Dow Jones has moved into Zone of Palpable Financial Instability

I have seen the top of the Dow Jones index as 16,800, but when the ECB loosened monetary policy to an extent never before seen last week, the Dow Jones lofted over 16,800. It is now hovering below 17,000, but there are concerns that it should not loft higher.

I refer to an article by David Weidner at Market Watch, 3 Reasons the Dow doesn’t Deserve to be at 17,000. He gives 3 very fundamental reasons…

“There are many reasons this rally feels empty.”

  1. “No one is really buying.”
  2. “Corporate earnings are flat.”
  3. “There are no alternative investments.”

Welcome to the end of the business cycle as determined by Effective Demand. Keynes wrote about effective demand and profit rates.

“Now if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D. Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.” (source)

What is Keynes describing? When the expected proceeds (D) of employment (N) equal the supply price (Z), profits will be maximized. This point is called effective demand.

I have an equation for effective demand that predicted this moment of flat corporate earnings.

Effective demand >= Real GDP output * (effective labor share)/(composite rate of utilization of labor and capital)

Thus, when, effective labor share = (composite rate of utilization of labor and capital), profits will be maximized.

In other words, when output is equal to effective demand, the business cycle has reached its top. This has been the pattern for all decades that we have consistent data for.

In the past 6 months, effective labor share was still a bit greater than the composite utilization of labor and capital. But they are now equal. Once again, the aggregate signal for profit levels, namely stocks, is running out of steam at this effective demand limit.

Stocks could move higher if monetary policy continues to loosen to greater levels or effective demand rises, but we are now pushing palpable levels of financial instability. Further loosening of monetary policy only makes the eventual fall that much harder.