Wednesday, October 7, 2009

Historical Trends and the Current Economic Situation

This contribution comes to us from our valued subscriber, Simon Jester.

Historical records of market data are freely available online, usually in the form of raw numbers.  By downloading the information (DJIA and/or S&P 500), and using a spreadsheet program it is a simple matter to turn the data into a graph that shows trends quite readily.  The curves of these graphs interest me because they relate to market conditions.  Obviously, the following is an historical analysis, not a crystal ball into the future.  The future can always be much better or much worse as it deals with the unique circumstances of the present.

One of the ways I 'normalize' market data is by taking a monthly sampling to dampen down the “day to day” noise of market trading. This results in a fairly smooth graph for both the Dow Jones and S&P, except for periods of severe market turmoil.  Since having more complete data sometimes obscures trends with chaotic ups and downs this method is an easy way to get a feel for the trend, although a more rigorous method is to plot all data points and use a trend line to point out the underlying movements.  However -as seen in all chaotic systems- new patterns can emerge because no single incident has the exact starting conditions of previous incidents.  What follows looks at similarities between our current economic situation and those seen during other periods in history. Just as importantly, a look at the differences between the situations may present opportunity.

With several graphs available for a given time period measuring such things as unemployment, inflation, the Dow Jones Industrial Average, S&P500, trade deficits and Federal Government Deficits (see links provided below) the logical step is to look for correlating curves in the data.  Does one go down while the other goes up?  Do they rise and fall at the same time?  Does one have the same curve as the other, although separated from it in time (implying a cause/effect relationship)?

It is my opinion that this sort of “meta-analysis” can be useful in understanding trends between systems within the economy, very similar to how weather data can be used to explain the population of foxes in an area.  The right mix of sunny and rainy days at the right time produces a good growing season, causing the rodent population to explode, causing more kits to be born per litter the following year, causing the fox population to go up and the rodent population to go down.  In real life there are more predators of rodents than just foxes, but relationship to predator, prey, and population holding capacity of an environment is well understood in the biological sciences.  For the purposes of this article we will take a look at an artificially limited economic model, one that looks at the relationship between government and economy as a biologist would look at predators and prey.
The two worst economic situations in living memory are the Great Depression, and the Stagflation of the 1970's followed by the worst recession in our history in the early 1980's.  By setting a bar graph for the monthly closings for the last decade, September 1999 until present, it becomes obvious that we are in a large percentage dip.  The “stock market crash” of 1929 was only the beginning of the fall, as it would continue for the next few years, with only the occasional dip upward, until hitting rock bottom.  For the next seventeen years the DJIA would “hover”. 

Fast forward to 1975 and the election of President Jimmy Carter.  Jimmy Carter inherited a mess with the oil crisis and yet even with the stagflation economy the DJIA 'hovered'  Comparing the DJIA with the S&P500 the data correlates well simply because they are measuring sticks for the same markets.  It is interesting to note that while unemployment and inflation soared in the late 70's to 1980 the hovering of the markets actually reflects a net loss in value due to inflation.  In the 1930's the markets hovered, unemployment was high, but inflation was not a major factor as the longest periods of monetary deflation in our history increased the buying power of cash.

What correlates and what doesn't?  Unemployment follows a crash in the market according to the example of the Great Depression, but unemployment follows inflation by about two years in the case of the 1973 to 1983 data.  Since a market crash and inflation represent the same thing, the loss of wealth, it makes sense those moves would cause unemployment.  Is the correlation valid in showing a causal relationship?  The data suggests this is the case.

Up until now I've discussed the movement of the markets in time.  Now to insert the political environment in which markets act and react.  FDR and his “New Deal” possibly extended the Great Depression by upwards of seven years.  The idea was to spend the economy into health, invest in America, and create jobs by public works.  Jimmy Carter had a similar approach to economics, although to his credit he lobbied for modest tax cut. Carter ended up fighting his own party in Congress as to how to stimulate the economy, but ended up bailing out Chrysler in 1979.  Sounds very familiar to me.

Another data source for consideration is Government spending as a percentage of GDP.  The graph of this data shows spikes and waves.  Spikes represent a fall in GDP or Government spending jumps.  Waves represent an increase in GDP or a drop in spending.  The largest spikes on the graph are World War One, the Great Depression, World War Two, and the current spending in fiscal year 2009.  For the first time since WWII spending exceeds 40% of GDP.  Note that spikes in GDP spending do not happen during good times.

The price of gold is a useful economic indicator.  Historically the peak of gold prices was in 1980 during an economic dark period. A rapid rising trend starting in 1972 and was exacerbated by the oil crisis and “stagflation”.  While the price of gold 'fell' during the following years it never fell below the 1979 price and is a good benchmark of how much value the dollar lost on the world market.  I cannot use the Great Depression’s gold market prices because of the confiscation of private gold under FDR and the artificially fixed market price under the New Deal.  But it is safe to say that during economic downturns gold and other minerals represent a safer place than currency to store wealth.  Right now the price of gold is again hovering around a peak. If it continues hovering that means the dollar is not being devalued rapidly, but given China’s movement towards gold and away from the dollar I expect gold will lead the international market.

Now that we have inserted the political arena into our thought experiment we only need to look at economic recovery under tax increases and increased government spending.  The bottom line is that recovery is long and slow.  When FDR died and a more business friendly Truman took over it marked the beginning of real economic recovery from the Great Depression. When Ronald Reagan cut taxes even with almost 10% unemployment it spurred economic recovery.  Right now the Democrat controlled Congress is fighting with the Obama administration over how much to increase taxes to pay for the spending they have in mind.  Inflation concerns have pushed international investors away from the dollar and into precious metals to preserve wealth in the face of a falling dollar.  Unemployment is already high and I think it will go higher as inflation concerns grow and markets reach bottom.  My best guess is unemployment will peak between 11.5 and 12.5 percent during the first half of 2010 as the post-holiday fall in employment compounds other contributing factors.

Currently the S&P is on a rising trend, but based on historical data this is either a blip before a deeper fall, or the beginning of “hovering” action as the economy struggles.  Either option pushes economic recovery sometime into the future beyond the scope of reasonable prediction, however if taxes are increased market hovering is the optimal outcome. I repeat markets are chaotic systems which often defy all predictions, but if history has anything to teach us, it's that those who ignore it are doomed to repeat it.
Authored by Simon Jester.


Anonymous said...

Simon, your take on markets is awesome. I agree with your very timely analysis.

Anonymous said...

Congrats to you Simon. This piece elaborates on what I felt. POTC is a better blog because of your quality insights !
Avi B.

Anonymous said...

Well done, very well done. I like all the technical data a lot. But next time plz include a positive spin of what could take us out of these fundamental problems. Or a "chaotic" trade recommendation you think will be profitable. I love your mathematical explanations.

Anonymous said...

Cheers to another well done piece, and this time from a subscriber!?!?

Anonymous said...

Jimmy Carter and Obama are the same person in terms of policy, I agree.

Anonymous said...

very thorough, but what abt a trade idea???

Anonymous said...

Loved the analysis.
Elisabeth G.

Anonymous said...

We enjoyed the political element of FDR's New Deal and chart that showed the waves. Nicely done.
David and Judy

Anonymous said...

And we are in a mess now Simon. Do you think Obama is worse than Carter relatively speaking? I know the budgets cannot be compared, but I'm wondering your thoughts on their political philosophies.
Trader Raider