Market Watch - October 31, 2014
Is The Market Heading South?
Probably not! There are a lot of reasons the market could sell off. However, the market is as subject to human emotions as anything in economics. Right now the market remains strong because of great investor confidence. If investor confidence remains high, there will be no market sell off.
The market is around its all-time high; business conditions are better than they have been in years; companies, individuals and banks are holding more cash than at any time in history; and the country’s “wealth effect” has exploded.
Question: What is meant by the “wealth effect”?
Answer: The Federal Reserve’s “wealth effect” theory assumes that if there is a large increase in real estate and stock market values, it will inspire consumer spending. Consumer spending represents 65% of GDP. Recently, U. S. national wealth reached a record high of $81.5 trillion. The previous record was $68.8 trillion in 2006, which dropped to $55.6 trillion by 2009, before exploding to the current $81.5 trillion.
Value of U. S. Household Wealth |
|
| YEAR | TRILLIONS OF DOLLARS |
| 2006 | $68.8 |
| 2009 | $55.6 |
| 2014 | $81.5 |
Question: The Dow is selling at almost 20 times earnings. Please explain why the stock market is not in another bubble?
Answer: Consumer confidence is shown in price earnings multiples. In this market, investors are willing to pay close to 20 times earnings for a stock, considerably greater than the 14.2 times average over the years. Some very good things are happening in our economy. The U. S. is becoming one of the world’s low cost manufacturers again because productivity gains have been so great the last several years. Former low cost producers, like China, are suffering tremendous increases in costs, making them much less competitive than ten years ago. U. S. unfilled manufacturing orders are at a record high, and problems in other economies have forced wary investors to put money into U. S. opportunities. Importantly, borrowing costs remain low.
Question: Are other economies in trouble?
Answer: They are not so much in trouble as they are tremendously over leveraged. At this point in time, the U. S. economy is producing much more cash flow to cover debt than the rest of the world’s economies are producing.
Question: The government is talking about reducing quantitative easing sometime next year. Is that true, and will that help the market?
Answer: It’s probably not true. The consumer does not really understand quantitative easing, which is nothing more than a disguised name for creating, or manufacturing, money. Citizens do not understand that quantitative easing is strictly to pay for the government’s deficit spending. The only reason quantitative easing has gone down from $1.2 trillion a year to $450 billion now is because income in the economy has increased. Tax revenues are therefore at a record high; high enough that they have reduced the need for the government to continue making so much new money. Government expenditures have not been reduced at all. Increased tax revenues from an improved economy are the reason government money making has been reduced, not because the government has gotten expenditures under control; nor is there a plan to get expenditures under control.
Question: How can the market continue to remain at these levels if government expenditures are not under control and if there is no plan to get them under control?
Answer: Investor confidence. As soon as investor confidence wanes, the market will deteriorate in value. Causes of reduced investor confidence are debt, war, high interest rates, declining employment, a tight loan market, and cash shortages. None of these events are now occurring. And with so much cash in the economy nobody seems to be concerned with the government’s debt and spending habits.
Political Influence
While everybody is looking for answers to “what the market will do”, the market is simply not predictable. It is also subject to political influence. The last several years, and now particularly, the political balance in this country is dictated by three groups of people:
2012 Census Bureau Statistics |
|
| Full-time Workers | 103,087,000 |
| Government Employees* | 16,606,000 |
| Private Sector Employees | 86,481,000 |
| Hard Welfare Recipients** | 109,014,000 |
(*) 12,597,000 state and local, and 4,009,000 federal.
(**) Food Stamps, government housing, Medicaid, and other means-tested programs.
There are 22.5 million more U. S. citizens that work for the government, and are on welfare, than those people that are working in the free enterprise system, which supports everything. Welfare recipients are unlikely to vote for a candidate who is going to cut back welfare. Government employees would vote likewise because a significant percentage of their jobs are devoted to serving the welfare class. Workers, taxpayers and non-dependent government citizens are the minority, and they support this country’s economy. They are additionally the ones who own stocks, real estate, bonds, and other assets that the government taxes. So this latter group who is involved in the stock market, and in the management of the nation’s assets, has to realize there can be no over-night change in the voting balance. Factored into our future economic thinking must be the continuing increase in the size and cost of government. We have been through several cycles of large government expansion since WWII. The cycle we are currently living through is the largest, most expensive, ever. As important as it is to the nation’s cash flow, it is impossible to predict how this voting block will affect the market.
SUMMARY
It is odd that more wealth has been created in a shorter period of time than any other time in history, and nobody seems to notice. Household wealth is up 18.5% over 2006s record, even after a disastrous downturn from the recession. For the hugely bloated stock market, one would expect much more excitement than now exists. There is no cocktail party chatter. No long coffee shop talks about which stocks to buy. The public seems bored with the richest market in history!
As long as cash flow is increasing the market should continue to hold its own, and perhaps increase from these levels. Investor confidence is unlikely to be undermined until excessive government expenditures, and interference, provide enough anxiety that the cycle of positive investor confidence turns negative. Current conditions indicate it is unlikely we will face undermining investor confidence anytime soon.
When values are high we need to be especially wise in picking stocks. Fewer good values are available. Even with crummy returns, there is nothing wrong with holding cash while waiting for the right values to become available. Patient investors are rewarded with higher returns.
Caveat Emptor.
George Rauch
October 31, 2014
