Yesterday, the Dow closed at 7552, below the lowest monthly close of 7591 in September of 2002. The 2002 bear market was caused by uncertainty related to post-9/11, post-tech bubble and various high profile accounting scandals. Mostly, consumers were feeling insecure about their future (due to the fear of more terrorist attacks) and investors were mistrustful of the stock market.
At the time, the U.S government intervened aggressively to prevent a further deterioration of the stock market, and to prevent its malaise from spreading to the general economy. Sarbanes Oxley legislation combined with aggressive monetary policy and credit deregulation was an attempt by the US government to restore faith in the stock markets and to induce consumers to spend more. By 2002, it was un-American not to spend. The problem was that the Consumer only had pocket change. Individual savings were at historical lows in 2002 and 2003, with less than 1% savings rates compared to the three previous decades when consumers typically saved 7% of their incomes. There was the proverbial problem of getting blood from a stone, a challenge that was solved (as we all know) through asset leverage.
Consumers were induced to leverage their net worth in order to buy more. According to testimony to Congress by Alan Greenspan on February 17, 2005, by 2004 consumers were creating disposable cash by leveraging increases in Net Worth driven primarily by the value of their real estate. According to Mr. Greenspan at the time, the Net Worth to Income ratios were at historically high levels and even higher than the ratios leading up to the tech bubble. Persistently low interest rates, combined with increasing home values and ongoing credit deregulation provided mortgage brokers and bankers incentives to create high risk credit products that were used to induce lower income families to become homeowners…and spend. Everyone was becoming upwardly mobile, consumerism ruled, and the American Dream was thriving. People leveraged their inflated Net Worth to spend above their economic bracket. Meanwhile, the financial engineers that created and managed the architecture underlying the Great Spend made gobs of money.
The US consumer spending frenzy became globalized. Suddenly Chinese, Indonesian, and Indian factories were deluged with orders to help fulfill the American Dream. Giant middle classes formed, creating their own spending power and consumer demand. Resulting materials shortages and the thirst for energy created possibly the single largest commodity boom ever, which persisted a full year beyond the beginning of the collapse starting in August 2007, and we know well what has transpired since.
Are we at the bottom? Earlier this year I was certain that the stock market would bottom at 2002 levels and then begin a slow recovery spanning the following 6 to 8 quarters. It was my belief that once the false post 9/11 boom was effectively wiped out, markets would regain momentum as consumer net worth to income ratios aligned to those of previous decades, and consumer savings rates returned to 5% to 7% of net income. With current deflationary pressures, caused by a clamp on consumer spending, we may in fact be seeing the front end of the adjustments happening right now. It should be an austere Christmas.
However, there remains risk that a bottom has yet to be reached. Unlike today, in 2002 the financial markets were fairly sound. Uncertainty was limited to unsavory accounting practices of a handful of high profile Companies. Despite continued intervention by Governments worldwide, the current state of the worldwide financial sector remains unstable at best – this a much greater scale of pain than illegal accounting practices by a handful of US companies. This is not a stock market issue; it is a fundamental financial issue.
In 2002, government intervention along with the underlying theme that, if American consumers didn’t spend, the terrorists would win, drove an already leveraged consumer to more leverage. But it worked, and the Wall Street declines did not spread to Main Street. In hindsight, maybe it should have. If the 2002 downturn became a natural recession as it probably should have, maybe we would be dealing with a less severe reality today.
Main Street is probably just as opaque as Wall Street. In the infamous words of Dick Rumsfeld “there are known knowns, known unknowns, and unknown unknowns”. What happens if the buffoons that lead the US auto sector are unable to convince Congress that they have a plan? What is the next big industry at risk of collapsing? Who will bail out the construction industry? And what happens to municipalities as the tax base declines? Are the Chinese and Indian middle classes real, or will they disappear? Is the American middle class real? Will all of this uncertainty foment the re-emergence of trade union power and the unrest associated with it? And while the world reels, what are the terrorists planning?
I am hopeful that we have reached the bottom that seemed apparent earlier this year based on a 20 year chart. If not, the next leg down could be 6500 based on a 50 year chart.
Although there are many risks, there are also bright spots including the new Presidency. Hope is a powerful emotion to harness. If the new Administration can execute the basics while instilling hope with the battered American middle class, there is more upside than downside to the economy by the second half of President-elect Obama’s first term.
By attacking world symbols of capitalism on 9/11, Al Qaeda had hoped to throw the world economy into turmoil and immediate economic collapse. It is widely believed that Al Qaeda failed because the American consumer threw the world economy on its back and dragged it out of perceived danger. The question now is how much danger was there, really? How much damage was done to the American consumer and how long will it take for it to recover? And what will it become? While the US consumer recuperates, where are we heading? What are the possibilities of worse things to come?