To understand what has happened to the markets, we need to take a good hard look at what is happening with money, and to understand what is happening with money, we need to look at the Federal Reserve System. Whether we agree with it or not, the facts are that the Federal Reserve System (Fed) expands and contracts the amount of money that exists in our economy, and lately, the Fed has been expanding our monetary base at record rates. In fact, never in history has there been an expansion in the money supply as there has been since September 2001. Over the past fifteen weeks, M3 (the “broad” money supply) has increased an astounding $385 billion, which represents an annualized rate of increase of 18.5% in the money supply. What’s this mean? Very simply this means that the banks are loaded with cash, are willing to lend you money and are anxious to see you spend. The Fed believes the only way we can get out of this recession is to spend our way out, and the
Fed is therefore making it easy to borrow money.
Well that sounds great! Money is cheap. If the public bites, two things will happen:
The already debt burdened consumer will become further burdened with debt;
Inflation will come roaring back.
The next question is “what is the Fed’s intention” if the above is true? Most people think that the Fed does not like inflation. Contrary to popular opinion, the Fed not only loves inflation, but they are the greatest engine of inflation in history. Let’s see why:
We are a “consumer society” with consumer spending representing more than 70% of our Gross Domestic Product (GDP). One thing the Fed knows must be done to bring back growth in our economy is to stimulate the consumer to spend. One way to do that is to keep interest rates low so consumers become excited enough to borrow money and spend that money on vacations, cars, washing machines and so forth.
The Fed not only loves inflation, but inflation is mandatory for the government to operate. Congress just passed a bill providing for the increase in the national debt to exceed $6 trillion. If the Fed “manages inflation properly”, while the public will be hurt because their purchasing power decreases, the Fed will be serving the government’s agenda well because the $6 trillion of national debt will be paid off in the future with cheaper dollars.
Because the economy is currently suffering from deflation in the stock markets and the commodity markets, the Fed is desperate to get inflation to return. Deflation, sustained over a long period of time as it has been in Japan, would quite frankly cause the United States of America to go bankrupt because we could not meet our obligations on repayment of principal and interest on the $6 trillion of national debt. With “deflated dollars”, we would be paying off the national debt at a premium.
(With inflation our dollars are worth less in the future. With deflation our dollars are worth more in the future. Therefore, if we had 10% deflation in the next two years, the “real adjusted value” of the national debt of $6 trillion would be $6.6 trillion, and similarly, if we had 10% inflation, the “real adjusted value” of the $6 trillion national debt would be $5.4 trillion. Deflation revalues cash. Holding cash during deflation is economically smarter than spending that cash because the value of goods is going down. This means that a pool of cash that buys ”X” amount of goods at this moment in time, will be able to purchase “x + Y” amount of goods in the future).
What Is Really Happening
Let’s see whether or not the Fed’s program is working. From the stock markets point of view, the market has come up very nicely since September. So we must conclude that the Fed’s increase in the money supply is temporarily working insofar as the stock market is concerned.
The commodities market, however, which generally forecasts increases or decreases in manufacturing, is not doing so well. Commodities have crashed. Copper and lumber, two huge indicators of both industrial and building productivity, are at all time lows on a “relative” basis (adjusted for inflation). That is not a good sign. Because manufacturing and building are depressed, the number of jobs in the economy are being dramatically reduced. The result will be that fewer dollars will be flowing throughout the economy, and therefore tax dollars will be reduced.
The year 2001 set a record for bankruptcy’s. With bankruptcy’s rampant, and government revenues reduced, the government will not be able to meet their obligations which will result in deficit spending (spending money you do not have). Deficit spending can only be accomplished if government’s borrow money. More borrowing means greater future obligations. If those future obligations are offset by inflation, highly indebted government’s can survive. On the other hand, if we go into a deflationary cycle that is prolonged, like Japan, we could be mired in a downward cycle similar to the thirteen year recession that has existed in Japan where banks, industry, individuals and the government are barely holding on simply because of the difficulties of servicing their debts.
The above paragraph points out exactly “where we are” at this moment in our economic history. The government is desperate to get us to spend money. The government is desperate to re-inflate the dollar. They are doing everything in their power to get us to spend money and to re-inflate dollars.
How Does This Affect What We Should Do With Our Investments?
In spite of the “advice” from Wall Street, and their allies at the Fed and in the Federal government, the stock market is more expensive than it has been at any other time in history. The hype about getting in on the next rally makes one wonder how stupid Wall Street and the government thinks we are as investors. Further investments in stocks in this market would not be wise if one understands that the potential for further capital gains is remote, indeed.
Furthermore, 55% of return on stocks the last 80 years has been from dividends. Currently, dividends are averaging less than 1.4% of the cost of stocks, which is the lowest dividend yield in history.
There are only two types of investors: (1) value oriented investors and (2) everybody else. Since the stock market is paying dividends of less than 1.4% with price earnings ratios in excess of 30 times earnings, one must conclude there are very few values in the market for “value oriented” investors.
The prudent investor will realize this. They’ll keep their cash in short term and medium term money market instruments, and they will sit on the sidelines and wait for opportunities in the future. Imprudent investors will jump on the bandwagon and try to ride the market up another 200-400 points. The imprudent investor may make a few bucks, but the “opportunities” to make money are far exceeded by the possibility of losing a significant percentage of ones investment.
Caveat emptor!
George Rauch
January 10, 2002
