With the Dow Jones Industrial Average between 9,000 and 10,000 points, we are being advised by our stockbrokers, their firms and CNBC (Wall Street’s parrot) to (1) either get ready for buying opportunities, (2) switch into “quality” stocks, (3) be on the lookout for a “new” bull market, (4) hold on to your stocks or (5) be patient and “go with the flow”.
Forget it. Forget all it!
Dow Theory
Charles Dow began to pen his voluminous ideas on “Dow Theory” more than one hundred years ago, during the 1890’s, a rough and wooly speculators market that crashed and ultimately lead to all of the legislation from which we suffer today in the Federal Reserve Act of 1913. Dow’s Theory can be summarized thusly: “The ultimate return for investors will only be realized when stocks are purchased at a value that offer an opportunity for the market price to increase over a period of time”. What is value? And how does one determine when a stock is at a value that is a buying opportunity?
Here is the key: The broad market (Standard and Poor’s Index of 500 Stocks which include all of the Dow Jones Industrials) has historically returned an average annual compounded rate of return of 10.8%. Over the last seventy-three years, the time during which reliable records have been kept, 6.2% of that gain has been from appreciation of the stock and 4.6% of the 10.8% gain has been from dividend yield. The average price earnings ratios of stocks during that time has been 13.7 times earnings. Current price earnings ratio levels in excess of 20 times earnings and dividend yield’s of 1.4% indicate, historically, that at these price levels, an investor may expect an average rate of return over the next ten years of only 5%, less than half the seventy-three year average. Does it make any sense, then, to purchase stocks at this level, and take all that risk, when one can buy high rated tax-free bonds that yield almost 5% and “riskless” government bonds that yield more than 5%?
Before answering a question like that, one should
examine a range of broad economic facts:
The July 2000 Dow Jones World Stock Index was at 18,233 points. It is now under 13,000 points, indicating a serious worldwide down turn in stock values, which we are now calling a recession.
The NASDAQ has lost more than 70% from its high of last year, the greatest percentage decrease in history. Six leading NASDAQ stocks alone account for losses aggregating more than $1.2 trillion dollars in less than twelve months. Cisco, the darling of the stock market two years ago, has, all by itself, lost almost $500 billion dollars of value, and it is still over valued by historical standards.
The US purchases 20% of the world’s exports. A weakening world economy will cause our trading partners to lower prices in desperation in order to create cash flow, to reduce their inventories and to meet their own financial obligations. This is very deflationary at a time when the Federal Reserve System is inflating our money supply at historically dangerous rates.
The Federal Reserve System, as of January 17th, was increasing MZM (Money of Zero Maturity equals cash, checking accounts, savings accounts, and other immediately redeemable money market instruments) at a rate of 10.4% annually. As of March 28th, the latest figures available, MZM was being increased at a rate of 28% annually. That is extremely inflationary. Now we have the forces of deflation and inflation working against each other, a very dangerous game.
While Wall Street is talking about a bear market bottom creating buying opportunities that kick off a new bull market, no bull market has ever started with the DJIA at twenty times earnings per share with a yield of only 1.7%. In fact, the Dow is now selling in excess of past bull market highs! This bull market, which started in December 1974, began with the Dow and the S & P under seven times earnings and with the yield, on average, in excess of 6%! If one subscribes to the theory that this bull market started in 1981, instead of 1974, the Dow was at 7.7 times earnings and the S & P was at 6.7 times earnings while the yield on both exceeded 6%.
Consumer debt is at an all time high with average family credit card debt of more than $7,000.
In 1987, before the October crash, household assets indicated real estate values of $6 trillion dollars and stock values of $2 trillion dollars. Last year, the latest published government statistics indicate that the household value of real estate has increased to $11 trillion dollars (almost a double) while the value of stocks was $14 trillion dollars, a seven-fold increase! This is a strong indication that there is a disproportionate value of stocks to real estate before we discuss whether or not real estate itself is over valued (and also at risk of major decreases in prices).
The world dollar index topped out in October of 2000 at 118.22. Since then the dollar has lost 7% of its value, which puts the stock market at risk. If investors who move large amounts of money around the world see a continuing degeneration in the value of the dollar, they will sell stock, further depressing our markets, in order to invest their money elsewhere. To protect the dollar, the Federal Reserve System would try to increase interest rates (therefore making dollar based investments more profitable for foreigners) in the face of a gathering recession where consumers are already cutting back on their spending. Higher interest rates mean a higher cost of money, which usually means the costs of consumer goods go up (and their purchase by consumers would then, therefore, decrease).
US household savings rates are at an all time low. Current indications are that savings rates are increasing because of consumer’s concerns about this recession. Since two thirds of our economy is based upon consumer spending, an increase in the savings rate, which sounds good, is a disaster. An increase in saving in a recessionary market further cuts consumer spending and adds fuel to the recession. This is currently one of the problems with the Japanese economy.
Over this nineteen-year bull market, our production capacity has increased dramatically to accommodate our huge increases in sales and production. A significant increase in this capacity has been financed by debt. To the extent that companies continue to develop further excess capacity because of a prolonged recession, it will be more difficult for companies to meet their obligations to pay for the capacity increases that have materialized over the last several years.
There are over one hundred major mutual funds that have lost at least 40% of their value in the last twelve months. In addition, over one hundred mutual funds have been closed down this year alone.
Phew! That’s enough for today. Broad economic facts would indicate that the wise investor would not “buy” the continuing push by stockbrokers to “add value now” to their portfolios. Wisdom would indicate that far greater values may be down the road. The wise investor will sit tight, accumulate cash and wait for an historical bear market bottom based upon strong and solid historical Dow Theory.
George W. Rauch III
April 2, 2001
