Market Watch - April 8, 2004
Over a hundred years ago Charles Dow, founder
of the Dow Jones Company (publisher of the Wall Street Journal)
and the man who developed the Dow Theory of Investing, said the
following: “There is always a disposition in people’s
minds to think that existing conditions will be permanent. When
the market is down and dull, it’s hard to make people believe
that this is the prelude to a period of activity and advance. When
prices are up and the country is prosperous, it is always said that
while preceding booms have not lasted, there are circumstances connected
with this one, which make it unlike its predecessors and gives assurance
of permanency. The one fact pertaining to all conditions is that
they will change. The tendency of prices over a considerable time
will always be towards values. To know values is to know the meaning
of the market.”
To be a successful stock market investor, we need to understand
two basic things: (1) is the primary trend of the market up or down,
and (2) is there enough underlying value in a particular stock to
assume there is significant potential for it’s price to increase?
Clearly, the primary trend of the market over the last several years
has been down. The secondary trend of the market since October 2003
has been up, but that rally appears to have reached its zenith.
If so, the primary bear market is likely to return in force and
test levels below 8,000 on the DJIA. We are four years into the
bear market, and Market Watch has previously noted it will take
6-8 years, at least, for the bear market to correct the excesses
(bubbles) created from 1974-2000. The government will continue to
fight this trend with abnormally low interest rates, which creates
a bond value bubble; excessive spending, which creates a debt bubble;
and continued easy money for home purchases, which creates a housing
price bubble and contributes to the debt bubble, all of which must
be faced in the future. Added to the stock market bubble in values,
we have a genuine “bubble economy”. These over-hanging
bubbles (prices far in excess of values) are likely to have a significant
negative impact upon the economic growth of this country in the
future which will adversely affect increases in the underlying value
of current stock prices.
What Reasons Are There For The Market
To Go Up?
During presidential election years the market usually goes up, and
while this is a non-technical reason, nevertheless it is an historic
trend. Secondly, many major market indices do not indicate that
the market has toped out, so from a technical point of view it appears
there may be some upside left in this market. Next we have an increase
in corporate earnings and an attendant increase in cash flow in
our economy. And finally, billions of new dollars a month are coming
into the market from pension funds and IRA’s which create
demand for stock and puts upward pressure on prices.
Economic Trends That Could Frustrate
Growth
Last year Japan bought $250 billion worth of U.S. currency in the
open market and used the dollars to purchase U.S. treasury securities.
Purchasing dollars with yen creates demand for dollars and pushes
the price up. Selling yen to purchase dollars depresses the price
of the yen. Japan purchased another $100 billion worth of U.S. treasury
securities in January 2004, and there is a bill on the table in
Japan to authorize another $100 billion purchase. The Japanese receive
a very small interest rate return on their investment, and as far
as the Japanese are concerned, it is a negative return because the
Japanese Yen continues to go up, and the dollar continues to go
down, in spite of the efforts to prop up the value of the dollar.
This has caused consternation in Japan to such an extent that there
is now a huge argument over whether or not Japan’s finance
ministry will continue to invest money in securities that are loosing
value. Should the Japanese decide to even slow down their purchasing
of U.S. treasury bills, interest rates on treasuries would go up
significantly. An increase in treasury bill rates would drive up
all U.S. rates which would do three things: increase the cost of
consumer borrowing, which is primarily pegged to short term rates;
increase the size of the government deficit because the cost of
interest on the government’s $7.1 trillion debt would increase
significantly; and reduce corporate earnings because the interest
burden on corporate debt would increase, consequently increasing
the cost of corporations doing business.
The consumer price index (CPI) and the producer price index (PPI)
have not even been released lately. There is a huge argument in
the administration concerning which cost increases are material
to the CPI and the PPI. Food prices are up. Gas is up. Insurance
is up. Housing is up. College tuition is through the roof, etc.
If inflation is as high as most of us think it is, interest rates
will increase significantly, which would cause bond prices to go
down significantly, which in turn would cause the country to lose
a huge amount of paper net worth. (The bond market is twice the
size of the stock market). One little antidote: for each penny increase
in the price of gasoline, the cost to consumers is roughly one billion
dollars annually, which is money that is deflected from the spending
stream for consumer goods. (The purchase of consumer goods comprises
about 2/3 of our $10.5 trillion GDP).
The mass media, in concert with the Fed, is finally talking about
the need to balance our budget and figure out how to pay for our
un-funded obligations to Social Security and Medicare, the cost
of which is spiraling out of control.
Conclusion
Market Watch started
with a quote from Charles Dow, perhaps the most savvy investor of
his time. Here’s a quote from Warren Buffett lifted from the
recently published Berkshire Hathaway annual report which was released
only a few weeks ago: “We’ve found it hard to find significantly
undervalued stocks. Our capital is underutilized now, but that will
happen periodically. It’s a painful condition to be in, but
not as painful as doing something stupid. I speak from experience.
I made a big mistake in not selling several of our larger holdings
during The Great Bubble. If these stocks are fully priced now, you
may wonder what I was thinking four years ago when their prices
were far higher and there intrinsic value was lower. So do I!” At the moment, Berkshire Hathaway is sitting on $36 billion of cash
and $12 billion of foreign currencies.
These two giants of investing have been successful because they
understand values. Charles Dow taught about values. Warren buffet
understands values and cannot find anything he wants to invest in
today. That should indicate to we mere mortals that the smartest
move might be for us to play follow the leader and sit on the sidelines
with our “underutilized capital”. We are far more likely
to prosper by waiting to invest in a market that has lots of value
then to pick and choose stocks in what is currently the most overvalued
stock market in history.
Caveat Emptor!
George Rauch
April 8, 2004
