Dow at 8,000

Dear Diary,

When we left off yesterday we were worried. What if we have seen the highs in US stocks and bonds – not just for the next five or 10 years… but for the rest of our lifetimes?

Yesterday, the Dow fell 272 points. No big deal, of course. But what if it continues?

Just six years ago it fell 51%. It could easily do so again – back down to, say, 8,000.

There would be nothing unusual about it. Fifty percent corrections are normal.

You know what would happen, don’t you?

Ever since the “Black Monday” stock market crash in 1987 it has been standard procedure for the Fed to react quickly.

But what if Yellen & Co. got out the party favors… set up the booze on the counter… laid out some dishes with pretzels and olives…. and nobody came?

What if the stock market stayed down for 30 years, as it has in Japan?

A Special and Unusual Time

It seems almost unbelievable… Every time US stocks have gone down since World War II they’ve bounced back… and hit new highs. We take it for granted that they will always go up over the long run.

But why should they?

The time between 1945 and 2007 is starting to look less and less like the “way things always are”… and more and more like the “way things were during a special and unusual time.”

It was more of an outlier than an average. The world was recovering from World War II. Populations were growing. New markets were emerging. People were starting new families and new businesses.

And perhaps most important, the world was just beginning the greatest credit expansion in its history.

Gold – which had kept the US dollar honest for almost two centuries – was taken out in two steps.

First, in February 1968, when President Johnson asked Congress to end the requirement that dollars be backed by gold. Second, in August 1971, when President Nixon ended the direct convertibility of dollars to gold.

Thenceforth, the flimflam began. We’ve been over the numbers before. No point in repeating them. Besides, the point we are making is obvious: When it comes to multiplying a society’s debt by a factor of 50… or increasing its debt-to-GDP ratio from 140% to 350%… we pass this way but once in a lifetime.

Credit can continue to expand for one… two… even 10 years. But not for 50 years. Not without trouble hot on its heels, at least.

Of course, the future includes a potentially infinite number of days. And we don’t know what will happen on even a single one. But if half a century goes by… and we wake up one fine day and discover that debt has risen to 1,000% of GDP… won’t we be surprised!

Pockets Full, Head Empty

Meanwhile, look what is happening to the Treasury market….

The Fed is supposed to withdraw from bond auctions this month. There goes one of the Department of the Treasury’s biggest and best customers… his pockets full and his head empty.

You’d think you’d see Treasury bond prices would fall. But no! They’re going up.

This curious trend has confounded analysts all over the world. If the US economy really were recovering, it should mean higher yields (and lower bond prices, which move in the opposite direction) as interest rates rise.

So, what’s going on? Are bond buyers making a mistake? Or is the economy really weaker than the recent jobs report would make it appear?

We’ll go with the bond market on this one. Low Treasury yields are consistent, after all, with sluggish growth.

And who can expect the same growth rate as we had over the last 50 years? From “bond king” Bill Gross:

Growth in the US and elsewhere has been facilitated in the past 30 years by the expansion of credit and leverage. Once capitalists recognize that they can’t continue to accumulate leverage at the same pace, growth slows. Demographics also are contributing to diminished economic growth. The boomers aren’t booming. They are getting older and retiring.

Most boomers need health care, but they don’t need another house or a third car. The aging of our society is putting curbs on economic growth. Thirdly, technology is a boon and a wonder, but it also has eliminated jobs that aren’t being replaced at the same pace. Apple is a wonderful company, but it doesn’t hire as many people as the old General Motors.

Finally, globalization is an issue. The US has been the world leader in globalization since the end of World War II. We have benefited from mercantilistic expansion, and because the dollar has been the reserve currency. Now things are turning sour elsewhere. When you fly into headwinds, you fly at a different speed.

We’ve spent our entire life in a credit expansion. We began life when the cork came out of the credit jug. We’ve all been pulling hard on it ever since.

Credit juiced up the economy… and the stock market. Heck, we’ve lived on it. We’ve taken TVs from China. Autos from Japan. Wine from France and Italy.

“Hey, we’ll pay you later,” we said.

What if “later” were now?

Regards,

Bill

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Another factor keeping Treasury yields so low is the lack of alternatives for yield-hungry investors.

The 2.3% yield on a 10-year Treasury note might seem puny. But it doesn’t look that way for Japanese or German investors.

In fact, it looks pretty darn healthy compared with the roughly 0.9% yield available on a 10-year German bund. And it’s positively towering beside the roughly 0.6% yield on a 10-year Japanese government bond.

It even looks solid beside the 2.1% you can earn on 10-year Spanish debt.

This isn’t reason to celebrate…

Because it signals that bond buyers see sluggish growth ahead not just in the US, but also overseas.

Remember, bonds carry “interest-rate risk.” Put simply, as interest rates rise, bond prices fall. And vice versa.

That’s because the yields on existing bonds start to look less attractive relative to new investments that reflect higher interest rates.

For example, a bond yielding 3% is a lot more attractive in a world where the interest rate on a cash deposit is 2% than it is in a world where cash deposits yield 5%. And prices adjust to reflect this.

A low-yield world means that investors don’t see interest rates rising anytime soon. Instead, they see a world of low interest rates… and low growth.

This isn’t the same world as stock market investors see.

Ultimately, stock market investors need the economy to grow so corporate earnings can grow.

Who’s right? Bond buyers or US stock market buyers?

We’ll find out soon enough…

But it doesn’t bode well for those buying stocks in the hope that the global economy is picking up.