Market Watch - November 7, 2002
Beware of “False Bottoms”Most people reading this column are aware of the fact that the market has had a big run up since the newly established lows in October. Many of us have heard from our stockbrokers that October 9th represented a bear market low and that the “rebound” has started. Don’t believe it! Volatility of this type in bear markets is professional trading of the following type:
Hedge funds positioning themselves because the market is “oversold” and therefore in a posture to spring back several hundred points.
Short sellers desperately covering themselves to avoid being wiped out. September 30th represented the end of the quarter when pension fund money is sent to mutual funds that have instructions from most customers to continue to invest their funds in common stocks.
Current Economic Facts
Oil is way above the price per barrel that existed before this recession began. We are an oil-based economy, and with China and other third world economies improving dramatically, the demand for oil will continue to increase. Unless the United states can stabilize the political situation in the Middle East, where most of the world’s currently recoverable oil reserves exists, the price will remain high causing us to spend vastly more on energy sources than we have in the last few years. This is the primary reason the Dow Jones Utility Index has been dragged down. The cost of doing business has become a cash flow catastrophe for utilities because of the cost of fossil fuels.
The three elements of production are land, labor and capital. Land (resources) and capital are now priced the same throughout the world, and the difference in production costs is labor. The average worker in China makes 40 cents an hour, 1/6 of what the average Mexican worker receives, and 1/40 of U.S. worker production costs. Last year 41% of China’s exported merchandise came to the U.S., creating a huge trade deficit with China, now the largest collector of dollars in the world. Potential pending problems for the dollar from our trade with China may become apparent before this recession is over. Last month China opened the Shanghai Gold Exchange. The Chinese yuan is not now convertible into any other currency. What would happen to the dollar if China continued to build up dollar reserves, continued to accumulate gold, and in several years made the yuan convertible into gold? Wouldn’t safe money flee to the yuan? And wouldn’t that be at the expense of the value of the dollar. The bottom line on China and the Pacific Basin is that cheap labor, and the build up of dollars, is going to continue to cause real cash flow problems for Americans. Eventually labor rates in this country will go down, or labor rates in the Pacific Basin will go up, or, as has happened in Japan, both. And as has happened with the yen, the yuan will get stronger while the dollar gets weaker. The mass of cheap labor in China is their main resource with which no country in the world can compete.
The Department of Defense Re-Organization Act of 1986 mandates that US Presidents formulate and send to Congress a continuously updated National Military Strategy. Rather than stressing a defensive posture, as in the past two hundred years of our history, it stresses a pre-emptive, or aggressive, posture in dealing with military powers around the world. The bottom line is that nobody will be allowed to develop the power to oppose the US. The US represents 50% of the military spending in the world, and much of the rest of the spending by other countries is dictated by NATO, or the United Nations, both primarily funded by the United States. The economics of this are that we will have continuous enemies which will require large amounts of our resources to be spent on homeland security, our defense budget, and other types of security, which expenditures generally add little to overall economic growth. Cash funneled through government is the least productive element of any economy. The larger and more expensive our government becomes, the less able is the United States to compete in world markets.
More than 50% of our graduate students in this country are foreigners. They return home and use their education to compete with America. China alone is creating 70,000 new engineers a year. When you don’t pay your telephone bill, the call dunning you to pay the bill comes from India, not Omaha, as in the past. The reason is the cost of labor. It’s cheaper to have people calling from India than it is to employ Americans. This represents an economic equalization of the cost of labor, which, in the long run, will negatively affect the U.S. standard of living.
Debt as a percentage of American’s disposable income has climbed to over 100%, the highest level ever. Since Americans save only a small percentage of their income, they are not in a position to weather prolonged cash flow difficulties. Furthermore, Americans continue to create obligations for themselves by adding to their second mortgages, their charge cards and their purchase of new hard goods “with no payments until next July”, all of which creates future cash flow obligations in an economy where cash flow is decreasing.
Japanese banks are technically bankrupt, and the day of reckoning is approaching. Our current trade deficit with China and Japan in 2001 was 83 and 69 billion dollars respectively. The saving grace for the Japanese banks is a continuation of the build up of dollars. However, China and Japan are in the grips of an economic war to export products to America that Japan can’t win because of the difference in the cost of labor.
State governments spend about $1 trillion dollars a year, roughly 10% of our GDP. All major states are facing huge budget deficits this year. The federal government is declaring we will have a $165 billion deficit this year, and history indicates that is understated. Our trade deficit is running $1.1 billion dollars a day. Unlike corporations who are cutting back, state and federal governments continue to expand. The continuing increase in the size of state and federal government adds to America’s $38 trillion dollars of total indebtedness, provides no productivity in the economy, and acts as a drain on resources. It is unlikely we can enjoy an economic recovery without solving the problem of a costly and continuously expanding system of government.
Conclusion
What we are hearing in the news must be looked at caustically. Brokerage firms have reported “bottom after bottom” in the stock market in order to encourage the retail customers to buy stocks. Brokerage firms make their money on the purchase and sale of stocks – any other activity is ancillary to the purchase or sale of stocks – and any other activity is also unprofitable if the public is not buying and selling stocks. Brokerage firms are now reporting the October 9th low on the Dow as a “bottom” representing a springboard from which the market will recover. Chances are great the October 9th low will be breached again, and the “bottom” of October 9th will become known as another “false bottom”.
There is no economic reason for a recovery at this time and every reason to believe we will have another three to five years of an economy continuing as this economy is reacting right now. This would be the best we could expect. Signs indicate this ”rebound” is technical, not economic. John Mauldin (www.2000wave.com) writes in his October 18th report that we are in a “muddle through” economy. Because of the size and power of this economy, we may just “muddle through”, but prosper we probably will not until the debt load is refinanced, until we come to grips with the problems of dealing with China, until Japan does something about their banking situation, and until our government gets revenue and spending into concert with each other.
Caveat Emptor!
George Rauch
November 7, 2002
