The Dow Jones: The coming Sovereign Debt Defaults

I’d like to address a reader’s email:

Your argument is that US equity prices must skyrocket because there will be a collapse in European bond markets (and thus capital flight into US equities). It might be worth having a close look at what happened in the 1930s.

The Great Depression was not started by the 1929 share-market crash but rather by a loss of confidence in bonds (due to the contagious effect of the failure of a systemically significant European bank – Credit Anstaldt). As I understand it the crash in bond values wiped out a huge amount of wealth and reset the rate of return criteria for investments generally much higher – and thus led to a renewed and long-lasting equity market crash.

I would be interested in your account of the relationship between current situation and the 1930s.

Indeed, the world faces looming massive sovereign debt defaultsin the next couple of years. This is the driving force behind the gigantic shift between global debt and equities markets.

We face a future comparable to the 1930s. With this in mind, let’s wind back the clock…

The Great Depression did start with the 1929 share-market crash. Global sovereign debt defaults (explained in above links) turned what would be a deep recession into the Great Depression.

The 1929 crash was a direct result of the roaring 20s — post-war innovation was off the charts. And this was marked by significant economic growth and an abundance of wealth and spending, which played a major part in defining the culture of that decade.

From 1921 to 1929, the Dow Jones rocketed from 60 to 400 points, creating many new millionaires.

Source: BBC
Click to enlarge

The bullish stock market was fuelled by excessive risk taking.

Similar to the average person’s views on property today, people back then thought stocks could only go up. Investor confidence was sky high. This resulted in excessive borrowing to punt on the stock market. Even banks were punting depositor’s money into the stock market — money that wasn’t backed by the government either.

Rising interest rates, large capital flows into from Europe into the US, and excessive risk taking led to the Dow Jones doubling between 1927 and 1929.  The writing was on the wall in 1929 when a number of companies reported poor financial results. And many believed the stock market was then a bubble.

The Dow Jones fell 62% in a number of months from its October 1929 high. It then bounced 50% into 1931.

And here’s where it gets interesting…

US President Hoover signed the now-infamous Smoot-Hawley tariff bill into law during 1930. It increased import duties by more than 50% for more than 890 goods. This law initially intended to raise prices to help farmers and grow US employment.

The results were catastrophic. The US Department of State said the following,

U.S. imports from Europe declined from a 1929 high of $1334 million to just $390 million in 1932, while U.S. exports to Europe fell from $2341 million in 1929 to $784 million in 1932.

Overall, world trade declined by 66% between 1929 and 1934.’

Smoot-Hawley did nothing to foster trust and cooperation among nations in either the political or economic realm during a perilous era in international relations.

Two years later unemployment had reached almost 24% in the US, more than 5000 banks had failed, and hundreds of thousands were homeless and living in shanty towns called ‘Hoovervilles’.

The Great Depression was caused because of the legal restrictions on world trade. And global trade restrictions led to the global sovereign debt defaults in 1931–33. The sovereign debt defaults, a direct result of the global trade protectionism laws, sent the stock market crashing by over 90%.

Many people lost everything they once worked for — stocks, property, bonds, and cash were sold to repay margin calls. Many of the wealthiest people jumped out of buildings to commit suicide.

President Hoover was blamed for the stock market crash. And this brought President Franklin D Roosevelt into power in 1932.

Franklin D Roosevelt (FDR) said on the radio the night before being elected that he wouldn’t confiscate gold. People were going to vote against him because gold was seen as the only valuable commodity.

Gold was the only financial instrument that had any value during 1931–33. And because US was the richest country in the world and owned most of the gold, this is why the US dollar sky rocketed from 1931–33.

On April 5th, 1933, FDR confiscated every gold coin, bar, and certificate, and people had to turn in their gold to the federal government.

This wasn’t surprising. World trade flows suffered because of the Smoot-Hawley tariff. And the US government was broke.

Roosevelt confiscated the gold to prevent people from profiting from the rise in gold from $20 to $35 in March of 1933. This devalued the US dollar by 60% (attempting to make exports more attractive and foreign bills cheaper to pay) which also devalued the US bonds backed by gold.

This is precisely why I say that it was a global sovereign debt crisis. Many European countries defaulted, delayed payments and cut interest payments. The United Kingdom, Europe’s largest economy at the time, cut the interest payment on its war bond from 5% to 3.5% in 1932.

Multiple South American countries also defaulted on their bonds.

People no longer trusted government, and started buying stocks again, sending the Dow Jones skyrocketing from 1934–37. Keep in mind that in 1935, unemployment was at roughly 25%. The stock market acted as a hedge against government.

Once again, European sovereign debt defaults are on the horizon. This time will be worse than last time, because everyone owns everyone’s debt — this wasn’t the case in Europe during the early 1930s. This could very possibly lead to a contagion effect once again.

We may likely see a global sovereign debt crisis. Governments are bankrupt and we’re witnessing the final stages of a government bond bubble.

This is a serious risk to the world’s financial system. It’s highly likely that sovereign wealth firms, banks and pension funds will go under — all of whom own a tremendous amount of bonds. We’ll witness a collapse in socialism — governments aren’t there to look after you; they’re there to look after themselves.

