Markets Hit 12-Year Low - How Significant is this for Stocks?

Markets Hit 12-year Low for only the Third time, but will this be 1974 or 1932?

With US indices breeching their 12-year lows financial journalists and analysts have been reaching for their history books. A long term chart of the Dow reveals that only twice before has the index wiped out 12 years of gains; back in 1974 and 1932.

As everyone in the financial industry is praying that investors will return to the market the focus has been on calculating if these previous retracements can tell us anything about when we are likely to hit this bear market's low. In short, when will this pain end?

"What we found intriguing is that the 12-year lows were breached at a critical juncture in the bear markets," JPMorgan Chase equity analysts gush. In 1932 the April 8 finish came three months before the market hit its bottom, while 42 years later, the Dec. 6 breach marked the exact end of the 1974 low.

So there you have it! The equity pain will - or rather might - be all over within 3 months. Except that having just two data points does not fill me with the same overwhelming confidence as self-interested parties such as JPMorgan Chase. This strikes me as a slightly more sophisticated version of "when is it time to buy shares?" articles.

It is also worth stepping outside the purely US markets, this is after all a global marketplace. The most depressing index by far is surely the Japanese Nikkei. Peaking at around 39,000 in 1990 it now languishes around 7,500: that is a loss of over 80% over a period of almost 20 years and is currently sitting at a level seen in 1981. The "12-year low" is, at least for the Nikkei, a complete irrelevance.

However, stock market indices are all denominated in their local national currency so to accurately compare indices one has to do so using a fixed currency. In 1990 the US Dollar was worth about 140 Japanese Yen; in 2008 the average was about 100 Yen, a loss of about 30%. This is a good time to recall that percentages are multiplicative and not additive. An 80% drop in the index combined with a 30% rise in the currency does not equal an overall drop of 50%, but more like a 74% drop in dollar terms. Even with this adjustment the Nikkei looks in very bad shape.

The fear is that the American and European markets will follow the Japanese, in which case this 12-year low will be consigned to the dustbin of false indicators.

How Much is the World Worth?

An alien race visits planet Earth and they like it so much they want to buy it. “How much is it worth?” they enquire. Hard one to answer. The data that is most available is the gross world product; the global equivalent of GDP. But this tells us the level of economic or monetary activity rather than the value of all the land. GWP in 2008 was about $70 trillion. When one looks at the level of debt and costs of bailouts throughout the world this number seems frighteningly small. Let's make some kind of estimate based on a price/earnings ration. Much of the highest priced land in the world is in metropolitan areas and it tends unless rented to not be earning anything. Let's pick a high but not ridiculous PE ratio of 40, making the Earth worth about $2,800 trillion. However, the current estimate of the size of the financial derivatives market is about $1,400 trillion. Half the world! This figure may even be an underestimate as it combines the regulated exchange traded derivatives (ETDs) and the largely unregulated over the counter markets (OTCs).

But our aliens are a shrewd bunch and they argue that this is hugely inflated; poor stitching, cheap lining, a bit tight round the shoulders - you get the picture. They argue that much of this monetary value is fictitious being brought about by money borrowed on credit being then speculated with in highly leveraged financial products. Any small losses in the underlying assets have become magnified to the point that many businesses have negative real values. Many banks are now worthless. Remember the warning that every derivatives broker gives that you may lose more money than you put in? The problem has become an epidemic and everyone seems to be staring down a black hole. The aliens look smug and say they can wait for the fire-sale.

In the meantime they do a further bit of terrestrial due diligence. George Soros was not in the best of moods. He sees no end in sight for this financial crisis. With reference to the collapse of Lehman Brothers,"We witnessed the collapse of the financial system," Soros said at a Columbia University dinner on Friday. "It was placed on life support, and it's still on life support. There's no sign that we are anywhere near a bottom." The aliens didn't look particularly out of place in a crowd of students, but did wonder why humans had switched off their telepathic abilities. The old man seemed to be in the midst of his own great depression. "How did you people make such a mess of things?" the aliens enquired. "Ask him." replied Soros, barely looking up but pointing in the vague direction of Paul Volcker.

Volcker had been the Fed chairman in the 1980's and had gained great respect for taming inflation. He was now back as an adviser to President Obama. He said things were going to get worse. "I don't remember any time, maybe even in the Great Depression, when things went down quite so fast, quite so uniformly around the world." What happened? Financial innovation is what happened. Borrowing and lending makes a nice tidy low-risk income but that was seen as too boring. When everything is measured by growth rates the financial sector wanted to grow faster – hi-tech finance for a hi-tech world. Except that financial hi-tech came with hi-risk. "These risky securities brought no benefits whatsoever to the public," Volcker lamented, "the invention of the ATM was of far more economic benefit than any asset-backed bond." The two men gulped down their brandies and Soros set to replenishing their goblets. The aliens nodded in agreement, taking cue from the pall that had enveloped the two sages.

On their way back to the mother ship one of the aliens spoke up,"We learnt all of this in ancient history. We could buy this whole place for nothing." They all knew what was coming next. "Let's offer them a new currency. Wipe out their debt and have our own central bank run the world. We could call it the Alien Dollar!" "Perhaps Astral Dollar sounds less threatening, don't you think?" interjected their leader. "They're bright but not particularly perceptive socially, maybe they'll swallow our ADs."