Listening to the “mainstream media,” one would think that we have nothing much to worry about in terms of a real economic downturn. Does it make sense to hold the belief that business-as-usual will simply continue? Have we entered a more enlightened golden age in which the business cycle no longer operates?
No. In short, what goes up must come down! Here is Martin Hutchinson’s comment on the reality of the business cycle. We may be in overshoot mode at the moment, but it will correct downward:
“In the end, it is likely that the market will again overshoot, as it did in the early 1980s, so that even well-run countries like Brazil and Colombia, or adequately run non-Latin countries like Turkey and Indonesia, will be forced into default simply by the absence of new bond market financing. In 1982, Mexico was poorly run and deserved to default, but Brazil was quite well run and could have survived default had the bond market remained open.
Needless to say, the world’s stock markets will not be exempt from the overshoot phenomenon. So far, only a few emerging markets, notably China, have experienced any significant downturn. In the West, stock prices are generally still well above those prevailing in 2006, considered at the time a boom year.
However, when the decline does finally come, it will be severe. Inflating the early 1995 Dow Jones Industrial Index level of around 4,000 by the increase in nominal GDP since then gives a value of 7,800 today, which may be considered the stock market equivalent of the 3.2 times house price-to-earnings ratio that is considered equilibrium in the housing market.
Needless to say, even a drop to 7,800 would cause consternation and hand-wringing among Wall Street and investors generally. It should be noted however that 7,800 is the equilibrium level for stocks, not a prediction for the bottom, which must of necessity be much lower, as price declines reinforce negative investor psychology and pessimism; 5,000, or even 4,000 would seem reasonable predictions for the Dow’s low.
Given the economic changes involved, the market may well take close to a decade to get there. After all Japan, subject to a similar bubble in 1990, took 13 years to reach its low on the Nikkei, which at 7,603 in April 2003 was 81% below its December 1989 high of 38,916. ”
His bottom line summary: “The overshoot phenomenon means we are not yet halfway through the current downturn, even in housing. It is most unlikely that deflation of the 1995-2007 asset price bubble will be accomplished in less than five years, since its deflation will be fought every inch of the way by politicians and Wall Street. Maybe we should start buying in summer 2012, but 2013 would be safer.”