We need to act now, not later. Buying quality stocks now — and gold companies at the right time — are the only ways to hedge against what’s coming.

If protectionism wasn’t put in place in the US during 1930, the Dow would have likely recovered during the sovereign debt defaults of 1931–33. Nonetheless, modern days are different. Trade represents roughly 10% of world capital flows — this certainly wasn’t the case in 1930. Financial transactions represent the majority of world capital flows today.

This is why you should see the Dow Jones rise this time around during the next wave of sovereign debt defaults. This bull market has absolutely nothing to do with company fundamentals anymore…even central banks see the risks and are buying equities. As they say, don’t bet against the Fed!

You’re about to witness a gigantic, global capital shift from the US$160 trillion debt market to equities markets (one third of the size of the bond market). The bullish US dollar and the thirst for yield will see gold sold off next year, sending more money into the stock market. And, thanks to the IMF, cash is no longer a safe option.

Governments are bankrupt and won’t look after you in the future; plan to look after yourself. They think they can fix any problem by raising taxes, increasing capital controls, and tightening regulation (like trying to regulate the internet). This is killing growth and driving unemployment higher.

The smart money is selling bonds and buying equities. 2015 will be a year when punters hunt for yield.

Gold doesn’t offer yield. And it will be smashed by the bullish US dollar.

When gold was trading at US$1,350 per ounce in early August, I explained to you how it’s falling to US$931 next year. It’s now trading at US$1,198.20 per ounce. I’ve shown Diggers and Drillers readers a detailed monthly analysis on gold and silver. If you’re interested in knowing where gold is heading in 2015 and when to buy it.

The only game in town is equities.

Have a look at the chart below. It tracks the Dow Jones Industrial Index. Each bar represents one month.

Source: Diggers and Drillers;
Click to enlarge

Today I want to show you how I arrived at my 26,100 point target next year. The Aussie should follow, albeit the returns won’t be nearly as good.

I went back to the 1980s to construct this above chart. Needless to say, the support and resistance levels are HIGHLY interesting and important. They define the 1987 stock market low, the 1999 tech bubble high, and the financial meltdown high (2007) and low (2009).

Let’s talk about some of the Fibonacci retracement levels…

The 38.2% Fibonacci retracement level acted as resistance from 1999 to 2006. The market just couldn’t go higher until it broke out in 2007.

In 2007 the market jumped quickly to the 50% Fibonacci retracement level and formed the pre-GFC high. The 2009 low retested the 23.6% Fibonacci retracement level which was support during the 1998 Russian bond default and 2002/03 market low. The Dow Jones flew past the 50% Fibonacci line last year.

The chart shows you that the Dow Jones has been in a strong bullish uptrend since 2011. We need to break the upper blue channel line on a weekly close to go higher.

On the weekly chart (not shown), this week we bounced near to the red trend line at 17,000 points. It’s plausible that we could see the stock market bounce towards the blue channel by year’s end. A 18,250 point close on the 31st of December isn’t out of the question.

That said, next week will set the tone as we head into January. But what were we’re witnessing is a very healthy channel trending bull market.

The US dollar is in the driving seat for the bull market rally and is set to go much higher next year. This is the key that many miss.

The bullish US dollar and the debt to equities switch could see the Dow Jones climb to 26,100 points by the end of 2015. A move to 26,100 points represents a 45% increase on the Dow’s current trading level of around 18,000 points.

Technically, 26,100 points represents the 100% Fibonacci retracement level — major support and resistance — dating back to the 1987 stock market crash low.

We’ve just gone through and held the 61.8% Fibonacci line; expect a bigger move as we head towards to 100% level (or 26,100 points) by the end of next year.

In summary, if we see a weekly close below 17,150–17,200 points next week, we’re likely heading lower in the weeks ahead.

The bottom line is that the Dow is making a very bullish setup for 2015. The market is extremely bullish. Sometime around the 22nd of January 2015, you’ll see an explosive blast to the north as we head towards 26,100 points by year’s end. The Aussie market should follow.

Jason Stevenson,
Resources Analyst, Diggers and Drillers

From the Port Phillip Publishing Library

Special Report: When Kris Sayce released the latest issue of his new investment letter, we all got a shock. In it he doesn’t recommend a high risk play. In fact, by his standards you might even say it’s ‘boring’. But according to Kris it’s ‘the single best stock on the Australian stock market…and it could pay out year after year after year.’

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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One response to “The Dow Jones: The coming Sovereign Debt Defaults

  1. This:

    “If protectionism wasn’t put in place in the US during 1930, the Dow would have likely recovered during the sovereign debt defaults of 1931–33. Nonetheless, modern days are different. Trade represents roughly 10% of world capital flows — this certainly wasn’t the case in 1930. Financial transactions represent the majority of world capital flows today.

    This is why you should see the Dow Jones rise this time around during the next wave of sovereign debt defaults.”

    is a huge leap of logic faith to justify why the opposite will happen to the share market compared to what it did during great depression. What does protectionism have to do with it? What effect does modern-day monetary policy fiddling have on it? Please explain!

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