Where is the Bottom?

The entry was updated December 10, 2008.

A picture of the Dow Jones stock value since 1930 gives some perspective on forcasting the bottom of the continuing stock market crash.

First, Reagan's drive for "less government" in the 1980s slashed the regulatory actuaries. They are the people responsible for helping ensure economic risks are well defined and transparent. This is one of the basic underlying assumptions of a market (perfect information).

Then, Clinton continued the trend that fostered excessive growth of the speculative financial services industry at the expense the real economy. Financial services don't produce anything. In a healthy economy, financial services represent a small fraction of the economic activity that facilitate investment in production of real products and services that lead to job creation and benefits shared widely by society. A financial services economy creates fewer jobs and distributes the wealth to a tiny fraction of the people.

Ours has not been a healthy economy for the past few decades. This unhealthy shift is expressed in a shift of profits from manufacturing to the financial industry in the table below.

Industry	1980 Profit	2005 Profit
Manufacturing	45%	18%
Financial	18%	45%

Our economy has become hollow, which underlies the original question: How far down will the hollow part of the economy collapse before it reaches the solid foundation (assuming we don't artificially prop up the hollow part by a bailout)?

We can explore this question in terms of the Dow Jones stock index shown in the graph above. Stock values started to go up in the mid-1980s in response to Reagan deregulation. The growth trend went up gradually indicated by the hand-drawn line that intersects the present year at a Dow Jones index of about 8,000.

Stock values started to shoot way up in the mid-1990s in response to Clinton's de-regulatory policies and the dot-com mania. We can see the dot-com bubble burst in 2000, and the re-bound induced by additional de-regulatory policies of George W. Bush between 2001 and 2007.

Once the hollowness of the economy was exposed in late 2007, the current big crash came, and we're all wondering "where is the bottom?"

If we believe that the growth spawned by Reagan policies was solid growth, then the upward trend line might suggest a bottom at 8,000. But was the trend in growth under Reagan policies real or itself hollow? I think growth under Reagan policies was somewhat hollow too. So, where is the bottom?

Lets assume that the stock value before the 1980 Reagan influence was solid. Lets also assume that the world population is a reasonable rough expression of an underlying foundation to support economic growth indicated by stock values.

The world population was about 4,400,000,000 in 1980, and the Dow Jones was 1,000. The world population was about 6,600,000,000 in 2007, a 33% increase. A 33% increase in the Dow Jones would be about 1,333. Not much increase. So, lets assume that in addition to 33% population growth, the product-demanding middle class quadrupled since 1980.

Assuming the Dow Jones companies serviced that demand, which it didn't, the Dow Jones would be 4,333, add inflation and maybe the bottom is at 5,000 - 6,000, which would be optimistic.

Remember, we're not talking about artificially inflated stock prices. We're taking about stock values that represent a solid underlying foundation of producing something demanded by real needs, not the "need" for the tiny elite minority to create personal wealth.

Update 1: I've added some more thoughts after talking to a friend. It might seem obvious, but the observation is that bottoms don't happen at the beginning of a recession, they happen at the end of a recession. Not sure I completely buy that, but there is some logic to it.

Update 2: Paul Krugman, December 19, suggests we might not be there yet. It has something to do with Tobin's "Q" Ratio.

Sources:

Manufacturing and Financial industry profit estimates are from Figure 2.1, in "Bad Money," Kevin Phillips. Original Source: Ray Dalio, Bridgewater Associates.