Market Watch - October 26, 2007
In spite of headlines predicting disasters from sub-prime loans, excessive U. S. borrowing, housing inventory build-ups, a continuously lower U. S. dollar, commodity inflation, gasoline prices, overextended personal debt, and war all over the globe, the Dow Jones Industrials August 16th low of 12,846 points was higher than the December 31st, 2006 close. Today, the market is 1150 points higher than the August 16th close. That represents a 9% increase from the August 16th close. So far this year, the Dow has gained more than 10%, a performance that is admirable and a performance that stock market investors would happily accept on an annual basis.
There is no indication that the market will go either down or up from this point, but the evidence is stronger that the market will stay at these levels, or increase, rather than go down.
Question: How can Market Watch make a statement like that? Isn’t there always a trend of up or down?
Answer: Yes, there is a trend of a bull market (up) or bear market (down), and in the case of the current market, the long term trend is up. There is also a secondary trend (intermediate trend). The secondary trend is currently “neutral” which means, in “financial speak” that the experts have no clue where the market is headed in the next few months.
However, this is also the most volatile market we have seen in our lifetime. Volatility frequently indicates market consolidation into a trading range. While nobody knows, this market appears to be consolidating into a trading range that will keep the market at levels elevated from the August 16th low. If the market remains at the 14,000 level throughout the end of this year, investors would have had a very good year.
Question: One thing that concerns us is that the daily headlines have pointed out that the dollar continues to decrease in value relative to other world currencies. Somehow it seems that a deteriorating dollar is not good for the United States. Does Market Watch have an opinion on this?
Answer: The dollar has been overvalued for years. Large deficits run by our federal governments out of control spending, and large international trade deficits, must mathematically undermine the value of the dollar. Trade deficits are a transfer of wealth to other nations. While other countries are busy creating their own deficits, the magnitude of the U. S. deficit is so great, and the borrowing from overseas to cover those deficits is so great, that the dollar is mathematically losing value more quickly than other countries whose profligate spending does not approach the magnitude of our profligate spending. The government’s current theory is that if we can maintain an adequate degree of flexibility, some of America’s economic imbalances, like the large current account deficit, the trade deficit, and the savings deficit can be rectified by adjustments in prices, in interest rates, and in exchange rates rather than through more gut wrenching changes in output, income and employment.
Question: That’s a whole bunch to think about. We were under the impression that government interference in the economy is what has created the problems. Isn’t that so?
Answer: You are correct in that government policies have created the general economic mess that exists in domestic and world economics today. The government is loathe to do anything that would create changes in output, changes in income, and changes in employment. Output, income and employment all have a bearing upon politicians being reelected. So far, though, the government’s manipulation of interest rates and foreign exchange rates has kept our economy afloat. Slowly, economic changes are occurring, and they are working on our behalf as indicated by the elevated levels of the stock market.
Question: What can be done to turn around our country’s $800 billion annual trade deficit?
Answer: The trade deficit is slowly being turned around because of the depreciation in the value of the dollar. U. S. exports are increasing. With a deteriorating value in the dollar, U. S. goods are cheaper for foreigners to purchase. As the dollar continues to go down in value, our trade deficit should improve. Products provided from America become more attractive in world markets as the U. S. becomes the low cost producer in various industries.
Question: There has to be good growth in credit to provide for economic growth. However, U. S. credit (debt) has grown from 150% of GDP in 1969 to 340% of GDP today. Won’t that come home to haunt us in the future because we just have too much debt?
Answer: Theoretically the mathematics of these huge credit (debt) increases indicate that we are looking at potentially huge future problems. However, there has been a conscious decision on behalf of the Federal Reserve System and the federal government to create enough inflation on an annual basis that when U. S. government debt comes due, it is paid in dollars that are vastly depreciated from the dollar value represented when the debt was issued. Rapid credit expansion boosts consumption, investment, employment and asset prices. Excessive credit causes asset price bubbles. The many bubbles that have been created over the last few decades have been a result of excessive credit increases. So far the government’s plan has worked and we have suffered no severe economic depressions. Whether or not the government’s policy will create severe economic problems in the future is unknown, and there is absolutely no way of forecasting what will happen.
