The Standard & Poor Index of 500 Stocks is currently selling at about 44 times earnings, an historical high, and the dividend payout’s average yield is just under 1.4%, an historical low. We are currently experiencing a bull run (a major up tick) in what is an extended bear market. Benjamin Graham wrote in his book “The Intelligent Investor” (which Warren Buffet says is “the best book on investing ever written”), that the “concept of investing requires maintaining a ‘margin of safety’”. With this market priced at these levels, there is no margin of safety.
If one examines a Dow Jones Industrial Average (DJIA) long-term chart, it is obvious that the current market has created a parabolic rise which began from a base that was built in the market during 1980-1982. The market is going to do one of two things:
As it has in the last few years, it will continue a sideways consolidation for an extended period of time and go nowhere; or
The bear market will be exonerated; closing the right side of the parabola, resulting in a continuation of the most devastating bear market loses in history.
One thing the market is not going to do is rise to any significant new levels. If the DJIA were to return to average historical levels, the market would be around 5000. The mathematical odds are much greater that a return to this mean will occur before the market realizes any substantial additional gains from these levels.
The only reason the market is at the levels existing today is because the Federal Reserve System is doing everything possible to keep the market from crashing further. Never has so much money been created out of thin air as the Federal Reserve System has created since September 11th. And while the Federal Reserve System may succeed in keeping the market from crashing further, it would be unparalleled in economic history if a market of “little or no value” obtained additional levels of “no value”.
Existing Opportunities
Are there opportunities to make money in a market like this? Indeed, there are a few opportunities.
Several A rated (investment grade), low price earnings ratio, high yielding securities are available. Companies like Philip Morris and US Tobacco, along with a host of A rated electric utilities that support low PE’s and yields in excess of 5%, are available. Intermediate term corporate and treasury bonds, as well as A rated municipal bonds, have attractive yields. Purchasing these securities, and reinvesting (compounding) the income is a sure way to succeed in this market (compared to purchasing already overpriced, low dividend paying, securities hoping that the securities will go up even more in value). With dividends and bond income paid out annually, an investor knows they are receiving a return on investment (rather than hoping that sky-high prices will go even higher). Reinvesting the income from those securities in additional high yield stocks or bonds is called compounding. Compounding has long been known among sophisticated investors as the “road to wealth”.
Compounding, and investing in high dividend paying A rated stocks and bonds, has not been in vogue over the last several years. Coincidently, in the last several weeks there have been many articles about the importance of companies paying dividends so that investors may enjoy immediate, and real, returns on their investments.
When the market is suppressed, or going down as it has for the last few years, investor’s interest in dividends is reestablished. This market has essentially gone nowhere the last few years, and both gold and bonds have outperformed the DJIA. Hence the new found interest in stocks that pay dividends, a real return, as opposed to stocks in which the investor can only hope for capital gains from an increase in the value of the stock. Further increases in values of overpriced stocks are virtually impossible to realize in markets such as these.
We keep reading that consumer confidence is returning, which is very important in an economy whose GDP is 70% dependant upon consumer spending. All of the consumer confidence in the world, however, probably cannot overcome the following: record individual and corporate bankruptcies, record individual, corporate and government debt, a down turn in corporate earnings not seen since the early 1950’s, and the following bubbles: real estate values, the stock markets, the value of the dollar, and a record trade deficit. A significant change in any of the above can create severe problems and cause a market that has lost $4.5 trillion dollars of shareholders value to have further significant declines.
The Prudent Investor
While there appear to be signs that the problems in our economy may be stabilizing, there is not sufficient evidence of a “recovery” to indicate a potential future big move in the stock markets. The potential remains much greater for the markets to deteriorate further than for the markets to significantly increase to higher levels.
Keeping significant percentages of ones assets in short and medium-term money market instruments, or high yielding, low price earnings ratio, A rated stocks will be the hallmark of the prudent investor. Rule number one in investing is “don’t lose money”. This market is a great big question mark, and opportunities to make money are scarce. We are in the third year of a bear market. Everybody loses money in a bear market. He who wins in a bear market is he who loses the least.
Potential Huge Economic Problem
The Japanese banking system is mathematically broke. To write off, and pay for, all of the non-performing debts in Japan would take more money than Japan has available. The only hope for an economy in that situation is that some other nations will give them credit. The only place Japan can get “credit” (meaning additional capital) of that magnitude is through the Bank for International Settlement and/or the World Bank. The American taxpayer is the primary provider of funds to those banks, and the American taxpayer owns the vast majority of those banks. Because the United States is the only country that has enough capital to guarantee the credit of the accounts for the Bank of International Settlements and the World Bank, the American taxpayer might be required to step up to the plate here pretty soon. Japan’s economy’s cash flow is significant, about half of the US economy’s cash flow, so the Japanese taxpayer may be able to bear the burden of a US sponsored bailout. But what the Japanese taxpayer will be doing is paying interest to banks owned by Americans. That can create huge resentment among the Japanese population in an area of the world that is already currently unstable. Historically this has been a prescription for war: hopefully, an economic war, not military (even though the former invariably precedes the latter).
Caveat Emptor!
George Rauch
March 22, 2002
