Why Dow 5,000 Remains Closer Than You Think

5/21/2557 BE, 11:40 PM Why Dow 5,000 remains closer than you think
Page 1 of 15 http://www.pbs.org/newshour/making-sense/one-economist-isnt-running-bulls-dow-5000-remains-closer-think/
Why one economist isnt running with the bulls:
Dow 5,000 remains closer than you think
Terry Burnham isnt running with the bulls on Wall Street: he still
predicts the Dow will hit 5,000 sooner than it will 20,000. Photo by
Flickr user trygveberge.
Editors Note: Just over a week ago, the Dow closed at an all-time high
of 16,715. Even Tuesday, when it declined, the Dow still closed at above
16,000.
But dont get accustomed to that, warns Chapman University professor
Terry Burnham. The former Harvard economics professor, author of
Mean Genes and Mean Markets and Lizard Brains, Burnham argued
on this page last summer that we would see Dow 5,000 before Dow
20,000. Ten months later, and a lot closer to an eventual end to the
Federal Reserves stimulus program, the Dow has crept closer to 20,000.
But Burnhams sticking by his prediction, suggesting that U.S.
macroeconomic policy is about to look a lot less fair to people who failed
to recognize it as foul.
Our lizard brains, Burnham has often argued, blind us to the reality
behind booming stock prices. Paul Solman interviewed Burnham about
his lizard brain theory in 2005.
Burnham has been a long-time critic of the Federal Reserve and
compared Americas dependence on printing money to the Stockholm
Syndrome last year. Now he updates his Dow prediction in light of the
markets recent highs, and identifies three macroeconomic hurdles to
reaching 20,000.
Simone Pathe, Making Sen$e Editor
On July 11, when the Dow Jones Industrial Average stood at 15,460, I
predicted that the Dow would hit 5,000 before it hit 20,000. On May 13,
the Dow closed at an all-time high of 16,715, and the index has risen by
5.9 percent since I made my gloomy prediction.
Beyond the stock market rally, there is good economic news. For
example, the U.S. unemployment rate has declined from 10 percent in
2009 to 6.3 percent as of April 2014, not far above its long-run average of
6.0 percent.
Is it time for me to surrender and join the bullish herd? No.
In this piece, I revisit the Dow 5,000 prediction and the economics of it,
and I identify three macroeconomic hurdles to reaching Dow 20,000.
The first of these hurdles is the U.S. Federal Reserves plan to end its
loose money policy of quantitative easing by October of 2014.
The Prediction: Dow 5,000 before Dow 20,000
Harry Truman said he wanted a one-handed economist because he was
tired of waffling economic advisers who made predictions qualified by
saying, but, on the other hand.
Most economic arguments remain unsettled because the antagonists use
obscure and movable metrics. For example, this years economic Nobel
Prize winners include University of Chicago professor Eugene Fama, who
believes financial markets are efficient, and Yale professor Robert Shiller,
who believes markets are irrational.
Commenting on their diametrically opposite opinions, Fama stated, we
agree on the facts. So it goes with many economic arguments; the two
sides can maintain contrary views for centuries with no clear winner.
I use the Dow Jones Industrial Average as a public scorecard. If the Dow
hits 20,000 first, I will be wrong, and I will make no excuses. Conversely,
if the Dow hits 5,000 first, I will claim victory, and I will not listen to ex
poste rationalizations from my opponents.
Former NFL coach Bill Parcells said, You are what your record says you
are. The Dow stands at 16,374, significantly closer to 20,000 than on the
day of my prediction. In the spirit of Parcells, I acknowledge the current
score, but concede nothing so early in the game.
The logic of the prediction
Fair is foul, and foul is fair. So say the witches in Macbeth.
I believe that U.S. macroeconomic policy is foul but has been labeled as
fair by many.
The fiscal response to the housing crises has been to overspend by
running very large U.S. government deficits. Similarly, the Federal
Reserve has flooded the world with money in the form of quantitative
easing and low interest rates.
