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The Dow's Money Illusion


The 2000 top was a top in the real SPX and Dow. The top in the Dow at present is a different story entirely.

Two things to note on the AAII bulls and bears statistics, which analysts have noted suggest public investors are extremely bearish relative to the more recent history of this sentiment poll.

First, in March 2000, bears spiked to 50 for the first time since October 1992 – eight long years in which the S&P 500 saw a 420% increase and the NDX advanced by 675% and both saw but one meaningful correction (1998). March 2000 of course was coincident with the price high in the SPX and NDX (the Dow peaked in January 2000). Imagine the headlines from that day if you will: "After the S&P 500 more than triples, investors are still bearish" or "Investors as bearish as they were at the start of the great 1990s bull market!", etc. Based on the statistics surrounding this sentiment gauge up until then, it would have been a major buy signal. Precisely at the top.

Second, the public was, of course, involved and bullish up to their eyeballs at the 2000 top. But the 2000 top was a top in the real SPX and Dow. The top in the Dow at present is a different story entirely.

The new all-time highs in the Dow now being registered are a form of money illusion – the denominator has changed, in this case the value of the USD. Why? Because of massive, record credit growth over the last seven years. In real money (gold), in commodity terms (CRB), and heck even in other fiat currency terms (Euro, Swiss franc), the DOW is nowhere near its 2000 peak. The Dow priced in gold after all is down 56% from its all time peak in 1999; the S&P 500 priced in CRB index terms is down 37%. Heck, the DOW priced in Swiss franc and Euro terms is down 21% and 26% respectively from its 2000 peak. And of course the NDX is down much more in real terms against almost anything you care to price it in.

Thus, the real price of stocks is still far below the nominal peak in prices achieved in 2000 when the public was gaga for stocks. Why is this important in looking at the context surrounding the AAII sentiment stats?

As all students of market history know, no two secular (hell, no two cyclical) tops are made quite like those that came before it – particularly like those that came immediately before it: each has its own particular drivers – macroeconomic, microeconomic, sentiment, participation, etc. To look for the same public participation in stocks now is to (1) miss the fact that the US is not making real price highs and thus the conditions are materially different and (2) that wherever the next top forms, it will almost certainly not be driven by the same dynamics (massive public participation) as the one that generated the real inflation adjusted (as opposed to the CPI adjusted) peak in 1999/2000. Rear view mirror investing is a form of illusion as well.

Hedge funds now make up about 50% of trading volume on the NYSE and in the corporate bond market on any given day. And they can be levered anywhere from two to 10 times their asset base. Whereas mutual funds can theoretically get 100% invested (and achieved close – 96/97% - in 2000 and now), hedge funds can get 200%, 300%, 1000% invested depending on the securities they trade and their risk appetites. The 19/21 days up in the Dow record recently set wasn't a function of your no-good neighbor trading ETFs – it's a function of hedge funds accessing a seemingly endless credit pool, driven by the free call option of 2%/20% economics, and fully embracing the type of moral hazard financial economics that the Fed, the BOJ, the PBOC, and the BOE have made public policy for the past five years.

If condo speculation on South Beach heats up again in three or four years, the probabilities that it will be the same set of folks who are getting burned right now are close to zero. If another several trillion in credit is generated over that ensuing four years and prices of SoBe condos are back at the levels that prevailed in the halcyon days of Summer 2005 (while gold, oil, food, and natural gas are up another three-six times), you can bet another whole group of players will emerge to exploit that moral hazard.

Happens every time.
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