Frequently Asked Questions

This month’s market watch will address some frequently asked questions.

Question: In the last few years the compositions of the stocks which make up the Dow Jones Industrial Average (DJIA) have been changed twice. How does this affect investors? Answer: Two ways. One is directly related to the current composition of our economy, and the other one is related to yield, (or the dividends paid on stocks). Years ago, the “DJIA” was comprised of strictly industrial stocks including many steel companies and other large basic manufacturing companies. Since our economy has changed and so many manufacturing jobs have been shifted offshore, many stocks in the Dow Jones 30 Industrials are not manufacturing companies. They are service companies like banks, insurance companies and retail distributors, many of whom purchase abroad the products they sell in the U.S. Next, many of these stocks have little or no yield. Fifty years ago investors expected a fat dividend when they invested in a company like Bethlehem Steel, but with high tech and distribution companies like Microsoft, Intel, Wal-Mart and Home Depot, for example, the dividend payout is now at a much lower rate of yield than in the past.

Question: Yields are generally very low with the standard and poor index of 500 stocks only yielding about 1.7%. Is this a new trend? Answer: No, it’s a temporary trend. Yields are low because the price earnings ratios of stocks are selling at historical highs. The market has an ebb and flow to it, and over the years as markets become very high priced, the percent of earnings payout (yield) is reduced. When stocks become priced reasonably again, and/or when the investing public begins to insist upon better yields again, yields will improve to 4%, 5% and 6%. These dividend payouts have never before in history been as low as they are today, just as price earnings ratios on stocks have never been as high.

Question: When can we expect the U.S. stock market to have a recovery? Answer: The U.S. stock market is already operating at a very high level of values. What the U.S. needs is a continued recovery in our economy to the extent where we can create enough cash flow to get the government deficit and our personal debts under control. Current levels of indebtedness, government spending deficits, and U.S. trade imbalances are the worst in history. But even at these levels, they are manageable, if we act now. Otherwise, the sheer mathematical weight of these imbalances will create an increasingly perilous situation for the U.S. economy.

Question: Can’t we expect some improvement in the stock market over the next 4-5 years? Answer: The stock market has a mind of its own, and in the long run, the market will be controlled by values. Short and intermediate term manipulation of the market is possible, but long term, values will rule the markets’ levels. The Vanguard Group of funds recently looked at the performance of 420 balanced mutual funds over the last 40 years. Only 7% of those funds added value on a consistent basis. They theorize that “Joe Public” has never made money in the market and should not be in the market. He is simply a victim of the Wall Street marketing machine, and at these values, an investor’s chances of making any money is drastically reduced.

Dr John Hussman (www.hussmanfunds.com) analyzed future market expectations by using a peak multiple of earnings on the standard and poor index of 500 stocks. (Peak earnings are the highest average earnings in a market cycle, which, for the current cycle, occurred in 2000.) The market is currently priced at more than 20 times peak earnings, values that have only been equaled in1929, 1972, 1987 and 2000. From each peak to the next peak, earnings have never grown faster than 6% annually. Adding the 1.7% average yield that currently exists on the S&P 500 would lead an investor to think that a total return of 7.7% annually is the best that could be realized, but only if the 6% compounded earnings return is achieved. Earnings are currently improving and should continue to improve. However, historically, once stocks reach 20 times peak earnings, at sometime during the next 4-17 years, stocks always decline to very low price earnings levels. In the 1970’s, for example, the S&P 500 sold at 5-7 times earnings (one quarter of today’s values) and paid out a dividend yield of more than 6%, 4 times greater than today’s yield. It would appear that over the next decade, at least, investors will be doomed to lose money in the stock market.

Robert Shiller’s book “Irrational Exuberance” further substantiates Dr. Hussman’s conclusions with a couple of key points:

1.		In 1901 the DJIA peaked at 25 times rolling 10-year average earnings. The next 20 years investors lost an average of minus .02% annually.

2.		1929 peaked at 23 times the rolling 10-year average earnings, and the next 20 years produced returns of only 0.4% annually.

3.		1966 peaked at 24 times earnings, and the next 15 years yielded minus .05% annually.

4.		Finally, the 2000 peak was 50 times earnings, all of which suggests real returns over the next several years could be negative.

Question: Isn’t the tremendous increase of 308,000 jobs created in March an encouraging sign? Answer: Any increase in employment is a good sign, but the numbers recently produced should be critically analyzed. In February, the U.S. Department of Labor had predicted a 300,000 job increase, and only 27,000 new jobs were created. In March, the government became ecstatic because of the 308,000 new jobs announced. And while there is a definite increase in cash flow in our economy, we should ask ourselves how employment could have increased in March when the unemployment rate actually went up to 5.7% and when total employment remains unchanged at 138.3 million jobs. In fact, the average workweek fell to 33.7 hours, close to a 40-year low of 33.5 hours per week. Service job’s wages fell 8 cents an hour, and they represent 230,000 of the 308,000 new jobs in March. Ex-fed official and investment advisor Lacy Hunt provides further answers: “ Of the 308,000 new jobs created, 296,000 are temporary or part-time jobs. Part-time workers aggregated 4.7 million jobs, and most of these individuals indicated they would like full-time work but cannot find a full-time job. Congress didn’t renew unemployment benefits, so many people took whatever they could get which accounted for the surge in people entering the work force in March. Finally, the average weekly paycheck in March fell an astounding 88 cents to $525.70 per week.” Hunt further points out that all of this fits into the trend of a lowering of the U.S. standard of living as other countries, primarily Asian, have an increasing standard of living as a result of their increasing cash flow.

Question: What has contributed to this difficult economic situation? Answer: While things could be better, they are not all bad. Our economy represents at least 30% of the world’s GDP, which is huge for a country with only 4 % of the world’s population. We have momentarily lost the habits that made us wealthy: instead of making goods, we buy them; instead of thrift and savings, we spend and consume; instead of lending money to the rest of the world, we borrow from them; and instead of “free enterprise”, our economy is increasingly controlled by burdensome government regulations.

Economic growth can have two different sources; (1) sound fundamentals making for self-accelerating growth, and (2) artificial monetary and fiscal stimulus. We have grown used to artificial monetary and fiscal stimulus by cutting interest rates, running budget deficits and incurring debt to the point that we are simply tapped out.

The Fed may be out of ammo at this point. Our sluggish recovery over the past few years has nothing in common with our past post war cyclical recoveries. They were also jump started by the Fed but were further stimulated by consumer buying from savings that had been accumulating during the down turn. During this last down turn, the only thing consumers accumulated was more debt.

Conclusion

If the economy’s cash flow continues to improve, if we can get our debts under control and if we can increase our rate of savings, we’ll remain competitive in world markets. But even if we do, the odds are great that the stock market will produce no significant increases in value over the next several years.

Caveat Emptor!
George Rauch
April 28, 2004

....