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July 07, 2008

Rational De-exuberance Markets Are Methodical; Not Random
by Bob Hoye

Part of the rationale underlying interventionist economics has been the notion that financial history is "random". Regrettably, the Random Walk Theory has been borrowed from physics by intellectuals with inadequate research in science or the history of markets.

As applied to economics it has allowed policymakers to impose fantastic ambition, resulting in massive currency depreciation with little alteration in the sequence of major events in market history.

Random Walk was a hypothetical construct in theoretical physics that does not prevail in the real world, let alone in the market place. Otherwise, the record outlined below would not exist. There are three major events in market history and they recur. One that provides considerable relief is the peak of the last business cycle that ends the "old" era of inflation. The next typically happens nine years later and it is the climax of a great financial mania. Some spectacular examples include the end of inflation in 1920 and the end of the "Roaring Twenties" in 1929. The equivalent dates on the first outstanding example were 1711 and 1720, with the notorious South Sea Bubble.

Of course, the third major event is the long post-bubble contraction, which in its early stages prompts considerable recriminatory legislation and remedies amounting to the application of yet more credit.

Where data are available to the month the comparisons become even more interesting. The duration of a tech-mania, the length of the first bear market and subsequent cyclical bull market are comparable--not random. The National Bureau of Economic research (NBER) determines the changes in the business cycle and the NY senior stock indexes are used to determine the stock market cycle and The Economist All Items is the commodity index we use.

* * * *

The post-1929 bear market ran for 34 months, which compares to the 31-month decline to October, 2002.

Commodities also have a recurring pattern in setting sensational highs on the last business cycle of the "old" era and then recording only minor gains as the extravaganza in tech stocks blows out. It seems that when the public speculates in commodities such as in 1920, there is little action in financial assets. Then when the game is in financial assets there has been relatively little interest in tangible assets.

However, there have been some outstanding concurrent booms in both tangible and financial assets. This was the case in the era of financial innovation that ran for some 115 months into September, 1873 when the US was running an experiment in fiat money. The first bull market out of the 1929 collapse included commodities as has the first bull market out of the post-2000 contraction.

On a shorter-term, there is also a significant pattern, which is the typical 55-day plunge that can identify the end of an outstanding bull market for stocks. This occurred in 1929, 1937 and 1973. As part of our post-bubble model we have been using 1937 since late 2002.

This time around, the Nasdaq took the 55-day hit down to late January when we used the 1937 top as a model for the rebound in stocks and commodities, as well as narrowing of credit spreads. The rebound and failure in stocks was reviewed in the May 26 ChartWorks and the replication has been remarkable rather than random, and the updated version is attached. Noteworthy is that the per cent decline to this week is the same as on the equivalent move in 1937.

Another important element has been the cyclical bull market in commodities. Coming out of the tech crash of 1929, The Economist All Items index rallied from the low of 8,046 in November, 1932 to 17,245 in March, 1937 for a gain of 114%. This time around, commodities ended a severe bear with the 9/11 panic at 87 in October, 2001 and the index has soared 212% to 271 in March of this year. It is working on a test of that high now, as the action in crude, natural gas and coal are generating rare upside exhaustion readings. These conditions are only found at big market peaks.

Even the policymaking establishment, which is still conducted on the premise of "random", is itself non-random:

"When you look at the mistakes of the 1920s and 1930s, they were clearly amateurish. It is hard to imagine that happening again--we understand the business cycle much better."

-- Greg Mankiw, Harvard economist and text book author, Wall Street Journal, February 1, 2000.

"[T]he Federal Reserve Law has demonstrated its thorough practicality, and thus secured the general confidence of business interests. The old breeder of financial panics, the National Banking Law, which had been a menace to American progress for two decades, has now been replaced by modern scientific system which embodies an elastic currency and orderly control of the money markets."

-- John Moody, the Atlantic Monthly, August 1928.

Yes, the writer was THE Moody and it is worth noting that the Fed was formed in 1913 and the two decades Moody refers to generally describe the latter part of "The Great Depression" that ended in 1895. Moody did not need to use the term "amateurish". In 1880s, leading economists began describing the post-1873 bubble contraction as "The Great Depression", and continued to do so until as late as 1939.

The volatility coming out of that lengthy contraction was impressive, and as recorded in a number of financial series, volatility has increased since the Fed opened its doors.

The markets have been tracking the "model" with remarkable fidelity, but there is no guarantee that the phenomenon will continue. Then there is no guarantee that it won't. Keeping in mind " we understand the business cycle" and "orderly control if the money markets", its best to consider the odds.

Note: For our subscribers a brief Pivotal Events will be sent out on Friday.

Link to Bob Hoye audio "Regular or Unleaded": http://www.howestreet.com/index.php?pl=/goldradio/index.php/mediaplayer/889

Bob Hoye
Institutional Advisors

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