization need not cause a U.S. recession, although it may slow emerging market growth.

But the return to conventional monetary policy will deflate the asset bubble and reduce corporate profits. That’s almost bound to cause a major bear market in stocks, with the Dow Jones index heading toward 3,600. Investors, both individual and institutional, will squall, but those newly restored to employment may rejoice to see, in Winston Churchill’s words, “finance less proud and industry more content.”

Comments

Am I reading correctly that you believe that there is a direct correlation between interest rates and employment? That up to a point, the higher the interest rate, the higher the employment? If so, on what basis are you basing that? And if it’s true, is that just not one more way that Bernanke is destroying the U.S. economy?
As a personal aside, I am a saver. For every $100,000 I have in CD’s I used to get $400-$500 a month. and I spent it. Now I am getting 40-50 cents a month. Nothing to spend! The man seems to be doing everything ass-backwards, and for that he gets reappointed?
What am I missing?

Posted by HappyLeader | Report as abusive
 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/