Market Watch - July, 2004
The stock market remains overvalued and in a
position where the average investor could get hurt again badly as
they did in 2000. We face deflation, on the one hand, from cheap
Asian labor, the ability to shop prices on the internet, world over-production
of goods, and vicious price cutting by retailers. We face inflationary
pressure, on the other hand, with real estate prices going through
the roof, interest rates moving up, historically high fuel prices,
and rapidly increasing food prices.
The broad money supply (M3) is increasing at the rate of $1.5 trillion
this year (14%) after a record increase of $1 trillion last year--money
printed out of nowhere with no asset backing--which could end up
being extremely inflationary. In the face of this huge expansion
of the money supply and the forty-five year lows in interest rates,
un-employment is still a problem, the Standard and Poor Index of
500 stocks is at the same level as it was in 1998, and the Dow Jones
30 Industrials are just below their price level of 12 months ago.
Corporate loan demand is tumbling, which means business has very
little appetite for capital improvements and new employees.
Greenspan just announced that, “the core price index”
only increased at the rate of 2% for the first quarter of this year
and the “core price index” leaves out fuel, food, and
housing prices, which makes one wonder about the purpose of the
“core price index”. The government announced last week
for May “higher than expected inflation, weaker than expected
economic growth, higher than expected increases in consumer and
producer prices, larger than expected increases in trade and current
account deficits, and a larger than expected increase in un-employment
claims”.
To top it all off the following groups of stocks are now in “descending
downward patterns”: home building stocks, semi-conductor stocks
(everything has a chip in it), retail stocks, and financial stocks.
Financial stocks (interest rate sensitive) comprise 53% of stocks
traded on the NYSE.
QUESTION: This looks like really bad news. Market Watch has written that cash
flow is improving. We are confused. Should we go to the flee market
and look for a Hari-Kari knife or should we shout with glee? ANSWER: Neither one. Cash flow has increased because of government’s
unparalleled manufacturing of money, the government’s deficit
spending, foreigners willingness to accept US dollars that continue
to depreciate in value, and radically increasing real estate prices
which has encouraged consumers to borrow against their homes and
spend the money. This points to a period of stagnation, indicating
that the market will mark time and go nowhere.
QUESTION: Why stagnation? With an increasing cash flow in our economy, doesn’t
this bode well for economic growth, and doesn’t this henceforth
provide potential for an increasing stock market? ANSWER: We have built into our economy about $33 trillion worth of debt.
From 1944 to 1981 we had an extended rise in interest rates and
from 1981 to 2003 we had an extended drop in interest rates. The
latter cycle is now over and has reversed itself. So we can expect
a long and gradual increase in rates. Increases in rates adversely
affect corporate earnings and take consumers money out of the spending
stream to service debt, money that would otherwise be used to purchase
goods and services and spend on vacations.
By far the most important single market, US stocks, is particularly
overpriced. There is little doubt that rapid increases in interest
rates would cause a world economic crash. The Fed continues to struggle
to keep interest rates low, and let them rise as slowly as possible,
hoping that inflation can be contained. This might provide for a
general, long-term deflating of the bubbles in stock prices, bond
prices, and real estate. That is the Fed’s plan and the best
we can hope for, but there’s no plan for increasing savings
and lowering our debts.
QUESTION: Well, isn’t the Fed’s plan working? ANSWER: Yes, miraculously it is working and we have so far avoided what
could have been a huge crash in our markets more severe than the
market sell off which has already occurred. Unlike the Japanese
Government in 1989, our Government acted very quickly when they
first saw the bubble deflating by reducing interest rates to 45
year lows and by flooding the markets with new amounts of cash so
that “easy money” was available. Our current position
is that this has worked, but it has worked for all the wrong reasons,
which will require a reckoning in the future. In the long run, making
money out of nothing with no asset backing creates inflation. The
stimulation of consumer spending by making money cheap to borrow
has created a bubble in debt that must be faced in the future. The
deflating of the Japanese bubble has been painful and has seen the
Japanese stock market move from almost 40,000 to just under 12,000
today. Comparable numbers in our market would move the Dow Jones
Industrials into the 5,000 area or about 1/2 of where it is today.
QUESTION: Are there any other bright spots, or potential problems, on the
horizon? ANSWER: The big bright spot is, of course, the sheer power of this country.
Economically, militarily and politically we have no peers. In spite
of the media questioning our leadership, the world would be far
worse off today without the US.
A big pending problem is the elections. We are currently fighting
two wars. The House of Saud is under serious pressure with the leadership
old and frail and the youth split between pro Islamic and pro western
factions. The Middle East holds 75% of the World’s known oil
reserves. The American lifestyle is dependant upon a large continuous
flow of reasonably priced oil. Should the US and it’s allies
pull out of the Middle East, it would be very dangerous for the
US economy.
Fifty years ago the only great demand for oil and gas was from the
US. The rest of the world was destroyed and in reconstruction. Now
Western Europe demands copious amounts of oil and gas. The former
USSR is creating tremendous demand for petro chemicals. Last year
China passed Japan as the #2 user of oil and gas in the world. For
their own selfish economic reasons, these various regions are frustrated
by their own inconsistent thinking. If they don’t participate
with, and help, the US in the Middle East, they may have better
oil pricing, and a more available future supply. If that happens,
however, and it causes a huge reduction in consumer demand in the
US, then US purchasing power will be reduced, thereby throwing many
of those countries into a worse state of recession then that in
which they already exist.
QUESTION: Is there any stock market history that could give us a clue as to
where the markets might head in the next several years? ANSWER: There is. We had a bull market in this country from 1949 to 1966.
When the bull market became compromised in 1966, the Fed began to
create large amounts of money. From 1966 to 1973 the money supply
rose by 93%. From 1974 to 1981 we had price inflation that averaged
9.4% annually. Because of that inflation, by 1982 the market had
lost 75% of its value in real terms from 1966. Similarly, during
the increasing interest rate cycle of 1966 to 1981 we had a flat
stock market that went nowhere.
From 1996 to 2004, the money supply increased by 93%. Between 1996
and 2000 the market went from 5,000 to 11,700, and from 2,000 to
2004 the market has gone down as low as 7,400 and is currently at
10,400. The rapid increase in the money supply, and the attendant
rapid decrease in interest rates, would logically dictate that a
healthy bit of inflation is in our future. While the above sheds
a little light on what could happen, absolutely nobody knows, or
can predict, what will happen.
CONCLUSION:
Four things control stock prices: values, fundamentals, interest
rates and investor’s sentiment. Currently the value of the
S&P 500 stocks is unrealistically high. Fundamentals are poor.
Interest rates are increasing. But happily, investor’s sentiment
continues to remain high.
The bottom line is that investing in this stock market is a huge
gamble. It is obvious the market is in a long-term trading range.
Most investors only make money over a long period of time because
they invest in the market during a rising trend. The market is currently
in a downward trend. Having reached the bottom of the interest rate
cycle, and with interest rates now increasing, the investor is gambling
by being in this market.
Caveat Emptor!
George Rauch
July 2004
