Paper,
If blue chip stocks were to fall to their mean level based on multiple of earnings, sales, book value, replacement cost etc.... that would take the DOW/S&P500 down more than 50%. Since fear generally causes overshoots in both directions, DOW 4000 is not impossible.
Rather than speculate about the event that will cause it, I'd rather just make these points.
1. Mean reversion has been going on for 125 years in multiple countries.
2. The success of capitalism is based on the efficient allocation of capital. Since the usual relationships are so out of whack, either the world has been getting lucky for 125 years and the entire success and past relationships were an accident, the last few years are out of whack and we are in a bubble, or we are mismeasuring something now. Considering that every competent value guy I know thinks that earnings are more overstated now than in the past, I doubt it's the latter.
The reason these things happen is that we do not have free markets per se. We have a fiat monetary system. When you have free market savings and investment, that which is saved and lent diverts money from somewhere else in balance.
Under fiat money you can supply whatever amount of credit the loonies (g) demand regardless of the savings level. So you can generate low interest rates, high profits, high asset prices...you can have it all.
But clearly the ability to print money and supply credit gives you no control over where it goes. It can also cause all sorts of miscalculation depending on where it is directed.
Interest rates are lower than their savings based (free market)level and since we are supplying income streams in the form of credit that was not diverted with savings, profits are equally out of whack to the upside. We can similarly produce high asset prices with little or no savings.
It's simply a matter of the credit excesses manifesting themselves in a way that can't be propped up. (inflation, extremely large trade deficit, overcapacity, everyone tapped out, other)
It's different all the time. Or the Fed will have one of its rare feelings of responsibility and end it.
Wayne
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