Should We Jump Into This Market?

Absolutely not. Easy does it. Focus upon short term money market instruments and continue to accumulate at least “A” rated stocks that sell at a PE ratio of less than their historical average and pay a dividend equal to 4% of the purchase price, or better. Buy stocks that lead their industry. Stick rigidly with this plan and one can stay ahead of inflation, enjoy long term growth in their portfolio, lower risk, and sleep at night.

Question: The Dow just passed the record established six years ago of 11,722 points and zipped through 12,000. Shouldn’t the cagey investor be fully invested in stocks?
Answer: The average DJIA PE ratio is 18 times earnings today, considerably better pricing than the PE average in 2000 of 29 times earnings. The Dow would top 19,000, a 60% increase from current levels, if the PE ratio were 29 times earnings today. That could happen with all the liquidity that exists today, but the risk is great that the market might go down, rather than up. At these current levels of 12,000, the market is still severely over-priced.

Question: Why does Market Watch say the market is currently over-priced?
Answer: The historical DJ average yield is above 4%, and the historical PE average is 14 times earnings. At today’s prices, the average PE, as mentioned above, is 18 times earnings, or 30% above the historical average. If the market returned to average PE levels, the market would be priced at 9,500 points.

Question: Market Watch mentioned “liquidity”. Exactly what does liquidity mean?
Answer: Liquidity is cash available in the economy to invest and/or spend. There is a lot of cash available to borrow at the banks because the Federal Reserve System continues to create billions of dollars a week out of nothing. It’s a “dream come true” for governments: unaccountable creation of money out of nowhere. This “money creation” has theoretically helped to smooth out the rough spots in our economy. Government interference in the economy to smooth out recessions is at the heart of Keynesian economic thinking. The government has severely ratcheted up the creation of money over the last six years to stave off a potentially devastating recession. And while that has worked, for every action there is an opposite “correcting” economic reaction that will be painful when faced in the future.

Question: What correcting reactions are likely to be painful?
Answer: The administration told the public last week that the 2007 fiscal year will show a deficit of less than $200 billion, but that’s because the government plans to borrow $350 billion from funds like Social Security for a real deficit of at least $550 billion. The painful corrective action is that we have to pay interest on these borrowed funds and there is already a big shortfall in the Social Security Fund needed to meet future retirement obligations.

A further corrective action that’s painful is inflation. The continued creation of money out of nowhere, plus these outlandish deficits, is setting the stage for a healthy additional round of inflation, which hurts everybody. The government says inflation is under 3% per annum, but reputable independent economic studies (Harvard, University of Michigan, etc.) show inflation to be in excess of 7% currently. It is obvious that the dollar in ten years will purchase considerably less than it does today, just as today’s dollar purchases considerably less than 1996’s dollar.

Question: Market Watch has repeatedly pointed out that consumer spending has kept our economy afloat. Can we continue to count on the consumer to spend us to further prosperity?
Answer: Consumer spending has been tied into low interest rates, which rates encouraged home owners to borrow money against their homes. The residential real estate values in America represent about 1/3 of our national net worth of $54 trillion, or about $18 trillion.

Last year consumers borrowed $600 billion in the form of equity loans on their homes. The last eight months, inventories of homes available for sale have increased 38%—the largest eight month increase in history. Home prices have come down to the point where consumers, and lenders, must face the following difficulties:

1)		$800 billion of mortgages have negative equity;

2)		Another 10% of mortgages have no equity;

3)		If prices fall another 10%, a shocking 48% of homeowners would have negative equity;

4)		Household debt is $11 trillion, and $2.8 trillion of that amount will be re-priced at higher rates in the next 18 months because of variable rate mortgages.

5)		Bloomberg just announced, on Oct. 25th, that “sales of previously owned homes in the U.S. fell last month (September) to the lowest level in three years, and prices of single-family homes suffered their greatest annual decline since 1969.” Wow!

It would appear that the consumer is tapped out, and that the future use of their homes as ATM machines will slow down considerably.

Conclusion:

There is only one guaranteed course of action in the stock market, and that is the cycle of undervalue in stocks, to overvalue, and back to undervalue. David Fuller of the highly thought of FullerMarket service recently wrote: “We have often said that Wall Street is in a bear market, which we define as a generational long period of PE ratio contraction and rising dividend yields.” That continues to take shape.

Equally well thought of Marty Barnes, of the “Bank Credit Analyst”, writes: “The grinding equity bull market should continue. Valuations are decent and market multiples should expand when it is clear that the Fed has finished tightening.”

John Hussman of the Hussman Fund, who has been right much more than he’s been wrong, disagrees with Marty Barnes and writes: “The current climate in stocks is characterized by unfavorable valuations…..which are sufficiently high that total returns the next 5 to 7 years will probably fall short of Treasury Bill yields. This has been among the longest periods the market has gone without a 10% correction.”

Lowy’s Investment Services feels a brand new bull market started from the market low of 2002.

The above opinions are from four of the giants in the investment business. All are thinkers. Two are bulls while two are bears. Who knows what to believe? Record federal government deficits, record trade imbalances, increasing inflation, increasing taxes, decreasing real estate values, dysfunctional government! Lordy me!

Safe is smart. The plan outlined in the opening paragraph is the safest way to preserve money, create a good cash return on investment, receive good long-term capital gains, keep one’s risk under control, and sleep well.

Besides, before we get too excited about the market at 12,000, lets put into perspective a sentence previously published in Market Watch: “For us to be “even” in the stock market from the high of 11,722 six years ago, the Dow, because of inflation, would have to reach at least 14,000 points.”

Caveat Emptor.
George Rauch
October 27, 2006

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