Clem Sunter

A three horse race

2009-07-30 12:20

In response to my last column about the history of making money on Wall Street, "Tuscanite" asked whether I could provide some scenarios and probabilities on the future of the market - specifically the Dow Jones Industrial Average. Here they are.

The DJIA Derby is a three horse race. The favourite to win over the next five years is "Hard Times", which assumes a U-shaped recovery for the global economy. In other words, things aren't going to get worse, but they are not going to get better either for an appreciable period. The magnitude of debt is the cause of the recession and all the US and UK governments have done so far is increase the size of the problem. It takes years for them to reduce their budget deficits (and total debt) to a reasonable proportion of GDP. Meanwhile, rising inflation will cause a hike in interest rates and that, together with higher taxes to pay off the government debt, will make a significant dent on any resurgence in consumer expenditure. All in all, the US and UK economies stutter between growth and stagnation.

This scenario parallels the one that prevailed from 1966 to 1982 when the DJIA oscillated between 700 and 1 000 on no less than five occasions. Likewise, in the foreseeable future, it will oscillate between 7 000 and  10 000 as a mixture of good and bad flags provoke greed and fear alternately among investors. In this type of market, the best strategy is to trade in and out of stocks and catch the highs and lows of the DJIA.

The second horse in the race is a young stallion called "New Balls Please" which has some heavy-duty punters such as Obama, Bernanke, Brown and Darling. The recovery is V-shaped and all the indicators start turning positive later this year. In 2010, the property market turns, car sales pick up and unemployment falls.

Nevertheless, it will be a new game requiring new balls. Firstly, credit will not be easy to obtain for a long time. Secondly, the banks will be more heavily regulated and will no longer be able to gamble depositors' money on the derivatives market. Thirdly, the East will catch up to the West and probably lead the recovery. Fourthly, a new technological wave will power the next boom, as the emphasis shifts from improving the flow of information to improving the use of energy and moving away from fossil fuels.

This scenario is equivalent to the one that America experienced between 1942 and 1966 when the war started turning in the Allies' favour. US government debt at the time was more than 100% of GDP and fell continuously thereafter on account of the acceleration of economic growth in the 1950s. The DJIA went up 10 times from 100 to nearly 1 000. The breaking news in "New Balls Please" is that the DJIA has already launched itself in an ascent to 100 000 and this is the perfect time to get in for a long-term investor.

The third horse is a sneaky outsider called "Forked Lightning". In this scenario, the worst is yet to come because of some unexpected shocks to global stability at a time when confidence and stability are already fragile.

The shock could be the eruption of a trade war between China and America/Europe, a military conflict over Iran's stated objective of developing a nuclear capability, swine flu turning really lethal or a national bankruptcy much larger than Iceland. The markets just plunge.

The reason for the name "Forked Lightning" is that in this scenario, the DJIA repeats its dramatic behaviour between late 1929 and mid-1932. It peaked in September 1929 at 381 before dropping to just below 200 at the end of November. It thereafter recovered to 294 in mid-1930 before free-falling to 41 in mid-1932 (losing 89% of its peak value). In modern times, the DJIA fell from 14 164 in October 2007 to 6 547 in March 2009 before recovering to its current level of 9 000. In "Forked Lightning", the DJIA would establish a new low (below 6 000) in the next couple of years. Hence, the best strategy is to be in cash and bonds.

So what are the odds on the three horses? At the moment Chantell Ilbury and I give a 60% probability to "Hard Times", a 30% probability to "New Balls Please" and a 10% probability to "Forked Lightning". Given the recent recovery in Wall Street, the market appears to be attaching higher odds to "New Balls Please" and a zero chance to "Forked Lightning". Let's say 50-50 "New Balls Please" to "Hard Times".

We differ with the Wall Street bookmakers because there are no positive flags fluttering in the breeze at the moment. Things are less ominous, but they're not looking up. In the end, you as the reader must make up your own mind and place your bets accordingly. Remember buyers and sellers have exactly the opposite scenario in mind when any transaction takes place on the stock exchange. That's why the investment game is so interesting!

Send your comments to Clem

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