Why Dow 5,000 Remains Closer Than You Think

8/12/2019 Why Dow 5,000 Remains Closer Than You Think

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

Page 1 of 15http://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 highof 16,715. Even Tuesday, when it declined, the Dow still closed at above16,000 .

But dont get accustomed to that, warns Chapman University professorTerry Burnham . The former Harvard economics professor, author of Mean Genes and Mean Markets and Lizard Brains, Burnham argued
http://www.chapman.edu/our-faculty/terence-burnhamhttp://www.marketwatch.com/story/us-stocks-fall-retailers-hurt-by-earnings-2014-05-20http://money.cnn.com/2014/05/13/investing/stocks-markets/https://www.flickr.com/photos/trygve/


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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 theFederal 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 failedto recognize it as foul.

Our lizard brains, Burnham has often argued, blind us to the reality behind booming stock prices. Paul Solman interviewed Burnham abouthis lizard brain theory in 2005.

Burnham has been a long-time critic of the Federal Reserve andcompared Americas dependence on printing money to the StockholmSyndrome last year. Now he updates his Dow prediction in light of themarkets recent highs, and identifies three macroeconomic hurdles toreaching 20,000.

Simone Pathe , Making Sen$e Editor

On July 11, when the Dow Jones Industrial Average stood at 15,460, Ipredicted 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. Forexample, the U.S. unemployment rate has declined from 10 percent in2009 to 6.3 percent as of April 2014, not far above its long-run average of 6.0 percent.
http://www.pbs.org/newshour/making-sense/ben-bernanke-as-easter-bunny-why-the-fed-cant-prevent-the-coming-crash/http://www.pbs.org/newshour/author/spathe/http://www.pbs.org/newshour/making-sense/the-stockholm-syndrome-and-pri/http://www.pbs.org/newshour/bb/business-jan-june05-brain_5-10/http://www.pbs.org/newshour/making-sense/ben-bernanke-as-easter-bunny-why-the-fed-cant-prevent-the-coming-crash/


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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 itsloose 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 wastired of waffling economic advisers who made predictions qualified by saying, but, on the other hand.

Most economic arguments remain unsettled because the antagonists useobscure and movable metrics. For example, this years economic NobelPrize winners include University of Chicago professor Eugene Fama , who

believes financial markets are efficient, and Yale professor Robert Shiller ,
http://www.pbs.org/newshour/making-sense/nobel-laureate-bob-shiller-on/http://www.chicagobooth.edu/faculty/directory/f/eugene-f-fama


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who believes markets are irrational .

Commenting on their diametrically opposite opinions, Fama stated, weagree 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 youare. The Dow stands at 16,374, significantly closer to 20,000 than on theday of my prediction. In the spirit of Parcells, I acknowledge the currentscore, 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 asfair by many.

The fiscal response to the housing crises has been to overspend by

running very large U.S. government deficits. Similarly, the FederalReserve has flooded the world with money in the form of quantitativeeasing and low interest rates.

What is the impact of large, persistent government deficits and loosemonetary 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?
http://www.nytimes.com/2013/10/27/business/eugene-fama-king-of-predictable-markets.html?_r=2&http://www.pbs.org/newshour/making-sense/one-economist-isnt-running-bulls-dow-5000-remains-closer-think/%3Ca


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Weimar Germany experienced hyperinflation, societal instability and therise 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 debtlevels 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 havesuffered a severe economic contraction, and face a depression-levelunemployment rate of over 25 percent . Greece still has unmanageably high government debt levels.

Zimbabwe experienced hyperinflation that caused its economy tocollapse. Once a fertile country producing surplus grains and meat, many of its people are now hungry . Loose money in Zimbabwe created inflationand economic pain; it destroyed wealth.

Dow 5,000 is founded on a view that the U.S. is pursuing foul economicpolicies, which will one day be recognized as foul. Macbeths finalstatement 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 comingunwinding of some of these policies. Beginning in 2008 the U.S. haspursued three very aggressive and unusual macroeconomic policies:
http://www.nytimes.com/2014/01/04/world/africa/zimbabwe-food-assistance-needed-to-stave-off-hunger-crisis-officials-say.htmlhttp://www.economist.com/news/finance-and-economics/21576665-grubby-greenbacks-dear-credit-full-shops-and-empty-factories-dollars-theyhttp://countryeconomy.com/unemployment/Greece


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Quantitative easing: The Federal Reserve has directly purchasedtrillions of dollars of assets.

Very low interest rates: The Federal Reserve has kept short-terminterest 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 debtgrowth at some future time.

Reversing any one of these unusual macroeconomic policies is likely to bea significant hurdle to the economy. The next sections reveal the extremenature 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. Thoseinvestors 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 thestock market is an explicit goal of quantitative easing: Higher stock prices will boost consumer wealth and help increase confidence, whichcan also spur spending. Increased spending will lead to higher incomes

and profits that, in a virtuous circle, will further support economicexpansion.
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html


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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 canmeasure the size of quantitative easing by looking at the Feds balancesheet .

