Market Watch - January 3, 2007

Happy New Year - Summary of Last Year

2006 was a stellar year for investors in the stock markets. The Standard and Poor Index of 500 stocks was up 13.6%, the NASDAQ was up 9.5%, and the Dow Jones Industrial Average was up 16.3%. The gain in the stock markets started in August of 2006. Prior to then, the market had gone nowhere in seven years.

Interest rates seem to have peaked.

2006 represented a nice summary of world economic growth over the past 100 years. Economic growth the last century is the story of an expanding pie. Last year represented a continuation of this expanding global economic pie with increasing productivity, and asset values, around the world. 2006 was a year of economic growth and expansion throughout the world.

Concerns

In the process of these huge spurts of capitalistic expansion over the last 100 years, outsized displacements of economic and political power have led to wars.

The elements of production are land (resources), labor, and capital (money for investment). In the United States, for example, a large trade deficit represents an outflow of capital to other trading nations who take in more of our money than we take in of theirs. In the old days, the United States would have to settle the account in hard money like gold. Today, we are able to write a check from The Federal Reserve System which obligates future American taxpayers to pay the principle and interest on that debt. 80% of the toys that were purchased for the holiday season in 2006 were made in China. That represents a large displacement of labor from the United States to China who make cheaper toys by paying lower wages. Our technological superiority is overcome in the competitive markets of the world by a lower cost of labor.

A newborn baby’s share of the U. S. federal debt is $160,000.

The Heritage Foundation points out that the federal government spends more than $22,000 per household annually. The average revenue (tax) intake per family per year is $19,000, representing a $3,000 deficit per family which must be financed with debt.

U. S. assets represent $54 trillion of value. U. S. obligations include $38 trillion of debt. The magnitude of this debt is increasing annually. More worrisome are the unfunded liabilities for Social Security and Medicare which economists agree exceeds $50 trillion. Adding that to our $38 trillion worth of debt creates obligations of $88 trillion. With only $54 trillion of assets, our country is upside down. If we liquidated our assets to pay our $88 trillion worth of obligations, we would not only be left penniless, but we would still owe $34 trillion.
John Mauldin’s new study, syndicated last month, shows that 1/3 of the gain in GDP in the last several years has been a result of people spending equity extractions from their homes. The continued borrowing, and spending, of money from home equity loans, has caused 1/3 of the gain in our GDP in the last several years. This borrowing is adding tremendously to the mass of future obligations families are incurring.

Since 2001, 73% of new government borrowing has come from foreigners. Interest payments on these borrowings will be paid to overseas holders of the debt. Those interest payments are likely to be spent upon expansion of businesses outside the U. S. in competition with the U. S.

In 1979 the top 1/10th of 1% of tax payers paid 8% of income taxes; the top 1% paid 18% of all income taxes and the top 10% paid 47% of all income taxes. Today the top 1/10th of 1% of tax payers pay 17% of all income taxes, the top 1% pay 33% of all income taxes and the top 10% of income tax payers pay 67% of all taxes. How much more money can be taxed from “the rich” until we have a mass exodus of capital from this country? There have been numerous articles recently about wealthy Americans giving up their citizenship strictly because of taxes. The late Milton Friedman published figures just before passing away pointing out that in 1930 the total share of the U. S. economy directly controlled or dependent upon the government was about 11% of our GDP. Friedman pointed out that currently over 50% of our economy represents the government’s share of our GDP. This reduces the wealth creating machinery of free enterprise by subjugating the private economy to an auxiliary engine for government. Private resources remain under constant attack by government.

Because of huge debt obligations, we can be certain that inflation will remain in our future. Less than 100 years ago, when the Federal Reserve was founded (1913), it took only $1 to purchase what it takes $50 to buy today.

The median family has $3,800 in the bank; they do not have a retirement account; their house is worth $160,000 with a mortgage of approximately $95,000; and they have no mutual funds or stocks and bonds. The median family makes $43,000 annually and struggles to pay off their $2,200 of credit card debt. This means that 50% of American families are worse off.

Grave Concerns

In the January 2007 issue of Harper’s Magazine, Eisenhower was quoted as saying, “…until the latest of the world’s conflicts (WWII), the U. S. had no armament’s industry.” President Eisenhower then went on to coin the term “military/industrial complex” which was written about extensively by former Harvard economist John Kenneth Galbraith. In the Harper article, Professor Chalmers Johnson from University of California San Diego, states that the “business of the United States is armaments, weapons manufacturing, weapons sales and war”.

In the Middle East we are dealing with unreasonable and intolerant people. Unreasonableness can be dealt with, but intolerance coupled with aggression only leads to war. The history of the Middle East is a history of religious aggression that leads to submission of entire populations, followed by their attrition to other countries.

Iran, the fourth largest producer of oil in the world, ships its oil through the Persian Gulf where 1/3rd of the world’s oil supply originates. Iran is surrounded by mountains and has a population four times the size of Iraq. Iran has military command of the eastern and northern boundaries of the Persian Gulf. They have an army of just under one million men, 1,600 tanks, 2,200 armored vehicles, 3,200 artillery weapons, 300 combat aircraft, 600 attack helicopters, 3 submarines and 50 surface ships patrolling the Gulf. On the east coast of the Mediterranean, Syria has 215,000 men, 4,700 tanks, and 650 aircraft.

t is conceivable, taking into account all the above facts, that the “War on Terror” will suffice to create the next bubble. Think about it: military armaments represent the last area of manufacturing in the world where the U. S. still claims unequivocal leadership and superiority. With real growth of zero because of inflation, with the government desperate for revenues, with the real estate industry going into the tank, with tyrants, who cannot live at peace with each other, ruling many countries in the Middle East, why wouldn’t our government officials, and their partners in the military/industrial complex, lead us into war? War is profitable, it provides for employment, it is justifiable, and it’s a problem that won’t evaporate. We do it now or deal with it in the future.

Forecast

Neither Market Watch, nor anybody else, can forecast where the market’s going tomorrow, next month, or in the Spring. There is an old Wall street saying, however, that “the trend is your friend”. The market is clearly in a bull cycle, and the trend is up.

The current Dow Jones Industrial Average is 22 times earnings, way above the historical price earnings ratio of 14.5 times earnings. The chart points out how historical returns look, based upon P/E ratios, in the ten years after those price earnings ratios were realized.

With current price earnings ratios on the S & P 500 stocks of 19 times earnings, and current Dow price earnings ratios of 22 times earnings, the market is priced for returns over the next ten years of 5% from an historical point of view.

The investors who want long term growth and safety, will most likely succeed by purchasing A-rated, well known, dominant companies in their industry selling at historically low price earnings ratios, and/or historically high dividend yields.

Caveat Emptor.
George Rauch
January 3, 2007