Note: This is a “follow-up” to the article
What the Future may hold?

Part 1

In the twenties of the last century the world, and especially the United States, experienced an economical high. As a result of this, share and stock prices rose to unprecedented heights, beyond reasonable values. The underlying economy had decreased in strength without this being reflected on the stock exchange. Investors were euphoric and stock prices were forced up against all economic logic. ⁽¹⁾

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In my view the causes for the rise of the Dow Jones to unprecedented highs were the introduction of a new calculation method for the Dow on 1 October 1928, the introduction of the Dow-divisor, the extension of the Dow from 20 to 30 funds on 1 October 1928 and splitting the stock between October 1928 and November 1929 which was the last part of the acceleration phase of the second industrial revolution. These 3 factors caused the Dow to rise exponentially from 238 tot 381 points in de period October 1928 to September 1929, while the underlying economy strongly diminished in strength. Transitions Every production phase, civilization or other human invention goes through a so called transformation process. Transitions are social transformation processes that cover at least one generation. In this article I will use one such transition to demonstrate the position of our present civilization and its possible effect on stock exchange rates. A transition has the following characteristics(2): it involves a structural change of civilization or a complex subsystem of our civilization it shows technological, economical, ecological, socio cultural and institutional changes at different levels that influence and enhance each other it is the result of slow changes (changes in supplies) and fast dynamics (flows)

A transition process is not fixed from the start because during the transition processes will adapt to the new situation. A transition is not dogmatic.

Four transition phases⁽³⁾

In general transitions can be seen to go through the S curve and we can distinguish four phases (see fig. 1):

1. a pre development phase of a dynamic balance in which the present status does not visibly change
2. a take off phase in which the process of change starts because of changes in the system
3. an acceleration phase in which visible structural changes take place through an accumulation of socio cultural, economical, ecological and institutional changes influencing each other; in this phase we see collective learning processes, diffusion and processes of embedding
4. a stabilization phase in which the speed of sociological change slows down and a new dynamic balance is achieved through learning
    A product life cycle also goes through an S curve. In that case there is a fifth phase:
5. the degeneration phase in which cost rises because of over capacity and the producer will finally withdraw from the market.

Figure 1: Four phases in a transition best visualized by means of an S – curve: pre-development, take off, acceleration, stabilization

When we look back into the past we see three transitions, also called industrial revolutions, taking place with far-reaching effect ⁽⁴⁾:

1. The first industrial revolution (1780 until circa 1850); the steam engine
2. The second industrial revolution (1870 until circa 1930); electricity, oil and the car
3. The third industrial revolution (1950 until ….); computer and microprocessor

The Dow Jones Industrial Average (DJIA) index is the oldest shares index in the United States. A select group of journalists of The Wall Street Journal decide which companies are included in the most influential stock exchange index in the world.  Unlike most other indices the Dow is a price average index. This means that shares with a high price have a great influence on the movements of the index.  Calculating stock index values such as the Dow and presenting the index in a historical graphs is a perfect way of indicating which phase an industrial revolution is in.

Figure 2: The two most recent revolutions and the Dow Jones index

Dow Jones-index (graph) was (is) a fata morgana

 In many graphs the y-axis is a fixed unit, such as kg, meter, liter or euro. In the graphs showing the stock exchange values, this also seems to be the case because the unit shows a number of points. However, this is far from true! An index point is not a fixed unit in time and does not have any historical significance.
An index is calculated on the basis of a set of shares. Every index has its own formula and the formula gives the number of points of the index. Unfortunately many people attach a lot of value to these graphs which are, however, very deceptive.
The Dow was first published in 1896. The index was calculated by dividing the sum of the shares by 12:

Dow-index_1896 = (x1 + x2+ ……….+x12) / 12

An index is calculated on the basis of a set of shares. Every index has its own formula and the formula results in the number of points of the index. However, this set of shares changes regularly. It is therefore very strange that different sets of shares are represented by the same unit.
After a period of 25 years the value of the original set of 12 apples is compared to the value of a set of 30 pears. In 1929 only 2 of the original 12 companies of the Dow were still present.