What is the impact of large, persistent government deficits and loose
monetary policy? Here are some of the countries that have followed this
economic prescription: Weimar Germany, Japan in recent decades,
Greece and Zimbabwe. What happened to these countries?
Weimar Germany experienced hyperinflation, societal instability and the
rise of Nazism.
In the 1980s, Japans economy was the best in the world. More recently,
Japan has suffered a quarter-century of stagnation. Because of years of
government overspending, Japan now has the highest sovereign debt
levels among the large, industrialized countries.
Greece has both created and endured pain. It has created pain by
defaulting on its debt and taking repeated bailouts. It citizens have
suffered a severe economic contraction, and face a depression-level
unemployment rate of over 25 percent. Greece still has unmanageably
high government debt levels.
Zimbabwe experienced hyperinflation that caused its economy to
collapse. Once a fertile country producing surplus grains and meat, many
of its people are now hungry. Loose money in Zimbabwe created inflation
and economic pain; it destroyed wealth.
Dow 5,000 is founded on a view that the U.S. is pursuing foul economic
policies, which will one day be recognized as foul. Macbeths final
statement is I will not yield And damnd be him that first cries, Hold,
enough! Despite his resolve, Macbeth was destroyed. I expect a similar
unpleasant end to U.S. macroeconomic policies.
Three macroeconomic hurdles before Dow 20,000
If U.S. macroeconomic policy is currently foul, but perceived as fair, what
will cause the situation to change? One possibility is the coming
unwinding of some of these policies. Beginning in 2008 the U.S. has
pursued three very aggressive and unusual macroeconomic policies:
Quantitative easing: The Federal Reserve has directly purchased
trillions of dollars of assets.
Very low interest rates: The Federal Reserve has kept short-term
interest rates at zero. (This policy is known on Wall Street as Zero
Interest Rate Policy or ZIRP.)
Government overspending: The U.S. federal government has overspent
at an historic pace.
Quantitative easing is scheduled to end this year, and ZIRP may end next
year. Federal government deficits are on course to be large indefinitely,
however, the market may intervene and force a reduction in federal debt
growth at some future time.
Reversing any one of these unusual macroeconomic policies is likely to be
a significant hurdle to the economy. The next sections reveal the extreme
nature of current policy.
Hurdle #1: End quantitative easing
The Federal Reserve has pursued years of quantitative easing where it
buys Treasury and mortgage bonds from private investors. Those
investors then have cash on their hands, which they can use to buy
stocks, houses and other assets. Thus, quantitative easing creates higher
house and stock prices.
Former Federal Reserve Chair Ben Bernanke stated that pumping up the
stock market is an explicit goal of quantitative easing: Higher stock
prices will boost consumer wealth and help increase confidence, which
can also spur spending. Increased spending will lead to higher incomes
and profits that, in a virtuous circle, will further support economic
expansion.
If quantitative easing is designed, in part, to cause stock prices to rise,
what will happen when quantitative easing ends?
This effect of the end of quantitative easing is all the more important
because the programs scale has been increasing in recent years. We can
measure the size of quantitative easing by looking at the Feds balance
sheet.
As of April 23, the Feds balance sheet stood at $4,296,339,000,000.00,
up almost exactly one trillion dollars in the prior 12 months (see graph).
The Federal Reserve is planning to end quantitative easing in October,
just five months from now. The Federal Reserves taper plan is to go
from expanding the balance sheet at the fastest rate in history to zero new
bond buys by October.
What will happen when the Federal Reserve ends quantitative easing?
The amazing reality is that no one knows.
Economics is a lost field where leading scholars do not agree even on the
direction of the impact of the most important policies. Does quantitative
easing create jobs and support the economy? Federal Reserve Chair Janet
Yellen says yes; Stanford professor John Taylor, and others, say no.
The end of quantitative easing will be a fascinating test of the Federal
Reserves policies. Because quantitative easing has never been done
before in the U.S., no one knows what will happen when it ends. This
incredible, novel macroeconomic experiment is about to start.
Pop the popcorn, take a seat, and prepare to witness something historic.