Question: This is very confusing. Isn’t the real estate bubble really dangerous and couldn’t the huge increase in prices for real estate assets seriously affect this country’s economy?
Answer: As mentioned in previous Market Watch articles, it does not appear that the magnitude of the real estate problems is great enough to affect our entire economy. Obviously, with building down, jobs in the real estate sector have been negatively impacted. The real estate market can be compared to the stock market in 2000. The market in 2000 was way overpriced, and it backed off from 11,700 points to a level of under 8,000 points. Rather than go substantially below the 8,000 point level, however, the Dow remained somewhat level. As corporate earnings increased significantly to create levels of value that were reasonable in stocks by 2007, price earnings ratios on stocks that averaged over 20 times earnings in 2000 are now less than 20 times earnings. The market still remains overpriced from an historical point of view. But as inflation continues, and as real estate prices back off, the market will reach real estate values that are once again reasonable. In short, real estate prices will decrease to a level where mortgages can be serviced. The Fed has been relatively effective in creating policies where market prices fall to reasonable levels without crashing. Investors should keep their fingers crossed that these policies continue to favorably effect our economic outcome.
Question: The real estate debt concerns us because it seems as if it will ultimately affect the stock market. How does Market Watch view that?
Answer: There are four ways of handling debt. It can be repudiated, serviced, refinanced, or inflated away. Many real estate loans have already been repudiated, and more will follow, but so far the banking system has been able to absorb that. Most debt is being serviced and refinanced as usual. And all debt is being inflated away. As evidence, the purchasing power of the dollar since 1972 is only 20% of what it was in 1972.
Question: That means that the average asset would theoretically cost five times as much today as it would have in 1972. Is that correct?
Answer: It’s correct. Real estate prices, cars, and other hard assets have increased in price by about five times their 1972 prices. Similarly, long term debt issued over 30 years ago is being paid off with about 20 cents on the dollar today (as compared to purchasing power 30 years ago).
Question: Won’t the presidential elections have an awful lot to do with economic conditions over the next few years?
Answer: Not really. In fact, as you look at the last 30 years, whether Republicans or Democrats are in power, there has been relatively good economic growth. Both parties have been consistent in that the government grows, taxes increase, we get more regulations, and government gains more power as they continue to strip property rights and liberties from the general public. Greenspan’s new book was instructive in that he pointed out how the republican majority in Congress (Congress handles the country’s purse strings) have provided the same huge spending increases, and federal deficits, as the previous democratic congresses.
Question: Market Watch has been generally critical of government over the years, yet Market Watch testifies above that “government policies have been, and are, working”.
Answer: Touche! Government policy is not all bad!
Conclusion:
The stock market is in a bull market posture. There is more reason to hold good stocks than to sell them, particularly if the stocks pay a good dividend and have a relatively low price earnings ratio. There do not seem to be any warning signals on the horizon that have not already been discounted by the stock market. World economic policies are established by a combination of dominant world wide corporations (most of which are American companies), military might, the World Bank, the Federal Reserve System, the Bank for International Settlements, military and trade alliances, and big money (Wall Street). American’s have outsized influence in all of these areas at this time in history. It is important to remember that with less than 5% of the world’s population, the U. S. generates about 30% of the world’s annual GDP, and the U. S. dollar represents about 65% of all the money in the free world today. While our percent of GDP must go down, and while the amount of money represented in dollars in the world must decrease as the value of the dollar decreases, such decreases should not hurt the long term growth of America. Other countries economic success can only help us as prosperous countries create demand for products produced and marketed by Americans. As investors in other countries become wealthier, they continue to invest money in America by purchasing real estate here, by purchasing our goods and services, and by making investments in U. S. stocks and bonds. This trend continues to be consistent with what has happened to the American economy for the last 200 years.
The long term outlook for U. S. markets is excellent. While the stock market may not have any great leaps from these levels for a while, the intermediate-term outlook is not bad, and the long-term outlook for U. S. stock markets remains excellent.
Carpe Diem.
George Rauch
October 26, 2007
