Foundational Problems Inhibit Stock Market Growth

The Dow Jones Industrial Average has regained about 56% of it’s loses over the last two years. The judicious investor must ask themselves two questions:

	1.		Is there enough underlying value to justify the 56% increase from the Dow’s recent lows; and

	2.		Can we expect, and justify, further increases in the Dow from these levels?

In order to answer the above questions, let’s first look at some foundational facts:

	1.		Insiders (directors and high ranking executives of major corporations – The Establishment) in October sold 59 times as much stock as they bought in their companies. What? Yeah – 59 to 1 – and these people are better informed than we are. Where’s their confidence in an increasing stock market?

	2.		While it was announced that our economy grew at a rate of 8.2% over the last quarter, for the month ending October 31st, the wholesale price index increased at a rate of 9.6% annually. If these numbers are sustained, inflation is exceeding growth by 1.4% annually, indicating we are moving backwards, not forward.

	3.		We have just been stunned by the magnitude of government spending for the fiscal year just ended with a twelve-month national debt increase of $606 billion. For the upcoming fiscal year, the government estimates (and they always under estimate) a current account deficit of $500 billion, plus partial funding of $87 billion for Iraq and Afghanistan, plus $217 billion to be “borrowed” this year from the social security trust fund for a total real spending deficit of $804 billion. This is before the effects of the tax cut and before the cost of the new prescription drug bill are accounted for. We could be looking in this fiscal year at our first $1 trillion deficit. Staggering!

	4.		The government’s liability for unfunded future social security and medical costs exceed $44 trillion based upon an unrealistically low 75-year life expectancy. Every year these liabilities go unfunded, they increase by $1.6 trillion.

	5.		Foreigners have cut back purchases of US securities to $5 billion per month, down 90%. We need foreign money coming into our economy at the rate of $1.75 billion per day just to cover our chronically negative trade imbalance.

What’s the root of this problem?

Unsound government sponsored trade policies. Undisciplined and unchecked government spending. Government manufacturing of money out of thin air with no offsetting asset value. The government taking us off the discipline of the gold and silver standard.

Remember the controversial trade agreements of the 1990’s? This is the aftermath of those policies.

Remember the huge deficits produced by the Carter and early Reagan administrations? Remember the problems they caused? Today we are repeating, and magnifying, the undisciplined government spending and money manufacturing that caused those problems during the Carter and Reagan administrations.

Remember the stability of our currency when our coins were silver and we could turn a paper dollar into the bank for a real silver dollar? Remember our trade balance before Nixon suspended the settlement of international debts by no longer allowing convertibility of those debts into gold? Remember the expression from our childhood that “a dollar was as good as gold”?

Is there a solution?

In 1776 two very important documents were published. Thomas Jefferson spearheaded the authorship of The Declaration of Independence. Adam Smith wrote The Wealth of Nations. The Declaration was an argument against centralization of political powers. The Wealth of Nations was an argument against centralization of economic powers. The core thinking and central ideas of each of those documents were incorporated into our Constitution. We had no government deficits and no trade imbalances until we began to consolidate powers in violation of the spirit of the Constitution. When political and economic powers were centralized in the Federal government, we began to have problems.

The solution to our current dilemma is to reduce and decentralize the political authority of the central government and to get rid of and disburse the economic power of the Federal Reserve System. Until such time, matters will only get worse or stay the same -- they will not improve. If you give a bunch of politicians the right to borrow money, create money out of thin air, and spend without accountability, why would anybody in their right mind think that they (or any other group of normal human beings) would be able to resist the temptation to take advantage of opportunities to gain more power and create wealth for themselves? That’s why the Constitution specifically limited central government powers. The Founding Fathers believed in the validity of the core ideas set forth in The Declaration and The Wealth of Nations.

Is there somebody who shares these opinions that has more credibility than some boob on Longboat Key that writes articles?

The “big three” in investing are George Soros, John Templeton and Warren Buffet. They have each made billions investing money. All agree, and it’s widely published, that:

	1.		The market is way overvalued and is not a buy;

	2.		The Federal government’s and the Federal Reserve’s policies are at the heart of today’s problems;

	3.		Our trade imbalances, coupled with our growing deficits, are sapping the strength from this economy, inhibiting its potential future prosperity, and transferring (in essence, selling) our wealth abroad.

Warren Buffet, the biggest character of the big three, and a man whose sound bites are widely sought, recently wrote, “We’ve got more cash than ideas. Occasionally successful investing requires inactivity”.

Perhaps our best move as investors is to pay particular attention to Buffet, the most successful investor in history.

Conclusion

US fiscal policies have been successful at stimulating consumption but ineffective at stimulating production and capital formation. Capital formation occurs in a free economic environment where production is the least expensive, not in expensive labor markets where production costs are too high for products to be priced competitively in international markets.

The recently announced 8.2% increase in our GDP – annualized – is not from production. It’s from consumption and it’s built upon debt. The astute investor might keep three things in mind:

	1.		An improvement in the economy does not necessarily mean improvement in the stock market. Stocks are already priced to include several years of good growth.

	2.		There are two trends in the stock market: the primary trend and the secondary trend. The primary trend is down and unchanged over the last two and half years. The secondary trend is up, and has been for several months. It is unlikely with the current bloated values that the secondary trend can be sustained.

	3.		An improvement in the economy’s cash flow is desperately needed just to (1) sustain the country’s current borrowing mania, (2) to service the country’s existing indebtedness, (3) to meet this country’s unfunded future obligations.

Conservatively postured investors will remain in cash and short and intermediate-term money market investments. It is wise, if venturing into the stock market, to do so with gold and silver stocks and A-rated, low price earnings ratio, New York Stock Exchange securities that yield 4% or more.

As in past US economic recoveries, it will take years – perhaps a generation – to correct our foundational problems. In the meantime, as in past recoveries, the market will go up and down until solid economic footings exist from debt and spending that are manageable and under control. These market gyrations are likely to make mutual fund managers a lot more money than their investors.

Caveat Emptor!
George Rauch
November 30, 2003

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