Puplava Interviews Prechter:
JIM PUPLAVA: Joining me on the program this week is Robert Prechter, Jr. He is CEO of Elliott Wave International and author of the New York Times best-selling book, Conquer The Crash. During the 1980s, Prechter won numerous awards for market timing as well as the United States Trading Championship, culminating in Financial News Network naming him as “Guru of the Decade.” Prechter is a member of Mensa, Intertel, the Shakespeare Fellowship and the Shakespeare Oxford Society. First of all Bob, I want to congratulate you for your book, Conquer The Crash, making it to the New York Times Best-Seller List.
ROBERT PRECHTER: Thanks a lot. We worked hard to get it there, and I hope it helps some people.
JIM: We hear much in the press today from Main Street to Wall Street with a cry for help for the government to fix the economy. I want you to take some time to explain why it can’t be fixed. I thought it best that we start out with part one of your book, Conquer The Crash. Why we are headed for a crash and a depression?
BOB: Well, one of the reasons that the difficulty we face cannot be fixed is that the mistakes are not being made in the present. The mistakes were made throughout the 1980s and the 1990s, when the Fed helped the banking system create credit at an unprecedented rate. The last time we had anything close to that size of a credit buildup was in the 1920s, which eventually led to the crash of 1929-1932. I think the main underlying problem is one that is already there: the overbuilding and extension of credit and the flip side, which is debt. We are more in debt now than in any time in the history of the country. That is setting the stage for the problems we face.
JIM: Throughout the 1990s, there was this myth of a new era. Corporate productivity was supposedly to have increased. The economy was creating more jobs. American companies were more profitable. I think that a lot of that myth is still with us, because there is this belief that the American economy is going to get stronger. However, there never was really a new era. As you point out in your book, a lot of that is fiction, as we found out with earnings. The debt at all levels of society has risen, just as you have mentioned. Your book talks about similar situations in the US in the 1920s and in Japan in the 1980s. Why don’t you describe, for example, some of the economic performance during this bull market, because a lot of the economic accomplishments were below normal.
BOB: Absolutely right. Gross Domestic Product, for example, averaged 4½% per year from 1942 through 1966. That was the last time stocks had a really big move. In the 1980s and 1990s, it was only 3.2%, which is far less than 4.5. Industrial production in the 1980s and 1990s averaged 3.4% and back in the 1950s and 1960s, it was 5.3%, a very big difference again. This kind of thing is evident in all of the measures you might want to look at, including capacity utilization, which believe it or not, peaked at 91½% in 1966. In this big bull market, it peaked at 84.4%, and it is down in the 70s now. We have more capacity than we can use, obviously.
This has not been, nor was it, a new era. It is exactly the same kind of experience that we went through in the 1920s. The 1920s was an expansive period, but not nearly as expansive as previous decades. For example in the 1920s, we had a GNP increase of 48% over the eight years of bull market. In previous similar periods, it was 56% and 69%. Japan went through the same thing in the 1950s and 1960s, when it managed an amazing growth rate of 9½%. But from 1975 through 1989, when its big bull market was going on, it grew at only 4%, less than half the rate. What does this mean? It means that we have found a historical time when you can always bet on a crash and depression occurring. That happens when the stock market goes crazy on the upside and simultaneously the economy is weaker than at a recent previous time. That is exactly what we had in the 1980s and 1990s, yet not one conventional economist has commented on this. They don’t even look at numbers that are this long term. They look at month-to-month and quarterly, and that’s all they can see. But the most important message is what has been going on for the last 50 years.
JIM: In effect, haven’t we transformed our economy? We have gone from an economy that saved to one that borrowed, and an economy that invests to one that consumes.
BOB: And from one that produces goods to one that produces so-called services, which is really a joke. As a friend of my father’s used to say, “At the end of this, we will all make money by doing each other’s laundry.” It is a sad thing to see some of the greatest manufacturing companies of all time, that got their start in the United States, turn into lending and borrowing companies and other service companies. It is a sad thing, because it takes production of goods to make the entire economy work. You can’t have services without the goods that the services depend on. So the very thing that economists tell us is saving our economy is really another big negative.
JIM: I think a lot of people would be surprised that a lot of our big industrial concerns, such as General Motors, Ford or General Electric have really morphed, where a lot of the profit derived from the 1990s came from finance.
BOB: Yes, and it was the accountants who took over these companies, who figured out that they could make the books look really good this way. They were correct, but they were not correct if you take a multi-decade view. Financial booms and bubbles are rare things. You can look very good and be very profitable while the bubble is in force, if you are part of that game. But as soon as it ends, which it did in the first quarter of 2000, suddenly your profit margin shrinks, and your liabilities begin to grow and become more important than the cash flow that you are generating. I think that some of our major corporations are finding themselves in exactly that position today. That is one of the reasons why you have seen a dramatic drop in the amount of commercial paper being issued, because companies are feeling the squeeze.
JIM: In your book, you are talking about a depression and a crash. Experts tell us we will not have a depression again. The last time we had one was in the 1930s. They say it can’t happen again. Explain why depressions occur in the first place.
