Market Watch - February 25, 2003
The media continue to lead us to believe the pending war in Iraq is suppressing US stock markets. But why?
Here are some thoughts about the markets that relate to Iraq:
The bear market in stocks started in 1999, long before Iraq became a “problem” (this time, anyway);
Bear markets begin because stocks are priced at levels where demand to purchase stock is dampened by investors realizing stocks are overvalued. Stocks must then drop to a level where they are priced to provide a decent return.
Bear markets reach extreme overvaluation because they are built on excessive debt created by easy credit. As the market increases in value, stockholders feel euphoric over their increase in wealth. Our basic unavoidable human condition of greed overrides conservative judgment, and a consumer buying frenzy is commenced. Governments, individuals and corporations that act out on this buying frenzy use debt to add fuel to increasing market values until a “value bubble” is created (the left side of a bell shaped curve). What goes up beyond reasonable risk, and reasonable value, must be corrected over time, which means stocks will eventually return to their historical mean. Those mean values would currently provide a DJIA of less than 5000 points;
A reduction in the value of stocks will lead to reduction in demand by foreign capital to invest in those stocks. A reduction in demand for dollar-based investments will be followed by a reduction in demand for dollars, which will cause the value of a dollar to decrease. The debt bubble has caused the dollar to be overbought, over accumulated, over owned, and hence, over valued. New figures indicate that the world’s central banks hold 76% of their reserve currencies in dollars. As the dollar deflates in value from its inflated position, the value of currency reserves decrease resulting in less buying power for goods and services throughout the world. Foreigners own 14% of US businesses, 35% of the US treasury market, 23% of US corporate bonds and 13% of US stocks;
Over the last year and a half the dollar has lost 22% of its value against other world currencies. World paper financial assets are about $50 trillion. Individual and central bank gold reserves are just under $1 trillion dollars at current market values. A small redirection of the world’s paper financial assets into gold would create an increase in the demand for gold, and hence the price of gold would increase. While it is impossible to predict the result mathematically, a mere 1% redirection of the world’s financial assets into gold, equal to $500 billion dollars, would certainly cause the value of gold to increase dramatically. A 10% redirection of the world’s financial assets into gold, or $5 trillion dollars, would cause the price of gold to go through the roof.
The idea that Iraq is creating problems in our stock markets is far fetched. The problems started long before Iraq and will persist long after the Iraq situation is settled. Chances are that the market has already discounted what we have done with Iraq so far, although an all out war could further suppress the markets because the war is not budgeted and must be paid for by increasing government debt. This becomes yet another taxpayer burden which will reduce future cash flow in our economy.
When the government controls the money supply, the money supply becomes the engine of growth in the economy through easy credit. By creating more and more cash the government is able to keep enough cash in the economy so that less than credit-worthy borrowers will do a significant amount of borrowing. If credit is easy, people, by nature, are prone to spend. Spending increases tax revenue, and the more tax revenue available, the larger and more powerful the government can become. It is the nature of men to seek power. There is no profession that creates more power than politics with its twin evils of (1) the power to tax, and (2) the power to wage war. The more tax revenue, the larger the government, and ultimately, the more power. There is, therefore, no incentive, when the government controls the money supply, to keep spending in check.
Last year 17% of junk bonds defaulted, and corporate and individual bankruptcies reached records. The market went down, gold went up, individual and government debt increased, and savings were negative. The decrease in the value of the dollar is simply the rest of the world saying they are no longer willing to take a currency that is printed indiscriminately with nothing but the purchasing power of the American public behind it. The security of that dollar decreases when the buying power of the American public decreases, which is what has happened, and which is why the dollar has lost more than 20% of its value the last year. There is nothing to sustain the value of the dollar. There is little US purchasing power, and as the US economy has been the world’s engine of growth the last several years (since 1995 the US has accounted for 33% of the world’s GDP and 67% of the world’s growth in GDP), there is no engine of growth to rejuvenate the world’s economy. We are up to our ears in debt, and we continue to borrow more money. The fed continues to make easy money available and hopes that another spending spree will head off deflation, and create “modest inflation”.
Economically, the only way the current situation may be rectified is by a re-capitalization of the value of the dollar (which is essentially what is happening when the dollar goes down). The result must be a lowering of the standard of living in a debtor nation, like the US, while people in other countries, who are lending us money, and who are creditor nations, enjoy an increase in their standard of living. Capital outflow will continue to result in a decreasing dollar for the US. Capital inflow will result in an increased standard of living in a creditor nation, like China.
Why do financial TV personalities and writers lay so much blame for the stock market’s current position on Iraq? Are they dishonest, or stupid? They are neither. The investment community, which has self-interest in the market going up, sponsors much of the advertising for the talking head programs. The analysts at the stock brokerage firms, whose jobs depend upon a reversal of this market, influence financial writers whose paycheck is also dependent upon the market going up. These people are dealing with such a clouded set of facts, and so much emotional hope, that they are unable to analyze the facts and face reality.
Conclusion
The 200-day moving average of the DJIA hit a new bear market low on February 25th of 8645 and the 50-day moving average sank to a new low of 8306. At this writing, the Dow is at 7750, well below both moving averages and in full bear market mode.
The markets remain extremely dangerous for investors. Cash is king. And while treasury bonds and cash do not pay much, neither is an investor faced with another potential large decrease in the value of stocks, which the stock market is currently poised to produce.
Caveat Emptor!
George Rauch
February 25, 2003
