Should We Be Confused By This Market?

No, we should not be confused by this market. It is doing exactly what is expected. There is a giant amount of liquidity, meaning enormous amounts of money available today. “Excess” liquidity will cause investors to chase a limited supply of opportunities. Hence there will be an economically unjustifiable increase in the value of the stock market and in the value of real estate. Today we have inflated stock markets and inflated real estate values.

However, excess liquidity is a self correcting problem. And the way it is corrected is by inflation.

Let’s look and see what is happening to the monetary supply and see if we can relate that to what might be expected to happen to the stock market. The Federal Reserve System has eliminated publishing M3, the total money supply, because they deem the publishing of those numbers “unnecessary”. (Could it be that the Fed is creating so much money, so quickly, that they have done away with M3 to hide from us what is really happening?) The numbers below are close, and conservative, but actual numbers are not available:

M3 Money Supply	Money Created Last 12 Months	% of New Money
$11.6 trillion	$740 billion	6.5%

6.5% of new money created in the last 12 months is, interestingly, close to real inflation.
The government’s numbers would have us believe that inflation is a lot less than 6.5% but, in fact, it appears inflation is humming along at the 8 to 9% level.

Bull & Bear Market - Tops and Bottoms
# Years	Bull/Bear	Action	PE	Yield (%)
1929-1942	Bear	Buy	10.5x (*)	6.2 (*)
1942-1965	Bull	Sell	18	3.1
1965-1981	Bear	Buy	6.8	6.1
1981-2000	Bull	Sell	33.9	1.6
2000-2006	Bear	Buy Values Only	18.3	2.6

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

Look at the above chart. The bold years on the left side of the chart represent the end of a bear or bull market when values dictate optimum times to buy or sell. Notice that bull markets, at their top, have high price earnings ratios and low yields, just like today. Bear markets, however, are characterized by very low price earnings ratios and high yields. This chart indicates that we continue to remain in the middle of a bear market. Values have not yet deteriorated to a point where mass buying opportunities are available. There are currently some good buys in the stock market as we have mentioned in previous articles. Bank stocks and pharmaceutical stocks remain depressed and in a good area to begin accumulating the better companies. The rest of the market remains too high priced to make any sense out of any significant positions. This is particularly true when we can sit on our cash and receive interest payments equal to more than double the average yield on stocks.

We have mentioned before that we feel the bear market that began in the year 2000 will last for 10 to 15 years. Bull and bear markets tend to have 14 to 17 year time frames. We are only into the sixth year of this bear market, which followed an 18 year bull market from 1982 to 2000. Bear markets are created by economic dislocations like inflation, high debt and gross, government sponsored, economic dislocations such as outsized borrowing and untenable international balance of payment positions. Undisciplined spending has created massive current account deficits, such as ours, which is accumulating at more than $900 billion annually. Other economic facts that mitigate against the stock market turning in a strong performance for the next several years are as follows:

1)		The price of gold has rapidly increased. Gold is discounting the future value of the dollar. Expenses in this country are going up because of inflation; the enormous debt of the U. S. is compounding; and our unfunded Medicaid and Social Security obligations are so out of control that the country’s leading experts cannot agree upon the amount of the obligation within trillions of dollars.

2)		Bank credit has recently surged at a rate in excess of 13% annualized. Liquidity since 2002 has provided almost $3 trillion of loans against people’s homes, most of which has been spent on items that will produce no income. Consumer spending of 70% of our GDP can be expected to slow down with interest rates increasing, home building slowing down, and consumer income being eroded by high rates of inflation.

3)		The Dow is selling at almost 23 times earnings and yielding less than 2.3% against average historical price earnings ratios of 14.4% and average dividend yields of 4.3%; the S & P 500 price to book ratio is in excess of 3 to 1, more than double the historical norm of 1.5 times; the S & P price/dividend ratio is 54, about double the historical norm of 26; and the S & P price revenue ratio is at 1.5 times, almost double the historical norm of 0.8 times.

The above strongly indicates that the value investor is not being served by this market. Outside of what is mentioned above concerning a few industries which are currently a buy, there are no other buys in this market because no other values exist. Think about the frustrating times of the 1970s up to 1982 which we called stagflation. By all appearances, what do we have now? Stagflation!

The last 35 years, M3 (total money supply) has increased an average of 7.8% a year. During Greenspan’s tenure, M3 increases averaged 5.9% annually. Were it not for the fact that the European Union, Japan and most other free economies are increasing their money supply faster than we are, the U. S. dollar would be further in the tank than it is. Competitive increases in money supply have given the public an image of economic prosperity. America has been prosperous over the last 50 years, but we should bear in mind that we have “window dressing prosperity”. Destruction of our monetary system by creating dollars out of nothing with no value behind them, and no implied discipline like gold and silver, has caused our inflation adjusted economy to grow since 1971 at only 1/3 of 1% per year. Between 1945 and 1971, however, when the dollar was fixed to gold at $35/ounce, real U. S. economic growth was 4% a year.

Conclusion
We continue to point out that the stock market remains on tenuous footing. As Warren Buffet wrote in the current Berkshire Hathaway Annual Report: “The underlying factors (welfare payments including Social Security and Medicaid, and wars) affecting the U. S. current account deficit continued to worsen, and no let up is in sight. Our trade deficit hit an all time high in 2005, and soon, our balance of investment income will turn negative. As foreigners increase their ownership of U. S. assets (or of claims against our assets) relative to U. S. investments abroad, these investors will begin earning more on their holdings than we do on ours.” Mr. Buffet is saying that as long as the U. S. borrows 80% of the world’s loanable funds each year, we are creating huge obligations to foreigners which are compounding, and which will be extremely expensive to service and amortize in the future. Indeed, under current circumstances, our indebtedness will be impossible to service without massive increases in inflation.

It is more likely the market will go down, or nowhere, from its current levels, than it is that the market will produce significant gains in the next few years.

Caveat Emptor.
George Rauch
May, 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.

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