Economic Recovery Period: When the Stock Market Notices the Depression

Yesterday, the Dow was down 150 points the last time we checked it. And this morning, Asian stocks are falling again. China’s stock market has fallen below its 200-day moving average – a bad sign.

Is this a little correction in the long upward climb of stock prices? Is it a pause in humanity’s march to perfection? Or is it a resumption of the bear market that began 2 years ago?

The way we see it, things go up and down…round and round…back and forth. Human life may become more comfortable, with technical progress and innovation. But every life still ends in the same place it did a million years ago. Ashes to ashes…dust to dust…

And what about the life of a company? Or a stock? Or a bull market? You know the answer. They end up where they began, nowhere. Everything ends up in the same place…back where it started. The challenge, as near as we can tell, is to get there with grace and dignity.

Speaking of stocks, the Dow hit a low of 6,547 on March 9th of last year. Most observers believe that was THE low…the nadir of the bear market movement. We doubt it. Even at its low, investors were still fairly confident that stocks would perform well ‘over the long run.’ They saw the problem as a banking crisis…a liquidity crisis, not a fundamental failure of the economy.

And even at 6,547 the Dow had lost only about half of its value…leaving P/E ratios well above typical major bottoms. At major bottoms, you can buy almost any stock on the exchange for 5-8 times earnings. If you were buying the whole company, you’d get a yield on your investment of 15% to 20%. Nice deal.

But in March of last year, when the bear market found its first resistance, corporate earnings were falling too…leaving investors with P/E ratios closer to 20 than to 5.

The bounce lasted more than 9 months and recovered about half of what stocks had lost. If the bulls are right, stocks could correct here…and then go back to their bullish trend. If we’re right, on the other hand, they will fall all the way back to their March 9 low…and keep going, until they finally arrive at their ultimate low. Then, you’ll be able to buy major listed companies and get a decent return on your money – from the dividends.

If we’re right, the economy is in a multi-year period of correction, de-leveraging and depression. The stock market has to notice, sooner or later. And it is bound to get a little gloomy when it realizes what is going on. That should take the Dow down to about 3,000-5,000 on the Dow index. It could be much lower…

The latest figures – keeping in mind that we don’t believe any statistics unless we fiddled them ourselves – show new jobless claims down last week, but not as much as expected. Bloomberg quotes a ‘senior economist’ who tells us that the numbers are going in the right direction, but ‘very slowly.’ The four-week average number, meanwhile, is going in the wrong direction – it shows increased unemployment.

And what about the housing market?

It’s hard to get a clear picture of what is going on. According to Case/Shiller prices are rising in many areas. But so are inventories. It now takes a record 13.9 months to sell a new house – up 50% from a year ago. This must discourage a lot of sellers. Those who can afford it may prefer to hold houses off the markets – waiting for a better season.

The housing market is probably like the stock market, in other words. Just a little slower. The first wave down was driven by defaults, foreclosures and marginal, desperate sellers. The next wave down will be driven by inventories…population trends…and the depression. Many owners still believe prices will come back, when the ‘recovery’ really gets underway. Most likely, they will be disappointed.

If there is any recovery at all…it will be weak, lame and tentative. People wanting to buy houses will look for bargains. Owners will take advantage of every positive move to release more inventory – depressing prices for many years ahead.

What would change things? Well, there is little hope that the crisis will go away. Mistakes gotta be corrected. Leverage gotta go. Depressions gotta do their stuff.

But the nature of the depression could shift suddenly – from deflation to hyperinflation. We don’t expect it. But it could happen. And if it did happen, people might rush to get rid of paper dollars as fast as possible. You’d see a big boost in prices for just about everything – including stocks and real estate.

Even in this case, however, the increases may be less than the losses on the paper money itself. Very hard to predict. In hyperinflation all bets are off.

Do we expect hyperinflation in the US anytime soon? No. We expect years of Japan-like suffering. But we could be surprised…

The Daily Reckoning