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The Placebo Effect as the Dow Jones Passes 13,000

Stock-Markets / US Stock Markets May 01, 2007 - 12:32 PM GMT

By: Paul_Petillo

Stock-Markets

Consider Dow 13,000. We have already surpassed that mark and probably will do so repeatedly in the next several weeks. To skeptics such as myself, there is an underlying fallacy in numbers such as this. When DJIA hits new high water marks, it allows investors to fall prey to the big number fallacy.

The big number fallacy goes something like this: All big numbers, and we can certainly qualify 13,000 as a big number in terms of stock market advances, are considered infinite. There is the possibility that given enough time the Dow could lumber on towards infinity. And the chartists among us will agree, based on the pace of recent years that it could happen in our lifetimes.


Most would agree that the meteoric rise in that index of thirty industrials that occurred from 1990 through two small recessions and a market correction or two has been impressive. And as we further consider the big number fallacy we find the Dow 13,000 is larger than any other previous number and yet smaller than any other that may lie ahead and, to complete the infinite fallacy, the numbers are the same as each other. Being greater, less than and the same as is a feat that only numbers can accomplish.

The problem with such thinking is one of promotion. To most investors, big numbers can only get bigger. In December of 2003, I offered readers of this column the following suggestions when another big number was broached. The excerpt was from an article titled the Kiss of Dow 10k.

“ There are still some worrisome indicators ,” I wrote suggesting that 10k might be just a smoke screen of sorts masking deeper problems . “Right now though, it is important to think about how we should act, what we should do, and how disastrous mistakes of the past can lead us to profitable maneuvers in the future.”

You will remember that many of us were still stinging from the losses we experienced when the market seemingly fell from beneath our collective feet and this article sought only to forewarn investors from jumping in. It is a well-documented fact that investors like markets on the rise, disdaining the bargains of a market on the decline.

“Many of the pundits that I hear of late are encouraging trading in a market that is moving steadily higher. Buying into such scenarios takes more discipline than many people have. There are some simple guidelines you can use though that will make any correction in equities (oops! the bear in me is slipping out) less painful.”

To this day I remain skeptical – invested mind you, but not so certain that what we see is reality. My next suggestion sought to temper enthusiasm but not discourage the human element involved.

“Once you have made your decision to buy a certain stock, buy half as much as you would like. Your exuberance has probably taken over your research and trimming your enthusiasm for your decision is better done initially. This market is trading at very high levels and in spite of all of the potential, all of the growth, and all of the positive numbers, we have come a long way too fast.”

And that fact remains true today.

“There are some technical problems with the markets right now. [A] Lack of conviction means that money is simply moving around in as many issues as possible, a spreading of risk that isn't necessarily something that should be confused with diversification.

“Profits at many companies are up based on lowered guidance as reported to analysts. Underestimating profits is garrulous at best, lulling the average investor to sleep while selling their own shares at record levels.”

With companies briskly repurchasing their own shares coupled with the hot pursuit of potential leverage buyout candidates, the result, the current reporting season has been grossly underestimated. And the Dow goes higher.

Some critics have challenged the Dow' performance and questioned the benchmark's viability. The Dow is a price-weighted index giving member companies with rising stock prices higher visibility or weight within the index. As it crosses the 13,000 mark, only half of the Dow stocks were up.

Compared to the Dow, the S&P 500 has 347 advancing issues in an index that is calculated based on market capitalization. And yet, the index has yet to come close to the all-time closing high of 1,527.46 mark set in March 2000.

I was equally critical of the Fed asserting that their failure to raise interest rates was “timid” and “has allowed portfolio managers to run this economy.”

“And lastly,” I wrote, “productivity is not a good indicator that things have improved. As many of the current work force will tell you, excluding the temporary force that is shifting in and out of the only jobs available, capacity to produce is strained to human limits. When manufacturers begin to address this problem and rehire workers to meet growing demand for increased inventories, stock prices will begin to fall.”

In this market, only three years later, manufacturing jobs have shifted to service sector employment and in many instances for considerably less pay. Capital spending, the kind that improves productivity has been almost non-existent leaving many to wonder what is propelling these outsized stock gains.

The gross domestic product is down along with housing. Personal income is up and spending is as well. The economy is down; consumer confidence is on the wane. Regulators are threatening to throw SarbOx out as so much of a knee-jerk reaction while 41% of the profits these companies are reporting are coming from overseas operations. And the market shrugs.

While I suggested that “the kiss of 10k would be mostly a peck on the cheek” . The intervening years have led me to believe that rather than 13,000 being portrayed as the love child of that kiss, it should be identified as more of a placebo for an economy in trouble.

This market offers little in the way of substance and a good deal in the way of illusion. The Latin for placebo is “I shall please” and so the market has. Portfolios and retirement savings plans have benefited from the rise in stock prices. Those prices, acting as placebo, mean very little without underlying growth.

It would be wise to remember that in order for a placebo to work, there needs to be faith in not only the person administering the treatment, the markets, their cheerleaders, and the companies but the patient, the investor as well. Do you have faith?

By Paul Petillo
Managing Editor
http://bluecollardollar.com

Paul Petillo is the Managing Editor of the http://bluecollardollar.com and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via: editor@bluecollardollar.com


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