Hurdle #2: End Zero Interest Rate Policy
The Federal Reserve sets short-term interest rates. Since 2009, the
Federal Reserve has followed a zero interest rate policy (ZIRP) by
keeping rates at almost exactly zero (see chart).
ZIRP is an extreme change from normal interest rate policy. The Federal
Reserve controls short-term interest rates through what is called the Fed
funds rate. Over the last 60 years, the Fed funds rate has averaged 5.2
percent; today it sits at 0.09 percent. The Fed funds rate is used by banks,
and yields on Treasury bills and savings accounts are closely tied to its
level. When the Fed funds rate is 0.09 percent, savers earn 0 percent on
their bank balances.
The Federal Reserve argues that ZIRP is good for the economy because it
lowers the cost of borrowing. The idea is that businesses will build more
factories and buy more goods if they can borrow money at low cost.
Does ZIRP actually encourage companies to hire and invest? Perhaps.
However, ZIRP also encourages companies to perform financial
engineering where they use low-cost debt to increase stock prices without
creating jobs or increasing investment.
Consider the drug company Pfizer. On May 5, Pfizer reported a dismal
performance where profits dropped by 15 percent and sales dropped by 9
percent.
Pfizer has a $100+ billion plan to combat its crumbling business. As part
of that plan, Pfizer is going to borrow tens of billions of dollars by issuing
debt. This debt will cost Pfizer very little: Even a 4 percent yield on a risky
Pfizer bond looks good to some people in a world where the Federal
Reserve pays nothing.
How many jobs is Pfizer going to create with its $100 billion plan? Zero.
In fact, Pfizer will fire thousands of people. The Wall Street Journal
writes, In Drug Mergers, Theres One Sure Bet: The Layoffs.
Pfizer plans to use its ZIRP-fueled funding, not to create new drugs, but
to buy British drug maker, AstraZeneca. This corporate acquisition will
allow the two companies to reduce investments and fire thousands of
people. Additionally, because of arcane legal rules, Pfizer will avoid
paying billions of dollars in U.S. taxes.
In the case of Pfizer, ZIRP creates billions for Wall Street in fees, millions
for drug company executives, a larger U.S. federal government deficit,
decreased investment, fewer life-saving drugs, and thousands of
unemployed people. To paraphrase Austin Powers, yea ZIRP!
While the Federal Reserve believes that ZIRP is good, ZIRP has two main
costs beyond Pfizer-like financial engineering.
First, ZIRP punishes savers. Consider the example of my 86-year-old
father. While he was working, he paid his taxes, paid his mortgage and
saved for retirement. Unfortunately, the income from his pension and
Social Security is too low to cover his assisted-living expenses.
Because the Federal Reserve has set interest rates to zero, retirees must
choose one of two unpleasant alternatives: one, buy risky assets and hope
they rise in value, or two, draw down savings to pay current bills.
My father has chosen the second alternative; he has a low-risk
investment strategy, which produces a modest income. My father is
unlikely to lose his invested money, but, because his living expenses
exceed his income, he gets poorer every month.
Watching ones savings shrink is stressful. My dad asks me on almost
every phone call, Will I be okay financially? To which, I am tempted to
reply, as long as you die soon, everything will be fine.
ZIRP hurts seniors and other savers every day.
Second, ZIRP distorts economic decisions. For example, because safe
investments pay 0.09 percent, anyone who wants a higher return has to
buy stocks, real estate, commodities, risky bonds, or other risky
investments. The distortion is that many people who cannot afford
financial losses have been pushed by ZIRP to buy risky assets.
Warren Buffett said, You only find out who is swimming naked when the
tide goes out.
When the financial tide turns, risky assets will decline in price. Who is
responsible for the future losses that will occur on risky assets? In one
sense, individuals are responsible for their own investment decisions.
While individuals retain responsibility, the government officials who
create financial dangers are also culpable. We would be outraged if the
military placed landmines on city streets. We can also be unhappy with
macroeconomic policies that create financial landmines that will blow up
our retirement accounts.
