Stock Market Outlook Is Negative

Let’s review the Dow Jones Industrial Average (DJIA) point and figure chart. The theory behind this type of chart is that price encompasses everything including minor fluctuation in value, investor’s sentiment, time, projected earnings, and so forth. Only corrective (significant) price moves are recorded.

The increase in the market last year resulted in a “top” in January 2004 of 10,750. Notice descending patterns in April and July that have taken the market to new lows for the year. The new lows created a pattern of “descending tops tracing out new descending lows”. This means:

	1.	The bear market may have commenced another down leg;

	2.	The market’s next level of support is the 9,350 area from which the last major market increase began.

ECONOMIC FACTS SUPPORTING DETERIATING PRICE ACTION

From 1982 to 1999 the market increased in value by more than 1,300 %. Only 20 % of the growth in prices was because of increased corporate earnings. 80% was due to an increase in price-earnings ratios. In bear markets, price-earnings ratios tend to revert to their historical averages of about 12 times earnings, where A-rated stocks pay dividends yielding 4% or better. (That would put the Dow in the 5,500 range, for example.)

Ford Motor Company’s second quarter earnings tripled. Ford’s manufacturing business lost $57 million. All profit resulted from financing cars sold to customers. The vehicles are now worth less than the loans encumbering them. Ford’s security is upside down much like a bank’s financing portfolio would be upside down if the value of the bank’s outstanding loans was greater than the underlying assets securing those loans.

In 1988 our trade with China was virtually even at $6 billion. Now China buys $32 billion of goods from us while we buy $160 billion of goods from China! This has led to record trade deficits like July’s deficit of $69 billion, up 27% from July 2003’s deficit. The first 10 months of this year, the trade deficit exceeded by $21.5 billion the total deficit for all of last year.

The wealth of this country is being transferred abroad. This gradual transfer of wealth must negatively affect our standard of living. In the last 15 years the US deficit with the rest of the world is $2.7 trillion, which means there has been a net transfer of wealth from this country of that amount.

Total US debt rose from $4.7 trillion in 1980 to $34 trillion now. Debt accrued in 2002 and 2003 of $2.9 trillion exceeded total money borrowed from the Constitutional Convention in 1786 to President Reagan’s inauguration. The rise in debt from 1980 exceeded the comparable rise in GDP. Much of our growth during that period, therefore, resulted from borrowing on existing US assets. Those assets are now encumbered by a larger percentage of debt than they were in 1980.

Petroleum prices continue to reach records. Exploration to replace reserves has not kept up with consumption. Iraq alone has proven reserves of 115 billion barrels of oil which, by itself, would supply current US demand for 16 years. And this is without 90% of Iraq having been explored for additional oil.

The Middle East will probably absorb US attention and resources long into the future. In 1979 we had the Iran Embassy Hostages; the Beirut bombing in 1983; Lockerbie flight in 1988; New York Trade Center in 1993; Dhahran, Saudi Arabia Military complex bomb in 1996; Nairobi Embassy in 1998; Tanzania Embassy in 1998; USS Cole in 2000 and then 9/11. These were all Muslim attacks. A quick analysis of the line up of OPEC’s 11 counties yields the following: two have socialist governments; five are run by dictators or former terrorists; six have had some form of civil unrest in the last 10 years; and they control more than 78% of the world’s oil reserves. With unstable governments, full of unrest and poverty, it is hard to imagine how additional revolution and war are not a certainty. A “hint” towards whether or not the US will remain involved is the following written by VP Chaney in 1990: “Whoever controls the flow of Persian Gulf oil has a strangle hold not only on our economy but also the other countries of the world as well.”

Stephen Schurr wrote in the Financial Times in July “rising oil prices are being blamed for weak job creation, slower business and slower consumer spending. It may well turn out that rising crude oil prices are merely adding insult to a far bigger injury from which the economy suffers; and that is that the greatest stimulus project in economic history has come to an end. All it did was postpone-not avert-the inevitable after shocks of a huge bubble period”. Schurr is writing that in spite of interest rates at 50 year lows, federal spending that’s creating huge deficits, “printing” trillions of brand new dollars, and trying to convince the public that everything is ok, nothing has worked. We may now see the shocking results of bursting bubbles in bond prices, debt buildup, the stock market and housing which would further support the ancient saying that “there is nothing so bad that the government can’t make it worse”.

CONCLUSION

In listening to me dictate this column my wife piped up and said “can’t you write something positive”? Here’s positive: this looks like the stagnate market our economy faced in the late 1970’s. We made it through then even though there were challenges and even though that was the beginning of the transfer of our manufacturing overseas. A re-creation today of similar stagnant economic behavior would be quite acceptable given the external and internal challenges faced by our economy. So far the US economy has muddled through this last four years relatively unscathed.

The stock market has no upside. Wall Street spent $14 billion on advertising last year developing 40,000 messages in the mass media creating more than 100 “hits” per day. Still, the index of 23 leading mutual funds is down 8% this year, which means the average investor is down more than 8%.

In an effort to “beat the market”, Wall Street has created 7,700 hedge funds. Last year 75 billion new dollars went into hedge funds. Hedge funds have gone nowhere; however, hedge fund management has done very well. Hedge funds contributed $10 billion to Wall Street in commissions, and the 25 best-paid managers took home an average of $207 million apiece (Financial Times).

There are times when investors should think in terms of making money. There are times when they should think in terms of not losing money. This is the kind of market where investors should concentrate on not losing money, and remaining liquid, even though returns on cash are paltry. The old adage of “those who understand interest, collect it, and those who don’t, pay it” was never more appropriate than today. The bear market will remain for several years. In a bear market, 80% of stocks decline. Who’s good enough to pick the 20% that don’t?

Caveat Emptor!
George Rauch
September 2004

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