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 gofrom 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?
http://www.pbs.org/newshour/bb/business-july-dec13-fed_12-16/http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm


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The amazing reality is that no one knows.

Economics is a lost field where leading scholars do not agree even on thedirection 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 FederalReserves policies. Because quantitative easing has never been done before in the U.S., no one knows what will happen when it ends. Thisincredible, 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).
http://www.thisviewoflife.com/index.php/magazine/articles/economics-is-a-lost-field


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ZIRP is an extreme change from normal interest rate policy. The FederalReserve controls short-term interest rates through what is called the Fedfunds rate. Over the last 60 years, the Fed funds rate has averaged 5.2percent; 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 itslevel. When the Fed funds rate is 0.09 percent, savers earn 0 percent ontheir 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 morefactories 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 financialengineering where they use low-cost debt to increase stock prices withoutcreating jobs or increasing investment.


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Consider the drug company Pfizer. On May 5, Pfizer reported a dismalperformance where profits dropped by 15 percent and sales dropped by 9percent.

Pfizer has a $100+ billion plan to combat its crumbling business. As partof that plan, Pfizer is going to borrow tens of billions of dollars by issuingdebt. 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 FederalReserve 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, butto buy British drug maker, AstraZeneca. This corporate acquisition willallow the two companies to reduce investments and fire thousands of people. Additionally, because of arcane legal rules, Pfizer will avoidpaying billions of dollars in U.S. taxes.

In the case of Pfizer, ZIRP creates billions for Wall Street in fees, millionsfor 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 maincosts beyond Pfizer-like financial engineering.

First, ZIRP punishes savers. Consider the example of my 86-year-oldfather. While he was working, he paid his taxes, paid his mortgage andsaved for retirement. Unfortunately, the income from his pension and
https://www.youtube.com/watch?v=XpS4fCF4tqohttp://online.wsj.com/news/articles/SB10001424052702304393704579532141039817448http://www.pfizer.com/news/press-release/press-release-detail/pfizer_reports_first_quarter_2014_results


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Social Security is too low to cover his assisted-living expenses.

Because the Federal Reserve has set interest rates to zero, retirees mustchoose 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 isunlikely to lose his invested money, but, because his living expensesexceed his income, he gets poorer every month.

Watching ones savings shrink is stressful. My dad asks me on almostevery phone call, Will I be okay financially? To which, I am tempted toreply, 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 safeinvestments 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 affordfinancial losses have been pushed by ZIRP to buy risky assets.

Warren Buffett said, You only find out who is swimming naked when thetide goes out.

When the financial tide turns, risky assets will decline in price. Who isresponsible for the future losses that will occur on risky assets? In onesense, individuals are responsible for their own investment decisions.

While individuals retain responsibility, the government officials whocreate financial dangers are also culpable. We would be outraged if the


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military placed landmines on city streets. We can also be unhappy withmacroeconomic policies that create financial landmines that will blow upour retirement accounts.

Neither a borrower nor a lender be. So says Polonius to his son Laertesin 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. Borrowersface 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 ReservePresident Richard Fisher said, Sometime in the next 100 years, interestrates will go up. So who knows.

The end of ZIRP will be an enormous change to the economy. After yearsof ZIRP, any rise in interest rates is likely to cause some risky assets toplummet in value. Investors who own these risky assets will suffer.Borrowers, on the other hand, will have to re-learn how to live with debtcosts 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 inalmost every year since its inception. Since 2008, the pace of that debtincrease has been historically large. How big?
http://blogs.wsj.com/economics/2014/05/04/feds-fisher-too-soon-for-talk-of-rate-hikes/http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20140319.pdf


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Part of government spending has been used to produce a web page thatreports 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 totalU.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 GreatDepression. Readers can decide for themselves what has been purchased

for the deficits over the last decade.
http://www.treasurydirect.gov/govt/reports/pd/pd_debttothepenny.htm


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Second, consider the current fiscal situation as compared with anotherone 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 thepopulation 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 indebt 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, relativeto 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 quantitativeeasing and ZIRP soon, the federal government is making no suchpromises. The Congressional Budget Office projects large federalgovernment deficits forever.

Click on the graph to see full CBO data.
http://www.cbo.gov/publication/45229http://www.cbo.gov/publication/45229http://www.pbs.org/wgbh/americanexperience/features/general-article/death-numbers/


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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 debtcan continue to climb for decades. However, it is also possible that themarket 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 pagein January:

We are entering an incredibly important and interesting time foreconomics. 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.
http://www.pbs.org/newshour/making-sense/is-your-money-safe-at-the-bank-an-economist-says-no-and-withdraws-his/

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Why Dow 5,000 Remains Closer Than You Think