Reckoning With a Delusional Stock Market

Poor Obama. The man is in way over his head. And what can he do? Few people understand what is going on in the economy…and none of them work for the Obama administration, as near as we can tell. The only one who seemed to be on the ball was his advisor, Paul Volcker. But Volcker got edged out by Larry Summers, a man with a long history of bad ideas on economic matters.

Summers is a stalwart member of that very special club – modern economists. Never has an unarmed professional group done more damage to a society than Summers and his colleagues.

“We cannot and will not accept any speed limit on American growth,” said Summers in a 1995 speech, rejecting the idea of higher interest rates to cool speculation. By 2000, the economy with no speed limit had smashed into an abutment. But Summers never figured out what the problem was. He was too busy wrecking a great university. He went on to apply the same ‘no speed limit’ philosophy to Harvard, where his building program was so costly the university years will probably never recover from it.

Ben Bernanke gives no hint that he has any idea of what is going on either. He maintains that modern central banking can’t see when economies are getting into trouble. But when they do…he knows just what to do to fix it.

What kind of strange GPS system is this, dear reader? It failed to tell us where we were before we ran off the cliff… But now, we’re going to use it to find our way home. Good luck!

But who worries now? We’re rolling along…convinced that trouble is behind us. Recovery is on the way; that’s what the signs say.

But wait…

Joblessness at a 26-year high, and rising….

Consumer credit just took the biggest monthly drop ever…it’s fallen 10 months in a row.

Nearly half of Florida’s mortgages are underwater…

Hey…what a recovery!

But the stock market doesn’t seem to care. Or notice.

The Dow rose 45 points yesterday. Investors seem to think that businesses are going to make a lot of money in the years ahead. How? How much stuff can you sell to unemployed people? But why else would investors pay 100 times earnings for a share?

The current price/earnings ratio is a subject of much discussion. Earnings collapsed in the depression. Prices did not. So if you look just at current earnings you come to a P/E ratio in the 100+ range. That means investors pay $100 for every dollar’s worth of earnings. If they intend to earn their money back – and nothing changes – they’ll wait a century to break even.

But earnings are expected to go up. So Robert Shiller used a 10-year moving average to compute earnings…smoothing them out to a “normal” level. Still, he says, the S&P 500 is overvalued by about 27%.

The point is, stocks are expensive. So, you have to wonder: what is going on? Are stock market investors really such optimists?

Or, is the federal government manipulating stock prices? It is spending trillions of dollars to give people the impression that things are getting back to normal. Why not spend a few billion more to manipulate stock prices?

We don’t know. The feds have shown themselves willing to do any fool thing…but rigging the stock market? Who knows?

We’ve got to reckon with what we’ve got. And what we’ve got is a stock market that is either manipulated…or delusional.

Stocks could only be worth current prices if this were a normal recession. But if this were a normal recession, it would be over by now. Stocks would be moving up in anticipation of the next boom phase. But this is not a normal recession. And it hasn’t come to an end. New jobs aren’t being created. Consumer credit is not expanding. And the only prices that are going up are the prices subject to speculation.

The real reason stocks are so expensive (assuming the market isn’t rigged) is that this is the beginning of a depression, not the end of one. At the beginning, people don’t quite believe it.

“We’re climbing out of a nasty recession,” said a financial expert interviewed on the radio this morning. “And we’re all happy to put this thing behind us as soon as possible.”

Stocks are high because people think they can ‘put this thing behind them.’ They can’t imagine that the depression will last for 5…10…maybe 15 more years. Nor do they realize that the US economy is permanently impaired…that the companies traded on Wall Street will have a very hard time earning profits in the years ahead…nor that the average American family may have reached the height of its wealth in 1973!

The disappointment will come…then the disillusionment…then the disgust…then the despair. It will be like walking down a staircase…each step heavier…deeper…and more depressing the last. And with each step, stocks will fall. Investors will begin to see things in a new way. And at the bottom, a whole new outlook will be common:

“America is finished as an economic power,” people will say. “Incomes are going down – forever; we can’t compete with the Chinese. Stocks were dreadfully overpriced; now they are cheap…but who would want to buy them?”

It may not happen like that. But somehow, some day…stocks will once again trade at low P/E ratios… Below 10…maybe down to 5. Then, they will be bargains.

How will you know when it is time to buy again? When you no longer want to.

The Daily Reckoning