Market Watch - May 28, 2003
Warren Buffet, Chairman of Berkshire Hathaway, recently wrote in a letter to stockholders: “Even after three years of the bear market, we still find very few stocks that even mildly interest us. This dismal fact is testimony to the insanity evaluations reached during the big bubble. Unfortunately, the hangover may prove to be proportional to the binge.”
How could the hangover be “proportional” to the binge? The Standard & Poors Index of 500 Stocks represents most US stock value. According to last weeks Barron’s, the current price earnings ratio of the S & P 500 Index, based upon the trailing 12 months earnings of the 500 stocks, is selling at 34 times earnings, and the dividend yield is 1.7%. How do we know whether or not this represents a buying area where stocks are cheap, or an area where stocks are expensive? We look at the history of PE ratios:
When Stocks Sell at a PE Of: Under 10 12 to 14 16 to 17 18 to 20 22 |
|
10-Year Compounded Median Returns Are: 17% 14% 11% 7.5% 5% |
When we buy stocks in today’s market with an S & P price earnings ratio of 34 and a low yield, economist Peter Bernstein (www.peterlbernsteininc.com) tells us we can expect over the next 10 years that our stocks will be down 1/3 on average from where they are today, including reinvesting dividends. And that is how the hangover can be proportional to the binge.
Is there any other evidence that might lend credence to Warren Buffet’s conclusion? Here’s a look at the Japanese NIKKEI over the last 14 years:
| DATE | |
VALUE AND VARIANCE FROM ABOVE DATE | |
| December 89 September 90 April 91 August 92 August 93 June 95 June 96 October 98 April 00 September 01 May 02 April 03 |
38,916 20,984 26,542 14,820 21,116 14,703 22,531 12,879 20,434 9,554 11,976 7,669 |
(high) (-46%) (+26%) (-44%) (+42%) (-31%) (+53%) (-47%) (+53%) (-62%) (+25%) (-36%) |
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With the variance in values in the Japanese market, which we are seeing over the last 3 years in US markets, one could conclude tremendous opportunities exist to make money. That’s obviously true. However, who’s going to make the money? The “mere mortal” investor cannot make money trading these highs and lows unless they have an iron stomach, a golden touch, lots of money and the luck of the Irish. Real investing, Warren Buffet style, is long-term investing in companies that have good dividend yields. And the success of long-term investing depends upon the valuation of stocks (PE ratios) at the time one makes the investment. Trading is speculation. Virtually nobody makes money speculating in stocks except businesses charging commissions.
The market bears tremendous risk even though the Dow is up 3% this year, the S & P is up 6% and the NASDAQ is up 13%. It is hard to see how this can be sustained. There are prolonged periods of growth in our economy where the market went nowhere. From 1963 to 1983 the market remained at the same level, yet that was a tremendous period of growth within the economy. The 1963 market’s levels were too high, and the 1983 market’s levels were too low, but 20 years went by with no long-term increases in US stock market values.
Why the markets may remain suppressed
Taking into account Warren Buffet’s and Peter Bernstein’s opinions above, add the following facts:
1982 |
2002 |
% Compounded |
|
(Billions) |
|||
US Debt |
$1,197 |
$6,282 |
7.9% |
M3 Money Supply |
$2,469 |
$8,287 |
6.0% |
GDP (in 96 dollars) |
$4,919 |
$9,440 |
3.5% |
US debt is increasing at better than twice the rate of GDP growth. If this was our personal financial situation, ultimately we would be bankrupt. The same happens to governments.
A Look At Gold and the Dollar
We have written a lot about gold and the fact that gold is in a bull market, up over 40% the last few years, while stocks are in a bear market. It is important to watch gold because an increase in the price of gold means a decrease in the value of the dollar, the currency that supports all of the world’s economies, and the primary reserve currency used to settle international debts.
Year |
National Debt (Billions) |
Gold Price Reached |
1973 |
$470B |
$127 |
2003 |
$6400 |
$390 |
Our national debt has increased 13.6 times and gold has increased only 3 times. In 1973 our national debt had approximately 7% gold backing and in 2003 our national debt has only 1.5% gold backing. If our 2003 national debt had 7% gold backing, the current gold price would be $1,716. It is mathematically difficult to see how gold will not continue to reach higher levels.
Two other significant events have occurred that could add tremendous value to gold, which value, by definition, undermines the value and purchasing power of the dollar.
On June 1st the Chinese, for the first time in decades, will be allowed to own gold. Remember what happened when Americans were allowed to own gold again? Gold shot up in value.
Australia now has physical gold listed on its stock market at the rate of 1/10 to 1 (if gold is $350 per ounce, you buy 1/10 of an ounce for $35). The New York Stock Exchange is preparing to do the same thing. What will happen to the price of number 79 on the periodic table if aggressive US brokerage houses start pushing ownership of physical gold listed on the NYSE?
Are There Bright Spots?
Money is coming back into the market. But it is hard to see with current valuations how the market is going to sustain any long-term advance from these levels. There does seem to be a cash flow increase in the economy. Supply is not the problem, demand is the problem. If demand picks up because cash is there for people to purchase goods and services, then we might just sustain current levels of economic activity. Opportunities for the stock market to take any great leaps from here are remote. But it will be helpful if the economy becomes vibrant again, and the economy’s earnings and economic values catch up with the currently overvalued market.
The awesome difficulties of financing both our trade deficit and our federal budget deficit are somewhat offset by the problems that countries who are accumulating our cash face themselves. For example, Asian economies are holding 1.5 trillion dollars. To sustain their own economic growth, and to avert their own substantial internal problems, they are buying US treasury debt.
Here is the circle of money; our money goes overseas to buy products that pays for the tremendous unemployment problems and cheap labor that exists in the Pacific Basin. That cash is “built up” because US purchases exceed the Asiatic countries net purchases of our goods and services. To sustain their own economic growth, these economies are trapped into purchasing US government debt, which is the financing that has provided for the continuation of the circle, year in and year out. If they don’t finance our debt, US purchases will decrease, thereby adding to huge unemployment problems in the Pacific Basin.
Can it be sustained? Who knows? Will the Chinese, being allowed to purchase gold on June 1st, with all their US reserve dollars, provide for a tremendous increase in the price of gold that will undermine the dollar? Who knows, but logically some continued increase in the price of gold and some continued decrease in the value of the dollar would be necessary to sustain any balance at all. The dollar’s value is the current Achilles heal of our economy – even more so than deflation which the government has pledged to avert regardless of how much money is printed and how much inflation is created.
Conclusion
If Warren Buffet and Peter Bernstein are correct, the current 10-year view for stocks is gloomy. It is important to remember that the stock market and the economy are two different things. Are they related? Of course. As Buffet has observed: (1) There are few stock market values, and (2) the “hangover may be proportional to the binge”. Then, what’s he investing in? Until the economy catches up with stock values, or until stock values decrease to at least mean historical averages, he’s buying preferred stocks, high-yielding corporate stocks, high-grade corporate and municipal bonds, and US government securities. Mr. Buffet agrees with economist John Mauldin (www.johnmauldin.com) - at best, we may “muddle through” these times.
Caveat Emptor!
George Rauch
May 28, 2003
