Market Update

Stocks today are expensive and provide very little in the way of dividend yield. With average price earnings ratios over 20 times earnings and average dividend yields of 1.7% on the Standard and Poor Index of 500 Stocks, from an historical point of view, an investor can expect to make very little in the stock market the next 5-10 years. It is likely that intermediate term yields on A-rated corporate debt, and U.S. treasuries, may exceed returns on stock over the next several years.

Question: Market Watch has previously written that cash flow in our economy is up, earnings are up, and the outlook is not as bleak as it was a few years ago. Why, then, is it expected that the stock market will not increase in value with the increase in cash flow in our economy?
Answer: There is no simple conclusion that can be set forth to answer the question, but rather, a series of interwoven, complex economic tug-of-wars going on that are transforming the world’s economy, and which, in turn, frustrate further increases in U.S. stock markets. Some of the more important are as follows:

1)		Consumer debt continues to rise. Household debt is $10 trillion or 115% of household disposable income. In 1945, household debt was 20% of disposable income. Debt cannot continue to rise faster than income, as is currently happening. Sooner of later there must be a pull back in consumer spending. Consumer spending represents about 2/3 of the U.S. economy, and U.S. consumer spending fuels the increases in GDP in other countries. America’s borrowing has been used to finance consumption, not investment. Debts incurred to finance investments are self-liquidating as they generate the cash flow necessary to pay the interest and retire debt. Debts incurred to finance consumption are not self-liquidating, and future interest and principle payments impair the solvency of the borrower.

2)		The welfare state has become more costly. In 1954, human resource spending was 19% of the federal budget. Today it is 66% of the federal budget. The only way to meet these obligations without deficit spending is to rapidly increase taxes, or institute massive spending cuts, both of which would be politically unacceptable, and both of which would hurt stock prices. The market senses this economic dichotomy. To compete in international markets the U.S. must price the cost of borrowing money and servicing debt into its products. The high cost of welfare must also be priced into the products. Those two things, coupled with labor rates that exceed by 20 times the cost of labor in the Far East, make it very difficult for U.S. products to be priced competitively in world markets.

3)		The Bureau of Labor Statistics (BLS) reports a net loss of 221,000 jobs in 6 major engineering job classifications over the last few years. Computer and electronics engineers are unemployed and cannot find work because China and India graduate 4 times as many engineers from college as the U.S. The big increase in intellectually oriented jobs that were predicted by government economists a few years ago has not materialized. The reason for that is not only the cost of engineering in the U.S., but also the inefficiency of engineering products in the U.S., rather than in the Far East, where products are now manufactured. U.S. corporations that used to manufacture here have outsourced so much that they have become marketing and selling machines. The “new economy” we were promised has, in reality, transformed the U.S. into a country that is losing both its manufacturing base and its wealth.

Question: Will Wall Street come up with some new products that will provide investors an opportunity to make money in the markets?
Answer: It is unlikely. Wall Street comes up with gimmicks to make money for Wall Street. For example, 10 years ago nobody ever heard of a hedge fund. Today, believe it or not, there are more than 7,000 hedge funds, which constitute more than 60% of trading volume on the New York Stock Exchange. With that many fund managers competing to profit from the swings in the market, the risk increases for investors.

Question: We have read lately that the government is creating regulations that will allow for offshore exploration for oil in the continental U.S. and Alaska. Shouldn’t that abate future anticipated shortages of fossil fuels?
Answer: Not really. The U.S. uses 20.5 million barrels of oil a day, more than China, Japan, Russia, Germany and India combined. Demand for oil is outstripping supply, unlike the past. The increasing demand in countries like Russia, China and India will, by itself, absorb planned increases in supply in the foreseeable future. The wild swings in prices of oil that have existed for the last several decades will be frustrated on the downside by increasing demand from both emerging and mature economies.

Question: With all of the dollar problems, and the buildup of U.S. debt, why do foreign governments continue to buy our treasury debt, and why do they continue to fund our trade imbalances?
Answer: They have no alternative. Korea, Japan, China, and even Germany with its record unemployment, cannot create enough internal demand to sell products within their own countries. Their largest customer, the U.S., must continue to consume if those countries’ economies are going to survive and grow.

Question: What about inflation? Isn’t inflation disappearing?
Answer: The government wants us to believe that inflation is “under control”. The purchasing power of the 2003 dollar was 9% of the 1945 dollar. Furthermore, since Greenspan took over the Fed in 1987, the dollar has lost 37% of its purchasing power. Math does not indicate that inflation has decreased, or that Greenspan has been an effective inflation fighting head of the Federal Reserve System. Currently, the rate of inflation is on the rise. The Fed is hoping that increased interest rates will slow the rate of inflation’s growth.

Question: If debt is such a drag on future earnings, how will we get out of debt?
Answer: Two ways: by inflating our way out of debt and/or by repudiating our debt. When Nixon refused, in 1971, further convertibility of U.S. gold for U.S. debts abroad, the U.S., in effect, repudiated our debt. That made the dollar the only international currency. Now, when we spend more than we make, we simply print enough new money to cover the cost of additional expenditures. As explained above, other countries really have no alternative but to go along with the U.S. plan. In the foreseeable future, there must be continued U.S. consumer spending to keep the world economic system running. This means: more debt; more inflation; additional transfer of U.S. wealth abroad; and continued downside pressure on U.S. stock markets.

Question: Is the situation we are in comparable to past economic situations?
Answer: Yes. The economics of today resemble the economics in the 1970’s, which led to stagflation. There has been a fivefold increase in oil recently, as there was in the 1970’s when oil rose from $2.20 a barrel to $11.50 a barrel. We had Vietnam in the 1970’s, and we have the Middle East now. In the 1970’s we had huge increases in government deficits, as we do today. In the 1970’s the U.S. dollar lost 50% of its purchasing power in world markets, and the same thing is happening today. We came out of the 1970’s successfully, so while we can hope for the same results today, the macroeconomics of the existing world situation, and the shear mass of the mathematics involved, indicate that a favorable extraction from the current economic difficulties could take at least another 5-10 years.

Conclusion

Seasoned investors think in terms of safety first, income second and price appreciation
last. The Dow closed in 2004 at 10,783, higher than today. Even if earnings expand at the peak of their historical long-term growth rate of 6%, in 5 years the price earnings ratio of the Standard and Poor 500 Index of Stocks would still be an elevated 18 times earnings. That is almost 30% higher than average long-term PE ratios of 14 times earnings. Based upon those facts, the annual projected return over that period of time would only be 4.5%, which is why it is likely that professional investors will opt for the safer returns of fixed income securities.

While the Fed has been effective in stifling a huge decrease in the value of the stock
market, there is no real reason to expect much of a further increase in the value of the market. Indeed, the creation of all this new money out of nowhere, the buildup of debt, the twin deficits, and the existing overvalued stock market mitigate against taking large positions in stocks in the foreseeable future.

Caveat Emptor!
George Rauch
April 1, 2005

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