by Nash Yielding

ABSTRACT

The following is an analysis of stock market action over the past 8 years, based on the correlation between the Post-Y2K Nasdaq Composite and Great Depression Dow Jones Industrial Index, plus an outlook for the next 4 years.

INTRODUCTION

No one could have predicted this crisis. At least, that is the story being told by every analyst, pundit, and politician who wants us to believe that they are doing their best to alleviate the situation.

Wouldn’t it be nice if the economy had suffered something in the past which was remotely similar to what we are going through now? Wouldn’t it be convenient if there were a game plan for the current crisis that might have told us what to expect—and might now tell us what to expect in the future? I believe that such a game plan exists as an underlying pattern in human psychology, and that we have been marching to its tune for 8 years now.

Whenever a major correction strikes the market, people like to compare the current environment to previous declines like those suffered during the Great Depression of the 1930’s, stagflation of the 1970’s, and a few relatively minor shocks along the way like 1946, 1962, 1987, and 1998. In recent weeks comparing the current financial meltdown to the Great Depression has become especially popular. Let’s take some time to figure out whether this comparison is valid or not.

The Great Depression was obviously an economic catastrophe. Industrial production ground to a halt and millions of people lost their jobs. The stock market fell almost 90%, unemployment topped 25%, and thousands of banks failed as production stalled and confidence plummeted [1]. Compared to indicators like those we’re still doing very well, even after the financial carnage of the past few weeks, which have seen the stock market fall 40% from its 2007 highs and the unemployment rate rise to 7.2% [2]. Even during the bear market of 2000-2002, the Nasdaq lost 78% of its value and unemployment touched 6% [3]. Real Gross Domestic Product barely declined [4]. Obviously there are some major differences between the Great Depression economy and the Post-Y2K economy. However, despite the differences, there are several significant similarities that are worth noting.

From 1925 to 1929 the Dow Jones Industrial Index (henceforth “the Dow”) enjoyed unprecedented gains, which were later discovered to have been highly speculative in nature. Beginning with “Black Tuesday” on October 29, 1929, the stock market sank into a decade-long slump that would not end until the middle of World War II. Similarly, from 1995 to 1999 the Nasdaq Composite (henceforth “the Nasdaq”) enjoyed a historic advance of nearly 600%, only to fall and stay well below its old highs for many years. Why the Dow then and the Nasdaq now? During the 1920’s, the Dow was largely made up of relatively new growth companies (like the Nasdaq in the 1990’s), whereas today most Dow components are well-established companies.

TECHNICAL COMPARISON BREAKDOWN

In fact, from a technical perspective the comparison between the Great Depression Dow and the Post-Y2K Nasdaq is extremely compelling (see Figure 1 above).

The Dow topped on September 3, 1929, and broke in late October; the Nasdaq topped on March 10, 2000, and broke in early April [point A]. Since the Nasdaq’s top at the beginning of this decade, it has been tracking the Great Depression Dow almost to the month (see Figures 2 and 3 below).

Immediately following their tops, both had significant initial plunges in price, followed by sustained rallies which retraced the initial plunges by approximately 50%, lasting about 100 trading days each [point B]. After the retracements both indexes rolled over, falling to their lows in 6 or 7 down waves over approximately the next 550 (Dow) and 525 (Nasdaq) trading days [point C].

Both indexes rallied to form a kind of “shelf base” following their lows [point D], before rallying significantly during years ending in 3—1933 for the Dow and 2003 for the Nasdaq [point E]. In both indexes, the 4th and 5th years were nearly flat (Dow) to slightly positive (Nasdaq) [point F], while 6th and 7th years were very positive [point G]. During the 7th year, both indexes formed very similar tops (variations on the textbook “head and shoulder” top) [point H], before rolling over and descending in a curve and hovering over the highs made in the 4th and 5th years [point I].

