Market Watch - January 26, 2007
Most of the world’s financial transactions
are settled in dollars, euros, yen and pounds. And there are lots
of all of them to go around. Central banks are creating money out
of nothing faster than any other time in history. When there is
more money than goods in an economy, the price of the goods will
increase to absorb the massive amounts of money existing to purchase
those goods. That is called price inflation which we are all well
aware of today.
Inflation puts special demands upon investors because the cost of
everything increases: real estate, cars, food, fuel, and so forth.
Because of all the money (liquidity) rolling around out there, stocks
and bonds become overpriced, too. If a stock is overpriced, the
stock is selling at a price earnings ratio significantly higher
than its historical average. Dividends paid by those stocks are
low by historical means. If a bond is overpriced, it means the yield
(annual cash return on the bond) is lower than at other relative
times in economic history. Interest costs on borrowed money are
under priced, and yields, therefore, are “theoretically insufficient
to provide for a reasonable return on the money borrowed”.
Money is cheap, now, from an historical point of view. Never has
so much money been so inexpensive to borrow.
Time changes the disposition and value of markets. But in the meantime
we need to be judicious about our investments. With lots of money
pushing up the price of everything, and yields lower than they “should
be”, there will become a greater demand for income. Stocks
that pay high current yields can be expected to increase in price
as demand for income increases.
Stock brokers are fond of touting “growth stocks” under
these circumstances. The problem with “growth stocks”
is that they are all selling at better than 18 times record earnings,
and their dividend yields are low. Large corporations, with their
overpriced stock, use the stock to purchase other assets. Wall Street
loves it because they are swimming in money; the government likes
it because it increases their tax revenues; and the economy likes
it because it keeps people employed.
It behooves the investor at this time to purchase well known companies
that pay dividend yields that are high by today’s standards.
Dividends act as a stop against the deterioration in the price of
stock. The cash dividend, when a stock is going down in price, will
cause the stock to act like a bond and place a floor upon the downward
movement of that stock. At that point, the stock trades upon its
dividend yield, just like a bond trades. These stocks are known
as “value stocks”. Over a period of decades, it is well
known that “value stocks” (low price earnings ratio
stocks that are currently out of favor and which have a high dividend
yield) outperform the sexy growth stocks.
Most investors understand this concept, but they do not know what
companies are available. Lots of information is available on high
yielding, dominate stocks. For example, Citigroup Inc. is yielding
3.6%; it’s an A stock; and it sells at 12 times earnings.
That is an excellent risk. Fifth Third Banks yield is 4%. It is
also an A-rated stock, and Fifth Third Banks sells at a price earnings
ratio of 15 times earnings. Home Depot, Merck & Co., Pfizer,
Popular Inc., UnionBanCal (Union Bank of California), Wal-mart Stores,
McDonald’s and Washington Mutual are all A stocks that are
depressed by historical standards. The above list of “value
stocks” represents companies that are well managed, and who
have a proprietary niche in their business. Their stock prices are
severely under-valued by the standards of this current stock market
of ours. There are many others, but these companies stand out as
being the most visible and secure of the well known undervalued
stocks, and they are all A-rated securities.
Fed Chairman Berneke Warnings about
Deflation
Dr. Ben Berneke, formerly a Princeton professor, and currently the
successor to Alan Greenspan as head of the Federal Reserve System,
was most concerned about deflation 24 months ago. He is one of the
leading proponents of the theory concluding the 1930s depression
and deflation resulted from “too little money in the spending
stream”. Dr. Berneke mentioned a couple of years ago when
he was a Federal Reserve Governor that “the Fed would drop
money from helicopters if they saw any indication of our economy
deflating”. That’s where he got his nickname “Helicopter
Ben”. He theorized that the Fed tightening of money in the
1930s, to let the economic problems work themselves out, was devastating.
He felt the Fed should have flooded the economy with new money as
they have today. If the Fed had created lots of money in the 1930s,
and it was floating around freely like it is today, there would
theoretically have been enough money out there to meet obligations
and avoid the depression.
A man who matches his deeds with his words, Helicopter Ben has been
pumping up the money supply at “Greenspanian rates”—he
knows it will create inflation, but he knows that the greater evil
is deflation. He does not want to have our economy face even a hint
of deflation.
When money is created out of nothing, there is going to be inflation.
Inflation becomes a result of more money around than there are goods
to buy. The price of goods increases to meet the supply of money.
We can criticize the Fed all we want for their policies, but the
facts are that we have had manageable inflation, relatively soft
landing, the market is up, the economy is fairly robust, and we
live in prosperous times. The outlook for world economic growth,
because of this money creation, is really very good over the next
5 to 10 years. Whoever said that government interference won’t
work?!
Conclusion
The Fed’s increase in the money supply, coupled with the money
supply increases from the rest of the world’s central banks,
has added a huge surplus of savings to owners of assets. Owners
of assets are enriched by the imbalance of money apportioned among
land (assets), labor and capital. Assets are increasing in value,
with inflation, like a rising tide.
Moreover, government feels that if we can maintain an adequate degree
of flexibility, some of America’s economic imbalances, most
notably the large current account deficit, the trade deficit, and
the savings deficit, can be rectified by adjustments in prices,
interest rates, and exchange rates rather than through more gut
wrenching changes in output, income and employment. But our current
policies critically undermine the value of the dollar.
Fortunately, for the United States, it is to no other country’s
advantage to see a plunging dollar. Unfortunately, our politicians
are involved in a very delicate balancing act instead of the noble
action of insuring our currency is unequivocally sound and “as
good as gold”. We are literally on the upper end of great
risk. We have become the world’s greatest spender, and greatest
borrower, and no currency has ever survived this test long.
The U.S. is now borrowing 80% of the entire world’s savings
to fund its deficits. We use 21 million barrels of oil a day; China
uses 6.3 million barrels; Japan 5.5 million; Russia 3.7 million;
Germany 2.6 million; and India 2.5 million barrels a day. So in
one day, the U. S. uses more oil than all of the above countries
combined. What happens if war creates a huge disruption in the supply
of petroleum products? Neither we, individually, nor our economy,
can survive profitably and happily without consuming a huge percentage of the world’s daily oil
output.
Inspite of these concerns, the market remains positive. The most
conservative position for an investor in this climate, which is
oddly the same position in which one is likely to make the most
money, is in the A-rated, dominant company stocks that pay a high
historical dividend, the so called value stocks. The balance of
funds can quite happily remain in 90-day treasury bills which pay
5%, double the cash dividend yield on the Dow Jones Industrial Average!
Be conservative and be careful. These are potentially perilous times,
the success of which has been built upon a house of cards.
Caveat Emptor.
George Rauch
January 26, 2007
