Market Watch - March 2, 2006

Seven Lean Years And Seven Fat Years

Last month we provided mathematical support for the stock and bond markets both being 30% overvalued. There is another hugely overvalued market we have not discussed that should ultimately affect both the stock and bond markets and that is the real estate market which has seen housing prices rise by an astounding $5.5 trillion in just 3 years. The housing market is beginning to decelerate in value. New home sales have fallen to the lowest level in a year, and the number of properties for sale has risen to the highest level in 10 years. All of this has occurred with the Dow spurting to a five year high even though the Dow has been very selective in its rise. Only four Dow stocks have risen to new highs and only two are within 2 percent of their highs, while 15 Dow stocks are down 20% or more from their five year highs. The chart below should be informative in trying to figure out, at least from a historical point of view, what we might expect over the next few years.

* High and Low extremes represent optimum selling and buying opportunities, respectively.

Question: We are coming up upon seven lean years in the stock market. After that can we expect seven fat years?
Answer: In examining the chart, notice that at this time the Dow Jones thirty stocks are selling at a price earnings ratio and a yield that is equal to previous bull market tops, such as the 1942 to 1965 market. It’s impossible to predict, but history shows that we can expect values to improve substantially over the next several years during which time great buying opportunities will become available.

Question: When will that occur?
Answer: Nobody can answer this question, but it can be pointed out that in addition to values still being overpriced, the average length of a bear, or bull, market over the last century has been around 17 years. We are only six years into this bear market, so history indicates we are not even halfway through the current bear market correction.

Question: Values have improved and the economy has improved. Why shouldn’t we expect the market to improve too?
Answer: The market may improve over the next several years. Odds are, however, that the economic dislocations we’re living with will have to be worked out before any substantial improvement in the market occurs. Economic dislocations create risk, and the market, like no other barometer, accounts for risk. Notice that the previous bear market from 1965 to 1981 saw average price earnings ratios as low as 6.8 times and yields as high as 6.1%. Current stock market values of 18.3 times earnings are more than double previous bear market bottoms, and yields of 2.6% are less than half of previous bear market bottoms. Bear markets exist because of bull market extremes. A bear market will persist until the economic dislocations of the previous bull market have been rectified.

Question: These are different times. Can’t the market reflect this difference, too?
Answer: The market can do whatever it wants. Smart investors play the odds. The odds are that values in the market will continue to improve over the next several years, and buying opportunities will be much better than they are today.

Question: Market Watch previously discussed the possibility of putting 30% of ones capital into Bank of America, the gold ETF (GLD), and US Tobacco. Why would it make any sense at all to have 30% of your funds invested now if values may get better in the future?
Answer: Bank of America and US Tobacco are both selling at very high yields with price earnings ratios much less than their historical averages. There are always industries in every market where certain values dictate it is time to buy securities in those industries. Banks, tobacco stocks and drug stocks are currently undervalued and represent buying opportunities now.

Question: What are the economic dislocations that need to be addressed?
Answer: Consumer prices are now increasing at an annualized rate of almost 9%; the market has priced into bond prices two more increases in the federal funds rate indicating that upward pressure on interest rates still exists; the money supply increased $700 billion last year; the trade deficit was $728 billion last year; the federal spending deficit was $650 billion last year; consumer borrowing was $600 billion last year, and we have an inverted yield curve.

Question: Can we break it down a little bit and start by explaining the inverted yield curve?
Answer: An inverted yield curve means that short term interest rates pay more to the investor than long term interest rates. The bond market is saying they expect a recession, which usually means interest rates will come down over the next few years. Bond buyers, therefore, are trying to lock in good rates for the long term.

Question: Will continued consumer borrowing, record trade imbalances, war and outsized federal spending deficits adversely affect the market’s performance?
Answer: Probably. Remember that bear markets exist to rectify the excesses of the past. In 1995 when the last part of the great bull market began to take the market to extremes, there was a federal spending budget surplus, no war, reasonable consumer borrowing and favorable trade deficits. Expenditures in excess of income create debt. Debt requires interest payments, and debt must be paid back. Interest and principle payments require future cash expenditures that otherwise might be used for more productive purposes.

Question: Won’t the government just print more money to meet our future obligations?
Answer: That’s the problem, and that’s what the market sees. Plus, inflation is now running in excess of 8%.

Conclusion
There are four wild cards in the stock market outlook:

1. Middle East;
2. potential further breakout of oil prices on the upside;
3. the U.S. housing picture;
4. the value of the U. S. dollar.

As we know now, we went to war in Iraq based upon a set of assumptions that were erroneous. Market Watch wrote an article published in March of 2003 entitled “The Real War-Euro vs. Dollar”. Iraq had begun selling oil in euros instead of dollars, the accepted currency for trading in oil throughout the world. Since dollars are 70% of the world’s money supply, conversion to yen, gold or the euro in oil pricing could have potentially devastating effects upon the cost of oil in this country and upon the value of the dollar. Iran has now announced a new oil bourse which will start next month and on which Iran will sell their oil in euros. The administration’s haranguing about Iran’s nuclear capabilities and political instability are carbon copies of comments we heard prior to U. S involvement in Iraq. Could the probable economic difficulty created by selling oil in euros instead of dollars be serious enough to affect the dollar’s value in international trading, and could it pre-empt a strike against Iran to prohibit their commencement of a new oil market in euros? Such a scenario would clearly affect the stock and bond markets.

The vibrancy of the U. S. housing market will influence both the value of the dollar in international markets and interest rates here at home. If interest rates increase, the dollar will remain more attractive for international investors and will probably retain its value. If interest rates level off and go down the dollar will be less attractive in foreign markets, and foreign investors will be less likely to continue to fund our large trade deficits by purchasing U. S. bonds. In summary, a reduction in interest rates in this country could save a currently deteriorating housing market, but make the dollar less attractive to foreign investors who are desperately needed to absorb U. S. trade and federal spending deficits.

Conclusion

Investors can look forward to instability over the next several months. Dividends are still historically low and price earnings ratios are historically high. The problems on the horizon dictate that the conservative investor will continue to keep a lot of their assets in cash, or cash related investments, and wait on the sidelines for values in the stock market to improve.

Caveat Emptor.
George Rauch
March 2, 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.