The most remarkable characteristic is of course the constantly changing set of shares. Generally speaking, the companies that are removed from the set are in a stabilization or degeneration phase. Companies in a take off phase or acceleration phase are added to the set. This greatly increases the chance that the index will rise rather than go down. This is obvious, especially when this is done during the acceleration phase of a transition. In 1916 the Dow was extended to 20 companies; 4 companies were taken out and 12 were added.

Dow-index_1916 = (x1 + x2+ ……….+x20) / 20

This way of calculating the index actually creates a kind of pyramid scheme. All goes well as long as companies are added that are in their take off phase or acceleration phase. At the end of a transition there will be fewer companies in those phases.

The shares of a number of companies were split during the years and for those shares a factor was added to the calculation. The formula is as follows (American Can is multiplied by 6, General Electric by 4).

Dow-index_1927 = (6.x1 + 4.x2+ ……….+x20) / 20

Things take a bizarre turn with the changes to the Dow Jones of 1 October 1928.
On 1 October 1928 the Dow Jones is enlarged to 30 shares.
Because all calculations are done by hand, the calculation formula of the index is simplified. The Dow Divisor is introduced. The index is calculated by dividing the sum of the share values using the Dow Divisor.
Because the value on 1 October 1928 must remain the same, the Dow Divisor is set at 16.67. The index graphs of before and after 1 October be a continuous line.

Dow-index_okt_1928 = (x1 + x2+ ……….+x30) / 16.67

On 1 October 1928 the value of the Dow is 239, so the sum of the shares is 3984 dollars. From that moment on an increase (or decrease) of the set of shares results in almost twice as many (or fewer) index points. In the old formula the sum would have been divided by 30.

With every change in the set of shares used to calculate the Dow, the value of the Dow Divisor also changes. This is done because the index which is the result of two different sets of shares at the moment the set is changed must be the same for both sets at that point in time. The same thing happens when shares are split. In the fall of 1928 and spring of 1929 8 shares are split decreasing the Dow Divisor to 10.47.

Dow-index_sept_1929 = (x1 + x2+ ……….+x30) / 10.47

From that moment on a an increase (or decrease) of the set of shares results in almost three times as many (or fewer) index points as a year before. In the old formula the sum would have been divided by 30. The Dow’s highest point is on 3 September 1929 at 381 points.
So the extreme increase followed by an extreme decrease of the Dow in the period 1920 – 1932 was primarily caused by changes to the formula, the constant changes to the set of shares during the acceleration phase of the second industrial revolution and splitting of s`hares during this period. Because of these changes in the Dow investors were wrong footed. The companies whose shares constituted the Dow index at that time also continued into the stabilization and degeneration phase.

Déjà vu

 Dow Jones Industrial Average

Figure 3 Exchange rates of Dow Jones during the latest two industrial revolutions. During the last few years the rate increases have accelerated enormously.

 During the acceleration phase of the third industrial revolution, starting in 1980 with the appearance of the microprocessor, history repeated itself. The set of shares making up the Dow was almost completely replaced. Many shares were split which changed the Dow Divisor considerably. At the moment the Dow Divisor is 0,132319125, whereas this divisor was still more than 1 in 1985.

Dow-index_1985 = (x1 + x2 + ……..+x30) / 1.116

Dow-index_2009 = (x1 + x2 + …….. + x30) / 0,132319125

This explains the exponential rise of the Dow graph in the nineties. A rise in shares of 1 dollar of the set of shares in 2009 actually results in 8.4 more index points than in 1985 (the opposite happens when the shares go down). This explains why we have such extreme movements of the Dow in the previous period. At moment the Dow is at 9665 points, if we were to use the 1985 formula this would be 1150 points. Again investors have been lead onto the wrong path.

