Considering the 'Broken Window' Theory

 | Nov 08, 2012 | 9:30 AM EST
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I have recently been writing a series of pretty depressed columns -- I don't like the markets and oil is still overpriced, as are stocks. Most of my columns have reflected this caution, and I have made few recommendations.

I've been writing how difficult I thought the fourth quarter was going to be because of the looming fiscal cliff, overexcited asset prices through endless quantitative easing and the so far underappreciated effects of super storm Sandy. I expected the stock market's recent downdraft and don't think it's over yet. I am choosing to keep target prices on some favored stocks in place and not jump the gun before they reach them.

You want some good news? OK, here it is: There will be a positive effect (at least on asset prices) to be gained from the hurricane, but it will only be felt (at the earliest) in the second quarter of 2013. Why? Well, it's the much maligned and mostly debunked "broken window" theory of economics.

It goes like this: In times of economic downturn, with slow growth and high unemployment, any stimulative activity can act to push an economy out of its funk. The classic example is a shopkeeper's window: Break it, whether by accident or on purpose, and the shopkeeper will be forced to spend, let's say, $100 to the glazier to replace it. That $100 travels from the glazier to pay his assistant, to buy raw glass and grouting and the money continues to cycle with a much argued "multiplier effect" through the economy at large.

The debunking of this theory and why you don't want to just run around breaking windows in a stagnant economy is the idea of where the initial $100 comes from. While it comes from the shopkeeper's pocket, his spending of it on glass meant that he could not spend it somewhere else, somewhere less unnecessary. Before the incident, the shopkeeper has a glass window and $100 in his pocket. At the end of our example, he's got a window and $100 less dollars. Nothing new has been created, no innovation, no progress.

Well, if there was ever a practical chance to test the economic effects of the "broken window" fallacy, super storm Sandy is it. With an estimate of damage now breaching $50 billion dollars, there are a lot of broken windows out there that are going to need fixing.

But, where's the money going to come from? Shopkeepers? Insurance companies? Yes, a lot of it will. But also a good amount will come from the federal government. I expect newly re-elected President Obama to fund low-interest rebuilding loans and outright relief for affected residents of the hurricane. To keep with our analogy, the shopkeeper will get a new window without taking the entire $100 out of his pocket.

Of course, on the other side, there's a further debt argument, a further printing of money argument and a further "stimulus in the guise of help" argument. All of that, while true, doesn't make it any less practical and likely.

But the positive effects of this rebuilding effort on asset prices, including stocks multiplying through the economy is not likely to be seen until the spring of 2013 when building stocks such as Home Depot (HD), Sherwin-Williams (SHW), Stanley Black & Decker (SWK) and dozens of others will get the sales pop.

Unfortunately, the negative effects will be felt first with a slowing GDP, missed earnings and a slackening stock market. So for now, I'm sort of back to my market depression and advising you to find those target prices and stick to them, at least through the end of the year. 

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