The Market Is Going Nowhere

The concluding paragraph in last month’s Market Watch was: “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”.

Nothing has changed other than the market has lost 500 points since last months article. It is extremely important to remember that an improving economy does not translate to an increasing stock market. Particularly when the market is already overvalued.

The Money Supply

The chart below compares the GDP growth to money supply growth. Notice that GDP grew 24% from 1995 to 2000 and that GDP in 2005 will be about 22% greater than 2000. Now notice that the increase in money supply during the same time was 43% between 1995 and 2000, accelerating to 52% between 2000 and 2005. The disproportionately large increase in the money supply, as compared to the increase in GDP, is why we have inflation. Anytime there is a disproportionately large increase in the money supply, there is more money to spend than goods and services that can be produced. The producer will therefore increase prices to absorb excess money in an economy.

GDP Growth Compared to M-3 (Total Money Supply) Growth

Year	GDP	% Increase	Total Money Supply (M-3)	% Increase
1995	$7.8 Trillion	N/A	$4.4 Trillion	N/A
2000	$9.7 Trillion	24%	$6.3 Trillion	43%
2005	$11.8 Trillion	22%	$9.6 Trillion	52%

Pundits of what our Constitution calls “gold and silver specie” point out that we had stable prices for 125 years in this country because of the gold standard. They point out that the only constitutionally sanctioned increase in the money supply comes from what can be additionally mined each year. That’s why we had 125 years of stable prices until switching to paper money. In the 1930’s and 1940’s, the US gold stock could be converted, one for one, to the M-3 money supply. For every dollar outstanding, there was an equal amount of gold backing that dollar. Today, gold and silver bullion owned by the government represents a tiny fraction of M-3 money supply….believe it or not, less than 2%!

Gold and silver retain their value. Historically, gold and silver have been in and out of favor, as currency, many times. Governments like paper money because they can create it out of thin air and pay for their spending deficits. When the imbalance of the increase in GDP, compared to the increase in the money supply, becomes so great that inflation causes a currency to have little or no value, governments are forced to return to gold and silver currency in order to re-establish confidence in the monetary system.

It is impossible to predict if and when that will happen to us, but it is certainly obvious that three things are happening:

1)		We have had a lot of inflation over our lifetimes;

2)		The rate of inflation is accelerating;

3)		Well managed, increasing inflation, is absolutely necessary if we hope to get out of our indebtedness (and our future Medicare and Social Security obligations) without a further currency collapse. The only alternative for us is to inflate our way out of these excesses.

The Good News

A growing money supply is a force for new growth in the economy. Our government, and many well-known economists, believes that further great US economic growth is on the horizon. The Federal Reserve System instituted policies that led to an increasing money supply and lower interest rates. If interest rates are low, there will be a greater demand to borrow money. The borrowing of money at lower rates helps insure the economic viability of investments. The profit from these investments will pay the principal and interest on the borrowed funds, more jobs will be created, and the economy’s growth cycle continues. Since we have not had a catastrophe from our current increase in the money supply, and the huge buildup in debt, we may conclude that the Fed’s program has worked so far.

US manufacturers continue to shift production to China (mostly) in an effort to increase sales by reducing costs. It’s working. In a free market, the low cost producer gets the order. Economists point out that China’s GDP of $1.35 trillion is equal to the GDP of California. Japan, too, has many plants in China. America and Japan’s GDP together equals $17 trillion, more than 50% of the world’s GDP, making China’s GDP equal to 8% of the combined US and Japanese output. It is pointed out that China is far more dependant upon us, as customers, than we are on them as producers.

China has forced American industry to become more efficient and to produce at lower costs. We continue to enjoy productivity gains.

For the time being the US dollar has stabilized. Central banks around the world realize there’s really no alternative to the dollar at this point. The Euro is facing a potential double whammy. It appears the French are going to reject the European Constitution. Further, Europe’s laws to protect jobs and provide 6 week paid vacations, along with medical care and other government “benefits”, is not able to be modified. The decline in the dollar, and the increase in our productivity, coupled with these problems in Europe, put us in position to continue to compete in the future.

Conclusion

The above is the government’s thinking. Call me Mr. Dubious. Even if everything that is being promoted by the government as outlined above works as planned, we still face many challenges:

1)		There is beginning to develop huge hostility between China and Japan over who owns the drilling rights in the sea that separates the two countries. And China is trying to block Japan from receiving a seat on the UN Security Council. The détente recently enjoyed is in jeopardy. They are locked in a struggle for regional leadership. China has the people, and Japan has the money.

2)		With US productivity increases, and a lower US dollar, China’s growth must slow down (and it is). That, coupled with an inflation problem that exceeds our own, puts China in a position where price increases are inevitable. Price increases make Chinese goods less attractive in world markets. China now produces half the world’s DVD players and digital camera’s, more than 1/3 of it’s personal desk top and lap top computers, and about 25% of it’s mobile phones, televisions and car stereos. It would be devastating for China to loose part of those markets. The question is whether or not China can maintain currency parity with the dollar. It cannot. Older readers will remember the same things happening to Japan and Germany 25 years ago.

3)		The US core rate of inflation is increasing rapidly. With inflation increasing, purchasers of debt instruments are not going to be happy with the current rate of interest. The forcing of interest rates upward will lower borrowing and therefore discourage investment in additional plant and equipment. Such limitations tend to slow down the growth of an economy.

4)		The US current account deficit is now running at 7% of GDP. Historically, nations with trade imbalances approaching 5% of their GDP are forced into vast reductions in the value of their currency. Such a scenario would indicate that the current stabilization of the dollar will not last, and that the dollar could loose substantial additional value.

5)		98% of the world’s crude oil producing capacity is being utilized.. The system is considered seriously stressed at 95% utilization. With 2% per year growth in petroleum demand, we need to find huge new sources of oil in order to avoid further, crucifying, increases in the price of fuel.

The prudent investor will be judicious about buying stocks at these haughty levels. It pays to remember that for every action there is an equal and opposite reaction. Any serious economic adjustment, to balance past irresponsible government actions, could be very painful. More importantly, mathematically and logically, any serious economic adjustment could send US stock markets into a downward spiral.

Caveat Emptor!
George W. Rauch
April 27, 2005

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