BOB: Well, the first thing you have to realize is that anytime you hear the expression, “Experts agree, when it comes to the markets and economy, you can pretty well bet against it and be safe. I think the reason that crash and depression are inevitable goes back to the very first thing we talked about at the outset of this interview, and that is the buildup of debt and credit in the system. I am certainly not the first one to recognize this as being a problem. Irving Fisher wrote an excellent paper in 1933 after the collapse, describing what the reasons for it were. He said that the build up in credit was the main reason. The Austrian economist, Ludwig Von Mises, talked about this in his seminal work, Human Action. Hamilton Bolton, one of the most celebrated Elliott wave analysts there ever was, wrote a paper on this very thing. He said that the biggest collapses are always preceded by a tremendous expansion of credit in a society. We have not only had a great buildup in credit, we have had a record buildup in credit—the largest ever. I think that fits the Elliott wave conclusion that we are entering, or are already in, the largest bear market in at least two centuries, which in turn will lead to the biggest economic difficulties in at least two centuries as well.
JIM: In your book you forecast a major crash for the stock market. It was surprising to me in looking at the business publications and investment publications in December. The consensus seems to be that we have had three years of negative returns. We have only had one time in our history when we have had four negative returns and that was in 1929-1932. So therefore, it can’t happen again this year. I take it that you would differ or take a different view on that.
BOB: This type of analysis is, to be charitable, quite thin to say the least. I think there are three crucial elements to market analysis. One is valuation. Another is psychology. Third is the Wave Principle, which is a price model of how the stock market behaves. Those are the three things that are most important in deciding where the market is going to go next.
In terms of valuation, I would say that there are three main bases on which you can value stocks: the dividend payout, the price/earnings ratio and stock price to book value. All three of those indicators -- we can talk about the specific numbers if you like -- still show the market as historically overvalued. There is still such a long way to go to get those numbers back into a normal range, much less into the area where you would want to buy stocks at a major bear market bottom valuation, that it is ridiculous not to pay attention to them. Three down years means absolutely nothing in the face of historical overvaluation.
Now you have the psychology problem, which you alluded to in your question. If you read the newspapers and magazines throughout late December and into January, you find that the people who are being interviewed are virtually unanimous in calling for an up year. For example, there were two or three magazines that interviewed as many as 15-30 people, major professional money managers, expert stock brokers, firm analysts and so forth, and we found that between 80 to 95% of those interviewed in those magazines were bullish. We just got the latest figures from Investor’s Intelligence, which reports twice as many bullish advisors as bearish. None of these indicators would be in this position had we actually made a major bottom in October. It is literally impossible that we made a major bottom because psychology did not reflect it and still doesn’t.
The third thing is the Elliott wave pattern. To me this is the most interesting, because we are actually approaching the point of recognition, which for Elliott wave enthusiasts means the third wave of the third wave, the center point of the decline. I think we are likely to hit it this quarter, and I think the rally attempt that we had in January was the last gasp for the bulls and we are already heading down into what could turn out the crash part of this bear market.
JIM: You know we are finding today that despite, once again, three years of losses, stocks still aren’t cheap. Does it surprise you in many ways? And is Wall Street trading the same illusion that they did with the new era by talking about pro-forma earnings? You will see individual stocks and sometimes the markets moving. A good example is the other day Merck beat estimates, but their earnings were up 1.6% and their valuations are still high. I guess my second question is, has the lack of capitulation by individual investors surprised you? I think last year was the first time in 14 years that money went out of the market, but it was under $20 billion. The public is still fully invested.
BOB: Absolutely. I read a statistic that said no more than 1 to 1½% of investors actually got out. This is utterly typical. The average investor stays in. He believes in the mantra he heard in the late 1990s, “buy and hold.” Well, he bought and now he is holding. It doesn’t take everyone to sell to make the market go down; it only takes people on the margin. As to your earlier question about being surprised: Actually, in one way, we are always amazed at the machinations of the market, how it can go a long way regardless of certain aspects of what we feel is reasonable valuation. But on the other hand, we are not surprised, because we have been forecasting all along that what would happen would be the largest bear market in over 200 years, something we call of “grand super cycle degree.” If we are going to see a bear market that large, it means that stocks are going to fall between 80 and 95%. The only way that the market could fall that far is for people to refrain from turning bearish. Once they are extremely bearish, by definition, you are at a bottom. Sure enough, here the S&P and Wilshire 5000 Index have both fallen 50% from their highs, and most people are still wildly bullish and fully invested. As far as I am concerned, this is rock solid evidence that indeed we are in a bear market of “grand super cycle degree,” with much more to go.
JIM: The blue chips have held up relatively well in this downturn. If you are looking at the Dow Jones Industrial Average, I think it is down 28-30% as compared to the NASDAQ. It appears to me that what actually happened on Wall Street and maybe with some investors is that when the internet bubble burst and the tech bubble burst, investors just rotated out of tech stocks and went back into blue chips. So the blue chips have held up fairly well. Did they start to break down this year?