Neither a borrower nor a lender be. So says Polonius to his son Laertes
in Hamlet. This may sound like good advice, but Shakespeares intent
was to portray Polonius as spewing paternal platitudes.
Poloniuss hackneyed advice might prove wise in ZIRP-times. Borrowers
face bankruptcy if they cannot repay their debts. Investors lose when
borrowers such as Greece and Detroit default, and there will be many
more defaults in coming years.
Yellen said ZIRP is likely to end around six months after the end of
quantitative easing. In contrast, on May 4, Dallas Federal Reserve
President Richard Fisher said, Sometime in the next 100 years, interest
rates will go up. So who knows.
The end of ZIRP will be an enormous change to the economy. After years
of ZIRP, any rise in interest rates is likely to cause some risky assets to
plummet in value. Investors who own these risky assets will suffer.
Borrowers, on the other hand, will have to re-learn how to live with debt
costs that are no longer artificially low. Maybe Pfizer will have to create a
new drug to boost its stock price.
Hurdle #3: End Federal Government overspending
The U.S. federal government has been spending more than it takes in
almost every year since its inception. Since 2008, the pace of that debt
increase has been historically large. How big?
Part of government spending has been used to produce a web page that
reports the public debt to the penny on a daily basis.
On April 30, the total U.S. federal debt was $17.474 trillion, up from
$16.738 trillion at the end of the prior fiscal year (September 30, 2013).
In the last seven months, the U.S. government has added over $100
billion dollars a month in debt (see chart).
How do we make sense of the size of recent federal government deficits?
First, recent deficits are the largest in history outside of World War II.
The largest increase in debt occurred between 1936 and 1945, when total
U.S. debt grew by 80 percent of GDP. Between 2004 and 2013, total U.S.
debt grew by 40 percent of GDP.
Between 1936 and 1945 the U.S. defeated Nazism and ended the Great
Depression. Readers can decide for themselves what has been purchased
for the deficits over the last decade.
Second, consider the current fiscal situation as compared with another
one of the most extreme in history the Civil War era. The country
ravaged itself and killed more than 2 percent of the overall population.
There were more military deaths in the U.S. during the Civil War than
there are active duty soldiers in the U.S. Army today (even though the
population is now more than three times as large).
At the end of the Civil War, total federal debt was about 30 percent of
GDP. Currently, federal debt is 100 percent of GDP, and the increase in
debt in the last seven years, relative to GDP, exceeds the entire federal
debt at the end of the Civil War. We have borrowed more money, relative
to the size of the economy, in recent years, than all the combined
borrowings for the Revolutionary War, the War of 1812 and the Civil War.
In short, drunken sailors wish they could overspend like the U.S.
government; they cant because no one will lend them so much money.
While Yellen predicts that the Federal Reserve will end quantitative
easing and ZIRP soon, the federal government is making no such
promises. The Congressional Budget Office projects large federal
government deficits forever.
Click on the graph to see full CBO data.
How long can the U.S. go on spending more than it earns? No one knows.
Japans debt-to-GDP ratio is more than twice that of the U.S., so our debt
can continue to climb for decades. However, it is also possible that the
market will refuse to lend to the U.S. at some point. Such events are
unforeseeable in timing, but when they occur they tend to be very rapid.
At some point, the U.S. government will stop overspending. The date of
this change is unknowable yet inevitable.
Summary Dow 5,000 thoughts as of May 2014
I have been a relentless critic of the Federal Reserve, arguing on this page
in January:
When the Federal Reserve intervenes in markets, it has two
effects both negative. First, it decreases overall wealth by
distorting markets and causing bad investment decisions. Second,
the members of the Federal Reserve become reverse Robin Hoods
as they take from the poor (and unsophisticated) investors and
give to the rich (and politically connected).
We are entering an incredibly important and interesting time for
economics. The end of unusual monetary and fiscal policy will reveal if
the U.S. economy can prosper without these interventions.
My prediction remains unchanged: Dow 5,000 before Dow 20,000.

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5/21/2557 BE, 11:40 PM Why Dow 5,000 remains closer than you think

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