After drifting along their lows for several months, both indexes then proceeded into capitulation [point J]. In 1938, the Dow capitulation was triggered by declines in commodity prices, a recession, and disappointment over the failure of the New Deal to spur the economy [5]; in 2008, the Nasdaq capitulation was triggered by a credit market lock-up and nationalization of major financial institutions around the world.

In a final parallel, the Dow/gold ratio and Nasdaq/gold ratio have posted similar declines. From its high in 1929 to its low in 1932, the Dow fell roughly 88 percent compared with gold. Similarly, during its post-Y2k decline the Nasdaq fell 90 percent against gold.

(All figures are as of October 2008.)

Both monthly and daily correlations are statistically significant.

COMMENTARY

Almost no one is talking about the similarities between the Great Depression Dow and Post-Y2K Nasdaq charts. With all of the supposedly brilliant minds in Congress and at the Federal Reserve “working on” the economy, it is surprising that no one has noticed the parallels. How many times have we heard the maxim that those who are not mindful of history are doomed to repeat it? And yet here we are exactly 70 years later, repeating the psychological and financial pattern of the Great Depression. People toss about words like “unprecedented” [6] and “unpredictable,” [7] but the similarities between the charts are undeniable.

The specific events underlying the current-day market are certainly different from the events which occurred during the Great Depression, but people’s psychological response to them is very similar, causing the pattern to repeat itself. The Great Depression and Post-Y2K time period shared three broad sociological trends: the collapse of a euphoric bubble, fear (both economic and political), and the growth of government power.

Exploding growth in new technology, relative peace, and loose monetary policy during both periods combined to produce the asset bubbles. Personal computers and the internet ushered in a new era of productivity at the end of the last century, while the 1920’s saw the invention of the television, spread of the radio, and mass production of the automobile [8]. The 1920’s began with the end of World War I, when the United States became an undisputed world power. The same thing happened during the 1990’s after the collapse of the Soviet Union. Both bubble periods saw explosions in the use of credit due to falling interest rates [9].

The government’s response to any crisis is to grow, and it takes advantage of its citizens’ fear to justify its expansion. The scope of the government’s power increased dramatically during the Depression, and it has grown dramatically again during the decade of the Post-Y2K slump. George W. Bush is compared with Franklin D. Roosevelt for a reason. During the Depression the government expanded its power through the New Deal; during the past few years the government has expanded through deficit financing, expansion of the Federal Reserve’s powers, and enactments like the Patriot Act [10], the Military Commissions Act [11], and Sarbanes-Oxley [12].

There is an almost universal consensus that the government should “do something” about the financial crisis, yet most people don’t stop to ask what the original causes of the crisis are, and whether the government contributed to the problem. Just like the asset bubble that ushered in the Great Depression [13], the internet [14], commodities [15], and housing [16] bubbles (and their ensuing collapses) were caused by government manipulation, especially of the currency.

Introducing more of the original cause (government manipulation) is likely to produce more of the same effects. Manipulation necessitates additional intervention to “correct” instabilities caused by the first intervention. This is what happened during the Great Depression, and the same thing is happening now. If we wish no longer to be subject to the instability of the boom-bust cycle (both financial and psychological), then we must eliminate their cause—which is the manipulation of governments.

PREDICTIONS and OUTLOOK

If the correlation between the Post-Y2K Nasdaq and Great Depression Dow continues, a few predictions can be made for the coming years (see Figure 4 below).

The recent market bottom will hold, and the bounce which started in November will continue into next summer, with the Nasdaq reaching as high as 2,000.

The summer high will be the third best shorting period of the cycle (following March 2000, and October 2007). From June 2009 through the fourth quarter of 2012, the Nasdaq should trade sideways much of the time, slowly falling back to its recent lows, possibly undercutting them. The nominal (dollar-denominated) bottom should occur around October 2012.

Will the pattern continue?

Nash Yielding is a student at North Carolina State University studying Science, Technology, and Society. Stay tuned for updates on his analysis at his blog.