While no one would have imagined several weeks ago that the Dow could drop to 7,000, it may make sense and could build a base from which the markets might recover.
The last time the Dow spent any time under 7,000 was in 1997. The markets had seen the tail end of the S&L crisis. The Resolution Trust Corporation, which began its work in 1989, closed shop in late 1995. The DJIA had been moving up as the banking crisis ended. It moved higher until 2000 when the tech bubble burst.
If the Dow hits 7,000 now, it will be on the way down, and not on the way up.
Up until recently, the economy would have been considered much better off than it was in 1997 or after the downfall of the tech industry. Real estate values were certainly higher and the value of assets on the balance sheets of financial institutions had gone up exponentially.
Corporate earnings were remarkably good in 2006 and analysts were forecasting that they would be substantially better in 2007 and 2008.
The market is not just devaluing earnings, assets, and leverage now. It is devaluing expectations. These were driven primarily by forecasts that EPS for many of the companies in the S&P 500 would continue to grow at double-digit rates and that home real estate values would continue to appreciate by at least 10% a year.
Stated as simply, the value of the Dow, which may fall further than it has already, indicates that none of the estimates about the broad economy for 2008 and 2009 will come true.
Economists are now suggesting that the recession could last three or four quarters. The GDP has not been under that kind of assault since 1973. The period of tough times caused the Dow to drop from more than 1,000 to 600. The reset of the Dow going on now is similar. If this is a tougher recession than the one 35 years ago, then the drop in the markets is likely to be more profound.
If the current view of experts is right, the drop in GDP will stop sometime the middle of next year. That would argue that the Dow would be stuck at about 7,000 until Q2 2009. If history is a fair marker, the market should have built a base and will start to recover.
Douglas A. McIntyre