Market Watch - July 4, 2002
Since last month’s Market Watch, the market has continued to deteriorate. Instead of selling at 44 times earnings, the Standard & Poor Index of 500 stocks is now selling at about 40 times earnings. Good values will not appear until the Index is selling at 15 to 18 times earnings and yielding more than 4%.
So far in 2002, all market indexes show a loss for the year. This is the third year in a row investors have sustained losses. If history is any indication, we have at least three years before the market will be in a position to provide attractive values for investors.
Bear Markets
The bull market that began in 1982 lasted eighteen years. One hundred years of stock market history indicates bear markets last roughly one third as long as the preceding bull market. Bull markets are aided by cheap, easy money – lots of credit. As individuals, corporations and governments borrow to take advantage of cheap money, manufacturing booms and housing booms. Then stock markets boom, thereby creating lots of cash. As consumers watch the increase in the value of their assets – primarily homes – the itch to borrow on those increases in value is too great to resist. Borrowing on those assets – home equity loans – continues to fuel spending which fuels the manufacturing and housing boom, which provides excellent corporate earnings, which, in turn, continues to push stock prices to higher levels.
Now, the increases in cash flow that fueled the boom are no longer available. Yet debt must be serviced. Personal and corporate bankruptcy is at an all time high because there is not enough cash flow to service the debt built up over the last two decades. Hence the recession and the bear market.
How do we know this is a bonafide bear market? Money makes the economy tick, so let’s see what’s happening on Wall Street:
65,000 jobs have been eliminated.
Wall Street has been caught cheating investors by coercing analysts to produce favorable research reports on stocks in which the analysts themselves did not believe.
Regulatory agencies are insisting that Wall Street’s clients receive honest information.
The “big money” indexes are hitting new lows on a weekly basis indicating big money is leaving the market and going into financial assets such as treasury bonds.
The earnings of Wall Street firms are down, and many are reporting losses.
Most telling of all, Merrill Lynch’s customers’ twenty favorite stocks are down this year more than 25% on average.
The above is classic bear market action.
What’s the government doing to help the market improve?
The Fed continues to flood the markets with cheap money. Even though that created the problem to begin with, copious amounts of cheap money may help us inflate our way out of existing problems. The trick is to create enough new money to provide for 3.5 to 6% inflation. Too much new money, however, can cause rapid inflation and run rates up to 10%, which could be devastating. High interest rates create high interest payments on the national debt. Since the economy cannot stand any tax increases, the alternative to meet expanding interest costs is to print more money to meet those obligations, which means increase the debt to even higher levels, the result of which will be even greater future interest payments.
Debt created the problems that currently exist. Politicians perceive more debt as the answer to getting us out of existing problems. The creation of more debt, though, is only going to postpone the day of reckoning. And so the problems of the debt cycle continue.
What about our huge trade deficit?
The government is committed to lower interest rates. But there is a catch 22. Lower interest rates make the dollar less attractive as an investment, which is why foreign capital continues to be withdrawn from US markets. Since there is less demand for dollars, the dollar is going down against other currencies. Theoretically, the cheaper dollar makes American goods more attractive to foreigners. Increasing foreign purchases of cheaper American goods will cause US manufacturing to increase, which will cause American companies to hire more employees, the result of which is a reduction of the number of people who are unemployed, and an increase in our economies cash flow.
That’s positive, but can it work? Countries tied to the Euro and the Yen also have cash flow problems resulting from their own past excessive build up of debt. It’s just not known, therefore, if a decrease in the value of the dollar will stimulate the purchase of American goods enough to reduce our foreign trade deficit. Furthermore, since we have moved so many of our manufacturing jobs overseas, a big increase in demand for “American goods” may mean more of a build up in cash for countries like Mexico, China and other countries where we have moved our manufacturing facilities, than for the United States. The Fed knows this is a problem. They do not have an answer, and it is a consuming worry for politicians in charge of our money supply.
Where can one put their money?
Both the five-year and the ten-year Treasury note have increased in value over the last month. Last month the yield on the ten-year note was 5.1%. Now the yield on the ten-year note is about 4.7%. It’s clear that when “big money” stock indexes go down, as they have, and treasury notes increase in value, big money is switching from stocks to cash. That represents a desire for income and safety because big money sees little current potential for an increase in the value of stocks.
If one is to succeed as an investor, the rule of thumb on Wall Street has always been “find out what big money is doing and do the same thing”.
We are beginning to see better investment opportunities taking shape in certain industries. Clinton administration policies pounded the drug industry into really good values in the early 1990’s. Investors who were fortunate enough to take advantage of the low PE ratios for Merck, Bristol-Myers Squibb, Abbott Labs, Eli Lilly and Pfizer, in the early 1990’s did very well. They did especially well if those securities were liquidated between 1999 and 2001. This last six months has seen drug stocks come way down in price to the point where the industry PE average is below 20. Cash yields have increased because the prices of stocks have come down and cash dividend payments have remained the same. It is not being suggested it’s time to buy into the industry. It is important, however, to point out that these dramatic value changes are indicative of bear market action creating better values as time goes on.
Both bonds and gold are in a bull market, and both have outperformed the stock market the last three years. The prudent investor will continue to remain in cash and cash equivalents like CD’s and treasury notes. Patience is extremely difficult when the media is aggressively push “stock buying opportunities”. But patience is imperative if an investor is to take advantage of the excellent buying opportunities that are likely to exist at the end of the current cycle, a few years hence.
The S & P has been down an astonishing 14 out of the last 16 weeks. A rally may occur. The prudent investor will not allow a rally to influence their resolve to avoid the market of these levels.
Big money will tell us when it’s time to put both feet back into the market. Not Yet!
Caveat Emptor!
George Rauch
June 20, 2002
