The dangers in extrapolating growth tre nds — Part three

[4 min read]

Projecting the past into the future is an easy trap to fall into…especially if the trend is an established one.

Former Fed Chair Bernanke made this mistake in July 2005 when asked about the inflating US housing bubble. His infamous reply was:

‘We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize…’

The moment you discount risk out of the equation is when the greatest risk exists.

That mentality is evident in the US share market.

Hardly anybody is expecting anything but more of the same old same old.

The market — ably supported by the Fed — is going to continue on its merry way to higher highs.

Let’s look at the Dow Jones Index.

Since the early 1980s, the Dow has risen from 800 points to 3,4000 points. Over a 40-year period, the Dow has posted an impressive 42-fold increase.

There’s that familiar arcing pattern we see in all exponential charts:

While we’ve come to accept this as normal market behaviour, it’s not.

For a little context, the previous 42-fold increase (from around 20 points to 800 points) took 90 years to happen…spanning from 1892 to 1982.

The Dow’s first exponential run-up occurred during the tech boom. This period of euphoria bought forth the ‘you can’t go wrong buying’ crowd.

When the Dow touched 11,000 points in June 1999, this book forecast even bigger gains ahead…

Then, as the air was coming out of the dotcom bubble, this slightly less bullish book was published in November 2000…

More than 20 years later, neither of these targets have been met.

But amid the current boom, optimism once again reigns supreme.

The Dow’s latest exponential run has the ‘you can’t go wrong buying’ crowd upping the ante.

As reported by HCF Live on 23 February (emphasis added):

‘The Dow Jones Industrial Average, an index that has astonished with its ascent over the past decade, likely will continue to astonish through the 2020s, rising to 50,000 by 2027.’

Why will this target be achieved?

According to the writer, the 40-year exponential trend (the one created by lower rates and higher debt levels) is going to continue without disruption…

‘Since I started in this business in 1981, the Dow has doubled five times, once every seven or eight years.’

What about the 16-year period (1965 to 1981) before they started in the business?

If you subscribe to his simplistic model, the Dow should have doubled and then doubled again.

Would you look at that…for 16 years the Dow went NOWHERE:

Why did the Dow flatline for 16 years?

Because this is what happened in the two decades prior…from 1945 to 1965…an exponential 10-fold increase…

But the Dow 50,000 is not a new story…

In December 2016, we were told…

Look at the fine print at the bottom ‘It’s just a math equation.’ Really?

Here’s one-half of the maths behind the prediction (emphasis added):

‘Companies typically grow their earnings over time. Assuming average growth of net earnings is 7% per year, we can compute that in a five-year period of time, the cumulative profits of a company will be about $40 for every $100 invested.

‘Extrapolating forward, we unearth more interesting results. The year 2020 marks where this math equation takes us to 25,000. In a mere 14 years, in 2030, the equation says the Dow would reach 50,000.’

There’s that (dangerous) word…extrapolating.

Even if the assumed earnings growth is correct (and you have to wonder how you get 7% earnings growth in an economy barely growing at 3%), this is only one-half of the math equation.

What about the multiple applied to those earnings? What if that changes?

The Shiller PE Ratio has a 150-year history of expanding and contracting…so why did the ‘smart insights’ make such a dumb oversight?

Here’s some maths to ponder.

Using the Rule of 72, earnings growing at 7% per annum would double over a 10-year period…$100 of earnings would grow to $200.

But what if, over that 10-year period, the earnings multiple shrank from 30 times to 15 times?

Here’s the equation…

$100 x 30 = $3,000

$200 x 15 = $3,000

If earnings double and the multiple halves, the price stagnates.

This is really basic market math.

Yet, you have an article, purporting to be a smart insight based on maths, completely missing the very important role the second part of the equation plays in the maths.

This is what happens in the good times, dumb oversights get ignored…until the market tanks and then everyone goes ‘Oh, I forgot about that.’

Remember gold going to US$5,000?

Cast your mind back to 2011.

At the time, gold was literally the ‘golden’ asset.

Recall the headlines?

Here’s a sample from August 2011:

This is an extract…

‘Rob McEwen has become a legend in the gold mining industry by skilfully assembling and building mining companies over the past 20 years. In this exclusive Gold Report interview, he explains his rationale for $5,000/oz. gold and $200/oz. silver and how the factors leading to those price levels will affect the industry and the companies exploring for and producing the metals.’

This prediction of gold heading much higher was made within a whisker of the peak in September 2011…at the tail end of a decade-long exponential curve.

After gold peaked in September 2011, the price fell over 40% in value…and is staging a second rally.

Will gold hit US$5,000/oz? Or if there’s another major sell-off on Wall Street, will it fall away in value like it did in 2008?

Extrapolation is fraught with danger.

What has been may or may not be what the future is going to be for a particular asset.

The greatest belief system in the world today

At present, the greatest belief system in the world exists with the crypto faithful.

Pick a headline…the price of bitcoin is headed anywhere north of US$100k to US$1 million.

The exponential arc has made a couple of appearances in the bitcoin chart.

The recovery from the first bubble in late 2017 has only served to reinforce the belief of the faithful in bitcoin.

The latest bitcoin bubble has popped, but not yet busted.

My guess is — and let’s face it, guesswork is all that bullish estimates are as well — when the Dow falls hard, the sell-off in cryptos will take bitcoin much closer to US$1,000.

Why?

Margin calls will need to be met. Stablecoins will prove to be anything but stable.

Panic will set in as the clunky blockchain mechanism struggles to handle the sell requests.

Part One of this series included this quote from Professor Kenneth E Boulding:

‘Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist.’

He also made this profound observation:

‘The future is bound to surprise us, but we don't have to be dumbfounded.’

Many people are certain to be absolutely dumbfounded by the market reversals that are embedded in the exponential charts.

They always are.

The extent of future falls may be a surprise to you and I, however, if history and mathematics are a guide, this could be a very pleasant surprise…one that presents cashed-up investors with an opportunity of a lifetime.

Regards,

Vern Gowdie,
Editor, The Rum Rebellion

Vern is also the Editor of The Gowdie Letter and The Gowdie Advisory — investment services designed to help everyday Australians avoid the financial pitfalls of a volatile economy and make informed decisions to grow their wealth for generations to come.