Market Watch - August 1, 2002
The reason investors continue to lose money in this market is because of hope and greed. Investors hope the market has gone down as much as it will. That hope causes them to exercise their greed. And investors continue to hold stocks instead of liquidating them in favor of cash.
The market continues to go down. The reason is that this is a primary bear market. Primary bear markets go down to a level where values reach, or go below, historical averages. The historical Dow Jones Industrial Average PE ratio is 14 times earnings, and the average dividend yield is 4.4%. The current market has a long ways to go on the downside before those values are realized.
Primary bear markets exist because of cycles of indebtedness. Governments create debt cycles. In this country, up until WWII, the build up in government debt was always due to war. Since WWII, our government has borrowed large amounts of money in order to redistribute revenue to lower income voters. The greed of politicians to retain their power by staying in office has been a powerful incentive to increase borrowing by the federal government. Political pressure has caused the Fed to create under-priced money at an artificially low interest rate, which has encouraged an irresponsible cycle of consumer and corporate borrowing to match the federal government’s borrowing.
The primary bear market will end when individuals, businesses, government and lending institutions have restructured their debt. Part of the reconstruction process involves restructuring lending institutions balance sheets to minimize risk.
During this process the earnings of corporations are severely hurt. Depressed earnings further reduce the underlying value of stocks. In the process of working out the debt cycle and rethinking the definition of “reasonable values”, the stock market will go down; hence the primary bear market.
All of the government and Greenspan discussions concerning “the improving economy” will not affect the primary trend of the market. All of the CNBC, and all of the stock houses, “buy recommendations” will not turn around this market. Believing the economy is improving, and therefore buying opportunities exist, will only cause the investor to lose more money. The primary bear market trend will not be reversed until good values become available again. The Dow is still several thousand points away from average historical values, let alone good values.
What Constitutes Good Values
Investors now realize that the Dow reaching 11700 represented ridiculous levels where no values existed. In primary bull markets, stocks will go to levels where no “value” exists. Similarly, the DJIA in a primary bear market is likely to go to a level way below historical averages where great values can be realized. The historical average Dow price earnings ratio of 14 times earnings would represent great values at less than 10 times earnings. The average historical Dow dividend yield of 4.4% would represent great values when the dividend yield became more than 6%. This could happen. If history is a reasonable gauge of market behavior, great values are likely to occur in the next few years.
But the only way to capitalize on those opportunities is to recognize that a primary bear markets exists, get assets into cash, and wait for buying opportunities to become available after the bear market is exhausted.
What Is The Government Doing?
Lately the Fed has been creating new money at the rate of more than $30 billion dollars a week. Yes, that’s correct, and it comes out to $1.5 to $2 trillion new dollars a year. In spite of the potential for runaway inflation, the Fed is attempting to ensure that plenty of cash is available to help absorb the impact of existing record bankruptcies. It might work. Frankly, this economy is in such a jam because of the Fed that there may not be any other way to solve the problem other than further irresponsible behavior which will result in deterioration in the value of our dollar (inflation).
If this plan works, it will not be a quick fix. We are two to four years away from a bottoming out of this market. The market knows of these problems and wants to go down. But the Fed, feeding the economy with money, is trying to act as a counter weight to further reductions in market values.
Real Money
An increase in the value of gold is a sign of the market becoming nervous when the Fed creates money like it has recently. Gold is real money with no debt attached. And gold appears to be in the beginning of a prolonged primary bull market. Gold, real money for the last 4000 years, has outperformed the Dow over the last two years. Generally, gold goes up when the stock market goes down. Sophisticated investors make the decision in primary bear markets to liquidate portions of their portfolios in order to invest in gold. In addition to providing financial security for those investors during these times, the price of gold will be bid up much like the stock market has been bid up over the last 20 years.
The Dow-gold ratio was last at 1 to 1 as little as 20 years ago (meaning that one ounce of gold would buy the DJIA). Whether or not that will happen in the next 2 to 4 years, nobody knows. But a simple way to look at whether or not gold is undervalued is to realize that the average wage in 1938 was $0.25 an hour as compared to $6.75 now. Gold was valued at $38.50 an ounce in 1938. If the value of gold was to track the increase in the minimum cost of labor, gold would be valued at a minimum of 27 times $38.50, or over one thousand dollars an ounce. At this writing gold is less than one third of that value.
Moreover, if the value of gold were to track the increase in our money supply from 1939 to the present, the value of gold would be several thousand dollars an ounce. The US money supply has gone through the roof while US gold reserves have deteriorated from 20,000 tons in 1939 (51% of the world’s central bank reserves) to 8,137 tons today (24% of central bank reserves).
This is not a plug for investing in gold, but rather a look at relative values in order for the reader to understand what could happen. There is no doubt that over a period of years the value of gold will increase relative to any paper currency. Gold has outlasted every single fiat currency ever invented by man.
Final Thoughts
Wall Street says, “Cash is trash”. Maybe so, but cash has outperformed stocks the last few years. The investor who owned a basket of stock two years ago has a lot less value than the investor who had cash two years ago. The cash investor can now buy more stock then he could two years ago. Values remain sky high. Cash is still an attractive investment. Indications are that the cash investor will be rewarded in the future by being able to purchase much more stock with that cash than can be purchased currently.
As Dow Theory guru Richard Russell* says:
“He who sells and runs away, lives to invest another day.
He who rides his securities down, isn’t going to be around”.
Caveat Emptor!
George Rauch
August 1, 2002
*(www.dowtheoryletters.com)
