With the near-record 678-point plunge yesterday and another rout in the making today, the Dow is getting killed.

Are we looking at the dawn of the second Great Depression and an end to the free market system?

Perhaps not. According to Martin Hutchinson, “the stock market’s long-term outlook is as upbeat as it’s been for some time. This painful stretch actually represents a very necessary descent from a turbulent balloon journey through multiple thunderstorms to a relatively safe landing – with only a moderate amount of damage to the actual balloon, itself.”

This from Money Morning:

In that respect, the future is bright. It’s a future where stocks are sensibly valued, abundant with bargains, and where investors can confidently look forward to the annual real rates of return of 8% to 9% that have been the stock market’s average over the past century.

As many readers know, I ascribe many of our current economic difficulties to a change in U.S. Federal Reserve policy that took place in the spring of 1995. From 1979 to 1995, the Federal Reserve followed a policy of monetarism, by which it did not allow the broad money supply to grow significantly faster than the economy as a whole.

That policy prevented inflation from taking off; it also allowed money to be a more or less constant measure in the economy, whose value and availability did not vary much from year to year. That had the enormous advantage of giving borrowers, lenders, buyers and sellers a reliable unit to depend upon, thereby allowing the free market system to work on an undistorted basis.

Beginning in 1995, monetary policy was changed. Since then, broad money supply has increased at an annual rate of almost 9%, compared with an annual growth rate of only 5.3% in nominal gross domestic product (GDP).

That may not sound like much of a differential, but over a long period, it changes everything. With money supply that’s advancing at a rate that’s two-thirds faster than GDP, purchasing and investment decisions get skewed – particularly over the long term.

Normally, this would cause inflation to soar. But in the 1990s, this didn’t happen – primarily because this shift in monetary policy, but in the 1990s it didn’t, because it coincided with the arrival of the Internet and cheap cell-phone technology. These technological paradigm shifts actually did make it possible for manufacturing to be easily outsourced all over the world, suppressing price increases, and inflationary pressures.

Even though this shift in Fed policy hasn’t caused much inflation (though that may be changing), the excess money sloshing around our financial system has nurtured big increases in asset prices – at a rate much faster than GDP itself was advancing – first hitting stocks and then, after 2000, real estate (and U.S. home prices, specifically).

After 2000, other countries followed the Fed’s lead and loosened monetary policy. As a result, asset prices have soared worldwide. The only exceptions: Stocks and houses in Japan (which both suffered through a decade-long bubble that ended as the 1990s began), and housing in Germany.

Now, we’ve hit a financial crunch and housing and stock prices are falling rapidly. To see where they might end up, you have to look at their long-run averages, compared to the factors that determine them. In the case of housing, you should look at average earnings of potential homebuyers to determine where prices should be. In the case of stocks, nominal GDP gives a good benchmark for stock prices.

Fed monetary policy was changed in February 1995; on the Fed’s own Website there is testimony by former Fed Chairman Alan Greenspan to the Senate that Feb. 23, explaining that he was about to turn to a more-expansionary policy (though he gave no indication that he, and his successor, would continue expanding for more than a decade). Money supply, as measured by the Federal Reserve Bank of St. Louis’s Money Zero Maturity (MZM), the nearest we can get today to the old M3 (which the Fed stopped reporting in March 2006), is up 205% since then.

GDP for the first quarter of 1995 was $7.298 trillion. In the second quarter of 2008, the latest data we have available, it was $14.294 trillion. Third-quarter figures will be published at the end of this month; we can reasonably estimate that third-quarter GDP will be $14.450 trillion. That’s a 98% increase in nominal GDP since 1995, so if shares have increased by 98% since then, we can regard them as being at the same relative valuation as they were in the first quarter of 1995, when this monetary misstep was taken.

On the last Friday of February 1995, the Dow Jones Industrial Average closed at 3,953.54 – it had touched 4,000 for the first time just two days earlier – ironically, the very day that Greenspan testified to Congress. That wasn’t a “bear market” value; it was 45% above the peak reached in 1987, before the record one-day crash, and up from first passing 3,000 just 4 years earlier. The US economy was expanding, four years after the trough of the 1991 recession. In other words, 3,953.54 can be regarded as a “reasonable” level for the stock market in February 1995, maybe a little high.

If the Dow had increased in line with nominal GDP since February 1995, it would today be trading at 7,829. In other words, in the entire period since Greenspan announced that change in monetary policy, the stock market has been in a bubble, floating like a balloon far above where it should have been. Even in 2003, it never got down to its 1995-equivalent value. Indeed, the bottom in February 2003 – at Dow 7,800 – still was about 30% above its 1995-equivalent value, which, at that time, would have been around 6,000.

The accompanying chart demonstrates this very well: The gap between the Dow and GDP illustrates the extent to which the stock market is overvalued. Only in the past few weeks has it started to descend towards its 1995-equivalent value of 7,829. [The Dow closed yesterday at 8,579.19, meaning that blue-chip index remains about 750 points, or roughly 10%, overvalued, according to this particular market-value analysis.]

It’s quite possible that in this bear market stock prices will continue falling beyond a Dow of 7,829. However, when the Dow is trading below 7,829, investors will be able to draw two very important and reassuring conclusions:

• First, if the Dow is below 7,829, it is below a reasonable long-term value, so there are stock-market bargains that will prove good long-term investments
• Second, unlike investors who bought into the stock market in 1999 or in 2007, and who brought themselves losses for more than a decade, by investing when the Dow is below 7,829 you can be assured that your investments will bring you the long-term average return on stocks of the past century, which equates to an average-annual return of between 8% and 9%.

The time to lose sleep over your investments was when the Dow was at 14,000. At or below 7,829, your comfortable slumber should be wholly undisturbed.

Source: In the Long Run, the Dow’s 40% Nosedive May Actually Turn Into a Safe Landing