The real melt down of the Dow took place after the stock market crash of October 1929. During the period 1930 – 1932 the Dow continued to decrease from 230 to 41 points in the end. The crucial question is of course, whether the current underlying economy is strong enough to keep the Dow at its present level. Will the companies that make up the Dow not continue into the the stabilization and degeneration phase? Will there be enough new companies to act as new carriers of the Dow? And will that happen?

I call on the financial community to have a critical look at the formula used to calculate the Dow. If the present formula is retained, investors will be misguided with every new transition.

Wim Grommen

Note:  This article, in dutch  “Beurskrach 1929, mysterie ontrafeld?” was published in January 2010 in a monthly magazine “Technische en Kwantitatieve Analyse”, a monthly publication of Investment Interests in the Netherlands.
 

Sources used:

• ⁽¹⁾   http://nl.wikipedia.org/wiki/Beurskrach_van_1929
  
• ⁽²⁾ Transities & transitiemanagement, casus van een emissiearme  energievoorziening, Prof. dr. ir. Jan Rotmans e.a. .
• ⁽³⁾ Transities & transitiemanagement, casus van een emissiearme  energievoorziening, Prof. dr. ir. Jan Rotmans e.a. .
• ⁽⁴⁾ Geschiedenis Werkplaatssite van Wolters-Noordhoff

Note: This is a Follow up to the article What the Future may hold?

 

Part 2: A new stock market crash, a pattern?

Every production phase or civilization or other human invention goes through a so called transformation process. Transitions are social transformation processes that cover at least one generation. In this article I will use one such transition to demonstrate the position of our present civilization and its possible effect on stock exchange rates.

When we consider the characteristics of the phases of a social transformation we may find ourselves at the end of what might be called the third industrial revolution. Transitions are social transformation processes that cover at least one generation (= 25 years). A transition has the following characteristics:

• it involves a structural change of civilization or a complex subsystem of our civilization
• it shows technological, economical, ecological, socio cultural and institutional changes at different levels that influence and enhance each other
• it is the result of slow changes (changes in supplies) and fast dynamics (flows)

Examples of historical transitions are the demographical transition and the transition from coal to natural gas which caused transition in the use of energy. A transition process is not fixed from the start because during the transition processes will adapt to the new situation. A transition is not dogmatic.

Five transition phases

In general transitions can be seen to go through the S curve and we can distinguish four phases (see fig. 1 from the article above)

1. a pre development phase of a dynamic balance in which the present status does not visibly change
2. a take off phase in which the process of change starts because of changes in the system
3. an acceleration phase in which visible structural changes take place through an accumulation of socio cultural, economical, ecological and institutional changes influencing each other; in this phase we see collective learning processes, diffusion and processes of embedding
4. a stabilization phase in which the speed of sociological change slows down and a new dynamic balance is achieved through learning

A product life cycle also goes through an S curve. In that case there is a fifth phase:

      5. the degeneration phase in which cost rises because of over capacity and the producer will finally withdraw from the market.

Three drastic transitions

When we go back into the past three transitions took place with far-reaching effects.

1. The first industrial revolution

The first industrial revolution lasted from around 1780 tot 1850. It was characterized by a transition from small scale handwork to mechanized production in factories. The great catalyst in the process was the steam engine which also caused a revolution in transport as it was used in railways and shipping. The first industrial revolution was centered around the cotton industry. Because steam engines were made of iron and ran on coal, both coal mining and iron industry also came to bloom.
This revolution ended in 1845 when Friedrich Engels, son of a German textile baron, described the living conditions of the English working class in “The condition of the working class in England“. The result of this revolution: an immense gap between rich and poor.

2. The second industrial revolution

The second industrial revolution started around 1870 and ended around 1930. It was characterized by ongoing mechanization because of the introduction of the assembly line, the replacement of iron by steel and the development of the chemical industry. Furthermore coal and water were replaced by oil and electricity and the internal combustion engine was developed. Whereas the first industrial revolution was started through (chance) inventions by amateurs, companies invested a lot of money in professional research during the second revolution, looking for new products and production methods. In search of finances small companies merged into large scale enterprises which were headed by professional managers and shares were put on the market. These developments caused the transition from the traditional family business to Limited Liability companies and multinationals.

