Smart Money: A Look At The Big Picture

Big money, that is seasoned and sophisticated, is leaving the stock market and moving into relatively safe investments that pay income. This is probably why the US Treasury Market bonds and notes continue to set new highs.

Big money (usually also called “smart” money) has three advantages over the little guy: (1) Smart money understands values, smart money has endless patience, and smart money does not need the stock market. Smart money thinks of only three things: safety, values and what lies ahead. Smart money knows that the way to riches is saving and compounding, both of which require knowledge, persistence, sacrifice and patience.
The retail investor might ask, “what is the advantage to smart money leaving the stock market and bidding up the price of the bond market?”, and the answer is, those who understand interest, collect it; and those who don’t understand it, pay it. The bulk of smart money is always invested in income producing securities.

CURRENT TRENDS AND THEIR ECONOMIC EFFECTS

Question: Where is the market headed over the next few years? Answer: Nobody knows. When we are dealing with the market all we are dealing with are probabilities. The market reached 11,722 in January of 2000. Five years later we have had considerable additional inflation and the market is more than 1,000 points below its high five years ago. So far this year, the mutual fund index indicates those investors holding mutual funds, on average, have lost a little over 2% this year.

Question: What about hedge funds as an opportunity to make money in these volatile markets? Answer: There are now almost 8,000 hedge funds, and 10 years ago nobody ever heard of a hedge fund. Hedge fund performance is down 1.5% this year, and recent articles and publications have indicated, “hedge funds can not take interest rates of more than 3.5% (federal funds rate is now 3%). A fed funds rate of 3.5% or more is estimated to cause massive potential failures of many exciting hedge funds. If the fed continues to raise the rate 1⁄4% at each of the next five meetings throughout this year, the fed funds rate would go from 3% now, to 4.25% at the end of December, 2005. It does not appear that this will happen; however, the fact that so many hedge funds could fold at interest rates only 1⁄2% higher than existing today adds an element of risk to investing in hedge funds that the average investor should avoid.

Question: The yield on the ten-year treasury note is 4.07%. Can’t we do better than this? Answer: There are several bond funds, and numerous good stocks, that sell at a yield of more than 4%. Stocks, however, add an element of risk to a portfolio that ten-year treasury notes do not add. The ten-year note is used to set variable interest rates on mortgages—it is the keynote security for examining yields. Many people do not know this, but over the last seven years, the tree month treasury bill has exceeded returns, including dividends, on the Standard and Poor 500 index of stocks.

Question: What about job growth? Isn’t that a good sign for our economy? Answer: Job growth certainly is good for the economy; however, when broken down, job growth does not look that good. For example, 60% of the job growth in the last year is a result of over 55 year olds finding jobs. The jobs they are finding are in the service sector of the economy. There are only two types of jobs that create lasting value; manufacturing and agriculture, because both enhance the value of assets. While agriculture output continues to hold its own in world markets, manufacturing in the US does not.

Question: Why is manufacturing not accounting for the increase US job growth? Annual reports of major manufacturing companies listed on the New York Stock Exchange indicate that manufacturing sales and income are up. Answer: Manufacturing earnings and income is up; but remember, most of these companies own more manufacturing facilities outside of the United States then they do inside the United States. All manufacturing plants owned by these corporations are required to be accounted for in their annual report. A breakout of manufacturing is the United States is eye opener. In 1965, for example, manufacturing accounted for 53% of US economic earnings. In 1988 that number had dropped to 39% of US economic earnings, and now, the economic contribution of manufacturing to the US GDP is only 9%. The US manufacturing sector is in depression with flat wage growth, job deterioration, instead of job growth, and increasing debt burdens to households. These economic facts are bound to cause additional damage to our economy and our future.

