The Big Picture

The market continues to go nowhere, trading in a range between its high and its low for this year. The DJIA high on March 21st of 8522 represents the year’s high, and while that may be bridged, the Standard & Poors 500 Stock Index still exceeds 30 times earnings per share and the yield remains below l.9%. It would be impossible to commence a new bull market from these already perilously high values without recreating the same bubble that existed in the late 1990’s that has caused so much pain over the last 3 years.

The big picture is this: debts are at an all time high and they are increasing at 8% annually while the value of our assets continues to deteriorate. The dollar has lost 20% of its value against other leading world currencies. The federal government deficit this year is going to exceed 5% of our Gross Domestic Product (GDP) and our trade imbalance will also exceed 5% of our GDP. The two 5% deficits will be funded by a huge increase in the money supply created by the Federal Reserve System through a combination of increasing debt and increasing the amount of money in circulation, the effect of which will further undermine the purchasing power of the dollar.
US airlines are now technically broke and loaded with debt. States, by their constitutions, are required to balance budgets and can only do so by tremendous cuts in services and employment. Unemployment continues to grow thereby negatively affecting the country’s cash flow and another round of Wall Street layoffs is imminent. Our manufacturing and service employment base is deteriorating in favor of cheaper manufacturing labor in China and cheaper service labor in India.

Alan Greenspan, the greatest inflationist in history, who has been at the apex of the deterioration of the value of our dollar, the apex of our increasing mountain of debt, and the apex of the continuous increase in the size of our government, is now being touted for another term as Fed Chairman, when, at the end of that term, he will be older than the current Pope.

The bright side of the economic picture is realized by examining the rest of the free world’s economies thusly: every problem we have is magnified in their economies. They have more debt problems, more government problems, more labor and unemployment problems, more production problems, more banking problems and greater deficit problems than we do here in the “Land of the Free”.

What can the government do?

Let’s examine the history of our government over the last 100 years, and see how we have handled enormous fiscal problems of this nature. There are three ways our government can stimulate the economy:

1. Lower interest rates, and create more money, so it is easy to borrow, thereby stimulating personal and business borrowing and spending;
2. Increase deficit spending, which increases the public debt and creates a future obligation;
3. Go to war.

Numbers 1 and 2 above are not working even though there has been a valiant attempt to stimulate the economy with both deficit spending and lower interest rates. That leaves us with the third “opportunity” to release our economy from pain, which is war. How can war help our economy out of its deep slumber?

We have destroyed the infrastructure of Afghanistan and Iraq. Two weeks ago we made the dollar the official currency in Iraq. Iraq is positioned in the middle of the east-west and north-south Middle Eastern trade routes. Reopening trade routes through the Middle East, rebuilding the infrastructure, and making the dollar the king of Middle Eastern currencies will insure the dollar will regain its purchase as the region’s primary trading currency. Further, contracts for the purchase and sale of petrol-chemicals will remain in dollars.

Outside of the US, Russia is the largest “dollar economy” in the world. After their collapse, Russia sopped up a huge surplus of dollars floating outside of the US, which played a large part in propping up the value of the dollar in the 1990’s. The government hopes that the same thing will occur in the Middle East.

If the destruction, and the commensurate cash flow from the rebuilding of Iraq and Afghanistan, is inadequate to provide for the return of a vibrant US economy, the US can probably rationalize “freeing” the following countries: Iran, Syria, Libya, Lebanon, and Indonesia (which just announced a couple of weeks ago that they were thinking of doing away with contracts in dollars in favor of contracts in euros). That would get the public’s mind off the mess we have here and provide lots of contracts for our international banks and manufacturing and trading companies. An increase in cash flow, and an increase in employment in the US, would clearly put off our day of reckoning for the unstable and untenable monetary system, which currently exists.

It is not the purpose of Market Watch to express political opinions but rather to analyze the economic effects of various trends. So, while no opinion is expressed concerning the propriety of “freeing” other nations, to do so would benefit our economy. Huge military contracts, and even larger industrial and banking contracts, will increase cash flow and increase employment in the US.

The potential ultimate effect of a series of “liberations” of other countries would be that the US dollar would become the world’s only currency. There has not been a one-world currency since the Roman Empire. The dollar already represents more than 80% of the world’s money. Europe is in worse shape than we are, as pointed out above, and Japan is technically bankrupt. Together they represent most of the balance of money in the free world that is not US dollars. Such a move would elevate the US economy to undreamed of power.

What does this mean for the market?

This might keep the market from further deterioration. But the above is only an analysis of what has happened and where we might be headed. At this point, no matter what the government does, there is no base for the stock market to provide material increases in value from current levels. Good values will return when price earnings ratios on the S & P 500 are less than 15 times earnings and dividend yields exceed 4%. To obtain those values one of three things must happen:

1. The market must go down another 50% from current levels;
2. The market could stay in its existing trading range while corporate earnings and dividend yields increase over a period of years (the preference of Wall Street and the US government);
3. A combination of 1 and 2 above.

The government and Wall Street are desperately attempting to keep the markets in these over valued trading areas. Should they succeed, and should earnings and dividend yields rise to meet current market levels, it will take years to do so. During that time, investors returns will be maximized by investing in high grade corporate bonds, short-term and intermediate-term US treasuries, and cash (that, admittedly, pays a very low yield) rather than risk the continued gyrations of the stock market that will exist until historical average values are realized.
Investors will be wise to accept modest returns and preserve their principal. The alternative would be to commit oneself to the anguish of an up and down market, where only the brokerage firms make money from commissions, while investors watch their capital deteriorate.

Caveat Emptor!
George Rauch
April 24, 2003

....