That Big Stock Market Drop
Because few speculators and investors understand the real-estate cycle and its relation to the business cycle, they have great uncertainty about where the economy is headed
March 1, 2007
Fred Foldvary, Ph.D.
Economist

On Tuesday, February 27, 2007, Mr. Market had a big fall, following a big drop of nine percent in the Chinese stock market. The Dow Jones Industrial average fell 533 points for the week, more than four percent, wiping out the year’s gains. The NASDAQ average fell by 6 percent, and the S&P; 500 dropped by 4.4 percent. Stock markets all over the world also slid south.

The US stock market had been rising for the past few years, after the big drop in the recession of 2001. Investors are now wondering, it is this the end of the bull market, or just a correction. A “correction” means that stocks have risen too fast, to levels beyond that warranted by fundamentals such as profits, and so they fall back after a speculative rise. Stocks then resume a normal rise due to increasingly better fundamentals such as growing sales.

The answer depends on where we are on the business cycle. I have been forecasting a recession around 2008, based on the real estate cycle. Real estate prices and construction peaked out in the USA in 2006. Every peak in real estate has been followed by a major depression. For a full explanation, see my article: "The Business Cycle: A Georgist-Austrian Synthesis" in the American Journal of Economics and Sociology 56 (4) (October 1997): 521-41.

So far, the real estate cycle is right on track. Residential real estate prices are on a plateau, falling in some places, but mostly steady, as properties stay for sale longer. Sellers are reluctant to reduce their offer prices, although in many cases the offer side benefits that in effect reduce the price. However, the economic indicators do not point to a likely recession this year, in 2007. Economic growth has slowed, but is still positive. Commercial real estate has been strong, although the Dow Jones US Real Estate Index looks like it peaked out on February 2007. It is not clear whether this is a long-term or short-term peak.

In the short-run, such as a year, stock markets are unpredictable, so for the rest of 2007 the US and other markets could rise or fall; nobody knows. Long-term investors who wisely follow “modern portfolio theory” should not be worried about this stock market drop. Their portfolios are diversified with mutual funds of stocks and bonds of various categories. Bonds rose while stocks fell, so a well-diversified portfolio did not get hit as hard.

Those who trade stocks for short-run gains usually place “stop loss” order with their brokers. For example, if one buys a stock for $100, one places a stop at $90 or $80 so that if the stock falls to that price, it is automatically sold. These stop orders make a large fall in stock markets feed on itself as stops are triggered and make the market fall further. But then bargain hunters scoop up stocks that are fundamentally good but fell just because the holders panicked.

Because few speculators and investors understand the real-estate cycle and its relation to the business cycle, they have great uncertainty about where the economy is headed and where stock markets are going. Alan Greenspan, former head of the Federal Reserve system, made some investors and traders nervous when he warned that the economic expansion could end in a year. He then hedged, saying a recession was possible but not necessarily likely.

The few economists who understand the Georgist-Austrian synthesis have been warning for a long time that a recession and depression are coming towards the end of this decade. The drop in the stock market is a warning of bad times to come. Even if stock markets recover and rise to new highs, the economy is flowing down a river towards a waterfall.

The exact timing of the down turn is not possible to know, but unless you live in Japan where its real estate market is finally recovering from a long spell of malaise, wise investors should be skeptical of real estate brokers who say that markets will pick up soon. There are deep monetary and fiscal structures in all the economies of the world that have caused real estate and business cycles. So long as these are in place, there is no way to avoid the next recession, which will take most people by surprise, but not you!

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Fred Foldvary, Ph.D.
Economist

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.