Question: Our total employment has grown in this country a lot since 1965, so where is the growth? Answer: The big growth in the US the last 40 years has been in the financial sector. Formerly the manufacturing sector imposed the most political influence in our economy. Now it is the banker and the financers who have the political clout. Bankers make money through loans, so they are always encouraging indebtedness. Our economy is further in debt than ever before in history as a percentage of debt compared to our GDP. While our agricultural output is holding our own in world markets, with manufacturing disappearing so drastically in only 40 years, the potential long-term effect can not be measured. While the long-term effect can not be positive, because something has never happen like this before, it is impossible to predict the ultimate fall out.

Question: Aren’t there some really good individual stocks like Google in which one could still invest and hope to make good money? Answer: Google has been in a parabolic rise for the last few months. Google has all the characteristics of the NASDQ five years ago when the NASDQ parabolic rise took the index to 5,000. The NASDQ now hovers around 2,000, 40% of it’s value five years ago. The reason the NASDQ crashed was because so many stocks had been bid up to prices where there was no value in those stocks. Google today is selling at 104 times earnings and 19 times its total sales. Not only is there no value in Google, but it is being purchased on the “greater fool theory”. People are buying Google at these ridiculous prices hoping it will continue to go up and they can unload Google on a greater fool.

Question: What will be the effect of increasing interest rate? Answer: An economy that is heavily laden with debt, like ours, suffers tremendously when interest rates rise. A 1% rise in the interest rates in the United States cost our economy about $300 billion additionally each year. That’s based upon our $30 trillion, plus, of debt. That $300 billion for each 1% increase in rates represents just under 3% of our current GDP. So far this year interest rates are up 2 full points which means approximately $600 billion has been taken out of the spending cycle in favor of paying additional funds to lenders. Lenders turn around and settle their obligations with this additional money; they pay employees; and they spend money. So the effect is not all negative. Where the pinch comes in is that 70% of our GDP is consumer spending, and to the extent that the consumer must pay more in interest when purchasing new cars, washing machines, and so forth, our economy will be penalized accordingly.

WHAT TO DO?

The numbers on the DJIA have improved over the last five years. The DJIA price earnings ratio is 18 times, a considerable improvement from five years ago. The standard and Poor 500 Index of Stocks is selling at 20 times earnings, also a vast improvement from five years ago. However, the long-term average price earnings ratio on the Dow is 14 times earnings, so the market remains overvalued and positioned so that the potential for it to decease is greater than the potential for the market to increase in value.

The market is currently locked in a trading range between the March high of 10,940 and April’s low of 10,012 on the Dow. Historically this is a very narrow trading range, and it is assumed that a breakout will exist sometime this year towards either the upper end or the lower end of the trading range. There are as many experts who think the market will break out on the upside as there are who think the market will break out on the downside. Nobody knows. What we do know is that we are in a bear market. It’s a long-term bear market and we are only five years into the bear market. Market Watch has consistently stated that until average long-term values have been breached on the downside to create extraordinary buying opportunities, the bear market will persist.

As stated in recent Market Watch articles, there is evidence that points out problems in Europe that are far greater than ours. The French just voted down the European Constitution, which effectively, long run, will undo the common market collaboration that has existed the last several years. Asian countries have high unemployment, problems with inflation, and undervalued currencies. Their outlook is neither good nor bad-it’s neutral. But they are desperate to retain the level of employment, at all costs, that currently exist.

Our yield curve is flat. What that means is short-term rates are basically equal to intermediate and long-term rates. The yield curve has been flattening as short-term rates go up and long-term rates go down. If this continues, it is an indication that big investors (smart money) sees a recession ahead.

Continued uncertainty, the wisest choice for investors is to sit on the sidelines with cash and cash equivalents, be happy, and wait these bear market trends out until more clarity exists on the economic horizon. As strong as we are, America continues to remain in a highly risky posture. Any number of major potential problems could materialize and send the stock market south in a hurry. Stocks can go up, too, in these markets; but, as mentioned above, the market is based on nothing more then a system of probabilities. Probabilities of the market breaking out on the low side of the trading range far exceed the probability of the market breaking out on the top side of the trading range.

Caveat Emptor!
George W. Rauch
June, 2005

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