From the January 2010 issue of Research Magazine • Subscribe!

The Dow at 100,000?

Paper money from banks' heaving balance sheets is inflating new stock and commodities bubbles.

Round milestones, the ones with many zeros, have traditionally been difficult for the Dow Jones Industrial Average to leave behind. The market hovered around 100 from 1906 until World War II -- with a brief interlude in the 1920s, when it hit nearly 400 -- and it needed a decade and a half to break through 1,000 in 1982.

And now, 10,000 has turned into an equally sticky barrier. The Dow first reached quintuple digits in 1999, but surrendered this level soon after the crash the following year. It regained it in late 2003, plunged last year and, with 2009 drawing to a close, broke through 10,000 once more.

Back in the late 1990s, Charles W. Kadlec, chief investment strategist at Seligman Advisors, wrote a book with a soon-to-become notorious title, Dow 100,000: Fact or Fiction. Remaindered copies of this masterpiece sell on for under two bucks, but Kadlec may end up looking like a prophet -- albeit for the wrong reason.

Dollar Value

The composition of the Dow has changed over the years and only GE remains of the 12 companies included in the index in 1906. But the Dow still reflects the dollar prices of its 30 constituent shares, meaning that the buying power of the dollar impacts the value of the index.

Even though the U.S. economy expanded dramatically during the 20th century, all of the stock market appreciation from 1906 to 1982 was accounted for by inflation. In 1982, a hundred 1906 dollars was worth $1,074.72.

Not so over the subsequent quarter of a century. Since the rally on Wall Street began at the start of the Ronald Reagan era, the consumer price index roughly doubled. However, the Dow increased by a factor of 15 by the time it peaked in October 2007.

There have been plenty of reasons why this was a golden age for stocks: a pro-business climate, falling inflation, a high-tech revolution, a new emphasis on profits and cost control, a more entrepreneurial environment, the end of the Cold War and the opening of China and Eastern Europe, the maturing of baby boomers, etc.

More interesting is why stock prices stagnated during the 1906-1982 period, which saw the emergence of the United States as a world leader and its blue chip companies as global conglomerates. Actually, in the early post-World War II decades stocks didn't stagnate at all.

In inflation-adjusted terms, the Dow rose almost as much in the quarter century between 1941 and 1966 as in 1982-2007. Over that period the CPI also roughly doubled, but the Dow jumped tenfold.

The problem years were the late 1960s and the 1970s, which was when inflation ran wild, nearly tripling in a decade and a half. Clearly, inflation was bad for business. It encourages consumption as consumers get rid of their depreciating dollars and depresses long-term investment and R&D -- because no matter what the company produces will be snapped up anyway, and raising prices is no problem.

Asset Price Inflation

Economics is a relatively new and imperfect science. Although it has attained the same status as physics and chemistry when the Nobel Prize for Economics was established in 1969, it has more in common with medicine circa 1901, when the Nobel Prize for Medicine was first awarded. Back then, diagnostics was an art, pharmaceutics were in infancy and case histories and medical statistics were not gathered or analyzed systematically.

Aside from the supply-demand curve and its relationship with price, all other theories in economics are constantly challenged by reality -- such as when in the 1970s we saw both high unemployment and inflation, which economists had said was impossible.

Recently, we have witnessed another amazing phenomenon. Consumer prices have been steady. In fact, most goods now cost less in nominal terms than they did a couple of decades ago, while their quality and variety have increased tremendously. Nevertheless, middle class families know that, while their incomes have gone up, they find it harder and harder to make ends meet.

Money just doesn't seem to go as far as it used to. True, there has been an expansion of the typical consumer basket, both because there are so many new products and because many previous luxuries are now seen practically as necessities. Nevertheless, there has been a clear decline in the value of paper money that economists have not been able to measure.

It stands to reason that money would be devalued. The U.S. Federal Reserve has kept interest rates low and, combined with the spread of sophisticated financial engineering, there has been an explosion of leveraging and credit creation. Since the dollar is a global reserve currency, our $700 billion-plus trade deficits spread liquidity around the world.

Whenever you increase the supply of some commodity -- in this case, money -- its value will inevitably decline. Just because economists have not yet found a gauge against which the depreciation of money is measured doesn't mean that the process hasn't occurred.

Consumer price inflation has been so low because of the dramatic expansion of production capacities around the world and intense competition based almost exclusively on price. Since the advent of the economic crisis, two contradictory things are taking place: major central banks are printing money and pumping trillions of dollars, pounds and euros into the financial system.

Yet, even though fiscal stimulus has boosted spending, consumer prices remain flat or declining.

On the other hand, there has been considerable asset price inflation. It started before the advent of the financial crisis in September 2008, when a series of asset price bubbles inflated one after another in various market segments, first in real estate, then stocks and finally in commodities. Initially, the crisis quickly deflated those bubbles, but by the end of 2009, driven by generous infusions of liquidity, the bubbles had begun blowing up yet again.

Central bankers continue to wring their hands because banks are not lending all that money that they have been pumping into the banking system. But demand for credit is weak.

This has created a vicious cycle, in which consumers are more concerned with repaying their existing debts while businesses don't want to invest in the absence of demand growth. Not surprisingly, laden with all that free liquidity on their balance sheets, banks become drawn into speculation in stocks and in commodity futures.

With so much money finding its way into those markets, it is no surprise that prices begin to rise uncontrollably, regardless of economic fundamentals. Too bad single family homes cannot be made into a commodity and traded in the futures market, because in this case house prices would have rocketed as well.

Possible Scenarios

There are several scenarios where the Dow could go from here. First, the current economic downturn could chart the same course as the Depression, when the market crash was followed by a rebound which was undermined by the persistent weakness in the real economy. This would make the remarkable rally since the start of March a flash in the pan.

Another scenario calls for an eventual surge in inflation. World central bankers would like to see some inflation, because it would spur consumer demand, whereas deflationary pressures only discourage consumption because consumers postpone their buying decisions in the hope of buying the same thing cheaper later.

However, if productive capacities installed around the world to meet credit-driven demand get destroyed in coming years, supply will tighten and prices will begin to climb.

A surge in consumer price inflation may be hard to stop, given the amount of money pumped into the system. After all, rising prices of commodities in particular represent inflation on a wholesale level, which could eventually be passed on to consumers. In this case, just as in the 1970s, stock prices will stagnate.

Finally, there is a third possibility, involving a never-before-seen situation. Consumer demand will remain lackluster, but producers in Asia, Latin America and Eastern Europe, and most notably China, will try to preserve employment at home by churning out more goods, keeping prices flat. Businesses will be able to maintain some profits by relentless cost control.

Central banks will continue to pump in liquidity in the hopes of jump-starting limping domestic economies, but the depreciating paper money will go on inflating asset bubbles. True, 100,000 may still be an exaggeration, but if this environment continues a few more years, the Dow may cover a considerable distance toward this level.

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