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May 24, 2010 at 03:17 AM
A few weeks ago I voiced my concern over the prior week’s massive dip in the stock market, the genesis of which we have yet to discover. I commented on the extreme amount of debt in Europe and here at home, and how this was an unsustainable path. This buildup of debt is simply the product of decades of overspending. Overspending, as it is, is simply leveraging future wages. As long as future wages continue to outpace the required debt payment, the “house of cards” can remain standing. However, if wage growth slows, debt defaults increase, and a downward cycle begins. This is precisely what happened as the housing bubble burst. Median home prices had outstripped median income. The ratio of median home prices to median income is normally around 3:1, but due to soaring real estate values, this ratio grew to around 5:1. This, my friends was a “bubble extraordinaire.” Moreover, during this buildup, so much of an individual’s wealth was tied up in their homes through mortgages and second mortgages, that when prices began to fall, homeowners found themselves underwater. Hence, they abandoned their homes, and the problem was exacerbated.
Here’s my point: Booms are always followed by Busts which are always followed by Booms!
I recall in the late 1990s, the trailing 10-, 15- and 20-year returns on the stock market were so much higher than the long term average, that a period of underperformance was inevitable. Perhaps I should say that the rapid economic growth during the ’80s and ’90s was not sustainable.
Let’s take a brief look at another period in American history from 1900-1929. This was a time of incredible boom which brought the production of American oil, the automobile assembly line, an incredible expansion of urban areas through massive road construction, and the mobilization of the American population. The economy grew at a very rapid, but unsustainable pace. This boom was followed by the most difficult economic contraction of the 20th century, a.k.a., The Great Depression.
Today, it’s been less than 24 months since we saw the near collapse of the entire financial system. Do we really believe everything has worked itself out in such a short time? When I discuss my concern about the stock market, I am not so much trying to “time the market” as I am trying to read the economy with the understanding that a healthy stock market relies on strong economic growth.