BOB: In my opinion, the answer to that is a definite yes. What you are describing is what happens at every classic top. Let’s take the top of 1968, which was quite speculative. The Value Line index went to a new all time high. A lot of tech stocks were running back then. The first thing the market did was fall hard into 1970, and then, if you recall, it rallied powerfully and made a new high in the Dow Jones Industrial Average in January 1973. In fact, there was even a late rally in 1973 that brought the Dow almost back to 1000 that peaked in late October. So the blue chips were trying their best to hold up throughout that period, and people were rotating to those. There was a group called the “nifty fifty,” which were the top blue chip growth stocks. Meanwhile, the secondary issues were weak and falling. Well, the blue chips finally did succumb. From late October 1973 until October-December 1974, they absolutely fell apart, nearly a 50% loss. So, I think you are seeing the classic distribution pattern again. You are seeing an initial drop in the speculative issues, which are now represented by the NASDAQ. You saw, finally, the secondaries take a big hit last year, in 2002. The blue chips have been eroding, but I think that they are heading into their collapse period as we speak.
JIM: What you don’t hear throughout all of this, what economists never mention, particularly when they talk about recovery, is the long-term deterioration of economic performance in the second half of the last century, which the first part of your book talks about. For that matter, do you see Wall Street talk about stock market values? It is almost as if either this is self-delusion or deliberate self-serving promotion.
BOB: You use an interesting word. You said economists “never” mention this. I usually stay away from extreme words like that, but in this case, you are absolutely correct. I don’t know of any economists even now -- much less at the appropriate time, which would be in 1999 or 2000 – who are warning people of what has been going on long term. Recently, in this latest year, there have been one or two economists who got a little bit of press by saying, “Look; things aren’t as good as everyone is saying.” So there are a couple of mavericks who can see what is right in front of their faces at this point.
As to the question of whether it is self delusion or simply profit seeking -- trying to keep people bullish so they will buy more stock -- is probably best answered by saying that there is symbiosis between the two. Wall Street certainly wants people to be bullish. If you are a money manager, you want your customers to stay in, and the only way that they will stay in your fund is if you and they stay bullish. If you are a broker, you want your customers to buy stocks, and the only way they will do that is if you and they are bullish. But at the same time, I think the true engine of the market is general social mood, which is shared by people throughout society. The general bullishness today is shared by individuals at all levels of sophistication. I don’t think it is all a cynical attempt to make money out of the poor suckers, because it is not only the poor suckers who are bullish but almost everyone in the system as well. If you speak to individual brokers and money managers, you will find out that they lost money, too, personally. They were invested in their own accounts and their own funds, and they have been getting killed. I think that the real answer is in what I call “socionomics,” which is a study of the overall psychology that permeates society.
JIM: That brings me to the next question, because the Wave Principle deals with this public psychology. Explain the significance of optimistic psychology, which even as you and I speak, still exists today.
BOB: The significance of psychology, in terms of the broad spectrum of society, is that it ultimately is the engine of progress and setback. If we take for example, the recessions of 1974 and again in 1980 and 1982, people were rather pessimistic at that time, which gave them a lot of room to improve their moods. As optimism increased from 1982 until 2000, it caused people to take a lot of social actions. For example, people in business felt more optimistic, expanded their businesses and hired more people. People who were investors began to take risks with their money and buy stocks and put some of their capital to work with start up companies. It showed up in other areas. People who were feeling friskier were creating happy upbeat pop songs, until at the peak there were bubble gum heroes all over the musical landscape. So optimism has all kinds of results. Most people think that events in the outside world are causing people to become more optimistic or more pessimistic. That is actually false if you study the chronology. The optimism comes first. You can see it in the figures. You can see it in the movements in the stock market; the results come later.
An important thing to add for our current time is that pessimism works the same way. Recall that people did not talk about recession until well into 2001, but the stock market topped in the first quarter of 2000. Pessimism increased, which ultimately caused the economy to contract. People were contracting their businesses, hiring fewer people and taking fewer risks. That ended up showing in the economic figures. To answer your question, I think that ultimately, the social psychology is the engine of economic change.
JIM: The Wave Principle is based on psychological factors, but what about some of the structural malinvestments, and let’s say the distortions, that were created by the credit boom? Don’t they provide, in one sense, the detonator for an economic and financial implosion?
BOB: Yes, but you also have to realize what the ultimate cause of those very excesses were. It was optimism throughout the society that allowed the people to extend credit to outrageously uncreditworthy borrowers and for those very borrowers to say, “I can borrow this money because some day I will be able to pay it back. No problem.” Both sides had to be optimistic in order for credit to be expanded to the level that it reached. How optimistic do people have to be to bid stock market prices to outrageous, historically unsustainable levels? It had to be extreme. The optimism is the ultimate cause. As you quite correctly point out, that optimism has built structural problems into the economy. So when I hear one of the Fed governors assure us that they won’t make the same mistakes that the Fed made in the early 1930s, I say it is too late. You have already made two decades worth of mistakes, and you can’t escape them.
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