Unexpectedly Intriguing!
March 25, 2009

Last December, Tyler Cowen asked:

Are there conditions, however rare, under which market adjustment and convergence does not occur? If a few of the vertices get stuck, can it become impossible for the economy to fulfill its mutating pinwheel program of change and adaptation?

To which, the ever-quippable Ironman at Political Calculations commented:

I would think yes. A series of disruptive events could prevent order from re-emerging. A realistic example of that would be an initial shock, followed by others or, more likely, a series of responses that prevent a new equilibrium from forming.

We hate it when Ironman* goes out and makes statements like this, because that means that we end up with a lot more work to do, especially when we haven't already done the work to back up Ironman's wild claims yet.

S&P 500 Average Monthly Index Value vs Trailing Year Dividends per Share, April 1963 through February 1976 And now that Ironman has put us on the hook like this, we have to ask: are there any examples of anything like a series of disruptive events that acted to prevent the return to order (aka "convergence") in a market? Fortunately for us, we have a case study: the U.S. stock market from April 1963 through February 1976.

What makes this period of stock market history unique is that it begins with a period of order, which provides a context against which we can appreciate the magnitude of disorder resulting from a series of disruptive events. In this case, those disruptive events prevented order from being re-established in the stock market for a decade. Here's our chart demonstrating the emergence of order, then the breakdown of that order and the series of significant and disruptive events that acted to keep a newer level of order from re-emerging.

As a side note, we find that this period, perhaps more than any other we've reviewed to date, most closely resembles the period from June 2003 onward in which we find ourselves today. That said, here are the major events that we identify as coinciding with the milestones we marked on the chart above.

Major Events Coinciding with Stock Market Milestones, April 1963 through February 1976
Month and Year Major Event/Comment
April 1963 Following a period of disorder, the market enters into a period of stability, in many ways, very similar to the period of June 2003 through December 2007.
May 1965 Sudden, significant (greater than two standard deviations) downward shift in stock prices. We've previously noted that this kind of change is often an early warning that established order in the stock market is beginning to break down.
February 1966 Another sudden, greater than two standard deviation downward shift in stock prices. We've found that this type of move, following months after an earlier move, may indicate that a breakdown in stock prices is imminent.
April 1966 The last uptick in stock prices before the previous order in the stock market finally breaks down. In May 1966, the market breaks through the -3 standard deviation lower equilibrium limit that the market had established between April 1963 and April 1966.
October 1966 A micro-recession begins in the U.S., with corporate dividend payments falling for the next quarter.
March 1968 The stock market bottoms and begins a rapid recovery in April 1968 as President Lyndon Johnson announces on 31 March 1968 that he will not seek re-election, even after winning the New Hampshire primary earlier in the month.
November 1968 Richard M. Nixon wins the 1968 election for the U.S. presidency.
November 1969 Stock prices fall as the U.S. economy slows and inflation grows throughout 1969, officially entering into recession in December.
May 1970 Stock prices plunge following President Nixon's ordering the invasion of Cambodia on 30 April 1970 and widespread anti-war protests take place. Forward momentum of stock dividends stops.
November 1971 Stock prices bottom before the U.S. dollar is officially devalued on 18 December 1971 and the U.S. leaves the gold standard for setting currency values.
January 1973 Stock prices peak as a peace agreement between the United States and North Viet Nam is announced, including the return of U.S. prisoners of war.
October 1973 Israel is attacked by four Islamic nations beginning the Yom Kippur War. Vice President Spiro Agnew resigns in disgrace. On 16 October 1973, the Arab-dominated oil-producing cartel OPEC announces a total embargo of nations supporting Israel's defense, targeting the U.S. on 20 October 1973. The Saturday Night Massacre involving the firing of prosecutors investigating the Watergate scandal takes place.
March 1974 The OPEC oil embargo against the U.S. is ended on 17 March 1974.
August 1974 Richard M. Nixon announces he will resign as U.S. President on 8 August 1974 as a result of the Watergate scandal.
January 1975 The two-year long stock market crash of 1973 and 1974 ends and stock prices resume an upward trajectory.
September 1975 Stocks bottom after falling sharply beginning in July 1975, as another micro-recession takes hold in the U.S. with corporate dividends first stalling then falling for a six month period.

February 1976 Order resumes as the growth rate of both stock prices and corporate dividends stabilize. The long series of disruptive events affecting the stock market ends.

In case you're interested in seeing what other trouble Ironman got us into in replying to Tyler's post, here's the rest of his comment, beginning with another excerpt from Tyler's original post:

Today, banking, finance, and construction all need to shrink and indeed they are shrinking. Given the centrality of lending and project evaluation, is a sufficiently healthy banking sector needed for the pinwheel to properly turn? Must investors abandon their quest for liquidity to bring their information to bear on market prices?

You need to first define what a healthy banking sector looks like and does. What we know today is that a healthy banking sector doesn't look like what it did in the last decade, nor should it do what the banking sector did in the last decade. Instead, we should look at those financial institutions that escaped the carnage and make it possible for more of those kinds of institutions to rise to the forefront.

The biggest problem out there is that far too many people are consumed by trying to put things back the way they were. In a way, it's almost like they're trying to re-assemble a cow from a truckload of hamburger - what they're doing ain't pretty, nor is it likely to be successful.

The kind of equilibrium stability theory that obsessed Franklin Fisher was written off as irrelevant some time ago. Maybe people will start looking at it again.

Well, yes, now that you mention it, some are, although I think that an econometric approach is the wrong way to go.

The problem is that a lot of econometrics tries to shoehorn real world data around a Gaussian normal distribution, which ultimately requires one to assume the underlying datapoints are statistically independent of each other. That's not how the world really works.

That approach can be useful and periodically holds, once you adopt Paretian assumptions (where power-law distributions and interdependencies hold), how prices change become lot easier to explain. Even in our current situation.

We're going to have to reign Ironman in.

Previously on Political Calculations

We've been systematically going backwards through time to identify the major periods of order and disorder in the S&P 500. Here are the posts with our discussion, with links to the charts included in each post:

* Who is Ironman, anyway? This post is all that we have that offers intriguing clues!

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