Market Watch - May 31, 2007
On Wednesday, May 30th, the S & P 500 set a new record when it bettered its high established in 2000. This was the last major index to confirm the new bull market surge. Week after week the major averages are establishing new highs. This is a bull market that has discounted all bad news. The market is essentially saying that the bad news is not so bad, and that the economy will not suffer substantially in the event something breaks.
Question: What is meant by something breaking? What economic issues are there that the market has apparently discounted as not being material at this time?
Answer: The issues of the last several years that some economists thought might break our economy remain: staggering amounts of debt; federal government spending deficits; outsized trade deficits exceeding 6% of GDP; a shaky real estate market; and future U.S. federal obligations for social security and Medicare that can never be met.
Question: Market Watch has been writing for years about the risk of several of the above. How can the market just blow it off all of a sudden?
Answer: Let’s look at these issues individually:
Staggering amounts of debt. For years, the amount of debt created to produce another dollar of GDP has been climbing. Because our GDP continues to increase (it will exceed $14 trillion this year, up from just $3 trillion in 1981, and $10 trillion in 2002), the markets are assuming that the economy can handle and absorb the debt.
Federal government spending deficits: Federal government tax revenues (as well as state and local taxes) are way up. It’s estimated that federal tax revenues will exceed $2.6 trillion, up from $1.8 trillion in 2004.
Outsized trade deficit exceeding 6% of GDP: Historically, any trade deficit approaching 4% of GDP starts a run on the currency of the country with the large trade deficit. The U.S. trade deficit is the largest in history by a long shot, and the markets are unfazed. The market expects the earnings from U.S. overseas investments to produce huge earnings for stock holders of U.S. corporations. Theoretically, those earnings could offset our trade deficit. Mathematically, though, it is hard to figure out how those anticipated returns could ever turn the trade deficit positive.
A shaky real estate market: New home purchases surged in April as buyers took advantage of the biggest decline in home prices since 1970. There is plenty of real estate inventory available, but apparently the market feels those excess housing units will be absorbed without substantially hurting the economy.
Future US federal obligations for Social Security and Medicare that can never be met: Let’s face it—in an emergency, the government can simply change the deal. In a recent conversation with former House Majority Whip, Dick Army, he mentioned that the government will handle this problem by “means testing”. Means testing is simply a term that provides for reducing benefits to groups of people “who do not need the help”.
Question: Market Watch mentioned the S & P 500 just set a new record high and that it was the last major index to do so—what about the NASDAQ?
Answer: The NASDAQ is a market of highly speculative stocks, and it does not come close to the total value of the major indexes. The Dow Jones Industrial Average (DJIA) represents 24% of the total value of U.S. stocks and it’s only 30 stocks, and the S & P index of 500 stocks represents 75% of the total value of all publicly held U.S. stocks.
Question: What can we expect out of this market in terms of value increases?
Answer: That is an impossible question to answer, but we can objectively look at recent history. In the first four months of 2000, retail investors put $132 billion into the market. There is not yet evidence that retail investors are buying in this market, but rather, buying appears to be mostly institutional. Retail participation in this market could drive prices up rapidly. Should the market reach the levels that it reached in 2000, on a relative basis, the Dow could exceed 20,000 points.
Question: What is meant by “on a relative basis”?
Answer: The Dow Industrials currently sell at 18 times earnings. The Dow sold, at the height of the market in 2000, at almost 30 times earnings. This current market we are in would exceed 20,000 points if the price earnings ratios we saw at the height of the market in 2000 were applied to today’s market.
Conclusion
There have been hints lately that consumer spending is slowing down, yet the market absorbs this news and continues to increase without a major correction. The consumer represents 70% of U.S. GDP. U.S. GDP of $14 trillion is 30% of world GDP. Since so many goods are manufactured overseas, U.S. consumer spending increases the prosperity of our trading partners. Lost in this bull market are concerns of paying interest on the national debt. Lost on the public’s mind is any concern about ‘Freddy-Mac’s’ recent multi-billion dollar bailout of sub-prime home loans. Investors are willing to take lower average returns than in the past because of their belief that growth and prosperity will continue.
It is said that the U.S. is the only super power because we have the world’s most powerful military. But in reality, we are the only super power as long as the world is willing to accept our dollars. Our currency represents 65% of the world’s monetary reserves. Times are good. The dollar is going up in the face of experts saying it would go down. Continued prosperity looms.
Several Dow stocks are selling at their historically low price earnings ratio range. Citigroup, McDonalds, Home Depot, Johnson & Johnson, and Pfizer are a few. In spite of our economic dislocations, the market has a mind of its own. An old Wall Street saying is “The Trend is Your Friend”. Right now the trend is up, and all technical signs point to this being a big bull market.
Carpe Diem.
George Rauch
May 31, 2007
