Market Watch - March 30, 2007
Last month we wrote that, according
to Dow Theory, the bear market was dead and a new bull market has
been born. The demand to own and hold stocks is greater than the
desire to sell those stocks.
In view of this good news we cautioned investors to remember that
even though we are in a new bull market, huge amounts of risk exist.
This is a very high priced market. The DJIA price earnings ratio
exceeds 22 times earnings, and the average dividend yield is less
than 2%. (The historical PE average is 14.2 times earnings, and
the historical average dividend yield is 4.2%). In such a posture,
historically, at these prices, the DJIA has only been able to average,
with dividends, a return of 4.8% per year over the ensuing 10 years.
Then why is there a bull market? And how can an investor keep from
getting burned when price earnings ratios are this high?
Let’s look at each of these questions
separately.
Why are we in a new bull market?
Bull markets are simply a matter of cash. A certain amount of excess
cash is going to go into the market regardless of the market’s
values. Pension funds build hundreds of billions of dollars a year
in cash, and those funds need to be invested. More significantly,
there is a lot of cash floating around the economy available for
investment purposes.
Question: We are reading a lot about
America’s negative savings rate. With a negative savings rate,
how can cash be available to invest in stocks?
Answer: Good question. Here are the
latest statistics on central banks that point out how much new money
has been created by them this year: the Australian dollar is increasing
at the rate of 13% annually; the Euro is up at the rate of 9.3%;
the Pound is up 13%; the Chinese currency is up 16%; the Russian
Rubble up 45%; and the grand-daddy of them all, the United States
dollar, is increasing at the rate of 11% this year. All of those
increases are substantially greater than the forecasted increases
in GDP in each of those countries.
Question: Isn’t that inflationary?
Answer: Bingo! If the economy is
growing at a 3% rate, and currency is growing at an 11% rate, there
will be a lot more currency out there chasing a limited increase
in assets. The shortage of assets available to purchase, as compared
to the money out there to purchase those assets, will cause the
price of the assets to increase to reach the money supply available
to purchase them. That is the most fundamental form of inflation.
Question: The high for the Dow in
2000 was 11,722. The market is currently around 12,481, which represents
a gain of 759 points over seven years. That is only a 6.5% return
in seven years. The return is less than 1% a year, and treasury
bills are paying about 5%. Why would investing in the market make
more sense than owning treasury bonds?
Answer: One may be better off owning
treasury bonds. As pointed out above, the expected return on the
Dow Jones Industrial Average over the next ten years is less than
5%. We will discuss below the circumstances under which an investor
might eek out better than 5% compounded returns over the next ten
years.
Question: This is all very confusing.
We are in a new bull market, but it is already overpriced, and the
bull market was just recently confirmed last month. We have the
government making new money at a record pace, which encourages inflation.
The above Market Watch comments on the amount of money that the
Fed is making is amazing, and nobody knows those statistics. How
can it be rationalized that so little of this is known to the investing
public?
Answer: Again, a good question. Perhaps
the best thing to do would be to quote a communiqué from
the Rothschild Investment House in England, to its associates in
New York, when the Fed was being founded in 1913: “The few
who understand the system will either be so interested in it’s
profits, or so dependent upon its favors, that there will be no
opposition from that class. On the other hand, the great body of
people, mentally incapable of comprehending its complexities, will
bear its burden without complaint.”
Question: Is it a bad situation we
are in, or a good situation?
Answer: In spite of our federal spending
deficit and our trade deficit, America is very well positioned for
prosperity over the next several years. This is reflected in the
new bull market where several good stocks are bargains.
How Can an Investor keep from getting
burned when PE Ratios are this High?
The Dow Jones Industrial Average (DJIA) is the most widely followed
stock index in the world. The average PE Ratio exceeding 22 times
earnings means, mathematically, that there are a substantial number
of those DJIA stocks with price earnings ratios of less than 22
times earnings. The Standard and Poor Index of 500 Stocks bears
the same mathematical truths for a larger universe of stocks than
just the 30 DJIA stocks. There are many A-rated companies that are
dominant in their industry that sell for price earnings ratios substantially
under their own historical averages. Many pay good dividends of
around 4%, or better. These companies are known to be cheap. Theoretically,
in a bull market, the market will pull those stocks up, thereby
providing the investor with both nice dividend income and a nice
capital gain.
Question: How can you tell when these
stocks are available?
Answer: They usually come in bunches,
by industry. At the present time, the banking industry and the drug
industry have the most stocks whose criteria could define them as
bargains, or cheap stocks.
Question: Why would an investor purchase
stocks in those industries that appear to be having so much trouble?
The drug industry is mired in litigation. The banking industry could
suffer severe losses if they have to absorb existing bad loans along
with the forecasted failing loans in the real estate industry.
Answer: The reason these companies
are “cheap” is because the investing public is aware
of the risks. They are unwilling to assume the risks at any prices
but the present depressed market prices. There are many good companies
in each of those industries that can be purchased now at favorable
prices. With good management, the investor will continue to receive
dividends. Additionally, at some time in the future, those company’s
stock prices may become high enough that their price earnings ratios
establish the upper end of the average.
Question: We can see how people are
going to need drugs forever. But, what about the possibility of
these big banks failing when more and more loans are defaulted upon?
Answer: Financial stocks make up
22% of the Standard and Poor Index of 500 Stocks. Like great economic
empires before us, the US has lost its low cost manufacturing base.
Ultimately we will become an assembler in even sophisticated military
hardware and software manufacturing, because components will be
able to be made so much less expensively elsewhere around the world.
We are now, and we are destined in the future to be, the world’s
banker. The dollar represents more than 2/3 of all the money in
the world. The money business is one of the biggest growth businesses
in America. Our monetary systems managers are the best in the world,
and their skills have been learned from the best business educational
institutions in the world. Like the drug business, the money business
has been very good in the last several decades. All indications
are that our financial institutions are well enough managed that
the better ones will survive the potential surprises of the next
few years.
Conclusion
The market was pounded three weeks ago, yet it remains at a price
about 800 points above the 11,722 points registered in 2000. It
seems that the bear can no longer bring the market to its knees.
In a market confirmed as a bull market by Dow Theory, the best odds
for both holding onto your money, and making a nice capital gain,
exists in bargain stocks. Look for companies that are dominant in
their industry, that are A-rated by reputable rating agencies, and
whose stock sells at a price earnings ratio less than the company’s
historical average. By all means, ensure that those stocks also
pay a good dividend of more than 3% and that the company has a good
historical record of increasing their dividends.
Caveat Emptor.
George Rauch
March 30, 2007
