Market Watch - August 2004

When In Doubt, Stay Out!

As of July 26th, the DJIA was down more than 4% for the year; the NASDAQ was down more than 7%; and the S&P500 stocks were down over 2%. Corporate earnings and the nation’s cash flow continue to increase. Wall Street is saying that corporate earnings and increasing cash flow are a reason for the stock market to go higher. But since the market is already at historically high values, it is unlikely there will be a significant upward movement from current levels.

Personal indebtedness continues to climb to new highs. Corporate debt, on the other hand, has been reduced from $1.1 trillion in January, 2001 to a six year low of $871 billion as of May 12th, 2004. Corporate debt will continue to be reduced until excess manufacturing capacity has been filled. That may be a long time because manufacturing continues to move overseas. This movement offshore leaves additional U.S. manufacturing capacity that needs to be utilized.

President Bush has turned out to be the biggest spender of all times, yet Senator Kerry says he will introduce $621 billion of new spending in the next four years. He has also pledged to revoke the “tax cuts for the rich”.

The M3 money supply (total money supply) after surging for the first six months of the year is now contracting radically. At this point it is impossible to tell if economic growth is decelerating, if the economy is finally de-inflating, if consumers are finally tapped out and have little additional appetite to purchase much more than their needs, or all of the above.

The majority of stocks are in declining trends, and the Dow Jones Industrials are currently characterized by declining peaks. Declining peaks means that the market’s June high (peak) was below the April high. The April high was below the February high, and so forth, which is creating what is known as a series of declining tops, or declining peaks. The NASDAQ is even worse with both a series of declining tops and a series of lower bottoms. Unlike the Dow Industrials which have not been creating lower bottoms, and which have been trading in a narrower range, the NASDAQ is tracing out lower bottoms with each sell-off from its declining tops. (Each “bottom” is creating a new 12 month low for the NASDAQ).

Both the Dow Industrials and the S&P 500 have declined for five consecutive weeks, which is the longest string of weekly declines since October, 2002. Both indexes are hanging around their May 17th lows for the year. While it is impossible to determine for sure, it is known that contributing to this is the fact that China is now struggling with 14% inflation which is causing two problems: (1) China’s neighbors are becoming more price competitive in world markets than China and (2) now China does not have excess cash to use to purchase U.S treasury securities and help us fund our continually increasing federal budget deficit.

What the above points out is that we have three bearish phenomena:
	1.		Corporations paying off debt means they are not expanding and have little appetite for additional employees;
	2.		The sudden contraction in the money supply is a result of the public not needing so much money, which probably means a contraction in consumer spending;
	3.		A decline in China purchasing our treasury securities disrupts the circle of economic dependency from which we have been able to feel less pain during the current recession.

Market Watch has previously pointed out that 75% of the world’s known recoverable oil reserves are in the Middle East. The entire U.S. way of life depends upon a large, relatively inexpensive quantity of petro-chemicals. Oil sources must be protected at all costs for Americans to continue their existing way of life and for there to remain enough political stability for our current politicians, and the two-party system, to remain in power. While we citizens may not be aware that our 100 year love affair with the internal combustion engine could be on the verge of being over, our politicians do realize our current and future supply of oil is in jeopardy.

The world consumes 81 million barrels of oil daily, and the U.S., with 5% of the world’s population, consumes 25% of the world’s production or about 3 gallons per citizen daily. By 2025 U.S. consumption is anticipated to increase by more than 50%. But in addition to U.S. demand, the next greatest demand, respectively, comes from China (just passed Japan for the #2 spot and China’s auto purchases were up a staggering 70% last year), then Japan, Russia and Germany. The U.S. imports 59% of our national consumption with the Middle East playing an important part in that percentage. Increasing demand around the world, coupled with dwindling reserves, highlights a collision course with the U.S. way of life.

The highly touted Caspian Sea oil reserves are thought to be less than half of their estimated volume of a few years ago. Like Shell’s surprising recent downgrading of their reserves, it appears that Saudi Arabia, the world’s largest producer, may have over stated their reserves, too. Furthermore, no new sources of oil have been found in decades in Saudi Arabia.

Russia, which enthusiastically collected money from other countries and large producers like Exxon, is now not honoring previous contracts. Exxon invested $50 million in a new promising Russian oil field that Putin has nationalized making foreigners leery of again investing in Russia. In addition to that, since winning a new term last spring, Putin has been consolidating his power like the Russian dictators of old. Banks (money) and oil have virtually been nationalized. He’s boasted about the successful test of “space guided missiles” which he says restores Russia to the world’s #1 position militarily (because America has no defense against these missiles, supposedly). Russia’s banks, like China’s banks, are now in serious trouble. It appears the current problems with Russia’s banks could far exceed the disaster they suffered in August, 1998.

Most wars are fought over money. Combined with the West’s demand for fossil fuels, the instability of the Middle East makes the world ripe for another major, history changing, war. The U.S. is already engaged in two giant, costly skirmishes in that area. The rest of the free world, most of whom are allies of ours, have great existing demands for oil. Their lives are also dependant upon a consistent and increasing supply of fuel. Current circumstances show great similarities to past events that led to World War I and World War II.

The U.S. stock markets continue to remain in a large, extended bear market cycle. The bull market in stocks reversed itself in 1999. The interest rate cycle reversed itself in early 2004, and from here on there will be a gradual increase in rates. These interest rate and stock market cycles are usually long, multi-year cycles, designed to correct dysfunctional economic conditions. While there are some positive economic signs like increasing corporate earnings and increasing cash flow in the economy, the markets remain overvalued with tremendous over hanging potential problems nationally and internationally.

From 1964 to 1981 the market went down 1%. During that time we had three recessions, oil shortages, 18% interest rates, war, stagnation and $850.00 gold. We all might remember that there were also pretty good times in spite of the economic problems. From 1982 to 2000 the Market rose 1,340 % (13.4 times) from 875 points on the Dow to 11,723. That huge upward cycle was highly speculative toward the end. Speculative cycles create excesses which we call bubbles that must be deflated before the markets (not necessarily the economy) can move forward again.

We are currently building yet another excess in our markets, which nobody has pointed out, in the Dow Jones Transports. The transport’s strength is impressive. But the stocks in the index are selling at an average of 59 times earnings and yield only 1.1% -- where is there any value in that?

Cash is king. The market remains a huge gamble. When in doubt, stay out!

Caveat Emptor!
George Rauch
August 2004