Is a Crash Coming?

Elliott Wave theorist Robert Prechter has been calling for the Big One for a while. He believes the Federal Reserve has encouraged our economy to get drunk on credit, and when stock markets fall, as they have, the next step is a deflationary depression. Even if you disagree, his new book makes fascinating reading.

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By Tom Jacobs (TMF Tom9)
September 12, 2002

If the herd is a contrary indicator, then all the anodynes from politicians, corporate executives, and the media argue against economic recovery and smooth sailing ahead. Consumers, too. One anecdotal sign is when living in a hot housing market, we talk about our houses the way we yammered about stocks during the last boom. Ever hear, "Thank goodness the appreciation of our house makes up for our devastating stock losses [nervous laughter]"? Worse, we're apparently throwing money at real estate in sizzling markets the same way we used to at stocks.

That's one reason I grabbed Robert Prechter's Conquer the Crash: You Can Survive in a Deflationary Depression when it landed at Fool HQ, though I did groan at the sensationalist title and threw it into the "to read" pile. It kept calling me, though, and once started, I couldn't put it down. Now I know why it's top 10 on all the major business book lists. Even if you disagree with the author's assertion that the U.S. is on the edge of, or even beginning a major deflationary depression, Prechter presents fascinating material in a readable, sober way.

This week, I'll cover the first half of Conquer the Crash, which makes the case for a U.S. and worldwide deflationary depression on the scale of those in 1720-1784, 1835-1842, and 1929-1932. Next week, I'll discuss the second half of the book, which provides advice for individuals -- though I'll give you a little now, so I don't leave you hanging.

Catch the wave
Prechter is the CEO and founder of Elliott Wave International, a company that sells products based on the financial worldview of Robert N. Elliott. Elliott, a business and government executive, gained attention through research and writing from 1938 to 1946. Until reading this book, I labeled the Elliott Wave theory as just another stock market timing hoax whose proponents were nut jobs. No longer.

Whatever the accuracy of his forecast, Prechter is an honest guy. He admits he called the previous market top way too early and missed huge gains. He says that while the coming crash may be starting, it could come in the next decades. But all the while, his patient, detailed, non-hysterical, factually supported argument is a potent antidote to the whistling-past-the-graveyard financial talk today. 

The harder they fall
Prechter, using the Elliott Wave theory, posits the wholly prosaic view that bull markets are followed by bear markets as severe as the preceding bull's magnitude. In his view of economic history, five wave cycles have invariably ended in profound bear markets -- deflationary depressions -- whether the U.S. government was running a surplus or a deficit.

Fifth waves are roaring bull markets, where immense optimism sucks in unprecedented numbers of individual investors. The stock market averages gain way more than the prior expansion, but the economy underperforms that expansion. Stock gains aren't broad -- advancers only outpace decliners by a slim margin. When the underlying growth slows, the markets fall. Hard. Prechter says that in the devastating bear market following a fifth wave, market averages fall to the level preceding the start of the fifth wave. Defining the latest as a mania, he says the Dow will fall to its August 1982 low, or 777. That's right, only three digits. Most readers probably think that's loony, but keep reading.

Bleeding indicators
Prechter saw the following major warning signs at the end of Q1 2002:

1. Historical -- and hysterical -- low in Dow Jones Industrial Average dividend yield. Investors demand yields at market bottoms and will accept that management uses cash for "growth" at tops. The DJIA yield has averaged 6.5% at moderate bear market bottoms. It dropped to 3% at 1929's peak. In 2000, it hit 1.5% and recovered to 1.8% to 2.1%.

2. Bond yield/stock yield well outside historical averages. The AAA corporate bond yield divided by the S&P 500 index dividend yield has, for every year since 1987, been a statistical outlier, and for every year since 1991, beyond even Sept. 1929's level. It has always regressed to the mean from those outliers.

3. P/E ratios beyond levels of historical bottoms. According to Prechter, the S&P 500 price-to-earnings ratio is twice the average level of a market top and six to seven times the bottom. And that's with accounting that has distorted true earnings for years and continues to do so. Today, many companies still mask true earnings by not expensing stock options and stating fictional returns from pension funds.