After the roaring twenties the revolution ended with the stock exchange crash of 1929. The consequences were disastrous culminating in the Second World War.

 3. The third industrial revolution

The third industrial revolution started around 1940 and is nearing its end. The United States and Japan played a leading role in the development of computers. During the Second World War great efforts were made to apply computer technology to military purposes. After the war the American space program increased the number of applications. Japan specialized in the use of computers for industrial purposes such as the robot. By now the computer and communication technology take up an irreplaceable role in all parts of the world.
The acceleration phase of the third industrial revolution started around 1980 with the introduction of the micro processor. The third industrial revolution has clearly reached the saturation and degeneration phase.

Dow Jones Industrial Average

Figure 2: Exchange rates of Dow Jones during the latest two industrial revolutions. During the last few years the rate increases have accelerated enormously.

 

Stock index graphs are fata morganas.

 What does a stock exchange index like DJIA, S&P 500 or AEX really mean?

 The Dow Jones Industrial Average (DJIA) index is the oldest shares index in the United States. A select group of journalists of The Wall Street Journal decide which companies are included in the most influential stock exchange index in the world.

Unlike most other indices the Dow is a price average index. This means that shares with a high price have a great influence on the movements of the index.

 The S&P index is a market value index. This index, compiled by credit evaluator Standard & Poor’s, includes the 500 largest US companies, based on their market capitalization

The Amsterdam Exchange Index (AEX) is the most important stock exchange index in the Netherlands. It shows the development of share prices of the top 25 funds of the Amsterdam Stock Exchange, based on trading. The AEX is the average price of the shares of those funds.

In many graphs the y-axis is a fixed unit, such as kg, meter, liter or euro. In the graphs showing the stock exchange values, this also seems to be the case because the unit shows a number of points. However, this is far from true! An index point is not a fixed unit in time and does not have any historical significance.

An index is calculated on the basis of a set of shares. Every index has its own formula and the formula gives the number of points of the index. Unfortunately many people attach a lot of value to these graphs which are, however, very deceptive.  (see discussion in the Part 1)

 

Fig 3: 3^rd industrial revolution and the S&P 500 

The two most recent revolutions and the Dow Jones index

Will the share indexes go down any further?

Calculating share indexes as described above and showing indexes in historical graphs is a useful way to show which the industrial revolution is in.

 

 Fig 4: Typical course of market development: Introduction, Growth, Flourishing, Decline

The third industrial revolution is clearly in the saturation and degeneration phase. This phase can be recognized by the saturation of the market and the increasing competition. Only the strongest companies can withstand the competition or take over their competitors (like for example the take-overs by Oracle and Microsoft in the past few years). The information technology world has not seen any significant technical changes recently, despite what the American marketing machine wants us to believe.

During the pre development phase and the take off phase of a transition many new companies spring into existence. This is a diverging process. Especially financial institutions play an important role here. These phases require a lot of money. The graphs showing the wages paid in the financial sector therefore shows the same S curve as both revolutions.

Historical excess wage in the financial sector

Investors get euphoric when hearing about mergers and take overs. Actually, these mergers and take overs are indications of the converging processes at the end of a transition. When looked at objectively each merger or take over is a loss of economic activity. This becomes painfully clear when we have a look at the unemployment rates of some countries.

New industrial revolutions come about because of new ideas, inventions and discoveries, so new knowledge and insight. Here too we have reached a point of saturation. There will be fewer companies in the take off or acceleration phase to replace the companies in the index shares sets that have reached the stabilization or degeneration phase.

In the graph below we see the share price/income ratio over the past two industrial revolutions. At the end of the 2^nd industrial revolution in 1932 this index reached 5. At the moment we are at 15. The index prices can still go down by a factor 3.

Industrial revolutions: share price / income ratio

 

Will history repeat itself?

Humanity is being confronted with the same problems as those at the end of the second industrial revolution such as decreasing stock exchange rates, highly increasing unemployment, towering debts of companies and governments and bad financial positions of banks.

