Market Watch - January 27, 2006

Markets At Least 30% Overvalued

Last month Market Watch mentioned that the stock and bond markets were 30% overvalued. Many requests have been received for explanation and mathematical verification of that opinion. Here ‘tis:

1. BONDS
The ten year Ttreasury note currently yields 4.51%. That means for every $1000 bond an investor will receive cash of $45.10 annually until maturity. The ten year treasury bond is used to set almost all variable rate mortgages and notes in this country. The long term return on the treasury bond is 2.8% over inflation. If one adds the current rate of inflation at 4.4% to the 2.8% that bonds have yielded above inflation over the last 50 years, the yield on the Treasury bond “should be” 7.2% or $72 per $1000 bond. If the price of the Treasury bond dropped from $1000 to yield $72 per bond, the treasury yielding 4.51% would drop in price from $1000 to $626 per bond ($45.10 divided by 7.2%). So, in real dollars, the ten year treasury note is over priced by more than 30%.

2. STOCKS
The historical Dow Jones Industrial Average (DJIA) price earnings ratio is 14.4 times earnings. The current price earnings ratio of 18.1 times earnings adjusted to the mean, would find the Dow selling at 8700, 2200 points below the existing market prices, or more than 20% below current prices. However, the historic cash yield on the Dow Stocks is 4.3%, and the current yield is 2.3%. The Dow adjusted for a reversion to the mean based upon yield, would cause the Dow to return to 5800 points (10,900 points x 2.3% = $251.00 divided by 4.3%). 5800 is 49% below existing market prices. An average of where the market would be based upon both yield and price earnings ratios would reduce the 10,900 Dow by 35% for an average price of 7,100 points.

Question: If that’s true, and it is hard to argue with mathematical facts, doesn’t the market currently bear an awful lot of risk?
Answer: Yes, the market is very risky. Not only is the market mathematically overvalued, but overhanging the market are all the economic dislocations Market Watch has been writing about: record trade deficit; record federal deficit spending; loss of manufacturing base in U. S.; high inflation; high energy prices; very expensive housing, and record high consumer debt; all coupled with a loss of higher paying jobs.

Question: We have read that these are new times and that all of the old averages really do not apply to markets today.
Answer: Market Watch heard that in the 1970s, the 1980s, the 1990s and here we are in the 21st century. Economic facts are economic facts and they don’t change—they’re timeless. Human emotions change. While we are in a period of high price earnings ratios and low yields, we have been there before in the last forty years. Every time in the last forty years when panic has ensued, the market has dropped way below its averages. Similarly, when people are optimistic, the markets rise well above the mean and become over priced. The truth of the matter is that nobody really knows where the market is going, and the only thing that we can reasonably do is to assess the current risk of the market. That assessment indicates markets are overpriced. Overpriced markets take steep dives when panic ensues. While panic has not yet arrived, we are set up for stock market problems with all the economic dislocations that exist today—more than any time since WWII.

Question: Most Wall Street analysts are very upbeat and see a good performance in the stock and bond markets over the next 12-24 months. Can you comment on this?
Answer: Wall Street analysts are too close to the forest to see the trees. Most analysts work for firms that deal in securities. More than 70% of the analysts believe the market is performing well and will continue to do so over the next few years. Until this sentiment changes, it is not likely that the market will go down severely. However, the market can go sideways like it has been doing for years, and essentially go nowhere. Analysts are trying to convince the public to stay in the market. Market Watch is suggesting that it’s wisest for investors to limit the percentage of money they have at risk in the stock market. Furthermore, if one has invested in stocks in this market, an investor is far better off to invest in high grade, A-rated, stocks selling at a low price earnings ratios and yielding more than 4%.

Question: If bonds are so overvalued as stated above, why would anybody invest in them?
Answer: Good question. Complicated answer which we will try to make simple:
1. Since Greenspan took over the Fed, the money supply has grown from $2 trillion to $10.3 trillion, far out pacing GDP growth;
2. Household debt has increased from $1.8 trillion to $10.8 trillion, far exceeding the increase in wages;
3. During Greenspan’s tenure, the purchasing power of the dollar has been reduced by 50%. Think about anything that you bought in 1982, and it costs at least twice as much today.

All that money floating out there is going to be put to use. Quite simply, if it’s not invested or spent on consumer items, it will be placed in treasury securities, now equal to $8.2 trillion, more than ten times the national debt during the Regan administration when Greenspan became head of the Fed. Many institutions are required to keep a certain percentage of their money in the safest investments. And the safest investments are still U. S. Treasury securities.

Question: All that extra money out there, then, has created huge amounts of excess savings around the world. Shouldn’t we be grateful to the Fed?
Answer: This is really a political question that only can be answered from either a conservative or liberal point of view. The liberal point of view is that the government is great, the Fed has done a wonderful job, and we should carry on by having continued government interference in, and regulation of, the economy and our monetary system. The conservative point of view is that we should go back on the gold standard, get rid of the Federal Reserve System, drastically reduce the size of our government and get back to the Constitution as our guideline. Market Watch has no opinion except to let readers know that they are at great risk in the stock market due to current economic trends.

Question: Isn’t there room for moderate thinking?
Answer: Moderate thinking is what has brought us what we have today. No question we live a good life and that lots of opportunity exists in America to do well. The question is at what point these economic dislocations created by the government will cause a severe economic crisis from which it would take many years to extract ourselves. Nobody can project whether or not something like that will happen—all we can do is be aware of the fact that it could happen and handle our investment life accordingly.

Question: Aren’t we just coming out of a severe economic downturn, and aren’t things getting better?
Answer: This country has been frustrated economically for six years, and we have “muddled through” this period because our government creates consistently huge amounts of new money. All that is required is paper, ink, machinery and some labor. As long as Americans, and as long as the rest of the world, are willing to go along with this scenario, we will be fine. However, historically, every single paper monetary system has failed, most with catastrophic consequences.

Question: What can we expect, historically, out of the market over the next ten years?
Answer: October Market Watch published a chart that showed the historical average increases in the market each ten years subsequent to the average ten year Treasury bond yield. That is published here as exhibit I. Right now, with ten year bond yields at 4.51%, we can expect, from a historical perspective, a 4.3% annual average gain (including dividends) over the next ten years in the stock markets. That yield might keep us abreast of inflation.

Conclusion:

The 4th quarter of 2005 GDP advanced at a rate of 1.1%, less than inflation in the 4th quarter, and much less than the 3rd quarter rate of increase in GDP of 4.1%. On the other hand corporate earnings last year were excellent, with many corporations establishing new earnings records. The wile investor will bide their time, wait for better buys to become available in the stock market and realize that patience in investing provides long term dividends. With price earnings ratios and yields having improved over the last six years, one is better off to be in short term Treasury securities or tax-free bonds, and limited percentages of stocks, with those stocks priced at, or below, their average historical price-earnings ratios.

Caveat Emptor.
George Rauch
January 27, 2006

*In future months, we will track these investments to see how they are doing and to commit further amounts of capital to the stock market when good buys become available.