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Spooky Déjà Vu In Markets

More analysts are comparing present markets to the 1920s. To many who have been watching the trends, there are some errie coincidences between the late 20s and late 90s.

Sarah Edmonds of Reuters in her May 31, 1998 article entitled Bay Street Beat: The Roaring Twenties reborn? draws some very interesting parallels between the two time periods. These are all trends unseen together since the 1920s.

• Stocks are soaring as they were in the 1920s.
• Interest rates have been on a long-term downtrend.
• Corporate profits are high and moving higher, pushing up return on equity.
• Government and consumer debt is monumental.
• Equities are at their highest price-to-book-value levels in 70 years.
• In the third quarter of 1927, the four-year trailing total return on the Dow Jones Industrial Average had risen 124 percent. In the third quarter of 1997, the climb was identical. In the fourth quarter of 1927, the rise was 110.1 percent. In the fourth quarter of last year, it was 110.66 percent.

Peter Gibson, chief strategist with ScotiaMcLeod Inc. thinks there are many similarities between 1998 and 1928. Gibson believes the risk of a significant stock market reversal and economic decline is ``great'' just as it was in the late 1920s. But he does not see the 1990s market bull falling to its knees yet. The recent volatility in North American stocks will likely be short-lived and markets should resume an upward trend in a few weeks, he said.

``(The markets) will show resilience as long as U.S. corporate profitability holds together and/or interest rates are falling,'' Gibson said.

``If the stock market continues to rise until return on equity starts to fall and interest rates can't fall, then you're in trouble. If you are ending the equity cycle because the relationship between interest rates and ROE breaks down, then there's no telling how far the market might fall."

``For the time being, I'm prepared to say that (the Federal Reserve) could probably keep the cycle alive for another three years. But because we are playing the proverbial game of musical chairs, and because there is so much at stake, I'd like to go out one year at a time,'' he said.

Gibson thinks the Fed will use the benefit of hindsight and not force the same sort of cut in short-term interest rates it did in 1928. That cut perversely forced long rates higher because of bond traders fears about inflation.

Other analysts see a greater risk.

``We've had, as I read it, a huge bubble in financial instruments in North America and to a certain degree in Europe. And it has kind of overextended just as it did in Japan and then the risk, of course, becomes implosion,'' said Tony Beale, a vice-president at Toronto-based Moss Lawson & Co.

There seem to be three major risks, Gibson said.

1. A fall in the stock market or a run on mutual funds, for any reason, could feed on itself because neophyte investors, who have rushed into equities in droves the past few years, may panic. A stock market crash would trigger a recession, which would result in deflation and then depression.
2. A sustained recovery in foundering commodity prices would have its own disastrous effects. Because real wages are already rising, a climb in commodities would instantly send inflation soaring, which would push bond yields higher and draw return-hungry investors out of equities.
3. Deflation is as dangerous. If consumers postpone buying on the assumption that they can pick up the car, the computer, the house cheaper next year, they will create a depression because sales and corporate profits will fall, large companies will lay off and fewer consumers will be in the market to spend.

Canada's comparatively high tax rate and low rate of personal income growth mean that it is actually more vulnerable to economic shocks than the United States.

Certainly we are traversing treacherous waters. An increase in interest rates could be the catalyst. A rise in interest rates triggered a sell-off in the twenties. Stocks purchased on margin meant that investors had to come up with cash to cover their margin calls so they sold off other stocks. This caused a snowball effect and the slide continued unabated.

Sound familiar? In Japan in the 1990s, banks offered loans to buy stocks leveraged at 95% loan to value on overpriced Japanese real estate. A stock market correction triggered a sell off of real estate and prices on both plummeted. Once started, this type of slide is next to impossible to stop.

The question is how long can North American markets remain immune to the effects of the Asian flu, stratospheric price/earnings ratios and extreme levels of debt? The truth is that no one really knows.

However, there is one certainty. When the correction comes it will be too late to get out until after the bottom falls out of the market.