The sky is falling, the sky is falling! Get out of the market now! Sell all your stocks and get into money market funds. Better yet, buy Krugerands and bury them under the compost pile.
You say you don’t believe me, that the market is rebounding nicely after each dip? Well, look at these charts. The first shows the Dow Jones industrial average over the last five years together with five years of the Nikkei 225 before Japanese stock prices collapsed in late 1990. The second compares the five years after the Nikkei collapse with the comparable period after the 1929 New York Stock Exchange collapse.
The first shows what is starting to happen, the second shows how bad it will get. So sell out now! If these charts don’t scare you, perhaps you have really been brainwashed with this “new economy” propaganda. Or perhaps you took a statistics course in college and learned how many ways “liars can figure.”
It’s true: All charts such as these prove is that if you give people a modern spreadsheet program, access to the Internet and an afternoon to waste, they’ll produce flashy evidence that the Roman Empire fell because of bad breath in dogs or that Al Gore actually did invent the Internet.
One of the first rules of serious research is that “correlation is not causation.” In other words, the fact that two events occur together or even that one repeatedly precedes the other does not mean that one causes the other. For example, I used to live in Lima, Peru, a seismically active area. Every time I heard all of the dogs start barking across the neighborhood where we lived, we had a tremor within 15 to 30 seconds. Thus I can conclude that barking dogs trigger earthquakes. And if U.S. stock markets rose in a pattern similar to Japanese ones, our markets are fated to collapse in the same way.
Not on your life. There is no logical or scientific reason to expect an outcome such as that. Two events that on the surface unfold in similar ways can have strikingly different causes.
The U.S. economy is very different from the Japanese economy in its structure, institutions and economic culture. The U.S. economy is strong for many fundamental reasons, such a productivity growth and new technology, that are only tangentially related to soaring stock indexes. It is fundamentally wrong to assume that because the big runup in the Nikkei a decade ago collapsed into a decade of stagnation, the recent U.S. runup must end the same way. That is my optimistic message today.
But while these charts cannot scientifically prove that something will happen, they offer circumstantial evidence that something might happen. An Old Testament writer observed that “there is no new thing under the sun.” Anyone who looks at long-term patterns in financial markets knows that long periods of sustained price increases are often followed by bear markets that claw back a substantial fraction of these gains.
If one looks at the news media from the late stages of bull markets, one reads very similar comments along the lines of “we are in a new era,” or “the old rules don’t apply anymore.” One also hears “the economy is fundamentally sound” and “the _______ (insert latest technology here) has changed things so fundamentally that this can go on for a long time.”
So if you are worried that the next dip in the Dow will turn into a sustained slide, I’m not in a position to reassure you.
There, have I confused you enough? Historical analogies cannot prove that something will happen, but do provide some evidence that it can happen. Are these just economist’s weasel words from someone who practiced for seven years at the Fed?
No, it is just a timely example of the limitations of economics. Economics is far from being an exact science, in fact it’s probably not a science at all. Economic theory and analysis can provide useful insights into many important matters. But they are no better for predicting the future of financial markets than a crystal ball.
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.