Two most recent revolutions: US market debt

Transitions are initiated by inventions and discoveries, the knowledge of mankind. New knowledge influences the other four components in a society. At the moment there are few new inventions or discoveries. So the chance of a new industrial revolution is not very high.

History has shown that five pillars are indispensable for a stable society.

 

The five pillars for a stable society: Knowledge, Prosperity, Security, Food, Health

At the end of every transition the pillar Prosperity is threatened. We have seen this effect after every industrial revolution.
The pillar Health of a society is about to fall again. History has shown that the fall of the pillar Prosperity always results in a revolution. Because of the high level of unemployment after the second industrial revolution many societies initiated a new transition, the creation of a war economy. This type of economy flourished especially in the period 1940 – 1945.

Now, societies will have to make a choice for a new transition to be started.

Wim Grommen

This article was published in “Tijdschrift voor het ECONOMISCH ONDERWIJS”, februari 2010

Sources used

Transities & transitiemanagement, casus van een emissiearme energievoorziening, Prof. dr. ir. Jan Rotmans, Dr. René Kemp, Dr. ir. Marjolein van Asselt, Ir. Frank Geels, Dr. ir. Geert Verbong, Ir. Kirsten Molendijk (all related to different universities in the Netherlands) , Geschiedenis Werkplaatssite by Wolters-Noordhoff.

—

Wim Grommen worked as a mathematics and physics teacher (10 years). He has been an ict trainer for 25 years. At the moment he is a trainer for Transfer Solutions, an ict company specializing in services for Oracle databases and applications and Java technology. For the past few years he has been studying social transformation processes and the S-curve.

The article “A new stockmarketcrash, a pattern?”, in dutch  “Nieuwe beurskrach, een wetmatigheid?” was published in February 2010 in a magazine “Tijdschrift voor economisch onderwijs”, a monthly publication of the VECON, A union of teachers in economic and social subjects in the Netherlands.
A reaction of a dutch professor of economics after reading the article: “I think about Churchill, ”this is not the end, it is not even the beginning of the end; maybe it is the end of the beginning.”

PS: Rising Price of Gold

Gold breaks through 1,900 Dollars an Ounce

Dow/Gold Relative Ratio

Source: http://www.stocks-for-beginners.com/gold-market-price.html

When we take the Dow Jones and divide it by the price of Gold we get an analysis tool called the Dow/Gold Ratio, which is comparing the markets directly and we can see which market is outperforming the other market. When the blue line heads higher, the Dow Jones is performing better, when the blue line heads lower, gold is performing better. In the short term this may not be so clear, but in the long term it can describe a very clear story.

Gold Market Price – Dow/Gold Relative Ratio, 1900-2010, Historical Average Is 10, Historical Support Is 5

You will notice that Dow Jones is generally outperforming the price of gold. Very approximate conclusion could be that every 20 years of Dow Jones outperforming the price of gold (shaded in light blue) is followed by around 10 years of gold outperforming the Dow Index (shaded in light orange). Average historical Dow/Gold ratio is 10.13. This means that based on historical average it takes 10 ounces of gold to buy one share of the Dow Jones index. At the moment (05-29-2010) currently Dow/Gold ratio is 9.46, which is already below historical average. Will gold market price stop rising at this point? It could, but even more probable is that it will grow a bit more, so that Dow/Gold ratio will touch historical support at around 5, before the cycle will turn around again.

Why Gold Price goes Up?

The markets are full of uncertainty today and experts’ opposing opinions add to the confusion.

• It seems that most of what is happening is driven by the government and central banks.
  You should pay attention to what they do, NOT what they say. Saying they support a strong dollar while adding several trillion dollars in debt is contradictory. What they are doing is printing currency like there is no tomorrow.
• Economic troubles in US  and Europe push the gold (and precious metals) prices up.
• China and India play major role in the increase of gold price ( http://www.firstpost.com/economy/here%E2%80%99s-the-real-reason-why-gold-prices-are-soaring-65530.html )