The Markets Are Overburdened With Debt

Current Status Of The Markets

The current status of the stock market is as follows: Mutual funds are fully invested. Cash as a percent of mutual fund portfolios is now at an all time low of 4%, equal to 1970, 1973 and 2000 levels. Investment sentiment is 81% bullish, an all time high. There is very little pressure to sell, and advisors are 57% bullish and only 19% bearish. M3 is expanding at an annual rate of $1.4 trillion, insuring that a lot of money is available to invest. The trend is up, and in the market, an old saying is “the trend is your friend”. Not only is there very little selling pressure, but currently, there are more buyers than sellers, which is keeping the market at these levels and could contribute to market increases from these levels.

Is It Time To Put More Money In The Market?

There are some fundamentals that mitigate against the market climbing from these levels. More importantly, these fundamentals could contribute to a drastic sell off:

Typically following a recession there is “pent up” demand for goods that fuels the spending recovery because people have saved and been reluctant to spend during the recession. There is now no pent up demand as consumers dramatically increased their debt obligations during this last few years, spent right through the recession and had “net” negative savings

The S & P Index of 500 Stocks currently sells at price earnings multiples in excess of 30 times earnings and yields only 1.6%. The following chart shows historical price earnings ratios and yields following recessions over the last 55 years. The way to make good long-term returns in the market is to take a position in something that is undervalued and stay with that position. Anything else is a gamble. The market is not only overvalued, it is selling at all time highs.

DATE	PRICE EARNINGS RATIO	YIELD
June 1949	5.4 x	7.6%
December 1974	7.5 x	5.1%
April 1980	6.8 x	5.7%
August 1980	7.9 x	6.3%
February 2004	31.2 x	1.6%

The Congressional budget office estimates deficits for the next ten years will aggregate $2.4 trillion, an estimate of $1 trillion more than the budget office’s estimate only 8 months ago.

The US economy is currently in the midst of the most profound hiring shortfall in modern day business cycle history. Employment is 2.4 million workers below the employment profile upturn in the early 1990’s. This indicates America is in the worst jobless recovery in history, primarily because jobs have been exported.

David Walker, Comptroller General of the United States, wrote a February 4th editorial for The New York Times pointing out that federal debt, plus the gap between government social security and Medicare commitments and money set aside to pay for them, exceeds $400,000 per family of 4. (You read that number correctly and four months ago Market Watch estimated the number at $500,000).

Because of the crashing dollar, and because oil is priced in dollars throughout the world, Americans will continue to pay more for fossil fuels which will increase our cost of living, as well as increase the cost of our manufactured products.

At this time in a recovery, industrial production is usually up. Currently, it’s still down 5%. A Haas School of Business study shows we are in danger of losing an additional 14 million white-collar service jobs, equal to 11% of the total US work force, as soon as they can be outsourced. 2.5 million manufacturing jobs have already been transferred overseas leaving manufacturing jobs down 19%.

Are There Technical Reasons For The Above?
A look at the chart below points out the change in the composition of income for major corporations in America. Notice that General Electric’s earnings from manufacturing since 1980 have decreased from 92% to only 50%. GE’s income from financing activities has increased from 7% in 1980 to 50% now, and this is a moderate example. General Motor’s earnings from financing activities currently hovers around 90% of income! This is a result of manufacturers having to finance the sale of their products to consumers in order to make the sale. Unfortunately, many consumer loans are “upside down”, meaning that the current outstanding loan balances are greater than the current market value of the products that were financed.

The next chart is scary. Total US debt is now 300% of our GDP. It’s never been this high, even in the 1930’s when debt reached 270% of GDP. In the 1930’s, however, not only did the government sponsor all the TVA programs and introduce social security, but the country’s GDP fell by 30%. Debt as a percentage of GDP in the 1930’s spiked because of a decrease in our GDP. That is not the case today. Today we have an unadulterated, fed/government sponsored increase in debt, which has caused an explosion in the cost of government. 50% of the federal government’s current budget is for interest payments and care taking (social security, medicare and medicaid, etc).

The last chart indicates just how much our government is attempting to control the economy. The “real” cost of fed funds means the published cost of interest rates less the rate of inflation. Notice that the real cost is now less than 0%, a carbon copy of what happened in Japan in the 1990’s. The thoughtful investor would ask themselves why the fed would have negative rates, and the answer is simple: with US government debt at $7 trillion and the rest of the country having debts of $23 trillion, higher interest rates might sink an already shaky economy. Logically, uncontrolled free-market interest rates would be 4% greater than they are now. 4% of $30 trillion of debt is an additional interest burden of $1.2 trillion annually. An additional expense burden of $1.2 trillion annually in a $10.4 trillion economy would clobber consumer spending, and consumer spending is at least 2/3 of our GDP. We could end up in an interest rate cost induced recession that would make the last few years look mild by comparison.

Do you remember the bank crisis and the savings and loan crisis in the 1980’s? The banks are currently borrowing fed funds at 1% overnight and simultaneously purchasing 4% treasuries, thereby creating a 3%, no brainer, book profit. The fed is trying to re-liquify the banks and build up the bank’s balance sheets in the event a further downturn occurs. The spread in interest rates earned by the banks builds up their reserves and makes their earnings look better than they really are.

Conclusion

From 1996 to 2000, 2/3’s of the world’s increase in GDP resulted from US spending. In the last two years, during this “worldwide” recession, a whooping 93% of the world’s increase in GDP is from US spending. The above charts indicate it’s all from huge increases in debt. If debt did not have to be repaid, and faced in the future, our future would be less cloudy and more predictable than it is currently.
This is a dangerous, overpriced market in an economy loaded with debt. It might be a good time to invest if stock values were low and primed to move upwards. But in the most overpriced market in history, with the displacement of capital that has occurred, and will continue to occur, any further upside increases in the market could be limited, indeed.

Caveat Emptor!
George Rauch
January 25, 2004

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