4. Money manager psychology. Pension funds and insurance companies hold stocks at historically high percentages, even with the market drops since 2000. At the start of 2002, not one money manager in a Tower Perrin worldwide study predicted the averages would decline this year, and they expected double-digit returns. La la la.

5. Individual investor psychology. The level of cash and cash equivalents as a percentage of the market value of stocks and bonds is at a 20th-century low. New York Stock Exchange margin debt is 50 times lows touched in 1965, 1970, and 1975. Viewed on a log scale, it's vertigo-inducing.

6. Media psychology. The largest number of bears is typically heard at the bottom, and one school of thought is that this happened with alleged investor "capitulation" in July. Prechter wrote this in Q1 2002, as markets hit tops following Oct. 2001's lows. The consensus was uniformly rosy. He said it was a bear market rally. So far, he's been right.

7. Total credit market debt as a percent of U.S. annual GDP. To make his point about over-indebtedness, Prechter shows that this hit 300% in 2001, versus a low of around 100% in the early 1950s, and a high of about 260% at the 1929 top. 

8. Explosion of non-self-liquidating debt. At the height of a boom, credit moves from self-liquidating to non-self-liquidating. A self-liquidating loan is tied to production. I lend you money to produce something that earns you a profit; you then pay interest and run your business. There is net wealth creation. Prechter posits an explosion of non-self-liquidating debt -- debt not tied to production. I lend you money, not for a used car to get you to work, but for a second car  -- a brand new SUV -- that you want "because it's cool." Non-self-liquidating debt includes loans for any purchase of depreciating assets that don't increase your production. Money lent to buy stocks on margin is non-self-liquidating. See number five. 

What happens?
When stock market and other asset prices fall, wealth evaporates (and Prechter disposes of that old saw, "Well, someone bought and someone sold, so the money just got moved somewhere.")  What follows is a vicious cycle of loan defaults, tightened credit, panic selling of assets, lower asset prices, loan defaults.... You get the idea -- what Japan has lived in for over a decade.

This keeps Alan Greenspan up at night. His greatest fear is that the only medicine he and the Fed have to fight a downturn will fail to cure the patient. All the Fed can do is increase -- inflate -- the money supply to allow for easy credit in bad times. Prechter explains how this works in detail, but every amateur student of economics knows the problem. The Fed can create all the conditions for easier credit it wants, but if lenders don't want to lend because they believe borrowers will default, or borrowers can't borrow more for consumption because they're tapped out or don't believe they can create more wealth, look out below! In one view, the Fed has been expanding credit since its creation in 1913, and sooner or later, the consequences of indiscriminate lending must be worked out of the system. Human psychology has not been repealed.    

There are many questions I'd like to ask Prechter, and I will try to reach him to do so. Does the changing composition of the DJIA to include a huge market cap non-manufacturing company such as Microsoft (Nasdaq: MSFT) affect its validity as a consistent historical measure of book value and dividend yield? Does book value tell you anything about assets of non-manufacturing companies? How much of the proliferation of stock ownership has to do with the creation of IRAs and 401(k)s, and not individuals rushing into the last stages of a mania?

And of course, inquiring minds want to know: What has he done with his own money?

What to do?
I'll present Prechter's prescriptions next week, but the Foolish advice you hear from us all the time is a good start. Pay down your debt, establish an emergency fund, live below your means. Our helpful discussion board community (subscription required, 30-day free trial to read) share their suggestions for paying off consumer debt and living below your means.   

In the meantime, if you want to talk about Prechter and the possibility of gloom and doom, drop in on our thoughtful Communion of Bears or join us on the Fool on the Hill discussion board. Enjoy Bill Mann's excellent recent column, When Will the Market Rebound? I also offer thoughts for patient investors in Party Like It's 1929. 

Have a most Foolish weekend!

Tom Jacobs (TMF Tom9) is a senior analyst at The Motley Fool. Big whoop. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.