Another False Picture

The media is giddy over the performance of the stock market the last several weeks. They should not be. The market is so over-priced that reaping any gains from purchases at these levels is going to be difficult. The Dow is priced to pay a dividend yield of 1.77%, less than half of what the ten year Treasury bond pays in interest. Making money in stocks is a result of buying at the right price. These prices are not at levels that will offer investors an opportunity to make money in the stock market over the next 5 to 10 years. Esteemed Barron's editor Alan Abelson recently wrote a few weeks ago, "Everybody's bullish, which is bearish".

Question: The market closed 2009 at 10,428 points, and it closed on December 31, 2010 at 11,577 points, an 11% year to year increase. The stock market is now hovering at 12,000. Why isn't there still a lot more opportunity for profit in the market this year if the market is already up 3-1/2% so far this year?
Answer: The market is not going up on fundamentals. The market is going up because of speculators. In December, margin account buying (purchasing stocks with money borrowed from the bank at a "broker's rate") was up 13% from November. This was because the latest round of stimulus funds became available in late November and December. Money put into the banking system by the Federal Reserve is always borrowed first by Wall Street speculators who use the loans to purchase securities on margin. This type of buying is what has created the bubbles in the market we have suffered from the last several years. The effect of the Fed providing so much new money for stock speculators (with Dow price earnings ratios at almost record highs, and with Dow dividend yields at almost record lows) is another stock market bubble. The "general public" is not back into the market—brokers who are speculating by buying stocks on margin are causing this market to go up without any fundamental economic reasons to do so. Based upon the historical average Dow Jones yield of 4.5%, instead of the current 1.77%, the market would be selling at 4,750 points instead of 12, 000. It's sobering to think about that. One can see, mathematically, what great risk exists towards a major market downturn.

Question: Are there any economic reasons that mitigate against the stock market continuing to act favorably?
Answer: There are the following:

1.	$13 trillion of government debt that requires interest payments every year, $5.2 trillion of which debt has been incurred in the past 4 years. This is simply unsustainable, yet there is no plan to contain, or stop, government borrowing.
2.	The economic future of the country depends upon risk taking. Nobody's taking risk. They feel they are already at risk. Businessmen are simply trying to hold on—they are doing nothing to add additional risk; indeed, they are doing everything possible to continue to limit risk. Corporations now have more cash than at anytime in history, and they are hoarding their cash, not "risking" their cash.
3.	The municipal bond market is falling apart. Several of our biggest states have severe financial problems, and a handful of them are, like our federal government, technically bankrupt. Because of state constitutions, the states may not declare bankruptcy. Congress can change that, and there is a movement to accommodate the states so they can eliminate, or restructure, current obligations to municipal bond investors.
4.	The European economic union is falling apart. Three countries have already been bailed out and three more are on the side lines. All "bailouts" result from a shortage of cash. As the EEU creates money to supplement cash that some member states do not have, the newly created money will inflate the money supply. The limited supply of goods and services will go up in price (inflate) to meet demand created by newly printed money, thereby, again, reducing the purchasing power of a country's currency.
5.	Excessive amounts of government spending the last two years have been financed from selling debt. Investors are now beginning to say "no more government bonds", and inflation is expected to exceed that of the interest payments on existing government bonds. One of our favorite stock market gurus says "the Fed can continue to print money until the bond market says that it can't". We are almost there. It's very difficult to sell government bonds at such low interest rates. An increase in interest rate, however, would have a significant adverse effect upon the cost of government because the biggest debtor in the world is the U. S. government.

Effect of Government

Every economic problem we have today can be laid at the foot of government, and the "too big to fail" bankers who keep them in office. We have overbuilt government. It's too big, and must be reduced in size, at all levels. Large government leads to war. War leads to debt. Too much debt leads to a disintegration of society, which is where we are today. We can make a choice to reduce the size of government now, and quit borrowing money, or, like previous civilizations, somewhere down the road we will face anarchy.

As our government grew in size over the last 50 years, it has accumulated power in direct proportion to the power that we, the people, have lost. For every action, there is an opposite and equal reaction. The larger the government, the more money they control. The more money the government controls, the greater the number of our population that is dependent upon government. We cannot compete in today's economic world with a government that costs as much as our government costs.

It is difficult for the public to grasp that the nature of government is to control. The power to tax is huge, and money control is people control. Greed and the lust for power are built into man, and particularly into politicians, which is why The Constitution was written, specifically, to limit the powers of government. Until the public figures this out, we will not be able to change our system. In pondering whether or not smaller government is wise, it's instructive to remember the words of last century's Lord Acton who said "The danger is not that a particular class is unfit to govern. Every class is unfit to govern!" And Thomas Jefferson said, "When the people fear the government, we have tyranny. When the government fears the people, we have liberty". It does not feel like our government fears the people.

Conclusion

Numerous studies have been published, and included in Market Watch, that indicate a market priced at these levels will yield at best, 5% annual gains for the next 5-10 years, and that includes dividend payments. The current myriad of problems is overbearing. We do not have the proper attitude and resolve in our government to make the economic and political changes necessary to allow the investor to prosper in the stock market over the next few years. Indeed, it's the opposite—we are set up for continued economic angst. And yet the current stock market is the second most expensive stock market in our history.

The announcement by government officials last week that our economy was growing at a rate of 3.5% was very misleading and dishonest. All of "the growth" is from stimulus spending which is borrowed money the public will pay interest on forever. Insofar as the potential for success in the stock market is concerned, the good news being fed to us by our government is nothing more than "Another False Picture".

Caveat Emptor
George Rauch
January 30, 2011

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