Market Continues To Go Nowhere

Last month’s article ended with the following thoughts:
There are eight leading economic indicators used to measure the vibrancy of our economy. They are now basically neutral, meaning it is difficult to measure potential for further economic advancement. Neutral is better than negative, but “neutral” is not a benchmark for the stock market to leap to new levels.

Leading indicators have deteriorated since then driven by five obvious changes in our use of the money supply:

1)		Money supply growth has begun to slow.

2)		Banks are beginning to liquidate Treasuries. The liquidation of Treasuries by banks adds cash to the banking system. With rates increasing, banks will attempt to loan money rather than hold government securities. Loan demand, however, is decreasing..

3)		Commercial lending has been going nowhere fast. There appears to be no recovery in bank commercial lending.

4)		A slowdown in real estate lending. This is the first sign of a slowdown, but with interest rate increases, common sense dictates a much bigger real estate lending slowdown ahead.

5)		We are now witnessing the first significant decrease in refinancing.

To add to the fun of analyzing our current situation and how the market might be affected, it’s important to take into consideration numerous additional economic trends.

1)		As of July 31st, 2004, the national debt was $6.7, trillion, and as of July 31, 2005, the debt was $7.9 trillion. This represents a 17% increase in only one year, and exposes additional government lies. (The “official on balance sheet” spending deficit was said to be $580 billion. But, hey, what’s a few hundred billion extra dollars in an $11 trillion, plus, economy?)

2)		Retail sales expectations have been reduced. Announcements of downgraded sales estimates by retailers like Walmart have caused the Dow Transportation Average to go down because fewer goods will be transported around the world (remember, the U. S. Economy represents 30% of world GDP - we literally dictate the direction of the global economy).

3)		Inflation rates for July advanced to 0.5%, 6% annualized. (Do not be alarmed. Our government has announced that the “core rate” of inflation advanced only 0.4%, or 4.8% annually. Of course, the core rate does not include food, or fuel costs, and the formula for the cost of housing in laughable.)

4)		8000 hungry hedge fund managers dictate the market’s action in a frenzy to report a profit. All hedge fund trading is short term gambling and has nothing to do with the long term outlook of the economy, the market, or long term values.

5)		The US savings rate is down to zero-probably even negative taking onto account inflation and the fact that since 2000, home mortgage and equity lines of credit have increased from $4.8 trillion to $8 trillion today.

Question: Can Market Watch see anything positive about our current situation?
Answer: Absolutely! The market remains way overvalued. Historical averages of yields and price-earnings ratios would send the Dow back to around 6,500 to 7,500 points. Even though values have improved over the last five years, had it not been for the Feds massive monetary intervention, the governments massive current account deficits, and our huge trade imbalances, the market would be far more reasonably priced (read that: depressed) than it is at current levels.

Question: Won’t our deficits, along with the Feds manipulation of the money supply, catch up with us and injure our economy severely?
Answer: Theoretically (and mathematically) they will. However, the “new” economic thinking is that government intervention in the markets stabilizes the markets rather than destabilizes them. Only time will tell if we’re making the right choices. The government is hoping that inflation will bail us out of debt, long run, and that continued consumer spending (which is now declining) will provide enough cash flow to fund further prosperity. It is felt that with continued consumer spending we should create enough cash flow so that government spending will be in balance with tax revenues; and long run, the negative trade deficit will cure itself through adjustments in the value of currencies.

Question: Isn’t it naive to assume our politicians will stay the course until all of these dislocations are reallocated in favor of the U. S. Economy?
Answer: Yes. Current dislocations are a direct result of prior improper political policies.

Question: Is there some history on what the market can be expected to do in the future?
Answer: Nobody can predict future market action. On Wall Street, today’s genius is tomorrow’s fool. We can focus upon one old market adage, however, and that is “Don’t fight the Fed”. Watch what is really happening, not what is being said.

With that in mind, let’s look at the mathematical truths, since 1965, of the effect of the ten-year treasury bond’s yield as related to the return on the Standard and Poor Index of 500 stocks.

Ten Tear Treasury Bond Yield	Subsequest Ten Year Return for S & P 500 Stocks
0-5%	4.3%
5-6%	5.5%
6-7%	10.5%
7-8%	13.2%
8-9%	16.7%
9-10%	17.5%

Based upon the above, as Market Watch has repeatedly pointed out, the stock market over the next several years may return less than the bond market with a lot more risk of decline than the bond market. As interest rates climb, we can expect that consumer spending and corporate earnings will decrease, thereby depressing the stock market further. The above statistics indicate that while there are only limited buying opportunities in the market now, if interest rates continue to increase, future good stock buying opportunities are likely to be available. But patience is required.

Conclusion:

Upside momentum in the market has tailed off, and it appears that a market “top” has taken place. Stocks remain unusually overvalued, and are likely to deliver disappointing long-term results to investors purchasing, or holding, at these prices.

The dollar’s purchasing power is equal to the dollar index in March 1995. The Dow is at the same level as it was in 1998. Merrill Lynch’s list of the 20 most widely held stocks is down for the year with only 4 stocks up in 2005.

Consumer spending has been the tail that has wagged the dog the last several years, and it appears to be slowing. According to a recent issue of Financial Times: “Many economists believe that the US has been living in a fool’s paradise. Its debt to the rest of the world looks set to rise steeply over coming years. By the end of the year, the US is likely to be paying more to service its debts than it receives in foreign income. As this happens, America will find itself borrowing not just to fund current spending, but simply to service previous debts – a position more commonly associated with a developing country.”

The way to make money in the stock market over time is to purchase stocks when they’re a bargain. Historically that means, on the Dow, purchasing stocks selling at less than the historical average price earnings ratio of 14.2 times earnings, and paying a dividend with yields in excess of 4%. We’re not there, and we won’t be unless the market sells off by another 30%, or corporate earnings and dividends increase by 30%, or a combination of the two.

At this point it appears we are still several years away from stock market values that can provide us anything other than mediocre returns, at best. Bill Gross, managing partner of giant bond fund PIMCO states: “Over time stocks don’t do any better than the rate of increase in a nation’s GDP, and the US rate of GDP growth is estimated to be about 5%.” The 10 year Treasury Note yields 4.2% with little risk involved. The conservative investor will stay with short and intermediate term bonds; A-rated, high yielding, low price to earnings ratio stocks; or cash, and bide their time by collecting interest until stocks are again a bargain.

Caveat Emptor.
George Rauch
www.gwrauch.com
August 27, 2005

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