This is a couple weeks behind the news, but I have a strong desire to address this issue (and I didn’t have a blog at the time). Many financial “gurus” have publicized this “Scary Parallel” analog chart of the Dow Jones Industrial Average from 1928-1929 and what is happening in the current period; to be honest I don’t see how these people can be “gurus” and not even take into account all of the facts!
First off, the market is cyclical in nature, meaning that there are high periods and low periods that are caused by an infinite number of external factors. With that being said, it is extremely improbable that two trends that are similar in nature will react in the same exact way. Let’s look at some basic economic principles and see why what these “gurus” is unlikely.
First and foremost, there is a difference between real and nominal dollars. Real dollars are adjusted for inflation over time and are easily accessible to the general public if they want to use it. Nominal dollars are those that are not adjusted to today’s dollar value (or whatever you are placing as your base dollar value). This means that when you compare nominal dollar values, the interpretations can be skewed.
I am not saying that these people with decades of experience do not have a sufficient feel for the market. In reality, they have the better intuition with the market. However, when they ignore very basic financial and economic principles they begin to lose credibility in their statements. In essence, the stock market is very easily influenced by a myriad of external factors that will never be exactly the same as a previous period (even if history does repeat itself).
Here is the “Scary Parallel” chart that has been publicized:
Now when I first got sight of this, I questioned how they came up with this chart and if they adjusted the dollar values for inflation? To my unsurprised, they did not do anything but slap the two trend lines into the same graph. Then I began to wonder if the people that proclaimed this graph knew the exact cause of the stock market crash in 1929? Whether they do know the history or not, I do and I will share it with you.
I recently had the opportunity to listen to a world renowned economist and Nobel Laureate by the name of Dr. Vernon Smith. His recent research has focused on indicators of recessions as well as the Great Depression. In most cases, especially the Great Depression and Recession, a leading indicator of the oncoming downturn could be seen in the housing market just before. What Dr. Smith had found was that a “bubble” of sorts occurred in the data. When housing markets seemed to skyrocket, they seemed to hit a climax and then plummet as did the overall economy. While there are many other factors that played into the cause of the Great Depression, including a shortfall in agricultural production in which were dependent on at the time, the housing market is seen to be a large contributor and indicator.
What made the Great Depression scar the nation so deeply was the coupling of drought, poor land conservation and the Smoot-Hawley tariff act. To clarify, a tariff is a tax that an importing country imposes on a good that the exporting country has to pay. The Smoot-Hawley tariff increased tariffs on nearly 900 American imports and caused almost all trade between the U.S. and all other countries to stop completely. International trade is vital in keeping our economy afloat and politicians were blind to that fact. Thousands of economists said a petition against the bill before it was passed, but no one on Capitol Hill listened. Below is a graph showing the massive decrease in trade throughout the Great Depression which can be found in an article within The Economist (Dec. 18th 2008 issue):
Now that we have covered the history of the Great Depression, we need to know what caused the Great Recession and how it is different from the worst period in our economic history as a country. There was a housing bubble that led us into the Great Recession, and this has been properly publicized within the media. This was a major cause of the most recent downturn; however, poor policies and divides in Congress added to the damage. So, the new question is, “If we account for real dollar values, it there still a common trend in the Dow Jones data or is completely different?”
The answer depends on how you look at the data. I took the liberty of taking that same data (which is available to the public on the F.R.E.D. website), and adjusting for inflation and altering the timeline a little I came up with the following graph:
In my opinion, there seems to be some sort common trend at the beginning of the chart which helps to support Dr. Smith’s point that the two economic downturns could have been caused by housing market bubbles. However, this is the only commonality. A key lesson to be learned here is that data can easily be manipulated to show whatever you want it to show. Be careful in how you look and interpret the data, but most importantly remember the basics.
There may be a common trend here, but I would have to run some statistical models to determine that conclusion. At the same time, with the adjustments I have made I don’t think that it is likely to exist. I hope that this has cleared up some misinformation out there about this “Scary Chart” and you can sleep better at night knowing that you cannot judge a chart without looking at the data behind it first. I have included links to all of these articles and graphs at the end of this entry, including a follow-up article from Market Watch on the “breaking of the pattern.”
I cannot say for sure what will happen in the near future with the economy. There are many variables to take into account and I cannot personally sit down and try to predict the future (mostly because this is not my area of expertise and I am a grad student who has a lot to do for other people!). When I get the chance I will try to follow-up on any articles pertaining to this “Scary Chart” and share my insights with you all!
Sorry about the long entry but I think it is well worth the read!
Smoot-Hawley Tariff: http://www.economist.com/node/12798595
F.R.E.D. Data Site: http://www.research.stlouisfed.org/fred2/